Returns concerns

LPs are sceptical about the potential of European buyouts to generate net returns in excess of 16% over the next three to five years. A survey by Coller Capital of 102 investors in private equity funds found that only 56% of LPs expect European buyouts to beat the 16% return mark compared with 65% in 2006. The lower levels of LP confidence exhibited this year take into account the liquidity crisis that has seen the number of mega-deals drop off dramatically since mid-2007. In spite of the decline in return-expectation, demand for the asset class remains unaffected. The research, which forms part of Coller Capital’s Global Private Equity Barometer, shows that over 45% of LPs intend to increase their private equity allocations in the next 12 months – a statistic virtually unchanged since 2005.

With consistently high demand, it is no surprise that GPs remain undeterred in their fundraising efforts. Just as Apax nears the final close of its E11.6bn fund, CVC is reported to be in the early stages of marketing a similar sized vehicle. “In previous downturns, the best returns have been from funds launched just after a downturn,” remarks Lord Charles Cecil, founding partner of Helix Associates. This is not to say these firms can rest on their laurels. “This downturn, however, is distinct from previous ones due to the shortage of debt available,” he explains. With the quantum of debt significantly reduced, buyout houses will be forced to invest a higher ratio of equity in order to complete deals, placing a greater premium on GPs who can add value.

Worry about the performance of mega-funds is widespread. Guido Justen, head of fund investments at German bank Helaba, expects returns from European buyouts in general to decline by 1.5-3% in the next 18 months before recovering. Conversely, Justen forecasts a long-term fall in returns from mega-funds. “The number of possible targets with enterprise values of E10-15bn in Europe is limited, thus restricting the activity of these types of funds,” he explains.

Cecil’s concern centres on how the funds that have bought the likes of Alliance Boots and those even larger transactions in the US are going to achieve the sort of returns that they and their LPs are expecting. “There have been very few, if any, IPOs of commercial companies of a size comparable to that which would be required going forward for private equity target returns and IPOs would require a gradual divestment by GPs rather than an exit all in one go,” says Cecil. There are also a limited number of trade buyers capable of making such large acquisitions. “It seems unlikely that there will be in the next few years, even larger funds able to provide a secondary exit of such a size as to give truly good returns,” confirms Cecil.

There have been relatively few large IPOs in recent years and trade buyers for a E10bn+ company seem unlikely. While there is potential for secondary buyouts, piecemeal break-ups or gradual IPOs – both with a possible negative impact on returns – seem probable.

Asia beckons
Cash and optimism go hand-in-hand. As more and more money is channelled into Asian funds, so too is optimism: 73% of LPs questioned believe that Asia- Pacific buyouts will recoup returns in excess of 16%.

Whether Asian private equity funds can match LP expectations is a moot point. The ability of emerging markets to absorb the weight of cash intended for them is far from certain. Should that money be absorbed, it will have an inflationary affect on asset prices in the medium term. “Some GPs focusing on Asian deals have some way to go on their learning curves,” comments Cecil. “LPs are expecting hiccups.”

Justen is similarly cautious: “We would only invest in Asia via a fund-offunds and probably not for another two years.”

Shareholders and stakeholders
More than half of the European LPs questioned believe GPs should account to a wider group of stakeholders on their large portfolio companies. North American LPs are less convinced – only one in three agree. “Being more transparent on larger companies in terms of disclosing revenue growth and employment figures would be part of an excellent marketing campaign for private equity,” Justen believes.

Sir David Walker’s guidelines will see BVCA members reporting details on portfolio companies exceeding a certain threshold (a £300m+ take-private or a private transaction exceeding £500m), or explaining why they are not, should they see such disclosure as a hindrance to their competitive position.

While this is a positive step, Cecil believes the scope of the guidelines could have been broader. “The report does not sufficiently recommend engaging with stakeholders including staff and local government bodies. Rather than company reports, a dialogue with these groups could be more effective at improving the public’s perception of the industry,” he says. While the Companies Act, due to come into play in 2008, may go some way to encourage companies to do this, it will come from each company, rather than as part of a private equity-driven campaign.

In the short term, investors expect 2008 to be less buoyant than last year. Half of LPs expect the pace of GP deployment of cash to slow over the next 12 months, compared with just 8-9% of investors in the last two years. The fact that LPs continue to steer an ever larger sum of cash into private equity vehicles suggests their outlook for private equity is in tune with that of GPs – in the long term, the future for the asset class is bright.

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• UK / Ireland