This content is from: Corner Office

Private Equity Firms Must Adapt or Die

After years of flagrant excess, the global buyout industry must now work harder to retain investors’ trust.

At an investor conference at the opulent Phoenician resort in Scottsdale, Arizona, last October, the senior partners of TPG Capital, one of the largest private equity firms in the world, told their assembled limited partners that they would do something unprecedented in the 18-year history of their business, formerly known as Texas Pacific Group: refund $20 million of investors’ money. After a year in which TPG hadn’t put as much cash to work as it had intended — a whopping $2 billion less than anticipated — yet continued to reap tens of millions in fees on its flagship fund, TPG Partners VI, the firm’s founders decided to return the roughly 1 percent management fee they had collected on the undeployed capital.

“We applauded their decision,” says Christopher Ailman, chief investment officer of the California State Teachers’ Retirement System, the second-largest public pension fund in the U.S., with $131.1 billion in assets under management. “We thought it was the right thing to do.”

The concession was not the first that TPG had made to its cash-strapped investors in the wake of the crisis. In January 2009, TPG — under pressure from some of its largest limited partners, including CalSTRS and the California Public Employees’ Retirement System — stunned the private equity industry when it offered investors in its flagship fund the chance to reduce the size of their commitments by 10 percent. Just under half accepted, lowering assets in what was then a $19.8 billion fund by about $1 billion. TPG was one of nearly a dozen private equity firms in the U.S. and Europe to offer investors the opportunity to reduce their fund commitments — the list also included Boston-based Bain Capital, London-based Permira and Boca Raton, Florida–based Sun Capital Partners. Like TPG, these firms knew they could not demand infusions of money from investors whose ability to meet those capital calls was severely compromised by the global financial crisis.

TPG’s recent actions were a tacit acknowledgment that even the largest private equity firms, humbled by the financial crisis, must now work harder to retain investors’ trust. “TPG and some of the other firms get it,” Ailman says. “Some of their investors have been with them for decades, and they need to do what is right for their limited partners as well as their own firms.”

Eager to demonstrate a renewed sense of fiscal conservatism — and to ensure their own survival — private equity firms are now acting with restraint. After years of indulging in debt-fueled excess, raising record amounts of capital, paying inflated prices for companies, leveraging them to the hilt and then charging those same companies investment-banking-style transaction fees, they are seeking to prove to their limited partners that they can act more responsibly. The changing dynamic of partnership, and the accompanying shift in the balance of power between the best firms and their institutional clients, appears destined to reshape the private equity industry. Those firms that successfully differentiate themselves must also be able to engage with their portfolio companies to implement critical operational changes — vital efforts in an era of muted economic growth.

In many ways, the industry’s renewed focus on operational excellence is taking private equity back to its roots. Firms whose partners have direct operating experience can draw upon their insights to help their portfolio companies recover; those that built their businesses on financial engineering will soon begin to fade away. The industry is destined to shrink, and the shakeout is likely to be brutal.

“We’ve been through a period of time in which huge amounts of money were raised and everyone’s funds were bigger than expected,” says James Coulter, a founding partner of parent TPG. “Based on the low level of commitments now, we would expect to see a 20 to 30 percent decline in the total number of significant private equity firms across the industry.”

The shakeout has started. In 2009 private equity faced its worst fundraising year since 2004, with $246 billion collected by 482 funds worldwide, according to London-based market research firm Preqin — 62 percent less than the record $646 billion in 2007. Institutions that were once willing to invest have backed away from the asset class, stung by its lack of liquidity and the demands of meeting capital calls during a crisis. Megabuyout businesses like Blackstone Group, Carlyle Group, Kohlberg Kravis Roberts & Co. and TPG that easily gathered tens of billions of investors’ assets when credit was loose and leverage cheap may now find themselves among those firms challenged in raising new funds.

Many large U.S. endowments and foundations got stung twice in the market downturn: As the value of their public equity holdings plunged, their private equity allocations, which were not marked down as quickly, ballooned as a percentage of their total portfolios, causing a huge imbalance. But private equity losses soon mounted. Harvard University’s endowment, for example, plummeted 27.3 percent during the 12 months ended June 30, 2009, wiping out $10.9 billion in capital from the now $26 billion fund; its private equity portfolio fell even harder, losing 31.6 percent.

