Scrutineer: Private equity plots a steady course out of credit storm

Published on Sunday 16 August 2009 21:14

INVESTORS who set sail on the private equity ship before The Great Storm broke must be clinging to their bunks and wondering when it is all going to end. I have good news and bad news: it won't, any time soon.

It's bad news for the obvious reasons that more companies are set to go into administration. Many who have held out this long will just not have the working capital to ride the upturn. And, in a troublingly large number of cases, the patience of their bankers will just run out.

But it's good news because this is the most fecund point in the cycle when private equity firms can take maximum advantage of lower prices and more realistic earnings ratios in a spate of corporate break-ups and divestments. Those in private equity funds with good connections and with cash to commit can finance the new survivor businesses that have the potential to deliver big returns as the recovery gathers pace.

Here in Scotland we have one of the biggest players in private equity. Standard Life Capital Equity Partners (SLEP) is a giant Scots-based business, run out of George Street, Edinburgh, that is barely written about and whose size has long been under appreciated. But it has been involved in many of the biggest private equity deals of the past decade.

SLEP, 40 per cent owned by nine of its 16-strong partner team, and 60 per cent owned by Standard Life Investments, has raised a total of almost 5.5 billion, with clients in 24 countries worldwide making it the fifth-largest such operation in Europe and the 13th largest globally. Clients include the California state retirement fund (Calpers) and 18 UK local authorities. Private sector pension fund clients include BAE Systems, DaimlerChrysler and ITT. According to Thomson Financial, it has achieved a gross investment rate of return of 19.5 per cent over the period from 2001 to end 2008 compared with a median performance of minus 10.7 per cent over the period.

SLEP is part of that greater trompe d'oeuil of Standard Life, whose "subsidiary" Standard Life Investments enjoyed a 17 per cent rise to 3.1bn in net new inflows in the last financial year, disguising an outflow elsewhere in the group. With third-party assets growing at an annualised 14 per cent and strong UK retail and European net fund inflows, Standard Life should be more accurately described as a giant asset management business with an insurance company subsidiary rather than the other way round.

Private equity activity is now picking up, but "there are still a lot of negative headlines to come out", says SLEP chief investment officer Peter McKellar. "This year the banks have had to take hits. Only now are we seeing debt for equity swaps. The issue for private equity today is covenants. It will bring out opportunities for people to be creative. There are many fundamentally good businesses, only with the wrong capital structure."

The credit crunch has deeply shaken what was, prior to the credit storm, a boom industry. The longer term market had exploded more than tenfold in size since the mid 1990s. But since the first half of last year private equity deals by volume and value have slumped by 42 per cent and 85 per cent respectively. Both European merger and acquisition activity and private equity deals are back down to 2001 levels. Buy-outs in the large-capital sector have dried up. Leveraged buy-out loan volumes have also hit record lows in the first six months of the year. But there are signs that the corner had turned. The second quarter of the year saw a small rise in both the volume and value of private equity deals.

However, default rates, taking the bond market as a proxy for the European buy-out market, are now climbing rapidly and have some way to go to match the peaks of 1990-91 and 2001-2. On the plus side, SLEP can point to a record of genuine value creation by its managers. The gains from private equity are commonly seen to flow from debt re-scheduling and financial re-ordering of a business. Important though these are, SL can point to a 104 per cent earnings growth among its mid size private equity businesses.

McKellar cites three factors that explain the attractions of private equity over plc status: alignment of incentives, focus on earnings and the ability to take a longer term view.

"You don't find many plc directors putting their houses on the line," he says. "Plcs also tend to be focused on the next 12 months. Private equity is focused on the next five years."

For private investors prepared to take that five-year view, the most readily available vehicle is the 154 million Standard Life European Private Equity Investment Trust. It has suffered a near 50 per cent share price fall over the past 12 months. But recent recovery has been dramatic – up 144 per cent over the past four months.

Private equity comes into its own at the very turning point we have now reached.