Deal With It

Banks aren't lending, investor defaults are looming, and mark-to-market is a pain. But private equity CFOs are forging a path through the downturn.
Tim BurkeApril 2, 2009

What’s in a name? When the name in question is SuperReturn International, an annual conference for private equity professionals, the answer is a lot of hubris and even more irony. A celebratory affair when private equity players were helping to fuel an M&A boom, February’s SuperReturn International raised questions about whether its name was still suitable given that private equity returns across Europe fell 25% in 2008.

If nothing else, though, the plight of the shindig is certainly symbolic of
what has happened to private equity firms in recent years. In 2006 and 2007, as Mark Spinner, head of the London-based private equity team at law firm Eversheds, recalls, they were the “golden children” who could do no wrong. “All they had to do was deploy money in the market, refinance two years later and then sell the asset,” Spinner says.

But then the tide turned. The biggest players, including big US private equity firms KKR and Blackstone, have taken massive write-downs on their investments. Others are agreeing to give money back to hard-up investors rather than hold on to it for deals that may never materialise. “Now [private equity firms are] actually having to work hard for their money,” Spinner says.

And that goes for their CFOs too. Like their counterparts in other industries—and indeed their own portfolio companies—finance chiefs of private equity houses are getting to grips with the challenges of the downturn, whether that’s frosty banking relationships, intense investor-relations exercises or balancing short-term reactions to the crisis with long-term growth plans. Now the actions of these spotlight-shy CFOs could determine how the next wave of private equity deals plays out—and whether the returns will be described as anything approaching “super” again.

Questions of Capital

A particularly pressing challenge for private equity firms is the disappearance of debt. The finance director of a mid-market pan-European firm says that when he attempted to secure €500m recently to refinance a portfolio company, he approached 25 banks, of which only seven were interested. Even then, the banks would lend only half the required amount between them, leaving the firm no choice but to walk away and hope to refinance another day.

For other finance chiefs, a lack of familiar faces is as startling as a lack of funds. “People you’ve done business with [for] the past four, five, six years who were at a particular bank or institution have gone,” says Ashley Long, CFO of GMT Communications Partners, a London-based private equity firm specialising in Europe’s communications sector. “And if they haven’t gone, their role is changing, their hands are tied or the bank has just basically shut up shop.”

Perseverance can pay off, however. In February GMT refinanced the senior debt facilities of portfolio company Redext, a Spanish advertising business. The company’s existing lenders—BBVA, Banesto and CAM—provided €26.5m of senior debt facilities for working capital.

At Mid Europa Partners, a private equity company which invests in central and eastern Europe, chief operating officer Bill Morrow has accepted that credit lines will now be “priced beyond all recognition” and much less flexible than once would have been the case. “The banking market is not shut; it’s just not the same,” says Morrow, who, in the absence of a CFO, oversees Mid Europa’s finances. “There’s no underwriting, it’s expensive, it’s clubs and so you have to deal bank by bank. It’s excruciating. But we’re still talking to people, still finding ways to do stuff. It’s not all gloomy out there.”

For firms unable to arrange debt funding, or which would rather not overload businesses with borrowing, there have been two choices: hang back from deals or use their own funding. At London-based Alchemy Partners, one of the two acquisitions completed last year—a €62m bid for Geo Networks, a UK-based optical-fibre network owner—was funded entirely through its own capital, with no third-party debt. For finance director John Rowland, a lack of debt is “no bad thing” for private equity if it prevents companies from over-extending themselves. “There’s nothing wrong with a levered business as long as you’re not over-levered,” he says. “The problem [in 2006 and 2007] was that sometimes the banks were offering more than they should have done, and it takes a lot of discipline from the investment committee to take less when it’s being offered.”

Even more worrying than banks refusing to back deals is the threat of investors in private equity funds themselves having to back out of commitments. In general, the management fees that institutional investors pay private equity firms give industry CFOs a degree of revenue visibility their peers in other industries can only dream of. “If I were a CFO of an industry company today, I think it would be extremely difficult to have one business plan for 2009,” says Christophe Florin, CFO of Paris-based AXA Private Equity. “In our business we don’t have that [problem].”