Investors’ pain was exacerbated by the private equity industry’s tin ear. Despite investors’ losses and liquidity problems, many firms persisted in making capital calls, putting their investors in a fix: For years institutions have relied on existing fund distributions to pay for new fund commitments. The financial crisis proved, however, that those distributions vanish when familiar market exits close. Under such circumstances, unfunded liabilities can become dangerous. Cognizant of the risk of future capital calls, and alarmed by the disproportionate amounts of loss-leading private equity in their portfolios, some U.S. endowments, including those of Harvard and Stanford University, explored selling huge chunks of their private equity holdings through the secondary market. Although few secondary sales were ultimately transacted in 2009, institutions have fundamentally altered their views of private equity — and are casting a gimlet eye at their other illiquid investments.

“Investors are rethinking their whole approach to illiquid investments, assessing the percentage they want to have invested on the ground relative to their uncalled capital commitments,” says Laurance (Laurie) Hoagland Jr., CIO of the Menlo Park, California–based William and Flora Hewlett Foundation, which has $6.7 billion in assets under management. “The numbers that people come up with in the end may be quite different, but I think those assessments will lead to some moderate reductions in the target levels that some institutions have to private equity.”

General partners who want the opportunity to raise future funds from their investors must now roll up their well-pressed sleeves and get to work helping their portfolio companies. They have little choice: Corporate debt loads reached unprecedented levels during the buyout boom. In 2007, the statistical peak of the buyout frenzy, 2,556 deals were done globally, worth an aggregate $658.9 billion, according to Dealogic and Preqin data. At the same time, leverage soared. Multiples of 6 times ebitda (earnings before interest, taxes, depreciation and amortization) were common, compared with leverage levels of just 3 to 4 times ebitda in 2001 and 2002, according to analysis by Partners Capital Investment Group, a Boston- and London-based private asset management firm. Not surprisingly, covenant breaches have become a real and present danger. So too are the lengthening shadows cast by “bullet” debt debentures, which were often used to leverage a company’s assets while postponing payment obligations to a future maturity date.

Just how much debt will come due across the corporate landscape — and when — is hard to gauge. Estimates vary across the industry. According to Standard & Poor’s data and New York–based hedge fund firm Perry Capital, the highest-priority leveraged loans in the U.S. will come due in rising multibillion-dollar increments during the next four years, peaking at more than $200 billion in 2014. But those totals only reflect first-lien loans, not the total amount of debt outstanding. More worrying still, Triago, a global private equity fundraising advisory group based in Paris, estimates that bullet debt debentures coming due between now and 2014 will ultimately total more than $500 billion.

“Private equity firms are already having difficulties because the banks are now calling them every day,” says Antoine Dréan, Triago’s founder, chairman and CEO. “They want to know how these reimbursements are going to be made, so there is a lot of debt restructuring going on.”

Given that refinancing debt is far more difficult and expensive in the wake of the credit crisis, some large buyout firms, like Permira, have come up with their own solutions. In 2009, Permira reduced debt across its entire portfolio by €4.5 billion ($6.2 billion), in part by buying back debt from lenders at a discount to relieve overburdened balance sheets — a solution it implemented for its troubled portfolio company Valentino Fashion Group, among others. “You have to make sure that your portfolio companies are protected,” says Charles Sherwood, a Permira partner with 25 years of experience at the firm. “One way is to reduce their cost base; the second is to reduce their debt.”

In addition to the debt challenges plaguing the industry, an enormous amount of still-uncalled capital remains outstanding across the private investment landscape: $1.1 trillion, according to Preqin — an overhang from the heady days of precrisis extravagance, when investors were plowing money into the asset class. Of that global total, some $508 billion is allocated to buyout funds, representing almost half of the entire private equity industry’s dry powder. Real estate funds have the second-largest share, with $187 billion still undrawn, followed closely by venture capital funds, with $159 billion. Infrastructure, mezzanine and distressed funds round out the list, with uncalled capital totals of $68 billion, $41 billion and $40 billion, respectively, according to Preqin. Most of the undrawn capital was committed in the peak credit bubble period of 2005–’07 and will need to be deployed fairly quickly unless private equity firms negotiate for extensions.

