Consistency the clue

Fortune has favoured private equity in recent years with low interest rates and robust economic expansion. Returns for top private equity managers have soared while those of the public markets have languished.

Now, with capital flowing in and prospects for a turn in the cycle in sight, the question becomes whether private equity’s outsized returns will hold up. Credit Suisse’s research suggests that the best private equity managers will continue to outperform corresponding public equity benchmarks and maintain strong performance.

Key drivers of recent returns

Examining the current market, four key factors have helped drive private equity’s recent robust returns:

* a broadening of the markets private equity players participate in;

* favourable economic and financing markets;

* improving acquisition pricing; and

* an evolving approach to investment management by the leading private equity firms.

We believe that analysing each of these areas offers insights into the factors that will shape future private equity returns.

Power in a growing footprint

First, the expansion of the private equity opportunity set has been facilitated by private equity’s growth along various dimensions. In the 90s, private equity was concentrated in a few core industries in the United States: financial services, consumer goods, retail distribution and industrials. Today, private equity is globalising. Transactions in the Americas, which accounted for 85 per cent of the worldwide total in 1994, had fallen to 65 per cent by 2005, according to Thomson Financial.

In that same period, investments expanded well beyond the original core industries. Private equity managers have gained expertise in a wider range of industries, while professional managers have gained an appreciation of the power of private equity to build their franchises.

In addition, private equity firms are raising larger funds and/or forming consortiums, which has expanded the market by enabling private equity firms to buy ever-larger companies. Despite this expansion, private equity fund transactions still represented less than 20 per cent of global merger and acquisitions (M&A) activity in 2006.

Second, the economic and financing environments have been excellent in the large private equity markets in Europe and the United States. Steady economic growth has provided good baseline company performance; however, big benefits have also come from a true ‘borrower’s market’. Interest rates have been very low and buyout firms relying on extensive debt financing have benefited greatly. Lenders have also been willing to make loans more freely, lending up to 70 per cent of acquisition prices versus closer to 60 per cent five years ago. The greater leverage levels clearly enhance the private equity fund’s return on equity.

The last piece of the leverage puzzle is that spreads for non-investment grade borrowers have dropped dramatically.

As a result of these factors, overall borrowing costs have dropped by nearly 600 basis points since 2000, putting financial buyers on a more level playing field with strategic buyers.

Favourable acquisition pricing

Third, M&A transaction valuations grew significantly between 2001 and 2005, rising from an average of 6.1 to 8.2 times earnings before interest, taxes, depreciation and amortisation (EBITDA). This factor alone created substantial returns, with an equity increase in value of approximately 10 per cent per year simply due to rising deal prices. Exits were not only higher priced, but easier to accomplish. With deal volume approaching US$22 billion, 2005 ranked as the second best year for buyout-backed initial public offerings (IPOs) in a decade. M&A activity rose from its 2002 trough to the level it achieved in 1998.

From cost cutting to business building

The fourth factor stands out as particularly important for the future: private equity managers have become smarter operators. Managing investments through a recession has caused private equity funds to focus on operational issues. More and more, successful investment demands a comprehensive strategy — one that places greater emphasis on operational improvements as a key source of performance.

To meet this challenge, the leading private equity firms have recruited seasoned executives from across the business landscape. The former chief executive officers of GE, IBM and The Gap and senior managers from companies like Target Stores, Nextel and Viacom now work in private equity. This speaks to the evolution of private equity managers from financial engineers to savvy business operators, willing and able to bring about lasting change in their investments.

In our view, this evolution represents the most significant development in private equity in the last decade. We think the transition it marks, from a philosophy of financial engineering or simple cost cutting to one of proactive franchise building, will figure importantly in sustaining private equity returns throughout the full business cycle.

The profit in tomorrow’s vintages

So how might private equity fare in a more restrained environment? We developed a model to look at potential returns, beginning by deconstructing the returns experienced in the current market. Those returns derive from three sources: the leverage from financial engineering; operating improvements in the business itself; and the multiple expansion that results from investing during a market low and selling at or near a pricing cycle high. In the recent past, successful private equity investments may have realised total five-year gross internal rate of return (IRR) gains in the mid-30 per cent range.

To arrive at an estimate of the levers driving those returns, we began with a ‘base’ return of 9 per cent, which represents the gain achieved by growing revenue and EBITDA at 5 per cent annually. (By deploying working capital more efficiently as it grows, an owner’s equity return can exceed its earnings growth.)

We then levered our model investment, financing 70 per cent of it with debt at an average cost of 7 per cent. That leverage adds another 9.4 per cent to returns. Through operational improvements, if we can boost annual revenue growth from 5 per cent to 7 per cent (causing EBITDA growth to rise to 10 per cent) and employ working capital more efficiently, we estimate returns will increase by an additional 10.2 per cent. Finally, applying a bit less than the most recent multiple expansion history, we could add another 7 per cent by buying into our model company at 6.5 times EBITDA and selling it off at eight times.

In creating a model for a less expansive future, we made the assumption that operational improvements function as an independent variable: good management is good management. We dialled down the amount of leverage available to 60 per cent and dialled up its cost to 9.5 per cent, closer to historic averages. We also built in a more modest .5 times multiple increase, which we believe possible when operational change improves earnings prospects.

Two factors stood out in this scenario. Not surprisingly, the returns did shrink. Falling into the low-20 per cent gross IRR range, they looked a good deal more modest than current returns, but they still outpaced the returns likely from public markets in the environment we forecast. Second, operating improvements assumed critical importance in the success of the investment. Under the first example, they only account for about one-third of the total gain. In the projected scenario, they account for the majority.

Our modelling thus anticipates the growing importance of operational expertise. While it means different kinds of gains from those we’ve seen in the past, it implies that well-run private equity funds can continue to outperform public benchmarks.

Sustainable outperformance

In summary, Credit Suisse’s view is that private equity returns will decline somewhat, but that the asset class will retain its appeal. While financing markets are likely to revert at some point to longer term averages, and acquisition multiples are more likely to contract than increase from here, operating sources of value creation remain easier to achieve. We feel that leading private equity managers can continue to exploit these other sources of value creation as the cycle shifts to a new phase. Investors, however, may have to exercise greater due diligence when investing in the sector.

Predicting manager performance is not easy, but history does provide a few clues. Manager returns do not revert to a mean. Evaluating private equity managers remains a complex task, but one critical to achieving good performance. The huge inflow of funds into private equity makes the task even more difficult, as successful managers raise extremely large pools of capital. These dramatically larger funds in particular may succumb to the temptation to pursue smaller gains.

Looking ahead, we anticipate investors will need to interpret these performance measurements against a changing market environment — one in which managers will need to excel in new areas, particularly operational capabilities.

For further information on Private Equity, please contact Simon Ford, managing director, Credit Suisse , on (02) 8205 4151 or via email at [email protected].

Issued by Credit Suisse Securities (USA) LLC (Credit Suisse). This article has been prepared for general information only, and should not be relied upon for the purposes of making investment decisions. While this information has been derived from sources believed to be accurate at July 2, 2007, neither Credit Suisse, its officers, employees or affiliates take any responsibility or provide any warranty regarding this information. All forecasts and estimates are based on assumptions that may change.