But a different problem arises when institutional investors no longer have the cash to honour capital they’ve promised to back deals. High-profile cases include the UK’s Candover Investments, which invests in funds owned by a private equity subsidiary, Candover. Now struggling with liquidity problems, Candover Investments said in March that it will not be able to meet a €1 billion commitment to Candover. Speculation is now mounting that Candover will not survive as a private equity house.

A prime concern for private equity players is that other investors could default on their committed capital. As Evershed’s Spinner notes, private equity firms could legally take their existing investments away from investors that default. But, he adds, few firms will be brave enough to take such action given that they might scare off future investors. “I expect that [would signal] the death knell for future fundraising activity.” Instead, private equity firms want to remain as close to their investors as they can, monitoring their financial position as vigilantly as they would their own portfolio investments. “Right now you really need to be close to your investors and understand where they are,” says GMT’s Long. “If you send a call notice, how will it be accepted?”

Where Did All the Buyouts Go?
With few houses deciding to bankroll investments on their own, a lack of funding has inevitably reduced the number of deals. In 2008 the continental European buyout market reached a seven-year low, with €44 billion of buyouts completed, compared with €108 billion in 2007. (See “Bye-bye buyouts” at the end of this article.) “When you are not sure, you don’t invest,” says  AXA Private Equity’s Florin of the economic uncertainty hampering the flow of deals.

Rather than chasing new deals, private equity firms are turning their attention to existing investments to make sure they come out on the other side of the economic slump in reasonable shape. “We’re monitoring our portfolio companies even more closely than previously,” says Graeme Murray, finance director of UK mid-market Dunedin Capital Partners. “One of the key messages across our investment portfolio and within the management company itself is the reduction of costs where possible and keeping close contact with our bankers.”

Though few CFOs have ever battled through a downturn as severe as today’s, private equity owners are hoping management teams at their portfolio businesses are clear about what needs to be done. “There’s a whole exercise around battening down the hatches and making sure the FDs and CEOs in those businesses really understand what’s likely to hit them,” says Rowland at Alchemy Partners. “We’ve got a few FDs and CEOs in our portfolio who have been there and done that and knew exactly what to expect. But there are some newer guys who haven’t really been through that cycle.”

For those who haven’t, there will be some tough decisions. A survey by investment bank Jeffries of 155 European private equity firms and banks found that 90% of German respondents, for example, say they foresee staff cuts at portfolio companies as the best way to beat the recession. (See “Differences of opinion.”)

Expectations of the dealmaking downturn

GMT’s Long says the key will be in CFOs’ ability to react quickly while still staying focused on the long term. “It’s easy to look at the mountains and it’s easy to look at the valleys and say, ‘[That long-term view] is nice,’” he notes. “But if you’re standing in the middle of a highway and there’s a ten-tonne truck coming towards you, you need to take some short-term actions. Some people in the past have not really done that—and have been hit.”

Get Real
One of the most significant struggles for private equity houses is valuing the businesses in their portfolios. The process is changing at many firms. At Mid Europa, for example, Morrow says he and managing partner Thierry Baudon used to take care of reviewing valuations. Today they’re scrutinised by every partner in the firm. Morrow, however, is hard to please. “In a fairly orderly market, we had relative confidence in our valuations,” he says. “In an entirely disorderly market, I have much less confidence that we can accurately value on a quarter-to-quarter basis, as required by mark-to-market [accounting], what our portfolios are worth.”

Indeed, Morrow isn’t the only private equity CFO who doesn’t necessarily think that mark-to-market is the right way to value a portfolio. The argument is that the only value investors should care about is the final value at which a business is sold—not an estimate of what it could be sold for at any given time. As Morrow sees it, if the company plans to exit a business in four years, using mark-to-market today “doesn’t bear any resemblance to reality.”

