Time for Private Equity to Pull the Trigger?

06-Oct-2009, CNBC.com

The famous World War II General George S. Patton used to say that he didn't judge a man by how high he climbed, but by how high he bounced after hitting the bottom.

It's probably worth considering this as we explore the world of private equity funds and the role they're playing in the biggest stock market rally in a least two generations.

PE firms have stumped up a measly 5 percent of the $1.46 trillion worth of deals this year (a figure down more than third from last year), their smallest contribution since at least 2000, according to Mergers & Acquisitions Report.

And it's not like there's a wave of cash waiting to get put to work, either. London-based research group Preqin says that, globally, PE funds have raised $38 billion in the last three months, 45 percent less than in the second quarter and a fraction of the $208 billion raised just prior to the credit crisis in the second quarter of 2007.

Here in the UK, the figures are even more bleak, with only 31 deals in Q3 with a value of just £556 million ($890 million) -- the slowest pace in a quarter of a century.

To make matters worse, previous (mostly leveraged) deals made with private equity cash are starting to come unglued: there have been 17-sponsored insolvencies in the UK so far this year, up 55 percent from 2008 and the highest total since the tech-bubble bursting aftermath of 2001.

In the US, the 62 PE-related Chapter 11 filings have already outpaced last year's total, the most recent being Colony Capital-backed  Station Casinos, which blew-up around $2.7 billion in equity.

The industry itself , especially in Europe, is going through some major upheavals, with respected veteran John Moulton stepping down from Alchemy Partners after a clash over strategy. Damon Buffini will give up his role as chairman at Permira and Guy Hands is no longer chief executive at Terra Firma (although he is chairman and chief investment officer).

So why the crisis of confidence and transactions?

To begin, the credit crunch isn't just about mortgages: with only $262 billion in syndicated loans sold thus far this year bank lending to the financial sector is only a fraction of its former self (one third of the second quarter in 2008, to be exact). That lack of juice squeezes the profitability of PE-sponsored deals, which typically rely on a big portion of borrowed money to complete.

Technical moves in the corporate bond market, along with record sales in Europe thus far this year, have also made life tough for PE funds. Companies themselves can fund acquisitions based on the yield of their own cash flows, their financing costs and the free-cash-flow yield of their target (a big part of the reason Kraft will be able to cobble together the $17.6 billion needed to buy Cadbury).

There are nascent signs of a PE recovery, though. Blackstone Group (+5.92%) is said to be close to making a $3 billion bid for the theme parks owned by Anheuser-Busch InBev, including Busch Gardens and SeaWorld. (Blackstone is a co-owner of the Universal theme park in Orlando, Florida, along with NBC Universal, a subsidiary of General Electric (+3.1%) and the parent of CNBC.)

PitchBook Data, a PE-focused research firm, estimates the private equity "overhang" (the difference between cash raised by the PE industry and cash invested) at around $400 billion.

With European shares valued at two-year lows (on a forward Price/Earnings basis) and expected to grow earnings by 25 percent in 2010 (compared to a 22 percent decline in 2009), PE firms could source a plethora of potential targets and keep a tidy bid premium into the current (albeit stalled) equity rally. 

And despite the conventional wisdom that mergers don't make money, many recent deals are fairing quite well: Towers Perrin studied 204 transactions of $100 million or more - made between September 2008 and May 2009 - and found that the buyers outperformed non-buying peers by 6.3 percent.

General Patton once said that courage was fear holding on just a minute longer. Private equity investors might paraphrase it to suggest that success is reticence investing just a little bit sooner.