Private Equity After the Downturn

8/12/2019 Private Equity After the Downturn

1/11http://executiveeducation.wharton.upenn.edu http://knowledge.wharton.upenn.ed

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WHARTON on...

Private Equity
http://executiveeducation.wharton.upenn.edu/http://knowledge.wharton.upenn.edu/http://executiveeducation.wharton.upenn.edu/http://knowledge.wharton.upenn.edu/


2/11Wharton on Private Equity 2009 University of Pennsylva

Private EquityAfter the Downturn

3The Coming Wall of

Refinancings: A Trial forPrivate Equity FirmsandTheir Portfolio Companies

Private equity faced a difficult environment in thewake of the recession, as credit markets worked

to absorb maturing debt from large leveragedbuyouts. Financial sponsors are scrambling to

prepare for the rash of refinancings set to come

to market in 2012, according to panelists at the2009 Wharton Private Equity & Venture Capital

Conference. Many firms have been focusing onportfolio company operations, exploring new

positions in the capital structure and consideringstrategic, synergistic transactions.

6True Turnaround Specialists Are

Poised to Survive in TodaysChallenging Private Equity Market

As the economic downturn forced an upswing

in bankruptcies during 2009, private equitybegan to turn away from traditional leverageddeals and toward investment in distressed

companies, according to speakers at the 2009Wharton Private Equity & Venture Capital

Conference. Expect a tidal wave of privateequity deals made in 2006 and 2007 to go bad

in the next few years, say specialists indistressed businesses. Also look for a sharp rise

in restructurings outside of bankruptcy court.

9India and China Offer Attracti

Private Equity Opportunities,but Without Majority ControlChina and India continue to offer highlyattractive opportunities for prudent privateequity investors thanks to their strong economfundamentals, which have helped them toweather the worldwide downturn better thanmany Western industrialized countries. Butsuccessful private equity investments in thelarge, emerging economies require carefulplanning and a regional presence in order toidentify lucrative opportunities, and to betteunderstand potential competitive threats.Learn more about PE investment in these

countries in this interview with Dalip Pathakof Warburg Pincus and Alastair Gibbons ofBridgepoint Capital.

THE WORLDWIDE ECONOMIC DOWNTURN HAS PUT UNPARALLELEDpressure on private equity (PE) firms, and the challenging times are likely to last

for the next few years. Deals that would have settled for about 15% in equity just

a couple of years ago now demand 35% to 40%, and as much as 75% for some

smaller buyouts. Perhaps most notable is the tidal wave of refinancings coming

due in 2012, which could test the survival of many portfolio companiesand PE

firms, too. This report outlines the key developments affecting PE and offers a

forward-looking view on possible scenarios in the sector in the years immediately

ahead, including in India and China.

2

Contents


3/11Wharton Executive Education Knowledge@Wharton

According to panelists who took part in adiscussion titled, Leveraged Buyouts:Strategies in Times of Turmoil, firms arefocusing hard on portfolio companyoperations, exploring new positions in thecapital structure and consideringstrategic, synergistic transactions.

Jack Daly, managing director of GoldmanSachs principal investment area, put thecrisis in historical perspective, noting that2007 and 2008 represent sharply different

markets. In 2007, the market was robust,with easy access to credit, liberal loancovenants, and the possibility of a $100billion buyout. By the end of 2008,everything was different. Today, wehave no credit market, he said. Lifehas changed. Buyout multiples havedropped, and deal volume is down 75%since 2007.

He pointed to an analysis by Ned DavisResearch of the ratio of credit to GDPover the last 100 years. Over most of thattime, the figure ranged from 140% to

160%, but it spiked to 265% before theGreat Depression. It rose to the highestlevels ever, more than 300%,approaching the current downturn.Returning to more natural levels willrequire high savings rates, inflation, or amassive markdown of bad debt, he said.

In the boom years from 2005 to 2007,private equity deals were completed withas little as 15% equity, leaving leveragedportions at a higher rate than in the 1980s

and 1990s. Since the economic meltdowthat began in late 2007, 35% to 40%equity has been required. For smallerbuyouts, Daly stated, the equity

requirement is 50% to 75%.

