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Private equity market disconnect hampering exit rates, says BDO

A disconnect between private equity houses and private equity-backed corporates has emerged and is hampering both exit rates and corporate growth ambitions which in turn could have serious consequences for private equity managers’ ability to raise new funds, according to corporate finance advisers at BDO.

BDO data suggests that private equity funds are walking a tightrope in relation to selling older investments and that a number of disconnects exist between corporates and their private equity partners, creating uncertainty for many management teams of private equity backed businesses.

Due to the economic downturn, private equity managers have delayed many planned sales of older investments and 72 per cent admit that the rate of exits in 2010 was low or too low. These delays contrast with the growing pressure to sell old investments since 86 per cent of private equity managers confirmed that achieving this was important when raising a new fund. In fact, 26 per cent said it would be critical.

Meanwhile, management teams are feeling the strain of delay, with 38 per cent saying that delays to planned sale dates has had an adverse impact on their growth ambitions for the companies they run. As a result, 46 per cent of private equity -backed companies now believe that a change in ownership would help accelerate growth.

Additionally, compared to last year fewer corporates now say they are behind target to achieve the original management buy out plans agreed with their private equity partners (from 60 per cent in 2009 to 43 per cent) while private equity managers remain unmoved (from 40 per cent to 38 per cent). This indicates that business performance expectations and objectives of each party are diverging and that private equity funds are walking a tightrope when choosing the optimum time to sell.

The disconnect is also underscored by disagreement on appropriate levels of debt in private equity-backed businesses. Private equity managers say that on average only 13 per cent of their investments are over leveraged compared to twice as many (27 per cent) corporates saying they had too much debt.

Growing businesses need capital and financing headroom and as 91 per cent of private equity-backed companies say they will be on a growth footing in 2011 (up from 56 per cent expecting growth in 2010), the demand from chief executives for more financing flexibility will add to the pressure to exit more quickly in the next year.

Alex White, corporate finance partner at BDO, says: “In the past, the private equity industry was often accused of being too focused on quick exits and critics would say this was detrimental for a business making long-term investment decisions. For many chief executives the reverse now seems to be true, with companies now feeling they have been owned too long by their existing private equity partner. Delays to planned sales are holding up growth and management teams are getting itchy feet.

“The bottom line is that private equity managers have been reluctant to crystallise low returns in funds by selling at a perceived low point, while many management teams are worried that without being released their companies will be held back from fulfilling their potential.

“However, the M&A market is much improved and a scarcity of sellers means company valuations have already recovered. Paradoxically this is supported by the private equity providers themselves. Eighty per cent of private equity houses want to accelerate the rate of new investments in 2011 and 60 per cent would be happy to increase valuations by ten per cent or more to close a deal. In theory this should support a stronger market for secondary buyouts in 2011, presenting an opportunity for management teams to re-engage in long term growth plans and for private equity houses to start to clear the exit logjam in their portfolios.”

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