GMT’s Long agrees. “Speaking with some of my peers, it’s clear they’re now saying whatever’s in the accounts doesn’t really bear a strong relationship to what they think the underlying value of the company is,” he says. Other private equity players describe mark-to-market as “trying to make an art a science.” For Tim Green, Long’s colleague and a managing partner at GMT, it’s an exasperating situation. “What you [have to] put down is the value at which an unrealistic view of a seller would be prepared to sell to a potentially willing buyer,” he says. “What the hell does that mean? It’s a bit of a joke.”

Fair-value accounting has led to some notable write-downs. London-based Terra Firma, for example, wrote down its portfolio from €7.8 billion in 2007 to €4.5 billion last year, leading it to give back to investors performance-related payments the management team would have accrued since 2004.

Yet the International Private Equity and Venture Capital Valuation Board (IPEV)—set up by pan-European private equity bodies—insists that fair value is the best measure of a portfolio comp­any’s worth. The board argues that institutional investors should be able to monitor the interim performance of a private equity asset. According to David Larsen, a managing director at adviser Duff & Phelps and an IPEV board member, “There is volatility with investments. To mask that volatility by not reporting it does not cause it to go away.” Most private equity firms have subsequently agreed to use fair value under the IPEV guidelines.

Rowland says Alchemy Partners is happy to follow the IPEV guidelines, if only because it gives the firm a reason to keep in constant contact with its investors to explain why a write-down under mark-to-market doesn’t mean a portfolio company’s worth is crashing.

Indeed, the lesson from all this is that close communication with investors is crucial for private equity firms. At AXA Private Equity, Florin says he is “on the frontline with investors” today. “As the CFO, the main objective is to get the best quality of information to your [investors],” he adds. Fortunately for Florin, he knows just what they want. He joined the firm in 1998 to help set up its fund of funds division—that is, an investment fund which invests in a range of other private equity portfolios—and so understands from such experience what investors want to know. “Now that I’ve moved to the other side, I have in mind the quality [of information] that the investors are looking for,” he says. “The more detailed the information, the better it is.”

Where Now?
The private equity landscape is still shifting. Following debates about its business model which have raged in recent years—particularly in the UK, where big buyout firms have been demonised as asset-strippers, and Germany, where they are still frequently referred to as “locusts”—the expectation is that the industry will create a pan-regional code of conduct, covering reporting and transparency, among others. The European Venture Capital Association, an industry body, sent a 300-page letter to the European Commission, which promised to work with it to develop a new regulatory framework.

CFOs, though, are wary of any new regulation. “The kind of risk we’re all concerned about is systemic risk and a blow-up,” Long says. “And guess what? What we’ve had [during the crisis] is systemic risk and a blow-up, which wouldn’t have been stopped by over-legislating against private equity firms…If you want to control leverage, pricing and over-valued assets, you can do it by sheer quantitative controls.”

While firms wait to see how any regulatory changes will affect private equity, AXA’s Florin doesn’t expect a return to the highly leveraged buyouts of recent years. Rather, he predicts, private equity will focus once again on growth capital. Back in the 1990s, he says, “private equity was almost only expansion capital or development capital. I think with the current crisis, our industry—or some players in our industry—will move back to [that] original business model.”

And some believe that new opportunities will arise from the downturn. Alchemy Partners’ Rowland says private equity is facing “one of the best periods for investing, probably since the last recession in the early 1990s.” He claims that historic returns for private equity are strongest coming out of a recession, when valuations are low and executive teams have the benefit of having managed through a downturn. Alchemy has a £300m special-opportunities fund, predominantly focused on distressed debt investments. Today it has yet to invest 40% of its available capital, so the firm has plenty of purchasing power for when the team decides the market has bottomed out. For Rowland, it’s a matter of keeping their options open. After all, as he says, “one of the challenges of the private equity business is that you should be able to invest through good times and bad.”

Tim Burke is a senior editor at CFO Europe.

European buyout values