According to Garrett Moran, seniormanaging director at the BlackstoneGroup, the economy is experiencing thmother of all recessions, and the stockmarket (early in 2009) is effectively sayinthat the financial sector is bankrupt. Henoted that during the last big wave ofprivate equity financing, hedge fundswere flush and found it easy to leveragesyndicated products. In 2006, financialsector market capitalizations had doubfrom just a few years earlier. Looking

forward three or four years, he said, theindustry will have decreased dramaticalwith hedge funds no longer leveragingdeals with 90% debt levels. All thesecompanies will have to refinance into amuch smaller market. So were going tosee a world of distress.

Questions About Viability

Moran referred to a wall of privateequity bank financing that will mature in

Private equity faces

significant challenges as

credit markets try to absorbmaturing debt from large

leveraged buyouts.

Panelists at the 2009

Wharton Private Equity &

Venture Capital Conference

said financial sponsors are

scrambling to prepare for

the refinancings that will

start coming onto markets

in 2012.

The Coming Wall of Refinancings:

A Trial for PrivateEquity Firmsand Their PortfolioCompanies


4/11Wharton on Private Equity 2009 University of Pennsylva4

2012 and 2013. Because of this, privateequity firms must increase cash margins.Blackstone has been meeting with itsportfolio company management teamsand scrutinizing projections for 2009 and2010. In order to conserve cash, somemanagers are closing plants and trying tosell assets, he said, but asset sales aredifficult in the current environment.Blackstone is questioning whether

business models and assumptions areviable even after significant cost cuts.Moran added that companies areskinnying down, taking a strategic lookat their models. If a portfolio companysmodel requires cash early on to meet thepromise of opportunity later, you have toget rid of it.

Operational team meetings are being setto devise 100-day plans focusing onissues such as supply-chain managementand sales programs. Basically,

management teams are being told to barthe door. Take more severe actions,said Moran. One course of action, forexample, is to ramp up outsourcing.

Private equity firms, Moran predicted, willexperience a slow-motion period over

the next three to four years in which firmscan restructure, buy back portfolio

company debt, or take other operationalsteps to be all set to have handsomereturns when the refinancing hits. Somecompanies are approaching privateequity firms about partnerships, headded, noting that Blackstone created apartnership with Bain Capital and NBCUniversal to take control of the WeatherChannel, with NBC as the operatingpartner. When the dust settles, there willbe more private equity going into

corporate partnerships than corporatemoney going into private equity firms.

Peter J. Clare, managing director at theCarlyle Group, predicted that creditmarkets would remain expensive forclose to two years, suggesting it wouldtake at least that long for the bankingsystem to get its bad assets off the booksand recapitalize.

Relationships Mean Less

Buddy Gumina, a partner in ApaxPartners, said the changing credit picturewould have a major impact on privateequity portfolio companies. In the last fewyears, as the economy boomed, bankswere eager to lend. If a borrower had aproblem, the bank would fall back onrelationships and cooperate withmanagement as it worked through thedifficulty. Now, he said, relationships nolonger rule. In todays market, the

reasonableness is often gone and[lenders] are instructed to push as hardas possible to extract as much value asthey can.

Private equity firms are on the defensive.Gumina said that while the firm once

spent much of its time on dealgeneration, the emphasis now is on

operations. We have clearly shifted in avery, very organized way within the firm.We are looking at each portfolio companyand questioning the business model, thecash flows, and the ability to survive.

Gumina said Apax is preparing more thanever to take advantage of potentialconsolidation or investments fromstrategic buyers or investors, especiallybecause it expects economic conditions

to remain murky for the next 18 monthsWe would rather do something todayand shore up the capital structure thanwait until later when there are feweroptions. From a limited partner standpothey are looking for us to be thoughtfuland creative.

Returns are going to matter a great deain the near future, he added, because

when it is time to raise money again,limited partners will want to see how weprivate equity firms managed theirportfolio companies during the recessioOne solution could be capital injectionand also being very operationally involvin the businesses.