Whether this postcrisis period proves an advantageous moment to invest remains an open question, and opinions are decidedly mixed (see “Private Equity: Doomed to Repeat the Boom and Bust”). Some of the best-performing private equity deals were struck in the first two years after major recessions, when valuations were still relatively low. But this time is different. Despite the protracted recession, valuations are not particularly cheap. Equity markets rebounded strongly in 2009, as governments around the world pumped trillions of dollars of liquidity into the global financial system, and are now looking surprisingly rich. The added pressure created by so much uncalled capital clogging the industry will also help support higher valuations, no matter what the economic fundamentals, as private equity firms, racing to work their way through a record capital overhang and raise new funds, compete with one another on deals.

Making critical distinctions among private equity firms has never been more important. The industry’s leading investors, whether endowments, foundations, pension funds or family offices, are only too keenly aware of the challenge. Some, like Hermes Fund Managers, the £24.6 billion ($37.6 billion) London-based asset management firm wholly owned by the U.K.’s BT Pension Scheme, have used the aftermath of the financial crisis to make opportunistic acquisitions in the secondary markets at attractive valuations, enabling the team to gain access to desirable funds. Others, like $2.4 billion Carnegie Corp. of New York, are trading around, literally bartering unfunded commitments among their peers to reshape their private equity portfolios. A few institutions are even willing to go it alone and invest directly. The C$87.4 billion ($86.4 billion) Ontario Teachers’ Pension Plan, which has its own private investment group, Teachers’ Private Capital, is keen to bypass private equity firms entirely and act as its own general partner, buying companies and building its own portfolios.

“With 50-plus investment professionals here focused on private investments, we feel we can originate opportunities, complete deals and manage them ourselves,” says Erol Uzumeri, head of Teachers’ Private Capital, which made headlines in January when it announced an agreement to buy Canadian mortgage insurance business AIG United Guaranty Mortgage Insurance Company Canada (the second-largest private mortgage insurance provider in Canada) from its troubled U.S. parent company, American International Group, for an undisclosed sum. “I feel it gives us a greater opportunity to manage our cash flow — and, frankly, allows us to access some of these opportunities on a much more cost-effective basis.”

Although very few investors are ready to abandon private equity entirely, they are scrutinizing firms more closely than ever, eschewing those that rely on financial engineering in favor of those with operational skills. For the more risk-averse institutions, middle-market buyout funds hold renewed appeal; for the more adventurous, corporate restructurings and distressed-investment opportunities are drawing fresh attention.

The concept of partnership — if not the practice of it — has always been integral to the private equity industry, but it nearly vanished at the peak of the credit boom in 2007. At the time, top fund managers used their popularity to negotiate ever more favorable terms with their investors, boosting management fees, transaction fees and carried interest. As top funds became oversubscribed, even managers with less than stellar track records were able to raise larger funds — and larger fees. Inevitably, as fee revenue became increasingly important to all firms across the industry, alignments of interest between general partners and their limited partners decayed.

“Whole ecosystems were created around buyout firms because the economics were so lucrative — placement agents, lawyers, consultants — and everyone was paid premium prices,” says Stan Miranda, founder and CEO of Partners Capital, which looks after the interests of a number of endowments and foundations in the U.S. and Europe, including 11 individual colleges at Cambridge and Oxford universities, the Royal Academy of Arts, the Nobel Foundation and the Victoria and Albert Museum. “Shrinking private equity, and shrinking its fees, would bring some rationality and efficiency back to the industry, but it isn’t going to happen voluntarily.”

