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I moderated at a private equity
conference in London last week on the subject of what private equity
firms are doing with respect to exiting in the current business
environment. Even if you are not from the private equity industry, I
believe the subject is still of general interest, as it provides
trends on what sophisticated market participants are doing in an
often difficult market.
The following chart gives an overview
of exits for the European private equity industry:
Private Equity Exits in Europe, 2007 to 2011 Q3
Source, European Venture Capital Association, Index Q1 2007 = 100
The main points made
at the conference about private equity exits were as follows:
1.
Not all sectors and countries are experiencing downturns. Poland has
been the most robust market, thanks to its strong macroeconomic
performance vis-à-vis other countries. There have also been certain
sectors, such as IT and technology, that have performed quite well.
So there were still 160 private equity exits Europe-wide (*) in Q3
2011, the most recent statistics available – just to strategic
investors.
2. The number of firms written off by private
equity investors is also surprisingly common – also 160 firms in Q3
2011, Europe wide, in Q3 2011(*).
3. Most private equity
owners have postponed exits on a number of their investments. So for
example, whereas in the first half of the previous decade, the
average hold was only about 4 years (*), that number has no crept up
to 7-8 years for many PE firms.
4. As it his harder to grow
top-line revenues in many sectors of the economy, private equity
firms may hope that multiples improve over time; but hope, in itself,
is not a strategy. Many private equity firms are putting much more
emphasis on operational improvements to build value.
5. One of
the reasons for which it is so hard to exit in the current market is
the difficulty of giving performance forecasts. In many sectors, it
is very difficult to predict what will happen even in a
three-to-six-month horizon – the time it takes to move from a
Letter of Intent (LOI) to closing. In this type of environment, a
seller can either give a conservative forecast (which will greatly
diminish valuation), or provide a more optimistic forecast. If this
more optimistic forecast is missed, it will devastate the value of
the firm even more than under the former scenario, because it
destroys the credibility of management in forecasting performance,
even over the short-term.
One strategy for avoiding the risk
of missing budgets is to diminish, as much as possible, the period
between LOI and closing. For mid-sized companies, this might be
accomplished in 10-12 weeks, provided that there is an extremely
thorough advance preparation, which would include having everything
ready that an investor would want to have at their fingertips,
including a completed data room, perhaps even with a completed vendor
due diligence. Some competition in the process, to keep bidders
moving according to a preset time line, can also help prevent the
process from lagging.
In a nutshell, while the environment is
not easy for most private equity firms, there are some excellent
strategies to deal with the current situation. For those private
equity firms with capital available, it is generally a buyers’
market, and the diminished credit available from banks in most
countries means that companies generally seek more equity.
While
there is something of a shakeout happening in the Central European
private equity industry, this is not happening as quickly as some
pundits were forecasting in the months immediately after the Lehman
crisis. It is primarily those private equity firms that show a good
track record, even during the tough times, that will be more
successful at raising funds. There is something of a flight to
quality among those institutions and individuals who invest in
private equity funds. It will be even more difficult for new entrants
to compete against 10-15 years of positive track record.
My
prediction, therefore, is that over the coming five years, there will
be fewer but larger private equity firms active in Central Europe.
(*) Statistics provided courtesy of the
European Private Equity Association.
Just think: If more people were
financially literate, there might never have been a mortgage crisis
in the US, or a Swiss franc lending crisis in Hungary and other CEE
countries. While everyone certainly has their fair share of blame
with respect to the recent crisis – Governments could have
regulated better and financial institutions may have done better risk
management – ultimate responsibility for financial decisions still
rests with the individuals that make financial decisions at the micro
level. Hence the theme of this article is that financial literacy,
and therefore financial education, must be at the root of averting
future financial crises.
Financial literacy is not just required
for entering into loans, mortgages, but for other basic life
decisions such as how much to save for retirement, buy appropriate
types and levels of insurance, making appropriate investments, etc.
The US Financial Literacy and Education
Commission defines financial literacy as “the ability to make
informed judgments and to take effective actions regarding the
current and future use and management of money.” It is of
importance to virtually all parts of the economy – households,
businesses, farmers, and so on.