Daly said he, too, is concerned aboutthe large amount of private equity debtdue to mature. Its unclear to me howwere going to end up dealing with thatin 2012, 2013 and 2014. It sounds like along way away but its going to be here

soon, he warned.

Sharply Lower Prices

Gumina noted that all is not doom andgloom in the private equity market. Whbuyers would like to see higher prices t

help complete exit transactions, he saidat the same time prices are sharply low

for those interested in strategic acquisitio

Regarding the risk-return ratio, Clareadded, the debt market representsone of the best investment options. Hesuggested thinking about this market atwo buckets. One is the debt of healthycompanies returning 15% to 25%. Theother is the debt of distressed companthat could be purchased to gain controthe business or drive it into a

When the dust settles, therewill be more private equity going

into corporate partnerships thancorporate money going intoprivate equity firms.

Garrett Moran,Senior Managing

Director, Blackstone Group



restructuring. Such an approach willbecome increasingly popular, he said,though it is still early in the process. A lackof covenants and other mechanisms thatwould trigger default sooner is delayinginevitable restructurings. Given thematurities, this is going to continue for fouror five years at a minimum. Were in the topof the first inning in terms of restructuringand distressed-debt opportunities.

Forced divestitures will also provideopportunity, he said. Major companiesunder pressure, such as AIG andCitigroup, will need to unload desirablebusinesses. It will take a while for buyerand seller expectations to line up.However, the companies that becomeavailable to us will be at valuations thatare more attractive.

Moderator Curt Cornwell, a partnerin transaction services atPricewaterhouseCoopers, askedthe panelists which industries wereparticularly interesting for distressedinvesting.

Gumina pointed to the retail sector. Hesaid his firm is looking at retailopportunities even though the industrywas banged up by extremely weak

(Christmas) holiday spending. Wehave to be creative. There are nostraightforward LBOs to be done, butthere are ways we can come in to shoreup the capital structure or help buy acompetitor and achieve synergy. Its anarea where having a good understandingof the space will matter.

Gumina said his firm wasnt seeing much

opportunity in the health care sector,though it is considered a defensiveinvestment. The sharp decline inconsumer spending has extended toelective procedures. Uncertainty over thefuture of the industry under the Obamaadministration also makes health careless attractive, at least in the near term.Longer-term, he added, both retail andhealth care will provide opportunities forcreative, smart strategies because theyare undergoing dramatic change andbecause, in past recessions, the price to

acquire competitors has declined.Cornwell asked speakers about howfederal government efforts to revive theeconomy through the Troubled AssetRelief Program (TARP) and other stimulusprograms would affect private equity.According to Clare, TARP was a good

step forward, but he said confidencewould be critical in restoring economicgrowth. We have to stop the massivefear and panic. Massive bank failurecreates fear and panic, and thats wherewe were headed. The TARP may nothave been the most efficient way to goabout it, but those big bold steps hadto be taken.

TARP and financial stimulus programswould provide opportunities for privateequity to recapitalize and revamp thenations financial structure, he added. dont think the government can afford tdo it by itself and will need to create astructure that allows private capital tocome in and build up an equity base forfinancial institutions. He noted, howevethat the process of restructuring andselling off bad assets had not evenstarted. Its a bit early to jump in, andtheres no reward to being early.

A second opportunity will come inremaking the financial sector itself, Clarpredicted. Restructuring the industry wcreate opportunities for new businessmodels that people have not thought ofyet and put private equity capital behindnew financial businesses.


6/11

Private equity specialists in distressedbusinesses, speaking on a panel titledFrom Vultures to Saviors: HowDistressed Investing Is Helping to Shape

Tomorrows Economy, said they expect atidal wave of private equity deals made in2006 and 2007 to go bad in the next fewyears. Given the number of opportunitiesand the lack of bankruptcy credit, manyrestructurings will occur outside ofbankruptcy court and could result in swiftliquidation. Kyle Cruz, managing directorat Centerbridge Partners, explained thatduring the private equity boom, manydeals were structured with loosecovenants and too much debt.