Change is possible under pressure, though, and investors are now working together to right some of the imbalances exacerbated by the credit bubble. In September 2009 the Institutional Limited Partners Association, or ILPA, a nonprofit organization dedicated to addressing the needs of investors, released a document detailing best practices for the private equity industry. At the top of the list were recommendations regarding governance, transparency and fees. Although the guidelines are not binding, general partners ignore them at their peril: More than 100 institutions, including CalPERS, CalSTRS, Hermes Private Equity and Ontario Teachers’ Pension Plan, have signed their names to ILPA’s document. The fact that such institutions felt compelled to support the ILPA principles, and one another, gives some indication of just how far the private equity industry had strayed.

“During the credit boom, private equity firms could potentially do quite well without actually generating great returns, and that was an imbalance that needed to be brought back in order,” says TPC’s Uzumeri. “With the involvement of ILPA, we’re now seeing movement in the industry to ensure better alignment of interests, particularly with regard to transaction fees — making sure that those are offset against the management fees so that they don’t provide a huge windfall for the general partners.”

Pressure is also mounting on management fees, which appear to be trending slightly downward in the aftermath of the credit bubble implosion. According to a survey released last June by Preqin, the largest private equity firms — those with funds of $1 billion or more — have cut fees, resulting in a 15-basis-point drop in the average management fee, from 1.80 percent for funds established in 2006 to 1.65 percent for 2009-vintage funds and those that were still being raised as of the second quarter of last year.

Limited partners are also concerned about governance issues. CalSTRS’s Ailman, who has been closely involved with ILPA, sees a particular need for private equity firms to empower their advisory boards, made up of their largest investors, to meet independently. He wants to see greater autonomy for these boards, much in the same way that the Sarbanes-Oxley Act of 2002 enhanced standards for U.S. public company boards and management teams.

“That is a key component we are asking for in the ILPA principles — that advisory boards be allowed to meet together without the general partner in the room,” says Ailman. “I think that simple addition would actually open up more honest dialogue.” Issues on the table for discussion at the advisory board level, he explains, would include such hot topics as how much fund capital should go into saving one portfolio company over another given the massive debt burdens that are weighing on so many of them.

“We need to be able to discuss whether some investments should be saved or some should be let go,” he says. “These are big-picture discussions that the advisory board should have.”

Downward fee adjustments and better corporate governance may not be enough, however, to assuage the pain of investors that put money to work in megabuyout funds at the peak of the credit bubble. Data analysis from Preqin indicates that more-recent fund vintages have suffered the greatest on-paper losses since the crisis began; buyout funds, which now make up 44 percent of the industry’s total invested capital, were among the most severely hurt. Megabuyout funds (defined as those with investable assets of at least $4.5 billion) raised in 2005 posted median internal rates of return of –2.5 percent a year through June 30, 2009, according to Preqin; funds raised in 2006 fared even worse, posting median IRRs of –19.3 percent. By comparison, small and midmarket buyout funds raised in 2004 onward significantly outperformed large and megabuyout funds of those same vintages, mostly because they don’t rely as heavily on leverage.

Although many of these funds are still in the early stages of their investment cycles and their returns could yet improve, experienced private equity investors feel dispirited. Some, like Miranda of Partners Capital, are concerned that the reduction in available financing for deals will force larger firms to change their focus and direct their attention to smaller, more easily leveraged deals. The heat of that competition, he fears, will keep valuations high for prospective buyouts and put increasing pressure on midmarket and even small-cap buyout firms, ultimately eroding their funds’ potential profitability as well.

“I already didn’t like megabuyout funds before the global financial crisis hit,” says Miranda. “But now I don’t know that I like middle-market funds or smaller buyout funds much better. Even those sectors, which are among the most attractive in private equity, are going to face this cram-down effect.”

Other investors, especially those who have exposure to the large buyout firms, are mystified by the relative inactivity in the wake of the market crash in March 2009, when valuations hit historic lows. Although 925 deals got done globally in 2009, down from 2,556 in 2007, the aggregate value of those deals plummeted 88.4 percent, to $76.4 billion, from the 2007 peak of $658.9 billion, according to Preqin. That lack of activity frustrates William Petersen, CIO of the Alfred P. Sloan Foundation in New York.

