Private Equity: Brighter Days Ahead?

After a tough 2012, PE looks poised for a good comeback, experts say

Private equity results have been less than stellar in the past few years, but a recent Bain & Co. report suggest the sector could see a turnaround this year.

Despite last year’s modest returns and the overhang of portfolio companies, the consulting firm and other sources say, PE-industry observers are optimistic about near-term results.

One reason for this optimism? Industry data shows that private-equity firms closed—or exited--129 funds in the first quarter of 2013 for a total of $67.1 billion, compared to $79 billion in the first quarter of 2012. And some firms are reporting improvements of 10-20% this year in fund raising.

Tough 12 Months

In its Global Private Equity Report 2013 report, Bain says the overall PE internal rates of return averaged 5.5% in 2012. This was the weakest performance since the 2008 financial crisis.

Several factors influenced that short-term performance.

Portfolio valuations, which are portfolio investments that general partners have not sold, reflected movements in the public equity markets, and equity markets in 2012 were volatile, according to the recent Bain & Co. report notes.

“In the 12-month period through June 2012, stock markets were prone to jitters about possible sovereign-debt default and a potential double-dip recession. That volatility took a toll on PE valuations, affecting PE fund returns in all major geographies and all size categories,” the report explains.

“Funds that focused on the European and Asian markets experienced more volatility in their valuations and suffered the steepest declines in their short-term returns. The swings were also more pronounced for the biggest buyout funds, in part because they typically use more leverage than the smaller funds do,” Bain notes.

Another factor affecting returns has been the growing inventory of portfolio companies that PE funds hold.

The goal for PE funds is to sell (or “exit”, in industry parlance) their investments for a profit. Exit strategies can include IPOs, sales to strategic buyers through merger and acquisition, and sale to another PE fund (sponsor-to-sponsor).

It’s been a difficult environment for exits, however. Bain & Co. report that “worldwide exit activity in 2012 fell below the pace of the previous two years. Exit conditions were inhospitable in Europe and Asia; North America gained some traction. Unrealized holdings in general partners’ portfolios increased to more than $2 trillion, an all-time high. Sales to strategic buyers were off as corporations hoarded cash in the face of macroeconomic uncertainty. Volatile equity markets stifled IPOs in Europe and Asia, but the IPO market held up better in North America. Only sponsor-to-sponsor exits were up in 2012.”

Other researchers have also noted the exit problem. According to data compiled by Seattle-based research firm PitchBook Data Inc., funds held an estimated 6,500 unsold portfolio companies as of year-end 2012. Those companies represented 69% of PE firms’ total assets under management as measured on September 30, 2012.

Reasons for Optimism

Despite last year’s modest returns and the overhang of portfolio companies, PE-industry observers are optimistic about future results.

In its “1H 2013 Private Equity Exits Report” PitchBook Data observed: “2012 marked the third consecutive year that both exit volume and capital exited have increased. PE firms executed a record 626 exits from companies headquartered in the U.S. during 2012, bringing in a total of $134.5 billion.”

Barring any major economic shocks, Bain adds, “prospects are good that 2013 will be a better year than preceding ones. Beyond struggling Europe, market conditions for PE are solid.”

General partnerships, it notes, have lots of “dry powder they are eager to put to work.” In addition, the debt markets of 2013 have had a good, strong start, “with both the cost and availability of borrowing for leveraged-buyout offers very favorable.”

Some high-profile macro considerations have improved both in the U.S. and China.

Finally, Bain & Co. is also optimistic on PE’s outlook as improved equity market performance in the second half of 2012 boosted portfolio valuations.

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