John Caple, a principal at BaysideCapital, said the volume of impendingcredit defaults will make lenders moreinclined to restructure deals outside of

the bankruptcy courts, if only because itwould be impossible to work through allof the court systems cases in areasonable time frame. He said that if alender has 20 companies in a distressedsituation and 10 are making somepayment, the bank may ask the privateequity sponsors of those companies toput more into the deal rather than pursuethe company in court. It might not be theright thing to do, he said, but it is theright thing to do given everything elsethey have to do.

Panel moderator David Gerson, a partnat the global law firm Morgan Lewis, askhow distressed deals differ from traditionprivate equity transactions that are base

on leverage and the promise of unlockinvalue through operational expertise.

Michael Psaros, managing director atKPS Capital Partners, pointed out thatcash usually isnt available to leverage idistressed situations. Most of thecompanies that his firm looks at havemanagers who are catastrophic failuresand need to be replaced with newleadership, or a chief restructuring officeto begin to create value. Thats ourworld, said Psaros, who added that aft

As the recession took its toll in the wake of the global financial crisis and bankruptcies

rose, private equity started turning away from traditional leveraged deals and toward

investment in distressed companies, according to speakers at the 2009 Wharton Private

Equity & Venture Capital Conference.

True Turnaround

Specialists Are

Poised to Survive in

Todays Challenging

Private Equity

Market

Wharton on Private Equity 2009 University of Pennsylva6



20 years in the corporate restructuringfield he had never seen so few truecompetitors in the business. Thatsbecause it is hard. It is as differentfrom the traditional LBO model asyou can imagine.

Cruz pointed out another reason whydistressed transactions are often moredifficult to structure: A companys debt is

frequently controlled by many parties thatmay have their own agendas, anddistressed times can place more pressureon agenda differences. For example,lenders holding the primary debt may bemore inclined to hold out for a betterprice than those who took on debt in thesecondary market and are looking for aquick way to monetize their investment.

Top Lines Getting Crushed

Gerson asked how the panelists begin tothink about valuation, given that prices

have been dropping like a sharp knife.Cruz acknowledged that valuations arechallenging because it is unclear wherethe market bottom is, and it isincreasingly difficult to forecast the future.

Psaros agreed that with the expectationthat the biggest problem facing theindustry in 2009 and 2010 will be fallingdemand. He described how a senior debtlender invited his firm to look at a deal foran RV manufacturer. The companyproduced 1,000 units in 2008 but had noorders backlogged for the first quarter of

2009. What keeps me up at night? heasked. Its this whole catching a falling-knife concept. Were seeing top linesgetting crushed like Ive never seenbefore. No matter how much a privateequity firm paid for a company, he said,or how the deal is structured or how wellthe company is run, with revenue declineslike those at the RV company, it isimpossible to make money for investors.

Another problem, according to MichaelFieldstone, a principal at Sun Capital

Partners, is that vendors are no longer aswilling to prop up their customers. For thelast 18 months, he said, many companieshave taken it for granted that vendorswould extend generous credit terms tokeep their own products flowing. Ascredit markets weakened and financialfirms pulled back, eroding balance sheetsprevented companies from continuing toprovide cheap credit to customers. Theliquidation of Circuit City, he said, is anexample of a company that went underquickly primarily because vendors

stopped supporting the business.

The panelists stressed that in todaysenvironment, with little or no leverageavailable, a buyouts success depends on

operational basics. According to Caple,obvious, easy-to-correct problems mustbe present to justify keeping a companyafloat. In distressed situations, you are

finding businesses that are wildly undepromising and spending money in reallsilly ways.

