Private Equity

By nearly every measure of market activity, 2009 has been a challenging year in the private equity market: Fundraising is down over 60%, investment pace is down 67%, distributions are down 60% and returns are down 20%. Faced with the tremendous public market volatility of the past year, many investors have revised their approach to illiquid private equity assets and will likely place more scrutiny on the quality of their private equity relationships going forward. We believe the fundraising challenges of the past year will persist in 2010 as limited partners continue to drop underperforming managers in favor of proven teams with tangible ability to drive operating improvements in acquired companies. Venture capital and buyout firms with incomplete teams, out of favor strategies and limited track records will be particularly impacted by this ongoing shakeout. While we expect private equity fundraising to rebound from the cyclical lows of 2009, total new commitments are unlikely to reach even half the peak levels set in 2008 and capital will be more concentrated with the most proven firms. This development ultimately portends well for long-term private equity returns and sets the stage for limited partners to secure more investor-friendly terms from general partners.

We expect to see leveraged buyout activity accelerate in 2010 as a more robust leveraged loan market returns and strong new issuance in the high-yield bond market continues. Stabilizing credit markets will also allow buyout firms to begin addressing a key investor concern – the refinancing of massive debts issued in 2006 and 2007 to finance very large leveraged buyouts. Considerable progress has been made on this front as buyout sponsors use an array of tools to chip away at these debts.

With regards to attractive private equity opportunities, in 2010, we believe new leveraged buyouts will feature attractive pricing relative to historical cash flow multiples, but with more conservative debt financing of generally less than 5.0x cash flow. Investors will also have greater ability to influence capital structures to their advantage, including liquidation preference and other structural downside protective features. Given that buyout sponsors were quick to address bloated operating costs at the outset of the downturn, we believe buyout portfolios are generally well positioned for profitable growth in a recovery scenario.

After a decade of underperformance, the shakeout of marginal managers in the venture capital space is well underway. Many venture firms will be unable to raise new funds during 2010 and will begin the long process of exiting the business. Given the scarcity of quality early-stage investment opportunities and the sensitivity of venture capital returns to capital inflows, we believe this is a healthy outcome. However, the low frequency of profitable exits will remain a problem for venture capital as there are few signs that the IPO market will stage a major recovery in 2010. In this environment, we believe some early stage venture capital firms will migrate their focus to later stage companies, effectively taking later stage risk at early stage valuations.

Despite the well-publicized liquidity crises of several large limited partners (particularly certain university endowments and financial institutions), the secondary market opportunity has not materialized as fully as we had expected. However, we believe that the enormous bid-ask spread that kept sellers on the sidelines during 2009 will narrow in 2010 as a handful of secondary specialists look to deploy very large funds. As an opportunistic secondary buyer, we will continue to take advantage of select opportunities to purchase quality assets at deep discounts to fair value.