It has been a challenging year for the private equity buyout sector. Deal volume is down, credit is scarce, dealmakers are nervous, and the economy is challenging. With money still in their funds, private equity buyers need to turn away from the giant deals of the previous year and find new investment targets.

The Wall Street Journal reports that the value of private-equity activity as a percentage of overall mergers and acquisitions deals has fallen to its lowest level in nearly seven years. For the year-todate at the end of September, global buyout activity was down 74 percent from the same period in 2007, according to data from Thomson Reuters. Global activity for the period in 2008 totaled $180 billion, a four-year low.

The decline in deal volume was greatest in the United States. At the end of September, buyout deals saw a 83.5 percent fall year-to-date, for a total of only $61.8 billion. Volume in Europe fell 61 percent to $70.7 billion and in Asia fell 25 percent to $18.8 billion.

Of course, comparisons to 2007 are tricky, since the private equity boom didn't end until last summer. Deals announced in the first half of last year included the $32 billion takeover of power company TXU Corp by Kohlberg Kxavis Roberts & Co., Goldman Sachs, and TPG Capital, as well as the $17.9 billion takeover of Clear Channel Communications led by Bain Capital and Thomas H. Lee Partners.

Lack of available credit is often cited as the major cause of the decline in leveraged buyouts. According to a statement in early September from Tony James, the chief operating officer of private equity giant Blackstone Group, the limit on bank financing for leveraged buyouts was about $5 billion. More recently, buyout executives have cited limits as low as $2 billion. Either way, to continue pursuing deals in the tens of billions, private equity buyers would clearly need to supply more than half the cash themselves rather than relying on credit financing.

Credit isn't the only factor limiting buyout deals. In the current economy, buyers are worried that the value of their target companies will decline. Afraid of paying too much, buyout firms are moving slowly and cautiously. Conversely, many sellers still have high expectations of their value, making it difficult to for buyers and sellers to agree on acceptable deal terms.

So what can buyout firms do? Many private equity firms are holding on to considerable capital, which they must ultimately use for deals or return to the investors that put money into their buyout funds. Taking advantage of the economic downturn, some buyout firms are buying up debt. Providence Equity Partners, for example, has recently acquired over $2.5 billion in credit securities. Another option is investing in distressed assets and financial assets that have been hard hit by the crisis on Wall Street.

The troubled banking sector is certainly an open target for investment. To encourage investment, the Federal Reserve has relaxed restrictions on investing in the banking industry. The new rules allow firms to own up to 33 percent of equity in a bank with minimal regulations. They also allow a buyout firm's representation to be up to 25 percent of the voting members of a bank's board of directors. Under the old regulations, a private-equity firm could have one director as long as its stake stayed below 10 percent of the voting-shares.

But the new rules will not necessarily lead to a rush on investment in the banking industry. Private equity buyers traditionally seek to acquire a controlling interest in their targets, which the new rules do not fully allow.

While the banks can definitely use the infusion of capital, they remain hesitant to allow outside firms, particularly ones with ties to commercial businesses, to have increased influence in the industry. Banks have fought hard to maintain the separation between banking and commerce, as seen in the industry's considerable opposition to Wal-Mart Stores Inc.'s plan to establish a limited banking charter.

It's difficult to see a clear path for the private equity buyout sector. Investment in distressed assets, smaller target companies, and the banking sector are ways that buyout firms can remain active, but they cannot be expected to generate the returns that the sector enjoyed when the economy was stronger.

Sources: Broadgate Consultants, Chicago Tribune, Reuters, Wall Street Journal