Existing management is more likely to breplaced in a distressed situation than a typical buyout deal where the compahas positive earnings. Psaros said thatbefore his firm takes on a distressedasset, it often installs a chief restructur

officer to ensure that honest and competemanagement is in place. He said hisfirm pulls from a network of individualscan rely on for the job. KPS has a smalin-house best practices group, butappoints managers on a case-by-casebasis. Fieldstone said his firm, too, hasa pool of experienced former corporateexecutives that it draws on when anew management team is necessary.This is a tough business. Its not forthe fainthearted. This is complicated,and even more complicated with the

liquidity crisis.Psaros notes how, in many cases, amanagement change can drastically alta companys prospects. Sometimes awe have to do is change out a CEO andeverybody below him just blossoms. Othe other hand, we have literally had tofire everybody down to the shop floorlevel. Those two extremes are fascinatinHe warned against buying into stereotypabout the management style of turnarouspecialists. Most people assume that successful manager of a turnaround is

high-testosterone, chest-poundingprofessional. We have seen individualswith that kind of personality be successbut we have also seen bookish, cerebrand methodical managers be equallysuccessful. Theres really no pattern.The key to managing a turnaround, hesaid, is to develop a plan and stick to itday by day, to ratchet up expectations.Big-picture professionals have no placin a turnaround.

Obstacles to Exits

Even if a company can be restructuredsuccessfully, private equity firms faceenormous obstacles in exitinginvestments today, the panelists said.Caple explained that in private equitysboom years, investors could exit deals just a couple of years. Now the timeframe is more likely to be five years. So will see very few exits in the near future,said, referring to deals completed shortlybefore the credit crunch. The market to businesses is nonexistent.

In distressedsituations, youare findingbusinesses thatare wildly under-promising andspending moneyin really sillyways.

John Caple,Principal,

Bayside Capital


8/11

In the beginning of 2008, Fieldstonenoted, buyers from India, China and otherAsian nations did allow for some privateequity exits, but that was because thedollar was weak. Now, with a strongerdollar, at least for the moment, even thatexit door is closed.

According to Cruz, the private equitymarket is in the early stages of the

distress cycle after an explosion ofbuyouts that peaked in the summer of2007. Activity fell to more rational levelsin 2008, and then ceased in mid-September of 2008, when LehmanBrothers filed for bankruptcy. In this kindof macro-environment, by fall and for thenext 12 to 24 months, you will seeincreasing true-distressed situations atcompanies that are coming back tolenders seeking relief, Cruz said. Weveseen some, but there is a lot more tocome.

Karl Beinkampen, managing director atMorgan Stanley Alternative InvestmentPartners, predicted a bifurcation in thedistressed market. He suggested thatsome buyers could handle deals formidsize firms when they run into trouble,but it isnt clear who would step in to takeover the large companies that went privatein the boom years and that may fail tomeet loan covenants in 2012 and 2013.

The sharp economic downturn and tightcredit markets are likely to lead to

increased asset sales under Section 363of the U.S. Bankruptcy Code. Thepanelists outlined strategies for acquiringdistressed assets through bankruptcy.Sometimes it is best to take a toeholdposition in firms through debt to havemore say in the firms disposition, Caplesaid. Other times, it is best to stay on thesideline, especially as valuations fall fast.Psaros recommended basing strategy onthe distressed companys capital

structure. It is easier to do an out-of-courtdeal for a company with only one or twomajor lenders, he said. If they havewidely syndicated credit it is muchharder to get together to do somethingout of court, especially in theenvironment today.

At the heart of the problem are theartificially high levels of credit and

consumption in the last 24 months.Much of what we have been using forhistoric reference was fundamentallyflawed, Cruz noted. We all wish we hada crystal ball, but all we can do is beextra-conservative and wait.

While the downturn is likely to generateextraordinary opportunity, private equityfirms that, early in the crisis, stepped intopurchasing corporate debt at lowvaluations in the secondary market gotkilled as valuations kept on falling, Caplesaid. It is hard for a private equity firm to

go back into this market if it has beenburned recently. How do you step in andsay, Now is the time. I think it is, but itsa tough thing to say.

The industrys tone, added Psaros, haschanged dramatically with thedisappearance of young cowboysworking at hedge funds who rushedin and bought companies or their debtwith little due diligence and loads ofleverage. It was nuts what happened in2006, 2007 and early 2008 with these

hedge funds.

