2010 was a comeback year for private equity. Deal volume nearly doubled, portfolio values were boosted by public market comps (thanks, FAS 157!) and PE firms found multiple ways to manage debt loads on bubble-era portfolio companies (leverage wall, what leverage wall?).
So what will happen to private equity in 2011? Here are five story-lines worth watching:
1. Desperation Deals
Private equity fundraising crossed the $200 billion threshold, and the $300 billion mark one year later. Combine that with a dormant fundraising market over the past two years, and you get hundreds of firms looking to raise new capital in 2011.
The good news for these firms is that most limited partners plan to increase allocations in 2011. The bad news is that the anticipated increases won’t be nearly enough to fill all coffers.
Top-tier firms shouldn’t have too much trouble, while the lower levels won’t even bother trying. Those in the vast middle, however, will have to answer the following question: “What have you done for your investors lately?”
Yup, it’s all about recent liquidity events. The best solutions are non-dilutive, but last year’s dividend recap rush seems to be slowing down. And IPOs are still hamstrung by debt-dubious mutual fund managers and long “bleed-out” times for significant shareholders.
So expect an onslaught of desperation deals by middling firms who view returns in the hand to be worth better returns in the bush.
To be clear, I’m not talking about distressed deals for troubled companies. Desperation in this case is attributed to the sellers who, under more favorable circumstances, would hold onto their portfolio companies for another 12 or 24 months.
2. Corporate Competition
As you’ve probably heard, corporate America is sitting on nearly $2 trillion in cash. President Obama sees that as salve for the country’s unemployment ills, but private equity firms view it as competition.
Strategic acquirers almost always can outbid a private equity firm, because even cheap debt is more expensive than cash-on-hand (well, at least now that mild leverage covenants have been restored). Moreover, strategics often can find strategic savings that allow them to pay higher deal premiums.
Private equity investors I speak with say that corporate competition began to seriously pick up in the second-half of last year, and is only expected to intensify in the year ahead. Tomorrow’s corporate buzzword is “consolidation,” not “divestiture.”
That means that private equity deal volume actually could rise next year, but private equity’s piece of the overall M&A pie could shrink.
3. Dipping Down
Back in the dotcom daze of 1998-2001, lots of private equity firms expanded their investment strategies to include venture capital. Some even raised dedicated funds (remember TH Lee.Putnam Internet Partners?).
Expect some of that nuttiness to reemerge next year, particularly if huge value is recognized via IPOs for companies like Facebook, LinkedIn or Zynga. Probably not early-stage investing, per se, but “growth equity” efforts like the next round for Twitter or Groupon.
Some of this will take the form of expanded efforts by firms that already straddle the VC/PE line (e.g., General Atlantic, Summit Partners), while some will be firms dipping down for the first time. Given that a number of early-stage firms also are investing more in growth equity (e.g., Kleiner Perkins, Sequoia Capital), valuations in this space should continue to rise.
4. Hot Sectors
Most private equity firms are opportunistic generalists, valuing one-off deals over attempts to ride macro trend waves. That said, here are a few sectors to which firms may pay particular attention next year:
- Energy: Last year’s second-busiest sector – behind perennial leader “consumer goods,” ahead of “financial services” – shows no signs of slowing down. A key driver here is shale. Not just exploration and production, but all of the associated infrastructure.
- Technology: Bunch of factors here: (1) The cost to grow a tech company has dropped dramatically over the past few years; (2) An increasing number of PE firms have tech practices; and (3) Big chip deals like Freescale no longer serve as cautionary tales, like they did just 12 months ago.
- Healthcare: The healthcare reform bill’s efficiencies and inefficiencies should become clearer in the year ahead, and PE firms will be quick to exploit where possible. Plus, healthcare currently represents around 16% of U.S. GDP, and that figure is expected to keep rising. No way PE doesn’t increase its piece, in turn.
- Retail: Some of this is backup inventory, or companies that failed to be acquired during the past couple of years. Some are real estate plays in which the actual retailer is a relative afterthought.
- Emerging markets: Not an industry sector, but still an area where private equity firms will devote even more money and resources. PE investments into emerging markets increased 110% between 2009 and 2010, according to Reuters, and the trend has no signs of slowing. Think BRIC and MENA specifically, but also surrounding frontier markets like Peru, Nigeria and Vietnam.
5. Firms will overpay
The classic private equity investment strategy is to buy at economic cycle troughs, and sell at cycle peaks. That’s why the best-performing funds of the past two decades were raised in recessionary years like 1991 and 2002, while the worst performers were born of boom-times like 1997 and 2006.
Unfortunately, private equity firms are suckers for a rally, and we happen to be in the middle of one right now. No wonder deal activity is on the march – often with premiums being offered for public companies that already are trading at multi-year highs.
If the economy continues to recover (which I expect) and PE firms continue to increase deal activity (which I also expect), then it is virtually certain that 2011 will prove a sour vintage. Investors can take comfort in pending realizations from those funds with the courage to invest in 2008 and 2009, but 2011 only will be positive for private equity in the short-term.