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Private equity executives confident about portfolio company performance

Senior executives from top private equity firms say they have essentially completed aggressive cost cutting within their portfolio companies and are confident about those businesses’ growth and profitability, according to results of an annual survey conducted by RSM McGladrey and McGladrey Capital Markets.

Many plan to increase hiring during the coming year, and most expect to turn much of their attention back to dealmaking.

This year’s survey polled 148 executives from buyout, mezzanine and venture capital firms during the first quarter of the year.

In a marked contrast from the previous year’s survey, PE firms have turned from an emphasis on cutting costs to a focus on growth – in some cases including staff additions. Almost one in three (31 per cent) forecast increases in staffing levels, compared to less than one in ten respondents (eight per cent) who expect staffing levels to shrink.

PE firms have reduced their involvement in day-to-day operations and areas such as human resources, information technology and purchasing; they now are concentrating on "big picture" issues such as strategy, lender relationships, finance and accounting.

"Last year, survey respondents told us they had largely suspended dealmaking and fundraising to focus on portfolio company performance – reducing employee headcounts, freezing salaries, improving business processes and reducing capital spending," says Bob Jensen, managing director with RSM McGladrey and a leader in the firm’s private equity practice. "But now they’ve made the difficult cuts and can focus on growth – whether organic or through acquisitions. We’re seeing PE firms returning to dealmaking, especially in the lower middle market."

This year more than half of survey respondents (56 per cent) expect to complete two to five add-on acquisitions in 2010, and almost half (43 per cent) plan on completing at least two or three platform acquisitions. Almost one in ten (nine per cent) forecast adding six or more platform companies to their portfolios.

While deal activity is expected to increase, raising capital and acquiring acquisition debt financing continue to be significant impediments to completing transactions.

"Raising equity capital is still challenging, largely because private equity, as an asset class, has suffered declining investment returns," says Hector J. Cuellar, president of McGladrey Capital Markets. "However, pension funds and other LPs are continuing to invest in private equity, with lower middle-market funds being the primary beneficiaries."

Other dealmaking challenges cited by survey respondents included sellers’ unrealistic valuation expectations (identified by 29 per cent of the respondents) and lack of attractive acquisition candidates (26 per cent). Cuellar is already seeing conditions improve and expects that to continue for the foreseeable future.

"As debt financing becomes more available, private equity buyers will be able to offer higher multiples, which in turn will attract more high quality sellers to the market," he says.

A significant concern among survey respondents is the relationships between PE firms and their investors. For example, more than three out of four respondents (76 per cent) are at least somewhat concerned about the implementation of claw back provisions; almost one in three (32 per cent) are very concerned. Moreover, 67 per cent of the sample expressed concerns about changes in management fees; 25 per cent said they were "very concerned."

In addition, more than nine in ten respondents (91 per cent) expressed at least some agreement with the statement "we are experiencing investor partner defaults and withdrawals," with 71 per cent indicating they "strongly agree" with the statement.

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