McKinsey on Finance

Perspectives on
Corporate Finance
and Strategy

The crisis: Timing strategic moves 1

Timing is key as companies weigh whether to make strategic investments now or
wait for clear signs of recovery. Scenario analysis can expose the risks of moving too
quickly or slowly.

Number 31,
Spring 2009

Just-in-time budgeting for a volatile economy 6

A volatile economy makes traditional budgets obsolete before theyre even completed.
Heres how companies can adapt more quickly.
The future of private equity 11
These funds face a credit-constrained world; they must adapt to thrive.
The voice of experience: Public versus private equity 16
Few directors have served on the boards of both private and public companies.
Those who have give their views here about which model works best.
The economic impact of increased US savings 22
US consumers are spending less and saving more. The economic impact of that
combination will depend upon how fast incomes grow.
Opening up to investors 26
Executives need to embrace transparency if they want to help investors make
investment decisions. But what should be disclosed?

11

The future of private equity

These funds face a credit-constrained world; they must adapt to thrive.

Conor Kehoe and

Robert N. Palter

1 Even the venerable 2 percent management

fee and 20 percent carry structure may be

vulnerable as limited partners respond to the
current crisis and the weakening performance of buyout funds.
2 Earnings before interest, taxes, depreciation,
and amortization.

Is there life after leverage for private equity? The global financial system is struggling to
work its way out of disaster: banks are flat on their backs, equity markets have plummeted,
and a business culture built on leveraged portfolios has come unhinged. The future of
private equity is one of the more intriguing questions for corporate finance and corporate
governance alike.
It may seem hard to be sanguine about
Yet the prognosis isnt entirely bleak. In
the sectors long-term prospects. With returns
our experience, the sectors strengths have
under pressure, private-equity firms
come not from its use of leverage but
will struggle to perform.1 The megabuyouts
from its ability to marshal resources, both
(deals valued at more than 5 billion)
human and financial; its strong incentives
that absorbed so much of the sectors capital to adapt quickly; and its active ownership.
since 2004 are nowhere to be found. Some
Opportunities do exist: megadeals may
limited partnersin particular, sovereignhave vanished, but not medium-sized or allwealth fundshave shown a willingness to
equity deals. Moreover, private-equity firms
bypass private-equity firms and strike out
are well poised to stand in as a new class of
on their own. With an estimated $470 billion
shareholder in the overturned publicin committed but unused funds, the sector
equity market, in developing economies, and
faces an enormous challenge just finding
in financial institutions. Despite the current
ways to invest. Finally, its portfolio companies, difficulties, it bears remembering that the best
with their high debt levels, may become
private-equity firms have persistently
financially distressed and default in the event outperformed both their private-equity
of only small downturns in sales and
counterparts and the public-equity markets,
EBITDA.2 Recent bankruptcies of several
in good times and bad, over the past two
private equitybacked companies hint
decades. The winners will be firms with the
at how dark the future may be.
wits to adapt to a much harsher environment.

12

McKinsey on Finance

Spring 2009

Managing the downturn

through external support networksthan

they had in previous downturns. In the
short term, all the committed but unused
capital could be turned to advantage
if it were deployed in overstretched portfolio
companies. And the lessons of the 1990
downturn, when the debt levels of private
equityowned companies were much
higher, suggest that even if such companies
go into bankruptcy, they are more
valuable than they would have been without
private-equity ownership,4 despite the
costly process of managing the reorganization. Thats good news for employees
and customers, if not equity investors.

Right now, the first priority for the vast

majority of private-equity firms is mitigating
the recessions impact on portfolio
companies and, to some extent, on cashstrapped limited partners.

