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The private equity new year started with news that The Blackstone Group, the world's biggest private equity firm, had been forced to ditch a $1.8 billion deal after it was unable to secure financing. A far cry from the start to 2007, when PE giants Kohlberg Kravis Roberts, Texas Pacific Group and Goldman Sachs pulled off the huge $44 billion purchase of Texas electricity utility TXU.



Blackstone - in a joint venture with General Electric - was unable to find the money to fund the acquisition of PHH Corp, a US mortgage and vehicle leasing business. PHH was demanding a $50 million break-fee from the joint venture.



US banks JPMorgan Chase and Lehman Brothers warned Blackstone in September that they might not be able to provide all the financing they had promised earlier.



The first half of 2007 had seen the M&A boom climax in huge PE buyout deals, made possible by a seemingly endless flow of money from the big banks. But the financial crisis, triggered by a surge in defaults in the US subprime mortgage market, halted the easy money. In the United States, total PE buyouts reached $64 billion in July. But in August they dropped to $8 billion, and they have not recovered since.



Before, banks had been able to sell on their loans to investors around the world, repackaged as collateralised loan obligations (CLOs) and other complex instruments. Now, fear stalks through the secondary market of investors, like pension funds, insurance companies, hedge funds, and other banks.



“Buyers of more complicated financial instruments, such as collateralised loan obligations, are on strike,” exclaimed a Financial Times reporter in January. Unable to sell on their loans, the big underwriting banks have been forced to cut their lending for new PE buyout deals. Instead, sitting on mountains of increasingly risky buyout-related debt, some banks are even trying to sell it at below face-value prices – 90 cents in the dollar or lower.



Planned PE deals have had to be renegotiated or cancelled, like the Blackstone-GE bid to buy PHH Corp. The biggest US flop was the end of J.C. Flowers' $25 billion offer to buy Sallie Mae, which lends to students. In Europe, British Airways and Texas Pacific Group dropped a proposed takeover of Spanish airline Iberia in November. And so on - according to Dealogic, $226 billion worth of deals were withdrawn in the year to November, more than twice the volume during the year-before period.



While financial turmoil has dried up the credit needed for new buyouts, PE firms also face the prospect of seeing stock market volatility reduce the value of the companies they already own. And they may become more difficult to sell off. Especially portfolio companies that PE funds, in order to quickly reap rich dividends, have loaded with debt. The cash flow from those companies, needed to pay back massive borrowings, is vulnerable to an economic recession or prolonged slowdown.



No wonder, then, that the exuberance of private equiteers has turned to gloom. At year-end, Deloitte's Debt Confidence Survey of operators in the City of London found that 86% believed that the "good times" were over. Private equity firms were the most pessimistic, with 94% of those questioned fearing the next few years would be far more challenging.



Deloitte's survey also found that 84% in the City expected banking covenants - or the terms on which money is lent - would tighten in 2008. That compares with just 39% who predicted a tightening at the beginning of 2007. As regards underwriting banks’ capacity to sell on debt, the majority of those surveyed expected institutional investors to be far more cautious about buying riskier debt, and to demand far higher returns when they did.



Financial markets had already been doubtful for some months. After going public in June, Blackstone’s shares slid steadily, losing more than 40% of their value by early January. Also shares in Fortress Investment Group, a diversified alternative asset management company, were down 29% after an initial offering on the public equity market in February 2007. In January, shares in the two firms dropped to record lows after analysts at two US banks cut their stock-price targets because of the private equity slump.



Shareholders have also been disappointed by several large hedge funds. New shares of GLG Partners, one of the biggest European hedge fund managers, and of Third Point Offshore, a public offshoot of the New York hedge fund run by Daniel Loeb, fell too, as did those of Och-Ziff Capital Management.



Notwithstanding the gloomy mood, the situation of the better funded PE firms is far from being hopeless. They still have some winning cards to play, the main one being the large amount of cash still on their books. And that money is long-term, as investors usually commit their money for about ten years.



So their vulture funds can wait until markets to bottom out and then pick up under-priced assets offered through distressed sales, including disposals by banks that are creaking under the debt that the same PE firms helped to build up during their buyout boom.



