As the private-equity market continues to grow, competing with public markets, it adds to overall capital market efficiency. However, a number of risks exist in the private-equity market, for example, instances of excessive leverage, difficulties in establishing ownership of economic risk, and issues with respect to the valuation of illiquid and complex assets. Today traditional asset managers are facing increasing levels of competitive pressure from alternative providers such as hedge funds and private-equity managers. "Private-equity houses are competing very aggressively for acquisitions," says Fred Becker, Corporate Finance Manager, BT Group, speaking at a Honeycomb Web conference. Private-equity firms have headed some of the biggest deals recently, with club deals and secondary buy-outs also becoming more common. Buyout firm Blackstone Group's huge deal to buy office building owner Equity Office Properties Trust for $23 billion in cash and $16 billion in assumed debt, in November last year, marked it as the largest private-equity deal ever. Europe is increasing its role in private-equity as well. Half of the top ten private-equity buyouts in 2005 were by European private-equity houses (UK included) and in the same year European targeted mergers and acquisitions reached 40 percent of global mergers, ahead of the U.S.
Today's financial climate is, what Becker calls, the “perfect storm” for mergers and acquisitions. The availability of cheap borrowing, particularly in the debt markets, and multi-year high stock markets have left private-equity firms as well as hedge-funds and investment banks flush with cash. In these conditions private-equity houses are increasingly approaching companies with plans for operational improvements seeking the same cost-saving and operational synergies that traditionally have attracted strategic buyers. The competition is fierce as more capital chases a limited number of assets pushing valuations through the roof. Today investment banks, for example, which traditionally were providing the financing to private-equity houses and were reluctant to compete, are now doing their own fund raising and either joining private-equity as part of club deals or competing for assets themselves: And hedge-funds, which traditionally have not been involved in private-equity, are making equity investments directly into private companies both in the U.S. and abroad.
Is all of this activity sustainable? Becker says if a number of potentially risky scenarios occured simultaneously they could have huge ramifications for global financial markets. A change in interest rates, he says, could affect the ability for private-equity firms to raise capital allowing strategic buyers, which offer operational strengths and synergies that generate better returns, to regain their advantage over buyout firms. A lot of recent valuations have future growth expectations built into them and, as Becker sees it, if these growth expectations are not met and the economy slows the financial models break down. Also, increased regulation could force private-equity houses to report in detail what risks they are taking and what returns are expected which might encourage investors to look elsewhere. Already the private-equity houses are trying to pre-empt legislation by regulating themselves and presenting more information.
Quoting a KPMG study Becker explains that private-equity can now compete with strategic buyers because they are getting much more involved in running the businesses themselves where they can of course provide lucrative incentives to management if business is successful. Additionally, financial reporting legislation like Sarbanes Oxley is making public company executives increasingly open to private-equity advances and the prospect of capital without the hassle of having to make filings to seek shareholder approval. Becker says a lot of private-equity houses have tried to leverage knowledge by hiring key management from corporates to run their businesses for them. Alternatively private-equity firms are getting directly involved in businesses which gives them strategic information about the industry or the company itself.
Private-equity houses are doing bigger deals in more places and operating with more partners. This has created an environment where they will continue to be a force in the mergers and acquisitions market and continue to challenge corporates. Pension funds today invest only 4-7% of their assets in private-equity, that's increasing, says Becker, as it does there will be more funds available to private-equity which will create more competition and more opportunities to invest. His advice to corporates is to be more proactive, leverage industry experience and create large incentives for key management to stop them being poached by private-equity houses.
“In the future,” says Becker, “I think there will be more convergence. You'll have corporates acting more like private-equity houses and private-equity houses acting more like corporates.”
Becker, F., The Effect of Private Equity on the M&A Market—Europe, Xtalks Executive Web Conference, November, 2006