Great exit-pectations

LPS PERSPECTIVE

What are the key drivers for the exit market in 2008?

DK: The overall economic development will drive opportunities in 2008 with public markets expecting the worst and preparing for a storm.

JHB/FFA: Turmoil in the market indicates more volatility than normal and exit opportunities through IPOs have worsened. We do not rule out an improvement towards the end of 2008, if today's concerns in the market will be overcome and the US economy is brought back on track. If volatility returns to normal and share prices rise again, based on a more positive view on the future, the IPO window can be re-opened. Trade sales are driven by companies' ambitions for increased M&A activity, backed by a healthy financial market, and cheap financing (lower interest rates).

With a strong fundraising climate, many buyout firms have the financial resources to make new investments this year. Additionally, they are well aware of the fact of that valuations have come down, and we believe that they are more eager to hunt for good deals through processes with an exclusivity element rather than trying to overbid each other in structured actions.

What type of funds will produce the best returns in the coming year?

DK: The mid-market will continue to perform well for the 'usual suspects', and it will be business as normal. These funds have a long track record in the market and strong relationships with the local banks to support financing. I don't think we will see large differences in the performance by the venture funds, since historically earlier staged funds have performed consistently since the tech bubble. However, life science venture investments are welcomed in the market and will produce stable results for investors going forward.

Which sectors will produce the best returns?

JHB/FFA: At the start of 2008 we have seen that investors prefer companies that have good earnings/cash flow today compared with companies with anticipated earnings some years into the future.

Oil service is a sector we believe in. Continued high oil prices will support the high activity within the oil and gas sector and produce good returns for well-positioned oil services companies realising their full potential, as well as companies developing game-changing new technologies that are attractive for the oil and gas companies.

What type of exit is likely to produce the best returns?

DK: We will see more trade buyers in 2008 than in previous years. If the public markets face further trouble, IPOs are likely to be avoided and trade sales favoured. However, the IPO window is not completely shut and successful listings will be dominated by flagship IPOs that can open for others seeking the public market. For instance, there are great expectations connected to the exit of EQT-backed ISS, delayed at the end of 2007. How the market receives this exit is likely to set the mood for some of the other larger private equity firms.

JHB/FFA: The best exit method will be via trade sale where the buyer is willing to pay a strategic premium. Another advantage of a trade sale is that the entire ownership holding (with only a few exceptions) is sold in the deal, as opposed to an IPO which is likely to include a lock-up period. Deal structures with too much of an earn-out element should be avoided from a seller's point of view.

Will you change your allocation to the asset class in response to the credit troubles?

DK: We are not looking to change our allocations to the funds we are investing in because we invest in mid-market funds that are less cyclical than at the larger end of the market. If a recession prolongs, we might allocate more capital to special situations funds that are well positioned to capitalise on the downturn. Historically, we have had a lower percentage invested in venture funds and we are not looking to reverse that trend.

JHB/FFA: In the long run we expect private equity to outperform listed shares by 3-5%. Such a premium is required due to the nature of the asset class and can only be realised if investments in private equity are being done consistently over time. Timing of investments is a difficult task. Missing out on some good vintages could obviously hurt an investor's long-term performance of this asset class, which is the reason why we stick to our strategy of committing capital to private equity throughout the economic cycle, roughly between EUR30-50m annually.

GPS PERSPECTIVE

What will be the key drivers for the exit market in 2008?

CS: We will see a much tougher buyout market in 2008, both for exits and acquiring companies. Large secondary transactions will become especially complicated both in terms of assembling the financing and because debt multiples will become lower. Breaches of covenants or liquidity issues which result in owners forced to sell can also create good buying opportunities. The Nordic IPO window is likely to become tighter due to poor market conditions seen recently on the Nordic exchanges. It is still possible to accomplish successful listings, but on a case-by-case basis and at a larger discount than compared with even the last quarters of 2007.

SI: Last year was very strong for the Nordic venture capital market, with both IPOs and trade sales yielding stronger returns than seen in previous years, but 2008 will be tougher. If the US enters a recession it will adversely affect the other financial markets in the world and also limit the public listings as an exit route. But there will be some local variations between the Nordic countries with Norway likely to perform stronger than its neighbours if the oil price remains high in 2008.

Which sectors will create the best exit multiples?

CS: Less cyclical sectors that are less affected by a slowdown in the local economies will outperform those more exposed. Sectors like healthcare and outsourcing, which are driven by underlying trends and demographics, will continue to deliver strong results. Companies in more cyclical sectors will be sold at a larger discount (if exited at all). If the oil price continues to be relatively high, oil service-related companies will also deliver strong exit multiples.

SI: There is a lot of talk about cleantech investments, but we are yet to see strong exit multiples in this segment. Due to the novelty of the sector, it lacks good realisations and it will still take a few years before we see stellar returns seen in other more traditional sectors. Cleantech shares similar traits with the tech bubble at the beginning of the millennium, with vast amount of capital available, but not enough good companies to invest in. In a few years we will see some exceptional cleantech exits, fuelling further investment appetite.

Which exit route do you believe will create best returns?

CS: Even if the stock markets experience a further fall, some companies can produce healthy results and be attractive to the public markets. But on a broader basis, trade buyers will likely provide the best exit alternative. Large strategic buyers have been less affected by the credit squeeze and strong performance has provided such industrial players with healthy balance sheets which enable them to acquire businesses using less leverage. Increased financial muscle from industrial buyers will likely give private equity firms more competition when selling and buying companies although many strategies will also vary. Small- and mid-cap secondary buyouts will continue to be executed in the less cyclical sectors.

Private equity firms will also face a tougher analysis of the best exit routes for portfolio companies. A single-track rather than a dual- or triple-track process will be available, and in most cases the best alternative will be selling to trade buyers.

BUYOUT VS VENTURE PERFORMANCE IN THE NORDICS

"Generally, Nordic buyout investments have performed slightly better than overall European buyout returns. This is not only illustrated by the CepreX index, but also by the more sophisticated models behind our PerFore portfolio risk management software, which is used by institutional private equity investors," says Dr Daniel Schmidt, managing director of CEPRES, (Center of Private Equity Research), an academic consultancy that specialises in private equity data aggregation and portfolio risk management.

CEPRES has conducted research on Nordic buyout vs venture performance over the past 10 years, and has developed private equity indices, called CepreX, used to measure historic performance of venture, growth capital/small-midcap buyout, mezzanine, and the private equity market. As the data illustrates, since 2005 the Nordic buyout performance has nearly doubled, marking the best ever performance in the Nordic market.

- Buyout gross returns (before all fees) have returned nearly 20x in the past 10 years, compared with 10x seen in venture.

- Nordic venture outstripped buyout performance leading up to 2005.

- Since 2005, venture has underperformed compared with buyout and yielded much more variable returns.

- Since 2006, venture performance has become more constant, indicating maturity among investors.

- Buyout returns flattened in Q2 2007 and are forecast to see a fall in 2008 if the market continues to wobble.

Schmidt concludes: "The Nordic region has a concentration of some very experienced buyout groups. On one hand, these groups have been able to seal off the market from international players. On the other hand, prices are boosted relatively high due to their own financial power and competition for deals".

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