Private Equity 2011: A Challenging Year, With Reasons For Optimism

Andrew J. Nussbaum is a partner in Wachtell, Lipton, Rosen & Katz’s Corporate Department. This post is based on a Wachtell Lipton firm memorandum by Mr. Nussbaum, Steven A. Cohen, and Amanda N. Persaud.

We will be neither the first nor, we suspect, the last industry participant to observe the challenges that financial sponsors, and private equity investors in particular, experienced in 2011. As we move into 2012, we do, however, find our glasses leaning more toward the full rather than empty side.

Limited Partners. The challenging fundraising environment has continued into 2011. Institutional investors, particularly public pension funds, are paring back the number of relationships, which bodes well for large established sponsors who are viewed as more stable and with deeper pockets to help buffer market volatility, In some cases, fund target sizes have been adjusted downwards, with economic and transparency concessions having become the new norm thanks in large part to ILPA. While concessions have varied among sponsors, what has become clear is that institutional investors remain committed to private equity and those capable of writing large checks are getting customized one-off arrangements with better economic terms. Whether through managed accounts, side-cars, direct investments, multi-strategy mandates or co-investments, institutional investors have taken advantage of the current fundraising cycle to actively partner with established sponsors in more creative ways, with the expectation of better returns in the long term.

2012 may turn out to be a mixed bag, but ultimately okay, much like 2011. Concerns about Europe may have a negative affect on fundraising, but capital coming available for deployment will need to find an investment and may contribute further to the differentiation we are already seeing between large established sponsors and everyone else.

Banks and Other Financing Sources. The traditional bank commitment market continues to be flighty and fickle. Volatility is high — the windows open and close, quickly and across various geographic areas, and hitting the market at precisely the right time is critical. Deals are thus limited, but for those who are able to time it right, deals are getting done. We have also seen the continued participation of other financial players, such as sponsor-controlled mezzanine funds and credit funds, and other alternative lenders such as hedge funds, who have entered the void. Some sponsors have been willing to commit greater equity to get the deal closed, as a bridge to a future refinancing. And the US public-to-private market saw a handful of large completed deals, particularly in more stable cash flow industries.

Equity Capital Markets. See above…. The IPO market, whose receptivity to private-equity backed offerings was already diminished, shut as quickly as it opened, and so on. Portfolio companies ready to move quickly, however, did succeed in their offerings; the dollar value of 2011 sponsor-backed IPO’s nearly doubled from 2010, while the number of offerings diminished significantly. We believe that it was the overall economy, and its impact on portfolio company performance, as much as the capital markets that may have resulted in a large number of abandoned offerings. As with debt financing, timing was critical to success – launching in a geography and week where the environment is accommodating is key, and therefore longer lead times and multi-jurisdictional tracks are often required. We may see some early exits, where exit is feasible, because the window may be shut at the more traditionally expected time.

The Courts. While Delaware courts have more than once demonstrated a certain distrust of financial sponsors, 2011 saw some true flashes of deep judicial cynicism for some conduct in the M&A marketplace. However, the basic lesson of Delaware M&A law remains the same: a well-thought out deal strategy, which takes into account the requirements of Delaware directors’ fiduciary obligations, and a well-functioning board, can succeed and those deals will survive challenge. The courts’ bedrock respect for directors’ business judgment, when evidenced by proper attention to material issues, remains intact.

Sellers. Many sellers cling to pre-financial crisis expectations for valuation, making whole-company transactions difficult to achieve. Extraordinary volatility makes it harder, not easier, to agree on terms. But the market is active with sales of divisions and subsidiaries, where valuation metrics are more malleable, and sellers can accept more creative deal terms, such as earn-outs, vendor financing and retained equity ownership. Those deals often bring much-appreciated liquidity to the corporate seller, as well as a concluding punctuation mark for the ownership of a troubled, under-performing and/or non-core business. All of which are an excellent fit for private equity buyers.

The Regulators. The ever-expanding labyrinth of US, UK and EU regulation makes doing business for financial sponsors certainly more costly and perhaps more difficult; whether the original policy objectives are served is a matter of debate. On the other hand, global competition policy, which increasingly disfavors highly synergistic mergers among industry leaders, may actually improve the M&A prospects for private equity buyers. Stay tuned.

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We look forward to testing our (slight) optimism in 2012. It may be a year for bespoke, if somewhat sporadic, dealmaking in an environment that is well-suited to the private equity investment thesis. Creativity and advance preparation will continue to be rewarded.

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