A Tranformational Time for Private Equity

I made some remarks at an ACG Boston event last night, specifically about how private equity is now in a transformational moment. Not a transitional moment (bull market to bear market, up cycle to down cycle) but something more fundamental. Here is the Cliffs Notes version:

* I view the current buyout situation through the lens of what happened to VCs after the tech bubble burst. After all, talking to a buyout pro circa 2006 was just like talking to a VC circa 1999. Rock star swagger, what me worry, we’ve taken most of the risk out of a high-risk asset class.

* Since 2001, there has been virtually no market for VC-backed IPOs. For example, over 19,300 U.S.-based companies have received VC funding since 2002, but there have been only 351 VC-backed IPOs in the same period. There have been some ebbs and flows, but outsized VC returns were largely based on an IPO market that really hasn’t existed for nearly a decade. It is the primary reason why the median venture funds from 2002, 2003 and 2004 are underwater.

* The resulting VC market has been one in which the wheat has separated from the chaff, and there’s much more chaff. It’s been transformational, in that the typical VC is no longer going to succeed (which, among other things, leads to a different breed of folks entering the business). Winners must find new technologies/markets rather than glom onto cloned ones, and then spend more time with CEOs in the boardroom than with your partners on the golf course.

* For buyout pros, the transformative event has been the credit crunch. Like the IPO market (which buyout firms don’t rely upon as much as VCs do), it will have ebbs and flows over the next few years. But it will not revert to the 2006 insanity in (most of) your business lifetimes. And, with the absence of “easy in, easy out,” most buyout pros will not be successful going forward.

* Why widespread failure and mediocrity? Largely because today’s buyout market has grown on the backs of a new generation of buyout pros who have never been through tough times. I’m not questioning their toughness, but rather their experience. How many “new” buyout pros have ever really sourced proprietary deals, or focused more on operational inefficiencies than growth potential? How many have ever used the types of late 1980s/early 1990s debt structures that will now be required? Moreover, how many veteran buyout pros will want to do the hard work again, after years of easy money?

* Many will succeed, and will do so fabulously. But I fear most will not, judging by how few seem to have really done the math on their own portfolios vis-à-vis their hurdle rates. It’s not a pretty outlook, but it certainly is a transformed one…