In a series of articles in Forbes, contributors from Bain & Company dissected the current state of the PE market and discussed the outlook for investor returns in 2012 and beyond. The good news was that PE Industry returns will still likely out-pace most other comparable investments. The bad news was that returns will likely be at their lowest since at least 2009. All things remaining equal, the Bain contributors concluded that those PE firms that can drive organic growth from their portfolios would be those that would excel in the industry.
Through Forbes, the Bain contributors concluded that the biggest problem in the PE industry was that PE firms were “awash in commitments” that they must realize in 2012. However, many of the companies that they were carrying – “up to 75%” of them – were well “below needed carry rates”. PE firms are stuck between the proverbial rock and hard place. PE firms have to exit much more investments over the upcoming periods, but those assets will not deliver the value that they need at the time of exit.
As we know from many sources, the broader market trends are not helping as most beta markets are flat. Moreover, most operating value and leverage opportunities have already been generated in holdings that have been in portfolios for 3 – 5 years and sometimes more.
What do Forbes and Bain say is the answer to this conundrum? “What could cause [higher return] exit activity to perk up in 2012? ………. high-quality companies with compelling growth stories could break through.”
This of course is much easier said than accomplished. Studies show that PE companies are loath to actively manage their holdings top-lines and most middle market companies under management simply lack the growth acumen needed to develop break out top-line growth plans in difficult, low growth markets.
As we have blogged many times, it is our conclusion that PE firms should seek out help from outside, growth related consultants to help them generate organic growth results for the longer term and more short term “compelling growth plans” to help them generate the most value from an exit deal.
The two articles that we cite on Forbes are listed below with the quotes from them that we think have the most meaning.
“That puts GPs in a bind. They cannot return cash to LPs and their investment professionals until they liquidate these frozen holdings, but the assets are not ripe for sale in today’s market on terms that are attractive to GPs. PE fund managers have successfully nursed their high-priced portfolio companies through the downturn, but GPs still hold the overwhelming majority of them at valuation multiples below what they need to reap to earn their carry. They will need to continue to work with their portfolio company managers to prepare them for eventual sale by creating additional value.”
“Evidence of the power of alpha in private equity is compelling. Oliver Gottschalg, a professor at the École des Hautes Études Commerciales (HEC) in Paris, demonstrates the alpha effect by comparing actual private equity returns to stock market returns of similar investments in company shares (see figure). In his most recent research with Golding Capital Partners, Gottschalg estimates that return margin to be worth an additional 5 percentage points. The PE alpha effect has been exceptionally strong in times of economic turbulence. By Gottschalg’s calculation, PE returns generated through alpha added 18 percentage points to PE performance during periods of economic recession.”