Predictions from deal doers

Private equity's make-or-break period may end in 2012

Preliminary figures suggest that 2009 has been the worst year for private equity since 1997 when it comes to deal values and volumes *. In 2010, we expect the outlook for private equity in the UK to improve in relative terms. Yet 2010 and 2011 will not see a full recovery of private equity, as the picture continues to be marred by the poor economic outlook. Challenges include the tough lending environment and the dearth of attractive investment opportunities.

Deal activity will almost certainly improve significantly from a very low base. The debt market is definitely showing signs of thawing - we have recently worked on a transaction funded by debt amounting to more than 4x EBITDA, a debt multiple we have not seen in the previous 18 months. At the same time, the target was a great business with great assets and good visibility of long-term earnings.

That transaction demonstrated how selective lenders continue to be, both in terms of what transactions they are supporting and in terms of what private equity houses they like to work with.

We have also seen an uptick in private company sale mandates since last September. Some of the vendors that mandate us just don't believe that valuations are going to increase dramatically over the next two to three years, but are concerned of an increase in taxes.

Even though there is a plethora of private equity houses that are interested in our mandates, we cannot be certain as to how many of those are going to be converted. It can be hard to tell who is committed to closing a deal and who is just trying to get into pole position.

In spite of all the challenges ahead, large buyouts announced in December indicate that large private equity firms have not given up on the buyout model, but are looking at innovative structures. I think prudent private equity houses with cash to spend will be making their vintage deals in the next two years. Providing the economic outlook improves, we should see a general private equity recovery in 2012.

- Mo Merali, head of private equity at Grant Thornton.

*Deal numbers and values are non-seasonally adjusted and based on announced deals, which offer the most current view of the M&A market.

2010 - Another difficult year or a vintage year waiting to happen?

The received wisdom is that 2009 and 2010 should provide vintage returns for those brave enough to invest and that may well yet prove to be the case, but the overall lack of confidence, the gap between buyer and seller price expectation, the lack of availability of leverage, pre-election political paralysis and the uncertainty on outlook and valuation have led to limited activity even in those markets (such as secondaries) where activity and opportunity were expected to be at their greatest.

So here are my predictions for 2010:

The number of transactions will increase, particularly in the mid-market, albeit still well below the levels of activity seen in the boom years between 2004 and 2007. This will be a reflection of a number of factors:

- the closing of the gap between buyer and seller expectation in terms of pricing;

- the increased activity in the debt markets, particularly around high-yield. One should also expect increased availability of senior debt packages but at low leverage multiples; and

- funds being prepared to do all-equity deals (such as the recent Apax/Marken deal) with the confidence that they will be able to refinance (with leverage) within a reasonable period.

More exits taking place. This will be for a variety of reasons including the need for GPs to show investors some returns before looking to raise new funds and the availability of the IPO, given the rise in the stock market. There are, however, question marks over how many companies will actually reach the market and much will be dependent on the success of the first IPOs to get away, as well as the appetite for public market investors to support private equity-backed companies given the negative publicity attached to the industry over the past two years.

With investors believing that the market is at or close to the bottom of the cycle, 2010 may yet prove to be a vintage year. While one should not expect it to be a smooth ride, it will, perhaps, represent the year that we see the first steps back to some kind of normality.

- Will Rosen, corporate partner DLA Piper.

VCTs to benefit from tax hikes

VCTs face threats and opportunities in 2010. The government has announced its commitment to increasing the provision of capital to growing UK SMEs through a number of new initiatives and funds. This could be perceived as a threat to VCTs, but the industry hopes that its existing infrastructure and resource will be deployed to meet this challenge. Similarly, a threat arises from new regulations that could raise investment risk through new funds having to invest greater amounts in equity rather than loan. That said, the industry looks likely to continue to benefit from subscriptions attracting 30% up-front income tax relief, which is a huge positive.

The introduction of the 50% income tax rate and further restrictions on pension tax relief for higher earners will be a significant stimulus to the demand for tax advantaged investments. In the absence of competing products, VCTs look set to benefit from considerable increased appetite from investors, with commentators expecting fundraising to expand by more than 50% in 2010*.

- Mark Wignall, CEO, Matrix Private Equity Partners.

*The VCT industry raised £153m in the 2008/2009 tax year, up on the £50-100m predicted, but a 30% decrease on the £220m raised the previous tax year. The sums are a sharp decline on the record £779m raised in the heady days of 2005/2006, when an attractive 40% tax break combined with buoyant market conditions to create a fundraising frenzy.

Expect fund lives to decrease, but not fees

The old Chinese curse wishes that you live in interesting times. Observers can be forgiven for thinking that fund terms have remained largely static for many years, but the interesting times have now very much arrived. 2010 looks set to precipitate a number of significant changes. The driver of such changes is plain to see, with various surveys suggesting that, while most investors remain committed to the asset class, they are not in a hurry to make significant new commitments for at least 12 months.

Of course, investors have been quick to exploit the demand/supply imbalance by publishing a "wish list" of terms under the auspices of the Institutional Limited Partners Association Guidelines. These Guidelines seek to increase investors' bargaining power in a collective fashion to ensure that they benefit from improved transparency and governance and cheaper fund economics. That said, private equity investing will always be driven by the search for alpha and managers that know their worth will not be giving up too much ground. Expect transparency and governance to be improved, as well as greater downside alignment, but don't expect fee discounting.

