Although difficult to separate, the economic slowdown and the credit crunch are impacting the private equity sector in very different ways, and it’s not all doom and gloom for FDs on the search for an investor. In fact, in terms of the economic slowdown, it’s very much business as usual.

Despite allegations of ‘business-flipping’ from some quarters, most PE investment strategies are premised upon holding assets for three to five years.

This means that the majority of investments are likely to experience a downturn during PE ownership and disciplined investors will plan for this possibility at the point of investment.

The fundamentals of what PE looks for in potential investees therefore tend to be the same at different points of the economic cycle.

We continue to look to invest in businesses with proven management, a defensible market position, robust cash generation, excellent growth prospects and strong exit story.

But be warned FDs ­ the credit crunch is having an impact on PE investment strategy. The PE market is experiencing tightened lending criteria, reduced debt multiples and the disappearance of the ‘covenant-lite’ structures that featured last year.

That said, the impact is different for different segments of the PE market. Large-cap transactions that rely more on financial engineering than profit growth to generate returns are struggling to secure the required levels of debt for deals.

Alternatively, many mid-market buyouts firms, particularly in the sub-£100m segment, are still managing to successfully secure funding for deals and consequently volumes in the mid-market appear to be holding up.

In fact, the reduction in valuations driven by the credit crunch and investor nervousness will begin to create substantial buying opportunities for mid-market PE players who can see beyond the current volatility. PE players are likely to begin targeting the following areas over the next six to 12 months:

Public-to-privates

As public equity investors’ risk aversion has increased, there has been a flight to investing in larger, more established ‘blue chip’ businesses. As a consequence, there is limited liquidity in the shares of many smaller but profitable and high-growth AIM-listed businesses whose share prices no longer react to positive news.

Furthermore, many have been left struggling to raise growth capital at a time when good value consolidation and rollout opportunities are presenting themselves in many sectors.

PE’s longer investment horizons and strong appetite to inject growth funding into high performance businesses will therefore represent an attractive alternative to public markets for management teams.

Restructuring

Inevitably there will be substantial indigestion caused by the glut of debt that has been available in recent years. ‘Solid’ but inappropriately financially structured companies will find themselves struggling to service expensive yields and meet repayments, particularly as the economic cycle begins to go against them.

As distressed sales become more prevalent, there will be a need to restructure companies’ balance sheets to more sustainable gearing levels. PE firms with solid banking partnerships and prudent approaches to leverage will be in a strong position to support management teams through restructurings and back on the path to profitable growth.

Undervalued sub-sectors

As ever, PE investors are looking for companies that appear undervalued relative to their long-term potential. Another fertile hunting ground for value may be sectors that are traditionally understood to have cyclical exposures but which have sub-sectors underpinned by legislative or structural revenue drivers that will enable them to outperform their sectors through the cycle. Examples could be providers of IT solutions to the recycling sector, or manpower to the renewable energy sector.

The range of buying opportunities amid the current volatility demonstrates the reliability and consistency of the mid-market. Furthermore, the strong level of buyout completions valued under £100m over the last six months demonstrates the deliverability of mid-market PE firms.

Independent mid-market PE firms therefore continue to be excellent partners for business owners seeking growth capital and deliverable buyers for vendors seeking full or partial exits.

Unlike trade buyers, private equity has guaranteed funding that is not impacted by the economic cycle. Independent PE firms have committed investors unlike captives, who are tied to larger organisations such as a bank, whose parents may withdraw support from their PE divisions in response to problems elsewhere in their organisations, whether driven by the credit crunch or the economic cycle.

Mid-market PE is still very much open for business. The current challenges, at worst, will drive a renewed focus in the quality of businesses invested in and the sort of controlled environment that a strong FD can bring.

Low down on mid-range deals

The number and value of UK PE deals plummeted in the fourth quarter with the slowdown expected to continue into 2008, KPMG has found.

UK buyouts valued at more than £10m fell to 25 in the final quarter of 2007, compared to 51 for the same period in 2006, according to the report. Similarly, the average value of UK PE deals fell from £154m to £94m year-on-year.

Following the Q4 slowdown and summer credit crunch, KPMG now believes 2008 deal values could be just half of those seen in 2007, and even fall to 2002/03 levels.

Bank lending to sub-£100m buy-outs became more 'complex' in November and December, with many bank clubs now being required for even modest levels of debt.

'Though the figures do not bode well for MBO activity in 2008, it is clear to me that with careful advice and the correct structuring, it is still possible to secure debt and transact deals in the mid- market - the $970m (£485m) loan for chemical business Almatis at the end of 2007 proves that deals can still fly,' said Michael McDonagh, corporate finance partner in KPMG's private equity group.

Mike O’Brien is a partner at Gresham Private Equity