Finding Optimism in the Private Equity and Venture Capital Markets
Much Shelist recently hosted a panel discussion titled "2010 Outlook: Private Equity and Venture Capital." After an unprecedented and troubling 2009, we were encouraged by the general sense of optimism shared by our panelists for 2010 and beyond. Leading indicators of deal activity in the private equity arena are up, and the number of venture capital deals grew significantly in the final quarter of 2009. Our panelists also pinpointed two important precursors to increased opportunity and deal activity in 2010: the amount of committed but uninvested capital and the ways in which many investors and portfolio companies have adapted during the economic downturn. In spite of these promising developments, concern still lingered about uncertain longer-term exit potential and the time required to return to a robust credit market.
A Difficult 2009 Gives Way to a More Optimistic Future
Not surprisingly, our panel agreed that 2009 was a difficult year, particularly for distressed companies that needed to sell and venture-backed companies that were raising a second or later round of funding. Companies unable to hold their financial ground found themselves in a buyer's market—facing lower multiples, buyer-favorable deal terms, extended due diligence and either delays in closing or an inability to close altogether. The panelists also noted an increase in the prevalence of sales under Section 363 of the Bankruptcy Code.
The panelists, however, were optimistic about deal activity in 2010 and provided recent anecdotal reports of seller-favorable terms for companies that were clearly succeeding despite the economic turmoil. One driver of expected deal activity in 2010 is an estimated $400 billion to $500 billion in committed but uninvested capital, combined with the fact that many funds are approaching deadlines to invest that capital.
The economic downturn has led some funds to restructure existing investments, whether to boost management morale, account for changing conditions or achieve a variety of other objectives. Securing advice from legal advisors with both transactional experience and a practical focus when counseling operating companies was highlighted as a critical factor in the successful and cost-effective implementation of such restructurings.
Lending Activity Up but Still a Long-Term Concern
Lending is critical to getting private equity deals done, especially in a traditional manner. Despite the challenges in 2009, the panelists observed that the availability of lending for private equity transactions is now on the rise. Although they raised concerns regarding future effects from the overhanging debt refinance market (including in commercial real estate) and possible government regulation, the panelists were cautiously optimistic about the lending climate in the latter half of 2010.
In this environment, creative approaches to capital structure are one way to combat a decrease in available senior debt. For example, investors that are able to purchase either debt or equity can provide subordinated debt in addition to equity to support capital requirements. Other strategies include back-ending payments through earn-outs, contingent payments and seller-financed notes. Rollover equity can also be used to plug a gap in the capital structure, including rollover equity with specified redemption terms. These creative approaches can form a bridge to the future, especially where buyers expect a portfolio company will support increased leverage in a future borrowing climate that is presumably more favorable.
Many of our panelists are anticipating a shakeout in the private fund market and agreed that fund teams with long track records of success are likely to suffer less (or possibly benefit) from this downturn. However, some sponsor teams will be unable to raise a next fund, and even those who successfully buck the trend may find that existing limited partners (including those with long-term relationships) may start from square one in their due diligence process when considering a commitment to a next fund.
Particularly for those raising a new fund, the panel noted the need to plan for an unpredictable future. One contingency plan for funds that are not generally seeking pension fund and other ERISA money but expect to make mostly qualifying investments, is to satisfy applicable portfolio requirements under the ERISA plan asset regulation starting with the first investment. This strategy would generally help limited partners who encounter unexpected distress in the future to transfer their commitments, with the fund's permission, in the secondary market, regardless of whether the transferee is governed by ERISA.
Our panelists noted that the trend of increasing government regulation is both a challenge and, for those companies that can adapt, an opportunity. Health care reform is clearly an area of broad interest, as is the recent HITECH Act, which extends to non-health care companies certain data security requirements and restrictions under the Health Insurance Portability and Accountability Act of 1996 (HIPAA). Other regulatory challenges that may also present opportunities relate to the Gramm-Leach-Bliley Act and the Red Flags Rule (which regulates the financial services and consumer credit industries), the growing body of federal and state privacy laws, and current uncertainty surrounding the estate tax system. If our 2009 experience is any guide, we may see pressure to close deals in 2010 if there is a threat of increased capital gains rates in 2011 and beyond. And, of course, given current proposals regarding tax rates and tax treatment (some of which could affect carried interests), experienced tax counsel will be necessary for structuring investments in this shifting tax environment.
Historically, funds raised immediately following recessions and other significant market downturns have produced substantially improved returns when compared with other vintage years. Predicting economic recovery is obviously challenging and multifaceted, but our panelists found encouraging factors and cautious optimism for 2010.