KUHN CAPITAL Wednesday, March 21, 2018
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Is the PE Model Broken?


Many private equity firms moved to the deal sidelines when the financial meltdown began, and many have stayed there. This is despite the oft-quoted fact that PE firms are sitting on big caches of dry powder, cash committed by limited partners that remains unspent. So whatís the problem?

Weíve had some undercover chats with partners at a few of the bigger firms, and this is the picture they draw:

  • Bank lending is still pricey and limited, constricting the PE firmís ability to get its necessary ROE. Most people donít think this situation will change for the better any time soon.

  • Problem children in the PE firmís portfolio consume time and motivate the firm to hold money in reserve in the event that more cash will eventually be needed to prop them up.

  • At the same time, the firm doesnít want to write off or write down these troubled portfolio companies since, by so doing, they would be forced into telling their limited partners the bad news. That kind of news doesnít bode well for future fund-raising efforts.

  • For several reasons, attractive acquisition targets seem harder to find these days. One reason is that the PE model is mature, with hundreds of firms employing thousands of analysts and cold-calling associates who constantly patrol various industries looking for deals. The business has become efficient and good deals are snapped up quickly (or priced up to the point of being a lot less attractive). The second reason is that with the recession continuing, few companies are generating top-line growth. In fact, in certain industries, there are only a handful of potential targets that are big enough, growing smartly enough, or that present enough opportunity for gains in operational efficiency. The recession has already motivated most surviving companies to cut excess fat.

    A few firm partners we know think these factors make the PE business unattractive, at least over the course of their careers, and as a result theyíre moving on. Theyíre the ones arguing that the ďPE model is broken."

    Others agree that the road ahead looks bumpy, but lending and the economy will eventually improve to the point where itís business as usual, albeit with some PE firm casualties along the way. So these guys are content to mind their sick portfolio companies, do the occasional deal, and collect their two percent management fee.

    We fall in the middle of this spectrum between the death of an industry and a return to the status quo. We donít see the model going away, but we certainly donít expect in the next 10 years to be entertained by the sort of high-priced mega-deals that characterized 2008. In fact, until the current over-supply of PE firms is reduced through Darwinian competition, and until cheap debt rises again (as it always seems to do), we think strategic buyers and sellers Ė not PE firms Ė will provide most of the deal action going forward.

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