Wall Street's Collapse May Boost Private Equity Markets

The collapse of the housing and credit markets that has crippled some Wall Street giants is likely to have a variety of effects on private equity, say faculty at Emory University and its Goizueta Business School.

The fall of Lehman Brothers, the sale of Merrill Lynch to Bank of America, and the decision by Goldman Sachs and J.P. Morgan to be placed under the purview of the Federal Reserve are driving big changes in financial markets, note faculty members.

One likely shift is a larger role for private equity providers in financing big-ticket deals. But liquidity concerns are likely to rein in their appetite for risk, despite the just-passed $700 billion bailout package, add faculty.

"The consolidation taking place in the financial markets means the playing field is getting a bit smaller," says Thomas More Smith, an assistant professor in the practice of finance. "With fewer investment banking giants available to service big-company deals, we may see smaller private-equity firms swoop in to fill the empty spots."

In fact U.S. private equity firms have picked up the pace of their fund-raising, says the Private Equity Analyst newsletter, published by Dow Jones.

Domestic private equity firms raised $222.6 billion in 264 funds during the first three quarters of 2008, 11% ahead of the $200.4 billion raised by 298 funds in the same time last year, according to Dow Jones.

Distressed firms are seeing strong interest from investors with 18 funds raising $37.9 billion this year, up 28% from $29.5 billion raised by 16 funds at this point last year, according to the Dow Jones analysis.

The newsletter also reports that mezzanine, or layered financing funds attracted $36.9 billion across 13 funds, compared to $3 billion across nine funds through the third quarter last year.

But if the distressed and mezzanine-financing segments were excluded, private equity fund-raising would have been weaker compared to last year, says Jennifer Rossa, managing editor of Dow Jones Private Equity Analyst.

"Buyout fund-raising continues to lag," she notes. "And fresh concerns about the availability of debt won't help."

The credit crunch has still spooked investors and is likely to dampen their enthusiasm for some time, according to Goizueta’s Smith.

"Despite the bank bailout, we’re likely to see reduced capacity," says Smith. "The fact that there are fewer players remaining may also mean a pullback in the variety of services and niche activity that is offered."

Small businesses are finding it tougher to access credit, and that could spur a shift in the direction of venture capital, adds Smith.

"For the most part, VC firms have targeted ‘sexy’ businesses with high-growth potential, like technology companies," says Smith. "That’s in line with their traditional exit strategies that often envision a five-year exit with high returns."

But lately, venture capital providers have been shunning startups and have instead been targeting later-stage companies with a proven track record. That could open the door for more staid firms to catch VC’s eye, says Smith.

"A small but growing advertising company, say, may not offer the same potential as a high-tech business, but it may offer more security," he notes. "As their credit gets choked off, more small traditional businesses may begin to approach venture capitalists. And according to anecdotal evidence, some VCs are paying more attention to them. It’s too early to call it a trend, because we don’t have the data yet. But the potential is there."

A Shift in How Deals are Done

In fact Wall Street’s woes are likely to drive a big shift in the way deals are done, observes Lawrence M. Benveniste, a chaired professor of finance and dean of Goizueta Business School.

"The changes we’re seeing in the investment banking landscape are opening up huge opportunities for private-equity firms," he says. "I expect they will move in to fill the underwriting and other voids that are left as investment banks retreat. Amid the turmoil for example, Blackstone [a global corporate private equity group] has hired some high-level Lehman professionals."

On October 2, the Blackstone Group announced it took on a partner and two managing directors who formerly worked with Lehman Brothers.

Private equity already has a substantial presence in the world market, but as it expands its footprint, companies are likely to see significant changes in the way that deals are financed, says Benveniste.

"Many of the recent transactions have been driven by access to credit and the potential to increase returns through leverage. Leverage ratios of 80% were not uncommon," he explains. "Debt financing has not exactly disappeared, but it is a lot tougher to obtain it. Private equity is available, but I believe that the price-EBITDA multiples on deals will shrink considerably and opportunities for Leverage driven deals will disappear. Instead, deals will be driven more by the potential to add value to the purchased company. This is the traditional model of private equity."

Relating leveraged transactions to the current crisis in the markets, Benveniste remarks that the "The devaluation of much of this leverage debt has contributed significantly to the current weakness in financial institutions."

Klaas Baks, an assistant professor of finance at Goizueta and head of the Emory Center for Private Equity and Hedge Funds, agrees that private equity players may score some gains in today’s financial crisis.

"Many PE firms that rely on leverage to generate returns will need debt financing, but the tight credit markets will put pressure on them," he says. "In this type of market, successful PE firms will add value through channels other than leverage such as improved corporate governance or operational efficiencies."

He says that as investment banks like Morgan Stanley and Goldman Sachs take on the attributes of commercial banks, private equity firms and hedge funds will likely fill some of the void. "We may see private equity and hedge funds start to perform functions traditionally performed by investment banks," Baks predicts. "But if government regulation is expanded to private equity and hedge funds, such a move may be inhibited."

He expresses some concern about the bailout plan, noting that "at this point we just don’t know the true level of toxic debt."

Baks also questions whether a $700 billion taxpayer-financed bailout will lead to a "moral hazard," or more reckless behavior on the part of financial institutions that believe they are "too big to fail and will be bailed out by the federal government if they get into trouble."

Ray Hill, an adjunct professor of finance at Goizueta Business School, also believes that the problems on Wall Street may drive more activity to private equity firms.

"Private equity firms will be able to attract talent from investment banks," he says. "Also, some private equity firms that did not become overleveraged are already moving segments that were traditionally handled by investment banking firms."

But that does not mean that the investment banking segment is about to disappear from the landscape, adds Hill.

"Goldman Sachs is not about to go under," he says. "Instead the group is likely to retreat from its historical risk taking model. I expect Goldman will still engage in merger and acquisition, advisory and underwriting functions, but will probably limit its maximum leverage to 10x, instead of 25x. The company will make its money through smarter investments instead of just riskier ones."

Looking at a broader issue, Hill worries that the financial crisis is now infecting the real economy.

"The argument made for the bailout by [U.S. Treasury Secretary] Henry Paulson and [Federal Reserve Chairman] Ben Bernanke is that we have a crisis in part of the financial system that may spread to the general economy," says Hill. "At the time they proposed the rescue plan, you could say that the real economy was slowing down, but probably not headed to recession. In the last two weeks, the leading economic indicators have become more pessimistic and the current freeze in short-term credit is likely to do further damage."

He notes that the bailout plan is still a few weeks away from being implemented. "It is no surprise that we don't see the benefits of the plan yet, but some of the adverse consequences of the credit freeze will not be reversible."

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