Is private equity dead?

There is an air of unreality about this year's private equity Super Return conference in Munich. Thousands of general partners, limited partners and their advisers have gathered to discuss deals that will never get done, investments that will never be made and funds that will never be raised. But beneath the outward displays of confidence, everyone accepts that 2008 will be a terrible year for the industry. The banking market is stuck and, following the recent falls in the stock market, many of the highly-leveraged deals done over the last year or so are now deep under water. The question is whether the good times will ever come back.

The answer depends on who you listen to. The conference has highlighted a divide between private equity "Mods" and "Rockers”. Mods such as Leon Black of Apollo and David Rubenstein of Carlyle believe there is nothing fundamentally wrong with the industry, that the banking market will eventually recover, that the next couple of years will prove a fabulous buying opportunity and that even the 2007 vintage of deals will ultimately prove shrewd investments. Rockers, led by perennial industry trouble-makers Guy Hands of Terra Firma and Jon Moulton of Alchemy Partners, believe the industry must change radically to adapt to new conditions.

For the Rockers, this gloom is partly a question of finance. Not only is the banking market likely to remain stuck for at least a year, as the banks continue to digest more than $US200 billion of loans still stuck on their balance sheets, but many doubt the loan market will ever roar back to 2007 levels. Rubenstein tried to cheer his audience with a chart that purported to show the leveraged loan market as cyclical over 20 years. Unfortunately, his chart didn't show the undulating curves one normally associates with a cycle, but a giant hockey stick that suggested a remarkable bubble starting in 2004.

The Rockers worry almost as much about politics. The UK and Germany have both changed their tax treatment of private equity over the last year. Changes in the US could come after this year's election. Meanwhile, general partners are coming under much greater pressure to demonstrate environmental and social sensitivity in their investments – both from politicians and limited partners. Joseph Dear of the Washington State Investment Board warned that his board was increasingly vocal in its opposition to investments that might lead to substantial job losses or curtailment of benefits.

How should the industry adapt? The Rockers each have their own prescriptions for the industry's recovery. But there are four main ways:

– Greater focus on operational improvements to portfolio companies. Every buy-out firm claims to bring strategic focus, but it's not clear that many do. Some buy-out firms have invested in operational expertise. If they can deploy this to turn around underperforming companies, private equity might even get a PR boost too.

– Avoid mega-buyouts. Some argue that the future for private equity firms is to concentrate on different sorts of deals, including small and mid-cap deals, emerging market investments and distressed debt. These are deals that do not necessarily require large amounts of debt, which means they are easier to finance.

– Circumvent the banks. If the banks can't provide finance for mega-deals, then private equity firms will have to go direct to those who can, such as Middle Eastern and Asian sovereign wealth funds and hedge funds. Blackstone has already invested in building this capability. Guy Hands believes others will have to follow suit.

– Don't just focus on financial returns. Even some of the Mods recognise the industry cannot continue simply to focus on financial returns if the social costs of restructuring damage the industry's reputation. For example, Rubenstein says Carlyle now weighs up the social and environmental impact of deals before going ahead.

Even if the Rockers are right, it is not clear how easy this manifesto will be to implement in practice. True, some mega-funds are already sniffing around mid-size and emerging market deals. But a $US10 billion fund cannot deploy its capital effectively in small deals. Nor is it clear that limited partners regard private equity investment in emerging markets as a priority when they can usually achieve similar returns at lower risk via hedge funds and emerging market listed equity. Meanwhile, few firms have the capability to raise their own debt finance direct – or are likely to do so in the near future. Most will remain dependent on banks. All of which means even the Rockers may end up being too optimistic.

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