Karen Mazurkewich, National Post · Tuesday, Sept. 7, 2010
Let's start with the good news. The long tail of the economic crisis is finally working its way through the private-equity sector. It may have taken longer for the shock waves of the meltdown to make their way to this end of the economy. But they hit hard, nonetheless. Now, finally, corners are being turned. Globally, private equity players have tapped investors for more money in the second quarter of this year than at any time since the start of the financial crisis. Even Canada's beleaguered venture-capital sector -- the hardest hit in the world -- is finally seeing some lift as this year progresses.
But despite the recent cause for good cheer, private-equity players -- the leveraged-buyout firms, the venture capitalists, the distressed-debt funds -- have emerged from the financial crisis and the recession that followed with deep battle scars. The reasons are all to clear. In the years leading up to the financial meltdown, private-equity firms ruled the investment landscape, luring investors -- typically pension funds, sovereign-wealth funds and wealthy individuals -- with the promise of king-size returns on deals that often ran into the billions of dollars.
The trend in Canada reached its zenith in 2007 -- when private-equity firms raised $370 billion dollars -- and then over-reached with the failed $52-billion leveraged buyout of BCE Inc. by a consortium that included the Ontario Teachers' Pension Plan along with U.S. private equity firms Providence Equity Partners Inc. and Dearborn Partners LLC. By the time that bid failed in December 2008, the party was over. The market crash was in full swing and private-equity firms were left with suddenly devalued assets on their books that they could not monetize to would deliver promised returns to their institutional investors. The result? Anger and frustration among backers, who first started to scale back their flow of investment dollars and then put pressure on their private-equity partners to improve their bottom lines.
The detente that followed has since warmed and relations between investors and private-equity firms are normalizing. But more than a few high fliers have had their wings clipped. Edgestone Capital Partners, a prominent Toronto-based private-equity firm, has seen change in its executive line-up. Winnipeg-based Richardson Capital no longer runs private-equity money for third-party investors and now invests only the money it holds in house. Venture West, once a dominant venture-capital firm with offices across the country, has essentially closed its doors.
More significantly, the landscape of the entire private-equity industry has shifted. Traditional investors are demanding more transparency from their private-equity partners and greater roles in the management of investments. Others, notably smaller institutional investors such as OP Trust, which manages the pension obligations of the Ontario Public Sector Employees Union, are starting to make their own direct investments, diminishing the potential capital available to the private-equity industry.
None of this is to say the era of private equity is under threat. Indeed, a recent report by London-based Coller Capital says that investors plan to speed up their commitments to private-equity funds in the next 18 months. But one thing is certain: With the boom years behind them, private-equity investors have become more selective, and the entire industry, going forward, is operating on a different dynamic.
If the increasing willingness of institutional investors to make direct investment points to one overarching theme, it's that they may have lost a degree of confidence in private-equity funds as an investment channel, especially if they are expected to pay fees to participate in deals. And that's not an unreasonable position in light of the circumstances, says Sebastien Burdel, a principal with Coller Capital. "What you saw develop in the boom years to some degree was a dilution of the quality of the private-equity industry as a whole," he says. "It was driven by a lot of newcomers who arguably should not been able to raise capital and should not have been doing deals."
The inevitable outcome of that population boom -- as is the case with any such boom -- is an eventual thinning of the herd. Burdel predicts the pool of funds will shrink over the next year or two. But is that a good thing? Industry reaction is mixed. On the one hand, Burdel believes a rebalancing is a healthy sign of a maturing market. Others worry that industry veterans might just walk away from their funds, leaving younger, less-experienced partners to pick up the pieces. That fear may be overstated, but this much is certain: The future leaders of private equity will be the fittest, those who avoided quick, slick, financial turnarounds, and focused on bringing real value to the companies they purchased. There will be fewer of them overall, but those that remain will have a laser focus on operations. Financial wizardry will be replaced by players with deep knowledge of the industry sectors who have a long-term investment horizon of five years to eight years, as opposed to the three-to four-year turnarounds done during the height of the bubble. Secrecy will be less tolerated. The remaining players will have to be more transparent, take smaller fees and be willing to cut investors into some of their deals.
But with change comes opportunity. A number of smaller companies are muscling up with fresh approaches to private equity. With less capital available from traditional players, they are taking on larger roles in the industry.
Among them is Toronto-based Kirchner Private Capital Group. A gun-for-hire firm, Kirchner originally built its brand as a turnaround specialist that larger private-equity groups would bring in to fix and sell broken companies within their holdings.
Today, with more funds under pressure, Kirchner has found a new line of work -- massaging under-performing portfolios. Instead of fixing individual companies, Kirchner conducts an entire analysis of a private-equity company's investment portfolio on behalf of the investors, and uses its experience in turnarounds to recommend which assets should be kept and which should be let go, with the eventual goal being to wind down the entire portfolio.
The economic crisis "exposed the weakness in portfolios," says Les Lyall, a turnaround specialist who joined Kirchner during a recent, widespread recruitment drive. "The challenges have become more present and visible. In the past, [investors] had two options: do nothing or sell the portfolio to a secondary fund at a significant discount… We represent something in the middle, to continue working with the portfolio and maximizing the value."
Meanwhile, in the struggling venture-capital realm, another Toronto-based firm, MMV Financial, has been gaining traction in the area of "venture debt" financing. Yet demand for this type of financing -- essentially, bridge lending to smaller that firms can't traditional bank financing -- is growing. "As equity pools shrank [after the economic crisis], there's been a squeeze on capital in the market," says Ron Patterson, who co-founded MMV in the late 1990s with Minhas Mohamed, and now serves as the company's executive vice-president. "Whenever VCs demand tougher terms, our loan option looks more attractive."
The upside of venture debt is that it allows firms growing out of the startup phase to access funding without having to turn to venture-capital firms, which would take ownership stakes that dilute the equity in the company. (MMV, which specializes in tech firms, actually does demand warrants that can be converted to equity from the companies it lends to, but the stakes only add up to 1% or 2%.) Still, venture debt is not the easiest money to accept. Making loan payments on a monthly basis can be difficult for young firms, and MMVs interest charges of 12.5% to 13.5% -- typical for this category of lending -- are not cheap.
David Nyland, president and chief executive of Toronto-based BluePrint Software, an MMV client, warns that this form of financing is not for everyone. "It takes a lot of discipline to stay current and pay the debt," he says. "Those who can't continue to make payments go into default."
That said, MMV's track record for selecting companies for loans is strong. In the decade or so since its launch, the firm has had to take over and resell at least seven startups to recoup its losses. But MMV puts its overall losses at only US$5 million over the years -- not bad considering that it has handed US$500-million worth of loans to more than 175 firms.
That track record hasn't gone unnoticed. MMV has recently grown its capital base to US$200 million, thanks to a capital infusion from Laurentian Bank, HSBC Bank Canada, and ROI Capital and is now lending US$80 million to US$100 million each year to some 30 companies. It is now also doing the majority of deals in the U.S. and boasts five offices across North America. "Ours is a good example of how Canadian companies need to be part of the North American platform," says MMV co-founder Mohamed.
True enough. And there's no doubt more opportunity for new or growth-oriented smaller players to take larger roles in the industry. After all, the crisis did not kill the private-equity model; it brought the players back down to earth. The industry may be less sexy and secretive than it once was but the remaining players -- both old and new -- will be stronger. In the process, a new niche of firms managing distress portfolios and debt have emerged. And a new era has begun.