Longer Investment Horizons

Gerson asked the panelists to describethe future of private equity finance. Capleresponded that future deals will be all-equity transactions with an investmenthorizon of five to eight years, not therecently common three to five years.Psaros added that debtor-in-possession

financing now lasts only six months withan up-front fee, and sometimes anadditional exit fee, which he said is arecent development.

Gerson wondered whether difficultyarranging debtor-in-possession financinto carry companies until they canrestructure would result in increasing fsale liquidations, while Caple pointed

out that, despite the economicdownturns severity, lenders are notforcing as many companies intobankruptcy as might be expectedbecause they know debtor-in-possessiofinancing is hard to arrange. Many banare being extraordinarily patient now. Itbetter for them to hang out and hope itgets better. Even if the economyrecovered in two to three years, he saidthe distress cycle will take five to sevenyears to complete given the financialmarkets weakness.

According to Fieldstone, the economiccollapse may be good in the long runbecause it can clean out the overcapacand inefficiencies that had beengenerated, like a forest fire that needs happen. Investors have to be especiallcareful about selecting companies thisyear and next, he added, but goodcompanies should survive and reap bigreturns when the economy recoversbecause there is significant investmentcapital on the sideline.

Id be hard-pressed to say Im excitedabout the recession, Beinkampen saidBut in a Darwinian view, todays businesclimate will winnow out less-focusedprivate equity firms, leaving greateropportunity for those that survive.Private equity wont disappear becausof the restructuring, he noted. Buttheres going to be a lot fewer folksoverall, and that will be good for thebuyout business.




WPEC: Following the recent scandalsemerging markets, such as Satyam inIndia, have PE firms re-evaluated theirapproaches to developing markets?

Dalip Pathak: The Satyam scandal India is obviously very unfortunate. It washocking both in terms of the fraudcommitted and equally in the length oftime it took for the situation to bedetected. It was also one of Indiascompanies which was more exposed tointernational business and capitalmarkets; hence, one would haveexpected higher standards of corporatebehavior. This occurrence has obviouslymade investors more cautious and will

make them more demanding in terms otransparency, which in any case is good

However, one should remember thatSatyam is not representative of Indiancompanies at large. With regard to Indiasince the opening of the economy in1991, the country has seen hugeimprovements in both capital marketsregulation and in corporate governanceIn fact, based on my 10 years experienin the Far East and six years experiencin Europe, I am convinced that the top-

India and China Offer Attractive Private Equity

Opportunities, but Without Majority Control

Despite the recent wave of corporate scandals, severe declines in

local stock markets from their peaks and a challenging regulatory

environment, strong fundamentals in China and India continue tooffer some highly attractive opportunities for prudent private equity

(PE) investors. But to succeed, PE investments must be carefully

planned and fully supported with a regional presence in order to

identify attractive potential opportunities and understand

competitive threats to Western companies.

To learn more about PE investment in this region, members of

Whartons Private Equity Club (WPEC) recently interviewed Dalip

Pathak of Warburg Pincus and Alastair Gibbons of Bridgepoint

Capital about their views on PE investing in todays transformed

environment. Dalip Pathak heads Warburg Pincus London officeand is responsible for the firms investment activities in Europe and

India. Pathak is also a member of the Advisory Council of the

Emerging Markets Private Equity Association in Washington, D.C.

Alastair Gibbons is a partner at Bridgepoint Capital. He led

Bridgepoints United Kingdom business until 2001 and then its

German business until 2006. He now focuses on Bridgepoints

business development and cross-border investments.

An edited transcript of the interview appears to the right.


10/11

tier companies in India pursue highstandards of corporate governance,judged by international benchmarks.Even some medium-size companies inIndia compare favorably with similarcompanies in industrialized countries.The reason for this is very simple:Medium-size companies in India need toaccess capital markets because of thetraditional shortage of private capital,

whereas in other parts of the world,similar-size companies are often privatelyor bank-funded and can get away withbeing less transparent.