“At the beginning of last year, there were market bargains everywhere, but almost no money got invested by private equity in 2009,” says Petersen, who oversees an endowment fund of $1.6 billion, including $290 million in private equity. “When the bargains were there, they didn’t buy. Now some claim that there wasn’t enough leverage available, but they could have used equity and leveraged some of those deals later. But they didn’t. And that is my problem with private equity: Deal activity is the hottest when the markets are the most bubbly, because there is a lot going on, because there are a lot of deals to look at. And that is what private equity does best — look at deals.”

Among the largest pension funds and asset managers, however, the long-term attractions of private equity provide compelling reasons to invest, despite the recent market chaos. Susan Flynn, head of Hermes Private Equity, is still positive about the asset class, not least because the crisis is now allowing her team to differentiate more readily among managers. Flynn and her team have reassessed all of their managers — in some instances deciding not to renew commitments despite long-established relationships. Although Flynn is favorably disposed toward buyout funds, Hermes still has a lot of unfunded commitments to be drawn down in that sector, she says, so the team doesn’t anticipate making significant additional commitments in the near future. “We feel we’re well positioned in buyouts,” she says, “because we made relatively few investments at the peak of the market.”

Eric Upin, former CIO of Stanford Management Co. and now CIO for Makena Capital Management, still has a favorable view of private equity but is keenly focused on investing with smaller, more operationally skilled fund managers. Larger buyout firms, he fears, are due for another round of pain as government-fueled liquidity dries up. “We think that the large megacap funds that have used a lot of leverage are going to be challenged when we get to the exit strategy for all this liquidity,” says Upin, whose Menlo Park, California–based firm oversees $13 billion for endowments and foundations. “In the event that interest rates climb higher or deleveraging resumes, it will be very tough for them to refinance outstanding debt, which has already been refinanced and pushed out for three to five years.”

CalSTRS’s Ailman, who has 12.7 percent of his fund invested in private equity, has encouraged his team to take a step back and critically assess the relative importance and role of every illiquid asset class in its portfolio, from private equity to real estate. Although asset allocations are holding steady at the moment — and CalSTRS is fully invested in private equity — the fund does have the option of taking its allocation up to 15 percent if circumstances seem to warrant an increase. But for the moment, Ailman is cautious.

“We want to be an investor, not an asset allocation target chaser,” he says. “I really want to remove any percentage goal for private equity. I don’t want the team to feel as though they have to deploy a certain percentage of the fund; I want them free to pay attention to where ebitda multiples are. When those multiples are getting too high, they should really back away; when they are very low, then we ought to be aggressive.”

Few investors are in any doubt that the economics of the buyout industry have fundamentally changed. Private equity firms will have to work harder not only to make investments but to retain their investors’ confidence. Deal sourcing will have to be active, not passive, and a greater sense of partnership will have to be extended to private equity firms’ portfolio companies, as well as to their investors, if buyout firms are going to profit. The emphasis on old-fashioned value-oriented investing has not been lost on some private equity partnerships in the U.S. and Europe, like Boston- and London-based Advent International Corp., whose executives welcome it.

“Instead of waiting for Wall Street firms to pass the hors d’oeuvres platter of prospective deals around — and merely pulling something off it while it is being passed around to everyone — we’ve long been focused on sourcing deals independently by conducting deep industry sector analysis,” says David Mussafer, who oversees Advent’s North American deal group. “Making the right selection is always a key element of any successful investment, but we have another advantage: We are willing to get involved in our companies and spend time thinking as industrialists, not financiers.”

The power of taking an independent approach was proved last year in the depths of the equity market crash when Advent signed the single-largest deal in its 26-year history: an unusual, $2.35 billion joint venture agreement with Cincinnati-based Fifth Third Bancorp to buy 51 percent of the bank’s electronic-payments-processing business, Fifth Third Processing Solutions.

Initially, Fifth Third didn’t want to sell when Advent’s financial services team, led by Christopher Pike and James Brocklebank, first approached the bank in June 2008. Not even the implosion of Lehman Brothers Holdings in September 2008 changed Fifth Third’s mind. Only as the entire U.S. banking sector hit the wall in the first quarter of 2009 did Fifth Third finally, and somewhat grudgingly, agree to talk about selling FTPS to raise much-needed capital. As the bank’s stock bottomed out at $1.03 a share on February 20, Fifth Third and Advent discussed the deal.

