Private equity groups (also called professional investors or financial buyers) are currently not getting as many deals done as strategic or corporate buyers, so it is easy to assume that because of the financial crisis this may be a permanent trend. Not so — many PEGs are taking a breather, but they’re expected to come back in force once the credit market loosens up a little.
What is a PEG?
It is helpful to take a look at what a PEG is and where they get their money. Although they come in many different flavors and sizes, the basic structure of a PEG is a manager/general partner and investors/limited partners. The manager(s) take a management fee for their work and usually some type of performance based pay. Investors for smaller PEGs may be high net worth individuals and for larger PEGs institutional investors and even other private equity funds. Large or small, the investors are hoping to enjoy a fairly high return on investment, which ranges dramatically depending on the investment risk, but can be 10 to 25%.
Investment in PEGs still strong
15% is not a bad return, is it? Especially with the turmoil in the market and in many securities, there just are not a lot of places to put investment funds. Indeed, investment in PEGs continued to grow through 2007 to a record $302 billion, as reported by Dow Jones Private Equity Analyst. Investment is down in 2008, but private equity still raised $133 billion in the first half of 2008. In this market that is impressive. For the most part, these are committed funds. The manager has access to the money and is expected to invest it.
As an indication of money continuing to flow into private equity, I present this e-mail that I received (on November 25, 2008):
We have recently established Bosworth Capital Partners, a private investment partnership looking to acquire and take a day to day operating role in a service-based or niche manufacturing business.
Here are two broad criteria outlining the type of opportunity we are searching for:
Existing ownership/management looking to transition out of the business
I have attached a copy of our brochure which includes more specific acquisition criteria as well as some information about our team. I’d enjoy the opportunity to tell you more about us and what we are looking for. Please let me know if you are available to speak over the next few days.
Life cycle of private equity
Now think about this – the typical life of a fund is seven years. In other words, the managers have to roll the money into acquisitions and exit those acquisitions in order to fulfill their goal of returning the appreciated capital back to their investors. So the bulk of the $450 billion of the last few years is ready and waiting, anxiously, to be deployed. They can’t sit on it too long or it becomes much harder to achieve their ROI goals.
Why is the credit crisis hurting the PEGs?
Although a PEG may show their investors they hope to deliver a 15% ROI, the PEG itself has to target a higher rate of return. For example, I know from working with PEGs in the middle market M&A segment that they typically target 30 or 35% ROI. To achieve this return, they use routinely use debt in their deals, even if they have $100 million in cash available to do a $10 million acquisition. Right now, saying that raising debt is a challenge is an understatement.
It becomes obvious why PEGs use debt each time I see a financial model that shows the effect leverage has on the ROI for the equity investor. In my next post, I’ll construct a simple example so you can see it too.