Turmoil creates opportunities for mezzanine investors

Peter Pfister was recently named the managing director of Asia-Pacific private equity at Deutsche Bank Private Wealth Management. Based in Singapore, he leads the private equity group's activities in the region and is responsible for origination, product development and supporting distribution for private equity investments. He shares with AsianInvestor his views about private equity and his outlook for the market.

How will private equity weather the current turmoil? Will the basic private equity model still work?

While the overall economic situation remains very challenging, we believe that the fundamentals for successful private equity investing remain intact: active ownership, full access to information, alignment of interests and a steady deal flow of under managed companies.

Given the long-term nature of the asset class and the influence private equity managers exert over entry and exit decisions, private equity is better positioned to adapt investment decisions to changing market environments. Private equity is one of the few asset classes that can thrive on the illiquidity that has caused significant problems for others. Private equity firms do not face the risk of investor redemptions, which means that they do not have to sell assets to meet fund redemptions, and it affords them the ability to step to the sidelines if market conditions are not attractive, and concentrate on improving the operations and profitability of existing portfolio investments.

Are institutional investors selling their private equity holdings?

It has been reported that a few large institutional investors such as pension funds, endowments and foundations are seeking to divest some of their private equity holdings in the secondary market. While this is true, it is not reflecting a general move to exit the asset class. Many sales in the secondary market are a response to liquidity needs, rather than an overall reduction of target allocations or an exodus from private equity as an asset class. As long-term investors, institutional investors need to continue to evaluate liquidity needs and rebalance allocations in light of the current financial crisis.

What are the prospects for private equity investing in the future?

Historically, private equity investments made during recessionary periods have delivered the best returns despite significantly reduced leverage. We believe that 2009 and 2010 will likely follow this pattern. Undoubtedly, leverage contributes to returns, but the notion that the highest returns in private equity are achieved primarily through leverage is misplaced. A study conducted by Boston Consulting Group in February 2008 shows that more than 50% of the value created by private equity firms came from improved sales and profit margins. Less than 25% came from the magnifying effect of leverage and a similar amount came from a rise in valuation multiples between purchase and sale.

Going forward, many deals will be done with little or no debt initially. These transactions can still deliver superior returns as a result of low entry prices which are expected to more than compensate for lower leverage and higher financing costs. The combination of low valuations and low levels of leverage could translate into transactions with improved risk-reward profiles relative to those before the credit crisis.

Which private equity strategies are taking advantage of the current turmoil?

The current dislocation in the financial markets has created compelling opportunities for distressed and credit-driven, and mezzanine, investments. In the current market environment there is an unusual opportunity for mezzanine investments to generate equity-like returns by taking credit risk. Because of the scarcity of subordinated capital and the shift in negotiating power from borrowers to lenders, many current mezzanine transactions are priced to generate equity-like returns of 18% to 25% per annum.

As in the past down cycles, we expect a significant supply of distressed investment opportunities over the next 12 to 24 months, driven by an increase in default rates, significant corporate restructuring, and turnaround activity which typically accompanies periods of economic weakness.