The private equity industry suffered heavily during the financial and economic crisis. When the credit markets experienced a sudden reversal in the summer of 2007, risk aversion rose sharply and the loan securitisation market dried up.
Private equity funds had to accept substantial writedowns on the value of some of their portfolio companies; in the U.S. the price of leveraged loans in the secondary market fell by 35% at times relative to their value at the beginning of 2007.
Without being able to borrow cheaply, critics argued that the private equity business model would collapse. Of course this view was exaggerated. The typical private equity business model revealed that it still offered a few strengths even in times of crisis: These included the ample capital reserves that the funds had collected while times were good, the strength and quality of management expertise, and experience of restructuring.
The level of investment activity bottomed out in mid-2009. Since then both the number and volume of transactions led by private equity funds worldwide has been rising in line with the general economic recovery.
One striking aspect this trend is that the volume of buyouts contracted much more sharply and is recovering more slowly than the number of transactions. This is because business has shifted towards small and medium-sized deals, whereas particularly aggressively financed mega-buyouts have become much less common. Consequently, the average investment volume per buyout fell from over USD 200 million in the first half of 2011.
The appeal of private equity funds that are primarily invested outside the United States and Europe has grown in recent years. There is much enthusiasm for emerging markets as a response to the skeptical outlook for the developed markets. Attracted by high growth rates in the emerging markets, many private equity firms are allocating capital to these markets.
However, strong growth is not necessarily synonymous with great investment opportunities. Investing in a hot or even overheating market is risky because competition for investment targets can drive prices up to excessive levels. However, emerging markets offer a few particular investment opportunities that increase the range of transactions potentially available. Furthermore, private equity has so far achieved little penetration in most emerging markets, which means that there is further upside potential. China, for example, still has more than 20,000 state-owned or state-controlled industrial companies, whose combined assets represent some 63% of GDP.
The classic private equity business model involves acquiring badly run firms, implementing reforms and resolving any conflicts of interest and then the firms are resold mostly at a profit. The more a company is in need of modernization, the more value a private equity buyout can potentially add to its business. The average quality of management practices used in emerging markets (China) is in many respects still well below that in our markets.
Despite the fact that private equity investments are strongly influenced by the debt markets, I think investors can diversify their portfolios with promising private equity firms that are still not fully valued.
A firms such as KKR&Co (KKR) is positioned favorably in emerging markets and offers still an attractive valuation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.