The lack of liquidity of private equity funds, even through the secondary markets, has resulted in investors focusing on the length of funds. Expect to see some funds being established with shorter investment periods (and consequentially shorter terms) or using annual vintages so that investors have more control over the long-term allocation of their capital.

In addition, fund managers will need to be increasingly resourceful in kick-starting fundraisings. Investors will not be under any particular pressure to be the first into a new fund and managers will need to find new ways to incentivise first closing commitments. Expect to see preferred co-investment rights, the allocation of Investor Committee seats and, perhaps more creatively, the weighting of early fund life deals to the first closers.

- Jason Glover, head of private funds group, Clifford Chance.

Exits overhang, savvy GPs pave way for busy 2010

I anticipate an interesting year ahead with the deal market warming up, at least for Q1 2010. Ernst & Young's research indicates that the current portfolio of European private equity investee companies yet to be exited is EUR600bn at cost. This means that the 2010 run rate for exits needs to be around EUR100bn to clear the overhang (assuming an average hold of three to four years and smooth profile of exits) - but this is double the best-ever year 2006 at the peak of the market, when EUR50bn was achieved across 99 exits. Adding to this is the wall of corporate debt that needs to be refinanced, with EUR2.5trn per annum of investment grade debt and a similar level of leveraged debt maturing over the next three years. All of this could test the fragile recovery of the banking markets and it could be very busy!

And we are beginning to see signs of life. The pipeline is the strongest it's been for two years. There is a mix of assets coming to market - from good quality assets on dual track IPO; a larger pipeline of corporate disposals and some decent investee exits.

The private equity houses continue to be smart; so vendors shouldn't expect toppy prices. Apax's approach for Marken looks like an interesting precedent, not least in terms of getting the best solution from both the banks and the vendor. Their approach is clearly being considered by others for the good assets known to be on the blocks. The blue-chip houses with strong banking relationships who have tracked an asset for a while are in good place to take a more aggressive position in a process without betting the farm.

All this means that pricing is hardening for good businesses but sub-scale, non-growth businesses won't get the focus from large private equity buyers. Those considering an exit need to over-prepare - it's the only tactic to reduce the risk of failure ... and you may need to get cracking to avoid the rush!

- Caroline Grounds, private equity partner, Ernst & Young Transaction Services.

Long-term partnership to reign supreme

Terms and conditions for LPs:

Generally, LPs are more determined than ever (at the staff and board level) to establish a better long-term equilibrium on matters such as fee levels, fee structures relating to carried interest, and especially transaction fees and other additive fees. Overall, the GPs are starting to show greater recognition of the "long-term partnership" aspect of the LP-GP relationship. To be clear, LPs are still willing to allow GPs to have attractive incentives to produce strong returns. The difference is that, on key negotiating points, LPs are tired of hearing that "you're the only investor pressing for that" because LPs know for sure that all LP investors are working to achieve better alignment in the LP-GP relationship.

Watching GPs carefully

In all market segments, especially in the large and mega market, LPs are looking for progress toward achieving realisations. LPs are paying close attention to the GPs' moves in the market (external) as well as any changes in their talent pool (internal). The tougher market conditions are revealing differences in the operating strengths of the GPs. The GPs who will do well are those who truly have better ways to originate investments, better judgment in how to structure their investments in a lower-risk way, better analytical intensity, and better execution capability working on a timeline. However, there are some GPs who, during the previous boom, fell into more of a "project-management style" of processing deals rather than putting together solid, sensible and sustainable structures. We've always steered clear of those managers who seemed to be more like deal processors. Our ideal GP group is a true team of intensively involved investors who consistently apply very good judgment based on superior insights and analytics.

- Michael Russell and John MacLean, partners, Altius Associates.

Fear factor to give way to creative deal doing

It's clear that the fear factor that existed for most of last year, which has helped to dampen activity, will have largely disappeared. This will help boost transaction flow, which will be assisted by a number of other factors: vendors will have become more comfortable with the lower price levels that they can realistically achieve, restructuring and unbundling will continue and there are many private equity houses with large amounts of cash that they need to invest.

However, although I foresee more activity in the mid-market £50-£60m enterprise value range, I think that the lack of leverage and the continuing reluctance for many banks to lend more than £40-£50m for any one deal will restrain the recovery in transaction flow in the larger deal arena. Also in the larger market, there are a number of highly-leveraged deals, which will need refinancing from the end of 2010 onwards and this could cause problems as it's likely that banks will not have sufficiently recovered to be able to meet these demands.

To successfully complete deals, there will be an emphasis on creativity and flexibility of funding as, though conditions will improve this year, they will remain challenging. In terms of the best areas to focus on, I would be wary of sectors that rely too much on personal consumption, as I think disposable incomes will be hit by the rise in VAT and other tax rises likely in the 2010 Budget. Cyclical sectors such as recruitment, capital goods and automotive will probably be among the better performing.

At LDC, we will remain active, but I don't see a huge leap in transactions as we have invested in 16 this year and would expect to do around the same next; we continue to believe in investng through the business cycle, backing British business and outstanding management teams.

- Peter Brooks, London managing director, LDC.

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