“We wanted to be open-minded about it, so we offered to buy 20 percent of FTPS, or 40 percent, or more — whatever they wanted us to do,” says Pike. “It is fair to say that they were ambivalent about it, so we encouraged them to stay in the deal and keep a big stake, with the understanding that we would partner with them to grow the whole business.”

Despite having introduced the idea of selling FTPS, Advent still had to compete in a bidding process, but won the day, largely on the strength of the team’s relationship with FTPS CEO Charles Drucker — and its willingness to sign a deal quickly, “before all of the moving parts were nailed down,” says Brocklebank. The final deal, struck as a joint venture between Fifth Third, which owns 49 percent of FTPS, and Advent, which owns 51 percent, was announced on March 30, 2009.

The deal was one of the largest LBOs completed last year, at a time when many buyout firms sat on the sidelines and didn’t invest, despite the radical drop in equity valuations. The difficulty of gaining financing was an issue for many, but it should not have been an absolute impediment — Advent solved its own financing challenge by asking Fifth Third for a loan. The bank ended up providing $1.25 billion of the necessary $2.35 billion. Not surprisingly, the day after the deal with Advent was announced, Fifth Third’s stock rose by 17.7 percent, to $2.92. (By the middle of last month, it had risen to more than $13 a share.)

The great irony of the financial crisis is that while it opened up opportunities for some firms, like Advent, it stung others, whose managing partners moved too quickly to try and capitalize on the turmoil. Perhaps the most startling large-scale mishap was the decision in April 2008 by TPG Capital\ to participate in a $7 billion recapitalization of Seattle-based savings and loan Washington Mutual, injecting $1.3 billion into the deal alongside several other private equity firms and hedge funds. TPG and its co-investors clearly expected a market bounce, but it never came. Instead, WaMu’s loan book continued to deteriorate as subprime losses mounted, and on September 25, just ten days after Lehman’s spectacular demise, the bank was seized by U.S. regulators. WaMu’s shareholders, the largest of which was TPG, were all wiped out. The only winner in the aftermath was JPMorgan Chase & Co., which bought the bulk of WaMu for $1.9 billion.

In the wake of that humbling loss, TPG focused its intellectual resources on making sure that its existing portfolio companies could all withstand the crisis. Cognizant that the companies’ management teams were working in relative isolation in their respective industries, TPG organized a conference call and Webcast for its portfolio companies’ CEOs in October 2008, offering them a forum in which to share their concerns with one another. It was an innovative effort by TPG, which has long been more hands-off in its oversight of its portfolio companies, and founding partner Coulter was surprised by the response.

“We got incredible e-mails back from our CEOs, thanking us for the call,” he says. “They all knew that global financial conditions were bad, but they didn’t realize that they were that bad.” TPG’s portfolio company CEOs stayed on top of operations by reforecasting earnings regularly through 2009 as the private equity partners worked feverishly to address potential debt covenant issues and prepare for a difficult market environment. As a result, Coulter says, TPG’s portfolio companies grew ebitda last year, even as the U.S., U.K. and Europe struggled to break the grip of the global recession.

Now, TPG is back on the deal path. In late February news broke that TPG and KKR were teaming up to make a play for Morgan Stanley’s 34.3 percent stake in China International Capital Corp., one of China’s leading investment banks. Although the amount of the bid was not made public, several financial publications have estimated it to be in excess of $1 billion. For TPG and KKR, the advantage of working as a team on the acquisition is that it would help spread the risk, especially in an environment where leverage is scarce and pricey. Although KKR refused to comment on the deal, Coulter is sanguine about the opportunity.

“When you look at emerging markets, one of the best ways to play the emergence of these economies is through the financial sector,” he says. “We have been longtime investors in financials, particularly in emerging markets.”