The capital markets impose higher

standards of governance on these Indianlisted companies. Furthermore, Indiancapital markets regulation today is of ahigh standard. However, while theregulations per se are of a high standard,enforcement has the potential to improvefurther. Despite this, Satyam and otherscandals have happened. But incidentssuch as Enron, Madoff and Parmalatprove that scandals of this sort happennot just in Asia. Rational and long-terminvestors should no more shy away fromAsia as a whole and India in particular

due to Satyam than they should fromthe U.S. due to Enron or Madoff. It isunderstandable if they are morecautious, and that is only appropriate.But the inability to put the situation inperspective will be unfortunate both forIndia and for investors.

WPEC: Given the dramatic decline inAsian stock markets [in early 2009], howhave you adapted your investment

strategy? Have valuations andmanagement styles adjusted to thosenew levels of growth?

Pathak: The decline in Asian stockmarkets has been sharper than that in theU.S. or the U.K. These markets areinherently more volatile because they arenot broad and deep, and their perceivedrisk is higher. That said, even at the peak

of the current crisis it has been difficult toidentify high-quality companies in Indiawhich one would consider cheap buys.Whilst GDP growth in Asia is currentlylower than in the past, in countries such

as India and China, growth rates are still

substantially positive, unlike the GDPcontraction that we see in Europe.

My suspicion is that the decline invaluations goes beyond a mere reflectionof the earnings potential of the corporatesector in Asia. Liquidity has been suckedout of Asian markets due to redemptionpressures in industrialized economies,and in most cases, this has penalizedvaluations disproportionately to theearnings potential or prospects ofcompanies. From a capital markets (as

opposed to an economic) perspective,emerging market equities have historicallybeen more volatile than developedeconomies markets because themarginal dollar (i.e., the dollar whichdrives near-term volatility) is typicallyhigh-velocity capital. That is, investorswho are seeking growth at reasonablevalue will reallocate capital to emergingmarkets when reasonable values are notachievable in the developed markets,

which is what happened in the late 199and in the mid 2000s.

As emerging markets begin to correcthis capital can go back home quiteabruptly, leaving the emerging markewithout a bid. This is a typical flightcycle. What happened this time arounis that volatility in developed marketsexceeded any precedent experience,

resulting not just in risk capital goingback home, but in its total capitaldestruction. So the redemption andmargin wave that struck hedge fundsand most high-beta capital after

Lehmans bankruptcy had a much mo

dramatic effect than during priorcycles. In fact, these precipitousdeclines in emerging market equitiestook place despite the underlying andrelatively favorable fundamentalperformance of the economies,financial system and individualcompanies in the respective markets

A key question now, since developedmarkets are still in significant disarray, iwhether emerging markets (especiallyChina and India, which both have

different, but very attractiveunderpinnings for growth) can developmore advanced sources of capital,perhaps even internally. This is importabecause liquidity from foreign flows migbe slower to return this time, yet there isignificant need for non-domesticsavings, at least in India, to support thehigh levels of growth in the recent pastManagement teams were slow torecognize the oncoming economic


Whilst GDP growth in Asia

is currently lower than in the

past, in countries such as

India and China, growth ratesare still substantially positive,

unlike the GDP contraction

that we see in Europe.

Dalip Pathak,Warburg Pincus


11/11

tsunami that hit in 2008. For example,there was a sense in India that thecountry was somewhat immune from theworld crisis. Furthermore, the severity ofthe global crisis was underestimated.However, by November 2008, mostIndian businessmen had recognized thatIndia would not go untouched, andsubsequently have been quick to reducecosts or take other measures appropriate

to the situation.

WPEC: Do you think there will be adistressed cycle in Asia that mirrors theU.S.? What factors limit PE firms abilityto execute LBOs [leveraged buyouts] inAsia, and how will those evolve?

