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Private equity funds that raised pools of capital from limited partners in the 2005 – 2007 timeframe are sitting atop approximately $260 billion in uncommitted capital or known in the industry as “dry powder.” There is tremendous pressure on the private equity firms to deploy this capital into transactions or be subject to returning it to their limited partner investors. It is expected that private equity funds are going to face tough competition, rising prices, reduced leverage, but this is still a better alternative than returning capital to investors.

When raising capital for their funds, private equity firms generally agree to invest the capital within five years or return it to investors. Returning capital to investors, also includes returning some of the management fees that the fund’s general partners have previously earned. Investors agree to tie up their capital for ten years, with all the money invested within the first 3 -5 years. For some US private equity funds the deadline to deploy uncommitted capital is rapidly approaching. It is estimated that US-focused private equity funds have approximately $51 billion that must be invested before the end of 2011 and approximately another $213 billion that needs to be invested by the end of 2015. In fact, some private equity firms are attempting to modify their limited partner agreements to give them more time to search for quality companies. Many private equity funds are rushing to invest at almost any price.

Historically, private equity funds have been able to maximize investor returns by using a considerable amount of leverage as part of their capital strategy. Private equity firms would typically leverage equity capital with loans from banks or bond investors. Private equity firms today are being adversely impacted by the credit crunch. Deals are now being completed using far less leverage than in the credit boom. During the credit boom, private equity firms relied on equity of 15% or less. Today a similar deal would require 30% to 35% equity, that is assuming that one can find bank financing for the balance. The lack of liquidity in the credit markets could certainly put a damper on private equity activity unless the funds are willing to put considerably more equity into a deal.

Three very important issues are simultaneously impacting the private equity space: (1) raising new money is not that easy to do anymore; (2) funds need to use their uncommitted capital or return it to their investors and (3) leverage being allowed in the deal structure is being dramatically reduced. The impact of these three factors is that funds will invest in lower quality deals to ensure that the majority of existing funds are put to work. The competition among private equity funds and strategic buyers to get deals closed will result in prices being bid up and the possibility of overpaying for far less than stellar companies. This buying frenzy will be somewhat constrained by the need to put substantially more equity into the capital structure in order to get a deal completed.

Many private equity funds are getting more involved in bidding wars for companies. Firms are putting high valuations on companies that they are acquiring, even though the high prices will in all likelihood reduce profits for their investors at the time of an exit. Given the relatively high prices being paid for companies and the reduced amount of leverage allowed in deal structures, investor returns in funds raised within the last 4 – 5 years are likely to be in the low to mid teens. Returns will be even lower after factoring in management fees paid to the general partners. Private equity funds typically charge an annual management fee in the range of 1.5% - 2% and also take up to a 20% stake of any profits. These returns in the low to mid teens are significantly less than returns in the mid to high teens that we saw a few short years ago.

Merger and acquisition experts do expect merger and acquisition activity to gain traction in the middle market very soon for two key reasons. First of all, private equity firms holding significant amounts of dry powder need to deploy capital and become active buyers of companies. The expectation is an increase in the dollar volume of buyout activity and that closely held companies will draw significant interest from the private equity funds. A second reason for the heightened level of merger and acquisition activity is the possibility of tax increases impacting business owners both here and in Europe. A tax increase could cause owners of privately held companies to sell sooner rather than later, in order to take advantage of lower tax rates.

Private equity funds all agree that competition has dramatically increased and prices to buy companies are rising. However, even in an environment of rising prices, private equity funds need to show the attitude to do more aggressive deals. If you are a business owner looking for an exit, now might be the time to act to take advantage of this attractive pricing environment.

Amper’s Private Equity Group works with some of the leading private equity firms in the region. If you are thinking about an exit or a possible recapitalization and would like to discuss the private equity option in greater detail, with one of the professionals in Amper’s Private Equity Group, please let us know.