In 2006, the future of the private equity deal market looked bright. Halfway through 2007, the crash in the subprime mortgage sector sent ripples through the broader credit market, darkening the possibilities for many equity deals already in play. Now, as we approach the third quarter of 2008, the future for the private equity sector is difficult to predict.

The tightening of the credit market has clearly had an impact on the private equity sector, making it harder to finance new deals and close transactions drafted back in the days of easy credit. Financing for leveraged buyouts has not completely disappeared, however, and there are hints that investors may be willing to support new deals. But many investors are also concerned about changes that private equity firms have had to make to remain active in the current economy, claiming that equity firms may have moved out of their areas of expertise.

According to a report from financial services giant Citigroup, investment capital for leveraged buyouts is slowly returning to the market. "It strikes us that there is still an appetite for leveraged paper to be sold with respect to some of the larger LBO deals that still have not closed," stated John Fenn, director of high yield strategy at Citigroup. Fenn notes, however, that it will take some time for the market as a whole to get comfortable with new leveraged buyout issuances and that we will not likely see equity deals with the same high purchase price multiples that were seen in 2006 and 2007.

Private equity deals are still being done, despite the difficult credit environment, and investment banks are still offering capital. The Carlyle Group, for example, has secured a new $800 million financing commitment from Bank of America, Lehman Brothers, and Credit Suisse, which supports its $2.5 billion acquisition of McLean, Virginia-based consultancy Booz Allen Hamilton. Tygris Commercial Finance Group arranged $562.5 million in senior secured debt financing from Credit Suisse, Wachovia, Barclays, and SunTrust and $100 million from Wells Fargo to complete its acquisition of US Express Leasing from DLJ Merchant Banking Partners.

Still, deal financing can be difficult. Equity players seeking to close deals are finding today's credit agreements often come with more restrictive terms and harsher penalties for breaches of covenant. Smaller deals have an advantage because they require fewer investors. It is likely that the level of lending will increase in the middle market sooner than it will for billion dollar deals.

Private equity firms are adapting to the new economy, finding new ways to pursue deals. But one new strategy has investors worried. In order to find new acquisition targets, buyout firms are looking to new markets, moving away from the industries and deal structures they favored in the past. Equity firms still have money in their funds, but without easy access to investment capital to back it up, buyout firms are turning to alternatives such as investments in emerging markets, taking minority stakes in public companies, or buying debt off their portfolio companies.

TPG, for example, stated that it is changing the industries that it focuses on, moving from large, leveraged buyouts to "offthe-beaten-path investments." James Coulter, a founding partner at TPG, stated that the firm was "moving to financial services, pharma, and things we didn't do last year." The company, formerly known as Texas Pacific Group, is changing the types of deals it pursues, moving away from areas where credit is particularly difficult, in a process that Coulter compares to seasonal crop rotation.

The problem with this strategy is that many investors feel that private equity firms are shifting the focus away from their areas of expertise. With the credit crunch forcing equity players to consider new industries and smaller targets, there is the greater risk that comes from moving into unfamiliar territory.

When investors provide equity buyout firms with capital for deals, they are betting on a management team having expertise and experience in the industries and types of transactions they are pursuing. Before risking their money, investment firms consider the track record of the buyout fund. It makes sense for equity funds to seek new investment opportunities, particularly with large-scale deals difficult to fund in the current credit climate. Unfortunately, it also makes sense for institutional investors to question these new strategies.

Three quarters of institutional investors in private equity are worried that private equity fund managers will move into strategies or geographies that they don't know enough about, according to a survey by Coller Capital. The concern is particularly strong in North America, where 84 percent of limited partners see strategy drift as a risk to their returns.

Nevertheless, it is likely that investment capital will remain available to the private equity sector in the future. Of the investors surveyed by Coller Capital, 33 percent stated that they planned to increase their allocations to private equity over the next year, while only three percent stated they plan to reduce their level of private equity investment. According to the survey, investors believe that the most attractive opportunities for equity funds are in sectors with long-term growth potential, such as healthcare and technology, while sectors that carry greater risk from economic downturn, such as real estate and consumer industries, are considered less attractive.

Are there any reasonable predictions for the coming year? With large funds still available to be spent, private equity firms can be expected to remain active in the deal market. The equity sector may need to come to some agreement with institutional investors on what types of deals to pursue, although some equity players will also seek opportunities that require less leverage.

Sources: Coller Capital, Investment Dealer's Digest, Reuters

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