Pathak: LBOs in much of Asia are rareevents. The reasons for this, particularlyin India, are fairly straightforward. MostIndian banks, relative to internationalbanks, have small balance sheets. Thereare strict central bank regulationsrestricting how much Indian banks canlend to any one company, and thisultimately controls the amount of debtthat any one company can have on itsbalance sheet, making the whole conceptof LBOs in India quite alien. Furthermore,Indian companies are typically founder-family owned or controlled, and Indianfamilies are disinclined to forego controlfor financial gain, even if the company isnot performing well, or if they can achievesuper-normal gains by divesting.

In Asia, this is very much a cultural factor,and unless this attitude changes, it will bedifficult for LBOs to thrive. In addition,most of Asia does not have the kind ofbankruptcy laws that exist in the U.S. Forthis and for other cultural reasons, you donot come across Indian banks foreclosingon companies or assets. They are moreinclined to try and reach settlement withborrowers. If this were not the case, wewould probably see the kind of disposalsand distressed asset sales that we see inthe West.

As Asian economies, including India,develop, we are likely to see the

emergence of bankruptcy laws, moreM&A and LBOs. In fact it is believed thatthere is a high likelihood that post theApril-May 2009 elections in India,bankruptcy laws could well beintroduced. This is desirable because thecurrent regime of regulation permits poorgovernance and inefficient use of capital.Worse still, it punishes the performanceof well-managed, high-quality companies

by keeping inefficient companies alivesupported by government banks or evenprivate banks.

The promulgation of bankruptcy laws willcreate a market for M&A andrestructurings which currently, though notnon-existent, is quite small. In conclusion,I think it is fair to say that the seculartrend is for Asian economies, particularlyIndia and China, to grow at significantlyhigher rates than the U.S. or economiesin Europe. The road will be bumpy on

occasion, because development is not aneat process. However, it is this verygrowth, together with occasionaldiscontinuities, that will continue tocreate unusual profit opportunities.

WPEC: How relevant are developingmarkets, such as India and China, to PEfirms traditionally focused on Europe?

Alastair Gibbons: The developingmarkets are becoming more relevant toPE equity firms with a European investingfocus. In evaluating potential deals or

portfolio company performance inEurope, it is important to understand howvalue is impacted by competitive threatsto European companies from thesemarkets and also the opportunities thatare available in India and China fromimproved commercial sourcing.

A secondary opportunity to develop saleschannels in those countries is alsorelevant, albeit much more difficult toachieve in practice. In the future, we alsoexpect more activity from Chinese andIndian companies looking to acquire

businesses in Europe. Consequently, aswe consider exit opportunities, we will

increasingly extend our net to Asia forprospective acquirers. As a middle-market European firm, we do notenvisage setting up a local team in thecountries to compete with local privateequity firms for local deals in the nearterm. However, for the reasonsmentioned above, we are likely toestablish representative offices toadd value to our portfolio companies.

WPEC: How have Western PE firmsneeded to adapt their investment stylefor the Asian markets? Which specificmarkets are most appealing and why?

Gibbons: Western PE firms have hato accept that acquisition of majoritystakes providing outright control isextremely difficult to achieve and, henchave had to shift their strategy to holdisizable minority stakes. The degree ofcontrol afforded is necessarily less and[therefore] more time is spent on goalalignment and relationship building witthe majority shareholder. The PE marketoday are largely growth-capital ratherthan buyout oriented, and less leveragavailable to be structured into deals. [Tmeans that] a higher proportion of targreturns must come from growth inearnings, either revenue-driven or costand efficiency-improvement-driven.

Regarding specific attractive markets,China and India are both interesting asthey offer enormous scale, strong long

term growth, burgeoning developmenta sizable consumer-oriented middleclass, low cost and an increasinglyeducated labor force. Furthermore, PEmarkets in these countries are stillrelatively nascent. They also presentmassive challenges, not least of whichare weak corporate governance regimeunreliable judicial systems and regulatoregimes, plus widespread corruption.Overlay on to that markedly differentcultures and a language barrier (for Chas well as an inadequate supply of weltrained or experienced managers, and conclude that market entry must becarefully planned and staged.
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Private Equity After the Downturn

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