Whatever the outcome of the deal for Morgan Stanley’s CICC stake, TPG is thinking creatively about extending the concept of partnership to other buyout firms as well as to its portfolio companies. Of course, consortia have always been a feature of the private equity investing landscape — their power to influence deal pricing is the source of not-inconsiderable controversy — but they can be especially useful in a market environment where leverage is hard to come by. Although financing is increasingly available, buyout firms still have to put up more equity for deals in the wake of the crisis: Average equity contributions in LBOs skyrocketed from a low of 33 percent of all funding sources in 2007 to 55 percent in the first six months of 2009, according to Partners Capital.

With leverage destined to play less of a role in driving future returns, operational expertise is once again in vogue. The gritty hard work of restructuring is familiar territory to veteran turnaround specialists like Wilbur Ross Jr., founder, chairman and CEO of WL Ross & Co., who has made a career of working with distressed and bankrupt companies. It has also attracted next-generation talents like Sion Kearsey, co-founder and managing partner of London-based Kelso Place Asset Management, which recently raised a new £100 million fund to invest in turnarounds and special situations. Neither Kearsey nor Ross expects a shortage of opportunities in the months ahead, as once-robust corporate entities, overloaded with debt and struggling to drive earnings growth, seek help.

“Yes, these companies will still need some sort of balance-sheet fix, but they will also need a fundamental business fix,” Ross says. “And not all financial sponsors are really equipped to deal with turnarounds — that is a threshold issue across the industry right now. Even if they were, though, turnarounds are almost by definition not as rapid an exit as those ‘wham, bam, thank you ma’am’ buyout deals, where you knew you could turn right around and pull the capital out.”

Kearsey, a former Goldman Sachs credit expert, has spent the past decade buying bankrupt and distressed companies for a few million pounds, then getting his hands dirty restructuring their businesses. Although his boutique firm is much smaller than Wilbur Ross’s, he is equally optimistic about the coming opportunities to invest in the U.S. and U.K. He expects new deals to be driven by the need for financial sponsors to invest fresh capital in struggling businesses. Some will, no doubt, but others, he says, “will simply chuck the keys back to the lenders and let them take control.”

But banks are not equipped to own great swaths of the British and American corporate landscape — their debt workout groups are already overloaded — which means that Kearsey’s phone has been ringing. For the 44-year-old Englishman and his team at Kelso Place, their unleveraged, disciplined approach is proving advantageous. Kearsey has little patience for those buyout firms whose partners indulged in the credit bubble excesses of 2006, 2007 and even 2008.

“The traditional piece of private equity — the fundamental focus on improving a company’s underlying business — just got lost over the past ten years,” he says. Operational improvements became irrelevant as debt multiples rose and market momentum carried prices higher. No one did anything for companies anymore, Kearsey argues, because there was no need to — asset prices increased automatically. General partners were able to turn around and sell a company in a year or two without making any significant improvements to its business practices. “Now,” Kearsey adds, “those LBO firms are going to have to work harder to improve their portfolio companies’ profits.”

Ernest Bachrach, co-head of Advent International’s Latin America group, expects to see a dramatic shift in the hiring practices of most large buyout firms as they retool for a changed investment climate. Many of the large firms hired a preponderance of financial professionals during the boom years, he says, and must now begin to right the imbalance in human capital if they are to profit from the industry trend toward operational improvement and fundamental growth.

“Buyout firms are going to have to repopulate,” he says. “They will have to get rid of some of their financial engineers and replace them with individuals who have actual production-line experience and operations expertise.” A few firms, he adds, have partners skilled in those areas, “but really not that many.”

The coming evolution in private equity will extend far beyond the need to simply hire new executives with experience on the front lines of industry, however; that shift is merely a manifestation of a broader and deeper cultural transformation being driven by the global investor community. Institutions frustrated by their private equity firms will translate their angst into action, rewarding general partners who are responsive to their concerns and realistic about the amount of money they can meaningfully deploy.

The future of private equity is not dismal by any means, but there is a sober new reality in play: Investors will be more discerning, and the effects of their decisions will be Darwinian. Those firms that cannot adapt will die. But once the flagrant excesses of the credit boom are finally burned away, the private equity industry will likely emerge with a renewed sense of purpose, profitability — and partnership.

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