Easy credit could prompt some setbacks for PE firms in new year

High valuation levels of 2012 might spell trouble ahead

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Contributing: Jessica Reed Saouaf believes availability of credit was partly responsible for high valuations in 2012.

Private equity in 2012 made a rapid recovery from the lows of the economic downturn, but firms might suffer a setback in 2013 amid the expected return of high valuations and easy credit, industry insiders say.

“Uncertainty has been the issue this year and will continue until everybody has a better sense of the politics going forward,” said Brad Morrow, senior private markets consultant in the New York office of consulting firm Towers Watson & Co.

In 2012, values rose to amazing heights, pushed up by lenders eager to get back into the game.

“As we look toward the future, valuations have gotten high, in large part driven by the availability of credit,” said Jessica Reed Saouaf, managing director and co-head of private equity at San Francisco-based Hall Capital Partners LLC, which provides outsourced CIO services to institutional investors. “(Valuations) reached levels I didn't personally think I would see so soon after the crisis.”

Ms. Reed Saouaf added that while it's possible high valuations will continue into 2013, it is likely worldwide macroeconomic issues and political uncertainty will temper the private equity industry's access to debt. “That would pull the industry back a little, which would be positive,” she said.

At the same time, private equity managers are sitting on a big supply of mature investments. They will be proactive in trying to sell portfolio companies or take them public, Ms. Reed Saouaf said.

Private equity managers had a combined $2 trillion in unrealized portfolio value at year-end 2011, the latest data available, up from $1.8 trillion on Dec. 31, 2010, according to London-based alternative investment research firm Preqin.

However, it is likely to be harder to generate exits in 2013 because of macroeconomic problems, Ms. Reed Saouaf said.

Managers in industries dependent on the federal government, such as the military and health care, will have added challenges, Mr. Morrow said, because of worldwide political and economic uncertainty.

“It will make it difficult to understand where the business is going or its value,” he said. “It makes it difficult to plan, such as for expansion, for hiring. A lot of it is a waiting game.”

This difficulty could add a year to a private equity firm's exit or growth plans for their portfolio companies. If private equity firms have to add a year to their plans, that could lower returns, Mr. Morrow said.

Seeing a slowdown

“We're not going into (2013) as benign as (2012),” said Gary Robertson, senior vice president at San Francisco-based consulting firm Callan Associates Inc. “There will be some kind of slowdown in the private equity market” as a result of economic uncertainty.

Commitments to funds, funds investing in companies and companies being sold could all slow somewhat, he said. “Uncertainty will affect the strength of the economy and the values put on companies,” Mr. Robertson said.

In 2012, while lawmakers tried to get their collective act together over the fiscal cliff and other issues, some managers tried to pull as much money as they could out of their portfolio companies by selling or refinancing them. Investors benefited because more capital was distributed to them from their private equity managers.

Private equity fund-of-funds firm Pantheon Ventures returned $2.2 billion in cash to investors in 2012, said Chris Meads, Hong Kong-based partner, in an e-mail.

More broadly, Mr. Meads said one highlight of 2012 that could positively affect private equity industry in 2013 is the “resurgence of the U.S. consumer.”

“U.S. households' ability to service and repay their debts has improved and is now as good as it has been in a decade,” Mr. Meads said. “And U.S. banks have recovered, thanks to the actions of the Federal Reserve and the Treasury, and are now as well capitalized as their Asian counterparts. Pantheon and the whole private equity industry will benefit from this, since the U.S. is still by far the biggest, broadest and best-developed private equity market in the world.”

Still, investors remain wary of illiquid investments, which could make 2013 another difficult fundraising year, Ms. Reed Saouaf said. 2012 was generally a difficult year to raise a fund, but not all firms had the same experience. The strongest consistent-performing firms were able to meet their fund targets fairly quickly from more selective investors. But a large number of firms took longer to reach their fundraising targets, and some were forced to raise smaller funds, she said.

“Ever since the credit crisis, the illiquidity premium was quite high and since then our clients ... have continued to invest in private equity but in smaller bite sizes because of the illiquidity,” she said. “There's a desire to be highly selective and the concentration of general partners continues.”

Still, there could be some bright spots for private equity in 2013. “My sense is that the most dangerous part of the global financial crisis is past, that there are modest signs of hope appearing in the U.S. (manufacturing jobs returning from overseas, consumer debt burdens, exports), that Europe is too big to fail, and that in private equity we have to adjust to slower global growth, in emerging markets as well as developed ones,” Mr. Meads said.

“That continues to favor (general partners) and investors who play the long game: active management, discipline in pricing, diversification and thematic investment based on long-term trends, particularly demographic ones,” he added.

This article originally appeared in the January 7, 2013 print issue as, "Easy credit could prompt some setbacks in new year".