In one “vulture” deal, reported by The Wall Street Journal.Online, Citadel Investment Group in mid-November bought a nearly 20% stake in E*Trade Financial and agreed to buy its troubled loan portfolio, which had a face value of $3 billion, for as little as 27 cents on the dollar.



Though mega buyouts are off for the time being in the United States and Europe, the big PE firms can continue their buyout spree in emerging markets like India, China, Brazil, South Africa, and the Middle East. There, infrastructure investments (transportation, water, power) along the lines of build-operate-transfer projects are among the businesses attracting PE investments.



PE activity is growing rapidly in those countries. According to estimates by the Emerging Markets Private Equity Association (EMPEA), there are some 89 Venture Capital/PE firms in Brazil, 115 in China, and as many as 160 in India. About 120 of the India-focused firms have raised money from outside India.



PE firms TPG, KKR and Carlyle have been strengthening their operations in Japan, where there has not yet been much private equity activity. Russia, with at present only 28 VC/PE firms, is another country where the PE business may soon take off.



Some observers believe that big PE houses like Carlyle Group, Bain Capital, Blackstone and KKR may come to look more like long-term investment conglomerates Berkshire Hathaway and General Electric. Also, rather than seeking total takeovers, they will continue a trend to seek smaller investments in public companies. In big companies, the investment would include a board seat and a say on major decisions, according to David Rubenstein, co-founder of Carlyle Group, the Washington DC-based private equity group, as reported by washingtonpost.com.



The play with sovereign wealth funds, state-owned funds with foreign investments, will become more important. The large SWFs, mostly based in the Gulf region and in eastern Asia, have emerged as investors in PE firms, partners in making investments, and potential buyers of companies owned by PE firms.



A headline-grabbing deal was last May’s acquisition of a 10% stake in Blackstone by China Investment Corp, China’s $200 billion SWF. Another example is Carlyle’s sale in the autumn of a 7.5% stake in its firm to Mubadala Development Company, an investment arm of the Abu Dhabi government.



SWFs may want to team up with PE firms when they buy stakes in companies abroad. In late December Temasek Holdings, one of Singapore’s two SWFs, made an investment in US bank Merrill Lynch alongside PE firm Davis Selected Advisors.



Assets held in key industries by a fund owned by a foreign government will always be controversial, especially where the fund lacks transparency and the government behind it is not beholden to open governance and the rule of law. To counter controversy, SWFs usually agree to play a passive role in the companies in which they invest and eschew board seats or management posts.



In such circumstances, making an investment alongside a PE firm, or through one in which it has a stake, may reassure a SWF that there will be pressure on management to fulfil commitments or even boost profits by drastic cost-cutting. An implicit PE-government partnership is illustrated by the case of Deutsche Telekom, where Blackstone has played an aggressive role for the German government, the much larger but more discreet shareholder. So much so, that management’s cost-cutting triggered last year’s bitter strike by UNI affiliate ver.di.



One leading institutional investor that has not lost faith in private equity is CalPERS, the $250.4 billion California Public Employees Retirement System, which covers the benefits of more than 1.5 million California state and local government employees. At its 17 December board meeting, trustees agreed to pour an additional $4.4 billion into the pension fund’s $20.6 billion private equity portfolio, for investments over the next three years. The PE investments are to be divided evenly between domestic and international assets.



A further show of CalPERS’ faith in private equity came in January, when it was reported that the fund had agreed to buy a 9.9% stake in PE firm Silver Lake. “The deal with Silver Lake is a sign that CalPERS remains confident that the private equity industry will thrive over the next few years,” observed a Financial Times reporter. CalPERS already has stakes in at least three other PE firms: Apollo Management Group., the Carlyle Group and the Texas Pacific Group.





Sources: FT.com, 26 Dec ’07, 1 Jan ’08; 9 Jan ’08 (2); International Herald Tribune, 30 Dec ’07; washingtonpost.com, 2 Jan ’08; Telegraph.co.uk, 22 Dec ’07, 2 Jan ’08; The Independent, 3 Jan ’08; Bloomberg News, 8 Jan ’08; Associated Press, 9 Jan ’08; THE WALL STREET JOURNAL. ONLINE, 2 Jan ’08; Pionline.com, 24 Dec ’07; The Economic Times (India), 15 Jan ’08.