Cheap money era is over, but there’s still opportunity
THERE are those in private equity who like to pretend that our industry somehow escapes the laws of supply and demand. They would prefer investors to believe returns – at least when they are healthy – rest on the “magic touch” of fund managers, rather than anything as mundane as the basic rules of economics.
It’s a stance which is both wrong and counterproductive. Wrong because supply and demand dynamics influence private equity returns as much as any other market. Counterproductive because the interplay of these forces at the moment underline why it is foolish to believe the doom and gloom surrounding Europe means an absence of opportunities for private equity investors.
Looking at the demand side first, it is clear there will be a real shortage of capital compared with the pre-crash for our industry. The overhang of money raised by private equity which could not find a home will soon run out. Raising new capital will be much harder. I suspect that we are on course to see little more than €50bn euros a year raised in Europe, about a third of levels before the financial crisis hit.
Not only will the aggregate size of funds be much smaller, but each purchase made is going to require more equity – perhaps twice as much as a few years ago. Leverage levels are low and there is little sign, given the lack of confidence, of them rising.
For the same reason, we will also have to factor in the huge amount of capital that will have to be diverted towards existing highly leveraged deals, which will need refinancing over the next couple of years. All this means a massive reduction in the amount of money around for new investment.
But tighter demand is not all bad news. The result of all the cheap money and increased investment before the crash was that prices were inflated and opportunities disappeared. Funds found themselves priced out of markets even where they had expertise. The position now is very different and prices will reflect the new reality. Many investors have vanished. Those that remain are much more cautious. At the same time as there is less money, there are signs of more opportunities. The supply side is beginning to look much better.
Banks are selling off assets to make their balance sheets healthier. Governments across Europe will be forced into the comprehensive privatisations which the UK completed a decade and more ago. Global companies, too, will be divesting themselves of non-core businesses, particularly those based in Europe. They will want to meet demands to reduce debts from their nervous banks and free funds to focus on growth areas in emerging markets. It will, of course, be the most obviously marketable assets which will be put up for sale first. But they are not always those with the greatest potential. It is the businesses which have been neglected – with little investment and poor management – which may offer the greatest opportunity.
The industry is going to have to work hard to identify good opportunities and put in the time, effort and investment to turn them round. The days of the quick buck, financial re-engineering and asset-stripping as the way to achieve good returns have disappeared. Patience, insight, but above all, hard work are going to be the key. It is back to basics for private equity.
Guy Hands is the founder and chairman of Terra Firma.