Constantly shifting winds ─ emanating from changing federal regulations, financial market conditions, limited partners’ expectations and geopolitical situations ─ are buffeting today’s private equity industry and compelling PE fund managers to be more creative and agile in their deal sourcing and deal making, says Finance Professor David J. Brophy, director of the Center for Venture Capital and Private Equity Finance at the University of Michigan Ross School of Business.
The challenges and opportunities facing PE investment firms will be discussed and dissected by seasoned industry pros at this year’s Michigan Private Equity Conference on Oct. 16 and 17. The event, now in its ninth year, includes a noon golf outing at Radrick Farms, an afternoon tour of the Big House and an evening dinner reception at Campus Inn on Thursday. The conference opens Friday at 7:30 a.m. in the Michigan Union ballroom.
“This is going to be one heck of a conference,” Brophy predicts. T. Bondurant French, the CEO of Adams Street Partners, will address a broad range of top-of-mind PE industry issues during his keynote “Fireside Chat” with Brophy on Friday morning. Later in the day, Kevyn Orr, Detroit’s former emergency manager, and Ken Buckfire, president of Miller Buckfire, will tackle weighty questions about the status of the Detroit bankruptcy and what they anticipate in the post-bankruptcy era. “Kevyn and Ken also will talk about the opportunities and necessity for private equity investment in Michigan in general, and Detroit in particular,” Brophy explains. “Our conference panelists are very authoritative on current fundraising issues, as well. We find that people appreciate the size and scope of this conference, and we draw interested parties from around the Midwest as well as both coasts.”
Brophy characterizes the state of private equity as very good, but notes that PE fund managers are dealing with knotty challenges in several different areas. These include:
Rising public stock market
“The cost of buying both private and public companies has gone up with the rising stock market to the point where that approach is a bit in decline,” Brophy observes. “Financial buyers are realizing that high prices and high valuations of companies may not yield great returns. In the public markets, the P/E ratio average has risen to roughly 18 from about 12 over the last two years, which is a significant increase.” He says this may indicate the peak of a market cycle. “On the flip side, when potential sellers of larger companies mark to public market ratios, they may choose to go public. The IPO market has been up and strong recently.” Brophy says these circumstances have compelled private equity investors to look more closely at the middle and lower end of the market and to adopt a “buy and build” strategy, i.e., buying a company, investing growth equity, putting management in place and increasing the value of the company to the point where it can be sold or taken public.
Contraction of the distressed debt market
“In the 2008 period, companies that had stretched their debt and then suddenly hit the recession were bankruptcy candidates,” Brophy says. “This was a huge market for private debt and equity, which acquired, reorganized and refinanced these companies to build them up. At this point, we’re not sure whether we’re in the middle or at the top of a boom. However, this market is still the second largest destination for institutional funds, after buyouts.”
Increased power of limited partners
General partners are finding it tougher to raise money from limited partners who are increasingly more cautious, inquisitive and judgmental. “LPs currently have the advantage in the marketplace and are looking more carefully at the funds they invest in,” Brophy says. “They are taking a harder stance on prior performance and how fast capital has been returned to investors.” In addition, some pension and sovereign wealth funds are skirting private equity funds altogether and making their own direct investments, co-investments and secondary investments. “To me, this represents a shift of power or influence between general and limited partners, which swings back and forth according to the cycle we are in,” Brophy observes. “Today, the power is swinging toward the LPs.”
Increased regulatory pressure has reached the private equity business, particularly with respect to the availability of leverage. The attention of Congress, the SEC and the bank regulators on private equity has increased the “regulatory nervousness” and cost of doing business for PE firms, Brophy says. “Many people believe that when we removed the Glass-Steagall Act and permitted investment and commercial banking to be done under one roof, we opened the door for a lot of bad things to happen,” he explains. “The whole set of current regulations puts a damper on the prospect of private equity as a growth engine. That’s the bottom line. It’s more difficult and expensive to do deals and get acceptable returns now.”
Global market uncertainty
“I think the biggest challenge is the global market,” Brophy says. “With global uncertainty, investors who developed an appetite for investing in other countries must now do so with great caution. The more these countries adopt policies, legal systems and financial systems that are stable and positive, the better off the global market will be and the better conditions will be for global private equity.”