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Comment: Investors find favour with small buyouts as bank liquidity dries up

Sergey Bolshakov, analyst, Argo Capital Management, outlines evidence of a growing trend towards smaller buyouts since the onset of the credit crisis.

Despite the meltdown in financial markets there is little evidence to suggest that investors' appetite for private equity funds is waning. According to research produced by Coller Capital, at least 97 per cent of the investors it surveyed plan to maintain or increase their target allocation to private equity over the next year. Equity markets' lacklustre performance is encouraging investors to turn their attention to 2009 private equity vintages.

While there are some bargain buying opportunities to be had in a market slowdown, the buyout industry is equally realistic about the limitations of the strategy amid shrinking credit lines. As the appetite for leveraged loans dries up, the majority of investors expect the current crop of mega-buyout funds to yield a median net return of less than 1.5 times over the standard life of a fund. Conversely, investors believe that small buyout investments completed since the onset of the credit crisis are likely to outperform large and medium buyouts. According to Coller Capital, 41 per cent of LPs expect small buyouts to achieve a median multiple of at least two times compared with just 26 per cent and five per cent of investors expecting such returns from mid-market and large buyouts, respectively.

The trend towards smaller buyouts has already begun to take root with deal size across developed markets significantly falling. In the UK, total deal value for 2008 was down 58 per cent to GBP19.1bn, compared with GBP45.9bn in 2007, according to data from the Centre for Management Buy-Out Research. In turn, the average deal value decreased by 49 per cent from GBP68m in 2007 to GBP35m in 2008. The research cites bank illiquidity as the main reason for a fall in the size of buyouts.

Small buyouts are typically characterised as any deal which is less than EUR100m in value. While small, such transactions usually exhibit strong growth potential over a relatively short period of time. Historically, they have also been loaded with much less debt than mega and medium-sized buyouts, thus relying more on operational growth and less on financial engineering.

The investment case for small buyouts turns more compelling when identified within an emerging markets (EM) framework. An affluent middle-class, a rising number of highly skilled managers, low labour costs, increasing intra-regional trade and lower household and corporate sector leverage are some of the factors that make the EM pipeline so appealing.

The buyout space in EM is currently less crowded, which allows experienced GPs to cast a wider net and take advantage of opportunities in a less saturated market. GPs with a strong track record in EM and a local network of contacts are well placed to originate attractive off-market deals.

From the target companies' perspective, conventional financing channels are largely closed today, making private equity funds a popular means of financing growth and refinancing their debt. With demand for private equity funding on the rise, GPs are in a strong position to negotiate favourable terms on their investments.

According to results from a recent KPMG survey, the sweet spot for buyouts in Emerging Europe is expected to be in the <EUR100m space in the next year. By contrast, buyout deals in the mega (>EUR1bn) space are deemed unlikely by 80 per cent of respondents.  With LPs already indicating their intentions to increase allocation to small buyouts in EM, a growing number of PE firms will be keen to focus on small buyouts in emerging regions. This could pose an additional risk to LPs as a greater number of firms with little expertise in high-growth markets attempt to enter the space. Hence, GP selection and thorough due diligence are paramount.

While LPs are enthusiastic about the investment opportunities in small buyouts in selected EM, perceived risks are still significant in most cases. At least 93 per cent of LPs identified geopolitical risks as a significant obstacle to the growth of private equity in the Middle East, while 59 per cent cited regulatory and tax environment as obstacles to investing in China, according to Coller Capital's survey results.

Meanwhile, in emerging Europe, local private equity firms cite management issues and the legal/regulatory environment as being among the obvious risks linked to the region, according to KPMG. Such risks are typical of EM in general, although most of them can be minimised by a rigorous investment selection process, appropriate legal structuring, tight portfolio management and a keen understanding of local and cultural nuances. 

In a recession prone environment, there is also a risk that smaller sized companies could be affected earlier than larger companies. In such an environment, GPs should exercise particular differentiation and discrimination in their investment process. Investing at low valuations with no front loading are equally important elements in the negotiation process.

The financial crisis is bringing about many opportunities in the small buyout and growth capital space allowing GPs to take full advantage of 2009 vintages and profit over a relatively short period of time. However, thorough due diligence and sound value analysis and structuring will be highly instrumental to the overall success in EM private equity investing over this period.

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