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Private equity firms escape credit crunch heat

With the sub prime mortgage loans crisis threatening to cripple some of the biggest companies in the world, can the …

With the sub prime mortgage loans crisis threatening to cripple some of the biggest companies in the world, can the private equity groups escape the brunt? The answer is a big yes – at least for those into real estate business.

Industry reports reveal that PE firms, especially those into real estate have dramatically escaped the impact from the financial crisis and are doing some brisk business mostly – unaffected and unfettered. According to a survey by Ernst & Young, Private Equity firms have been successfully raising the capital at a very robust level. “Capital flows to the sector are expected to increase or at least remain at the same robust level through the year and for 2008, a report published in Costar.com said quoting Ernst & Young findings.

“Despite the white-knuckle atmosphere of the credit crisis, it’s still a heady time for commercial real estate, and especially for private equity fundraising,” the report said. According to Ernst & Young, Beacon Capital Partners LP is believed to be quietly raising capital for its sixth vehicle in a series of investment funds that has raised more than $8 billion in capital over the past nine years.

Ernst & Young survey further reveals that real estate private equity funds raised $23 billion in the first half of 2007, and an additional 35 funds with targets of about $35 billion are in the process of fundraising. In 2006, $38 billion was raised. Another notable fund that closed recently is a $3 billion vehicle raised by The Carlyle Group, Carlyle Realty Partners V. “And there are more than a few heavy-hitters out there still raising capital,” Costar.com, the portal dedicated to providing information on commercial real estate said.

Industry estimates, according to Harris Williams & Co, show that private equity groups raised a record $197.6 billion in capital in 2006, compared with an average of $62.9 billion raised in each of the years from 2001 through 2005. “When combined with leverage, private equity groups have more than $757 billion in buying power. Private equity groups continue to aggressively pursue strong assets, and corporations are seeking out M&A opportunities to grow their business more rapidly than they could achieve through organic growth,” Tiff Armstrong, a partner at Harris Williams & Co., an M&A advisory firm told CE Online.

Financial experts attribute individual companies desire for PE funds to meet their financial requirements as the reason behind the minimal impact on PE fundraising. According to them, companies view PE group as an easy source of money for their financial needs and in turn these companies are a good business potential for the PE groups. There is a lot of business potential for PE groups in terms of financial requirement from the cash starved companies, say experts. “M&A continues to be a key strategy for corporations, and private equity represents an important source of growth capital and exit opportunities for mature investments and non-core assets. As long as companies continue to perform and there is health in the overall economy, we expect to see this trend continue,” says Armstrong. He says that the default rates in the sector over the past 3 years have been less than 1.5% and earnings remains solid.

In yet another strong case of defiance to the credit turmoil, figures from Probitas Partners, this September, have indicated that private equity firms are raising funds worth $540bn, suggesting further that the industry is ignoring fears about the credit crisis. Among the 537 funds coming to market in the next 12 months are ‚¬10bn ($14.5bn) funds from buyout firms CVC Capital Partners and PAI Partners, according to placement agent Probitas Partners. Both are significantly larger than the previous funds, at ‚¬6bn ( $8.7bn) and ‚¬2.7bn ($3.9bn) respectively, and are the largest from European firms.

A private equity intelligence report quoting Probitas figures, said that US private equity firm Kohlberg Kravis Roberts was targeting $28bn in three funds, while Apollo Management is seeking $15bn for its latest vehicle.

According to experts and bankers, private equity was well-placed to raise funds because the credit crisis would force down asset prices for purchasers, leading to higher returns on exit. Mounir Guen, chief executive of private equity firm MVision, said the industry took the credit crunch in its stride. He said: “The credit crunch has had little impact. Most firms and investors predicted and prepared for it, so it came as no surprise.”

However, since October and in the third quarter, there has been a drop in the PE fundraising. Private equity fundraising in the third quarter slowed to a relative trickle as 136 funds held final closes totaling $91 billion, the lowest level in two years for the corresponding period, according to Private Equity Intelligence. The 3Q figure, while still healthy, is nearly 50% below the $177 billion raised in the record-breaking second quarter. Preqin says the bigger concern is the fact that the number of funds closing dropped about 30%, indicating PE funds are having a harder time reaching their goals.

The mid-market, defined in the report as deals between ‚¬160m ($234m) and ‚¬1.65bn ($2.4bn), was the only segment to see both an increase in volume of transactions, from 41 to 49, as well as an increase in value from ‚¬23bn ($34bn) to ‚¬26.5bn ($39bn) and represented over 60% of the total by value, the PE Intelligence report said.

PE experts believe that despite an impact of the financial crisis on PE firms, there’s not much to worry about. With the increased cost of completing leveraged transactions by at least 200 basis points, experts feel that some transactions might not be completed, but those that fail, will be deals which were either too leveraged or places where the fundamentals were questionable. “Ironically by pulling the worst deals out of the pipeline, the credit markets are doing the private equity markets a favor. The `black eye’ associated with failing to get a deal done is much less painful than the `black eye’ associated with a large failed deal in the portfolio,” says Robert Crants, a private equity analyst and a managing partner and co-founder of Pharos Capital Group.

He says that by weeding out the worst deals, returns on private equity returns should improve in the out years. “For the deals that do get done, it is certainly possible that returns decline, as more equity may be required or actual costs of debt exceed projections, but except for the most highly leveraged deals, these costs should be manageable,” he says adding that the associated collapse in the equity markets is similarly a mixed bag. He says that the collapse might accelerate the exits and reduce the likelihood of some dividend recap transactions that pervaded the market for large deals the last couple of years; but prices for new transactions will be lower, and the market will ultimately stabilize and normalcy will return soon. “The impact, therefore, will be short-term for some transactions in firms’ portfolios, non-existent for others, and positive for new deals. All-in-all not much to worry about,” Bob Crants remarks.

For Tiff Armstrong, the current contraction in the credit market is an issue of supply and demand, and will work itself out over the next several months. “Private equity groups have large sums of capital that need to be put to work and continue to seek out quality assets. Furthermore, deals below $1 billion in value have been insulated from the credit contraction and we have seen continued strength in our firm’s middle market deal flow,” he says.

Armstrong however, points out that while larger deals getting more capital market support might take 4 – 6 months to work through the backlog, the middle market deals continue to get done at historically attractive levels. “More traditional lenders and structures are returning to the market and more club deals are being structured,” he says.

Cindie Jamison, a partner and national director of CFO services, Tatum, an executive and business consultancy services firm says that while the credit crisis and the increasing interest rates make the economics of a private equity harder, but there are many factors involved which can make a difference. “The size and wherewithal of the PE firm, the timing of anticipated exit, all these factors explicitly aim to minimize the impact,” she says.

Financial Times reported that PE deals have gone a bit slow but are far from out. Quoting deals such as Hellman & Friedman and Goodman Global, Bain Capital’s September 29 $2.2bn acquisition of 3Com and the Clear Channel Communications by Bain and Thomas H.Lee Partners, FT said that these new deals are a clear ­evidence that, for all the dire ­predictions of the ossification of the private equity machine, it is in fact alive and well and doing what it was designed to do: invest money in ­creative ways, seek outsize returns and collect fees.

According to Armstrong one stop lenders such as Allied Capital and American Capital Strategies are capitalizing on their ability to fund the entire capital structure without syndication concerns. While debt pricing has increased 100 – 125 bps and terms have tightened, experts predict that the middle market deals have no concerns as such.

“Between July and September, despite contraction in the debt market, Harris Williams & Co. closed 16 deals, demonstrating that corporations and private equity groups continue to remain active,” says Armstrong.

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