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Financial crisis set to reshape private equity industry, says Walkers

Despite the recent volatility within the private equity market, the industry’s longer term prospects remain intact, according to global offshore law firm Walkers.

Despite the recent volatility within the private equity market, the industry’s longer term prospects remain intact, according to global offshore law firm Walkers.

It argues that the financial crisis could leave the private equity industry transformed following a wave of consolidation, or completely reinvented with a brand new business model.

Some of the most popular asset classes for private equity in the next 12 months are likely to be infrastructure, emerging markets, and distressed banks, according to Walkers’ private equity team.

One sector that will struggle in 2009 is the secondary market, which has slowed down considerably since last year. In addition, the firm predicts an erosion of the hefty discounts currently available on senior debt, or debt which has a priority claim on the assets of a company.

"A number of factors point towards a more optimistic longer term position for private equity," says Richard Addlestone, a private equity partner at Walkers in the Cayman Islands (pictured). "Flexibility within financing structures should provide some refuge from current market difficulties for private equity firms.

‘While further weakness can be expected in the short term, there are hopes for a return to pre-credit crunch levels of investment and returns within 18 months. The silver lining is that, with asset prices at current lows, 2009 could be a great year for acquisitions, but first banks need to start lending to each other and to businesses."

In addition to good deals on assets, there are a number of other areas within private equity that present opportunities for investors, according to Walkers.

Heavy markdowns of between 40 and 60 per cent can currently be achieved on the cost of senior debt, although there is some risk if the underlying corporations that own the debt fail.

"These discounts are likely to be short-lived, so interested parties need to act quickly," Addlestone says.

Infrastructure funds, which have not been as severely impacted by the credit crisis, are earmarked for further growth in 2009, due to their role in bridging the funding gap in government budgets and their inclusion in some of the stimulus and job-growth plans of the new Obama administration.

The USD12.8bn bid to lease and operate the Pennsylvania Turnpike is a case in point. If approved by legislators, it would be the largest highway privatisation in US history.

"In the current climate, investors are responding positively to an asset class which offers both strong income flows and brick and mortar assets," Addlestone adds. "Infrastructure funds also fit in very well with the medium-to-long term horizons of investors."

Walkers says emerging markets will remain attractive to investors, although perhaps not to the same extent as in recent years since their growth is slowing, though not as quickly as other markets.

Interest in distressed banking assets by private equity participants and a desperate need for fresh capital from the financial sector has resulted in significant speculation about what role private equity might take in reshaping the post-credit crunch environment.

With some USD320bn of cash ready to deploy and private equity’s traditional strength in adding value and management expertise, struggling financial institutions are seen as particularly suitable investment targets.

"In addition to the regulatory obstacles which require significant investors in US banks to register as a bank holding company, the unfortunate events surrounding recent banking ventures from the likes of TPG in WaMu have made private equity firms cautious about investing in the sector," says Vicki Hazelden, a private equity partner with Walkers in the Cayman Islands.

Secondary market activity, where private equity investors can sell interests in existing funds and remaining unfunded commitments to the fund, has ground to a virtual halt. The large number of current sellers is in stark contrast to the previously competitive phase, where premiums of ten per cent on notional value were commonly commanded on sales.

"As a result of the credit crisis, certain over-allocated investors are looking to transfer their entire commitments in some funds. This clearly demonstrates what the industry is up against and how cautious investors are being," says Richard May, a private equity partner in Walkers’ British Virgin Islands office.

"Expectations of both buyers and sellers need to realign for the secondary market to begin functioning again, but there might be some bargains in the meantime."

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