Two in five buyout - Houses to collapse

The "perfect storm" created by the credit crunch, combined with reduced company earnings, collapsed multiples and limited partners' wavering loyalty, could see as much as 40% of buyout houses collapse in the next two to three years, with portfolio businesses sold off and teams dissolved. The startling figure - which quantifies what many have been speculating - is the result of a study conducted by The Boston Consulting Group and IESE Business School.

The report suggests that four factors will determine whether a GP will sink or swim in the coming years:

Timing of fundraising: The report states, unsurprisingly, that any GP needing fresh capital in the next year or two will struggle. In fact a straw poll by unquote" of 10 UK-based placement agents (servicing global clients) affirms this - the momentum required to successfully launch a fund is currently lacking, and so cash-strapped firms are preserving cash (perhaps at the expense of follow-on funds for current portfolio companies) and crossing fingers for a more buoyant climate in 2010. Even a handful of loyal LPs is unlikely to sustain GPs that are not top quartile.

The report further suggests that the oft-criticised capital overhang that has long "plagued" the industry may now come in handy. It estimates the median of overhang as a proportion of total funds raised in the last five years to be 56% - and that with investment levels declining, this could last up to five years. However, the standard deviation is vast, with some firms having 100% and others none at all.

Performance: Historically, LPs seek out GPs with top-quartile long term performance. The report suggests that GPs in the bottom half of the performance scale (so-called third and fourth decile) are less likely to be given a chance by increasingly critical LPs.

Anecdotal evidence suggests that even top-quartile performers will struggle. A chat with Candover's Charlie Green recently revealed that LPs are putting as much (if not more) focus on "your next investment" as they are GPs' track record. Fair or not, investors are likely to watch with hawk-like eyes the next few deals a GP does. For example if a top-quartile buyout fund invests in something now which trades flat for the next 12 months, an LP is likely to be just as adverse to re-upping in their next fund as it would be to backing another with a lacklustre track record.

Timing of exits and deals: Hindsight is a wonderful thing, and now everyone agrees that 2007 was a sellers' market. But a lot of buyout houses bought (a lot). The unremarkable finding here is that if a firm sold more than it bought, it is likely to fare more favourably than if it went on a spending spree in the run-up to the credit crunch.

Exposure to default-prone industries: If GPs pumped money into recession-resistant industries, such as utilities, they will be better-equipped to weather the storm than if they invested in ailing industries. The authors applied industry credit-default swap values to all respective portfolio companies of the firms analysed and found a variance of a factor of seven. The report points to the US auto sector as particularly bad, though here most would pity those with retail- or construction/housing-heavy portfolios.

A fifth of the firms surveyed in the study scored low on all four factors, indicating they will struggle to survive past the next two to three years. Should institutions significantly reduce their allocations to private equity (not wholly unlikely), this figure could double to 40%. More positively, 30% scored highly on all four. Your editor recently lunched with a banker, and we jotted down the names of those firms we thought would not go on to raise another fund. It's a thought-provoking (if depressing) exercise.

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