Lets look at some of the symptoms of
financial illiteracy in Central Europe today:
-
The vast number of households who
have taken Swiss franc loans in various Central Europe betrays a
lack of awareness of financial risks.
-
Huge segments of the population
are underinsured.
-
Huge segments of the population do
not save for retirement, lacking an understanding of the power of
compound interest.
-
People, like lemmings, tend to buy
stocks when markets are rising, and sell into down markets.
-
May households in Central Europe
invested the vast majority of savings into housing, often believing
that housing could not go down. Diversification of portfolio, and of
asset classes, is vital.
-
The lack of financial literacy,
sometimes even among owners of companies, surprises me. I have had
long discussions, for example, with a number of CEOs of major
companies who look at equity as free money, cheaper than debt.
Financial literacy may be likened to a
vaccination. If a certain percentage of the population is vaccinated,
a disease like polio cannot spread, and may therefore be eradicated.
Might financial education help achieve a similar result, eradicating,
or at least diminishing, the down cycle in recessions?
Do we have the level of confidence in
financial regulators that they will get the regulations right? And do
we have confidence in financial institutions to get their risk
management right? Without wishing to take anything away from such
efforts, are we not missing part of the equation, namely getting
people to make their own financial decisions in an informed and
professional manner? I would argue that financial literacy needs to
be part of the answer. The best protection is an informed consumer.
So how might we promote financial
literacy? While I encourage individuals to research on the web and
read extensively, there are also a number of government-sponsored
programs:
-
Many governments, such as in the
US, UK and Australia, have programs in place to promote financial
literacy (although I am not aware of any such programs in Central
Europe).
-
The Organization for Economic
Co-Operation and Development has extensively researched best
practices with respect to financial literacy in its member
countries.
-
A number of US states have made
courses covering financial literacy available in schools.
-
Australia mandated that its
schools must provide a curriculum of financial education, and
established a Financial Literacy foundation, and financed the
training of 2,000 teachers to teach financial literacy.
In short, at the micro level, financial
literacy can make the difference between a family prospering, versus
being financially wiped out. At the macro level, it can make the
difference between the growth or diminution of the middle class.
Possibly the rich get richer and the poor get poorer, as the saying
goes, because of financial literacy, or lack thereof.
As the author of this column, which
appears every two weeks, one of my missions is to help promote
financial literacy.
The chart below represents one of the most important charts for European financial markets in 2011, perhaps even for global financial markets*:
*Lou Basenese, Seeking Alpha
This chart may be broken into three phases:
In the pre-1999, pre-euro introduction phase, each country had its own interest rate on government bonds. Even before the euro became reality, interest rates began to decline and converge.
In the second phase, after introduction of the euro in 1999, it took just a year or two for interest rates to fully converge. For six or seven years, interest rates throughout the euro zone fluctuated together and were identical.
Finally, after Lehman went bankrupt in 2008, interest rates began diverging again and by 2011 had totally scattered. Notice that interest rates for countries like Germany went even lower, while Greece’s and Portugal’s interest rates jumped dramatically.
So what happened here? How does one explain the above chart?
In the first phase, rates converged because market participants believed that the advent of the euro would the risk of government debt for countries like Greece and Portugal. By the second phase, the complete concordance of interest rates (e.g. identical rates for Germany, Greece and Portugal) implied that market participants believed that the European Central Bank (ECB) would stand fully behind the debt of every country (e.g. even if there were a default in Greece or Portugal, the ECB would not permit investors to lose money).
After the Lehman debacle, interest rates diverged when it became increasingly evident that the European Central Bank did not have the monetary resources, and the German government did not have the political consensus or will, to save and hold harmless investors in bonds of all Euroland countries.
One might say that countries like Greece were “free riders” during the 2001-2008 period. Because their cost of debt was based on a false assumption, namely that the ECB and ultimately wealthier countries like Germany and Italy would come to the rescue, they could go on a borrowing binge, and not pay the full price of their profligacy. When their interest rates began to triple or quadruple, they entered a period of great financial distress, and wealthier EU countries had to come to the rescue.
The “scatter” effect has also been augmented by a diminution in interest rates in Germany, as investors in Europe and the world over have experienced a “flight to quality.” Demand for German government bonds increased, driving rates down.
The graph also underscores the importance of confidence of financial markets. The confidence of financial markets can make the difference between high interest rates or low interest rates on government debt, which in turn can make the difference between solvency or insolvency, where debt is denominated in a currency which a government cannot print (such as the euro).
So how do interest rates in Central Europe compare on 10-year bonds? The Czechs are doing very well at below 4% yields, the Poles are at approximately 6%, the Romanians at about 6.5%, and Hungarian yields have recently shot up to nearly 10%. (The above Central European yields are all in local currency).
A number of Central European governments would do well to reduce debt and otherwise restore a higher degree of confidence of financial markets. Take a hypothetical example: if reduction of national debt by 20% would allow a reduction of interest rate of 40%, the country would pay, over time, less than half of the interest it might otherwise need to before debt reduction and increasing confidence. (This is a gross oversimplification, because it neglects the effect of the maturity of loans – e.g. debt of governments is not at variable rates, but matures, and must be either paid off or refinanced).
You might ask, why are interest rates on government debt important for business owners? The answer is because government debt is typically the lowest interest rate applicable in that country – businesses usually borrow at a premium to government rates. There is also the possibility that government debt squeezes out private debt. In other words, the government absorbs so much capital from banks and other lenders, that there is little left for business. So every business owner has a vested interest in ensuring that government keeps their house in order.
Albert Einstein said that the greatest force in the universe is the power of compound interest. What we have seen over the past decades in US credit markets is compound, even exponential growth. In the chart below, the blue curve shows a perfect exponential curve, the red curve shows the actual level of US debt (in trillions of dollars).
A similar chart could be drawn for most of the developed world. Indeed, growth of money supply in many developed countries has also been exponential.
Note that from 1970 to 2008, there is an almost perfect match between US debt and an exponential growth curve. During this period, accumulating levels of debt acted like a steroid, powering the economy forward, contributing to rapid economic growth and rises in living standards.
Then in 2008, debt leveled off – see the squiggle at the end of the red line. You might say that the recession we are now feeling is caused by or correlated with cessation of credit growth (e.g. the removal of the steroid). We are experiencing withdrawal symptoms.
The trillion dollar question is: what happens to the squiggle at the end of the red curve? Let me present two scenarios moving forward:
(a) Governments hold debt under control (e.g. the red line might see dramatically reduced growth, level off, or decline). In this case, due to the cessation of credit growth, our economic growth (and hence consumption and standards of living) will stagnate or deteriorate.
(b) Debt returns to its old exponential growth pattern. This might happen if there is too much social resistance to deficit cutting, in which case governments may choose the less visible route of printing money and piling up debt through deficit spending. Steroids might make us temporarily feel better, but then we could be setting ourselves up for hyperinflation, possibly an eventual even bigger crash, as debt levels become even more unsustainable.
Is it possible for the debt binge of the past decades to end with a soft landing? If a narrow path between the two scenarios does exist, it would require consensus at the political level to find and walk that path. But political consensus seems to be giving way to polarization in the most important economies of the developed world.
The tyranny of the exponential curve – when applied to debt – is that as overall levels of indebtedness double every few years – it becomes increasingly difficult to escape the curve. If we do not escape the curve, and debt continues to double every few years, there are two basic scenarios: (a) if loans are denominated in foreign currency there is a default and collapse; (b) if loans are denominated in local currency, governments can print money and inflate themselves out of a debt problem, resulting in hyperinflation.
If we do bring our exponential debt growth under control, the removal of the constant stimulus of debt growth will result in a very different economic environment in the coming decades – certainly compared to the previous steroid-driven credit growth decades. Growth in the developed world would be much more moderate and standards of living would rise much more slowly, if at all – still better than default or hyperinflation.