Contrary to common perceptions, the challenges

portfolio companies face do not result from levered risky
investments

3 See Alexander Groh and Oliver Gottschlag,

The risk-adjusted performance of US buyouts,

Groupe HEC , Les Cahiers de Recherche,
Number 834, January 2006; and Viral V. Acharya,
Moritz Hahn, and Conor Kehoe, Corporate
governance and value creation: Evidence from
private equity, working paper, January 2009.
4 See Gregor Andrade and Steven N, Kaplan,
How costly is financial (not economic) distress?
Evidence from highly leveraged transactions
that became distressed, Journal of Finance,
1998, Volume 53, Number 5, pp. 144393.

Yet contrary to common perceptions, the

challenges portfolio companies face do not
result from levered risky investments.
The average private equityowned company, There will of course be failures, even in
the short term, and each private-equity firm
despite its higher initial leverage, is only
should move aggressively to reduce the
slightly riskier than an average public-market
threats in its portfolios cash, cost, and risk
company. Indeed, although the typical
position and to mitigate their effects.
leveraged buyout starts with more than twice
Whats more, since exits are now very difficult,
the leverage of its public-market counterit will be necessary to learn how to manage
part, its leverage is often lower on exit.3 In
addition, research shows that privateportfolio companies beyond the normal
equity firms tend to buy steady companies
three- to four-year cycle, without letting
whose volatility, before the extra leverage,
returns slip. Some private-equity firms
is about two-thirds that of companies listed
are already addressing this problem by
on public markets. Portfolios tend to be
simulating an internal sale when the initial
concentrated in companies and sectors less
value creation plan runs its three-year
susceptible to the effects of booms and
coursein other words, forcing themselves
bustsa critical condition for supporting the
to take an outsiders perspective to identify
higher initial leverage the private-equity
missed opportunities. These firms review such
model has typically deployed. Not surprising, companies and their industries and
private-equity portfolios, though spread
appoint new internal teams, if necessary,
across most industries, are underrepresented
to develop another value creation plan,
in the battered construction, automobile,
to change management, or to conduct a dueand financial-services sectors. We expect the
diligence process as if the firm were buying
revenues and before-interest earnings
the business anew.
of private equityowned companies will fall
less than those of companies listed in
Finally, many private-equity firms that
public markets.
expanded their staffs and opened new offices
during the recent investment surge must
Moreover, private-equity firms also enter
now make do with less. Even the top
this downturn with much stronger
performers can expect smaller funds and
operational capabilitieseither in house or
lower fee income in the next few years.

The future of private equity

13

Managing investors

entirely if they wish by investing their cash

directly. Their recent direct investments
already include the stakes that the government of Singapore and the Kuwaiti
Investment Authority took in Western banks
last year, as well as the holdings of directinvestment arms such as Mubadala Development (Abu Dhabi) and Temasek Holdings
(Singapore). It can be tricky for sovereignwealth funds to be assertive and active
owners, though, especially in Western companies. Investing through private-equity firms
raises fewer political hackles, but the firms
will need to sharpen their value proposition.

Private-equity firms will need to manage

their relationships with investors carefully.
Limited partners are not protected from the
general downturn. Some are having difficulty
meeting their commitments to provide
fundsin particular, because reduction in the
value of quoted equities has mechanically
increased the percentage of assets allocated to
private equity.5 Further, the difficulty of
exiting from portfolio companies means that
money from private-equity funds is flowing
back much more slowly than might have
been expected. Some supposedly liquid assets,
which limited partners could otherwise
have sold to finance private-equity cash calls,
arent nearly as liquid as had been assumed.
Except in extreme circumstances, limited
partners probably wont defaulttheyd risk
losing the cash they have already subscribed
and access to top fundsbut they may
pressure private-equity firms to reduce fees,
commitments, or both if investment
opportunities dont open up soon. In the
near future, limited partners may also
demand improved terms before subscribing
to new funds and invest lower amounts in
them. Private-equity firms should act strategically in these situations by giving some
limited partners more flexible terms if they
experience short-term difficulties. This
approach could play an important role in
maintaining relationships with attractive
long-term funding sources.

5 Private equityowned companies arent always

marked to market, yet the investors public

securities areso the value of the latter appears
to have declined much more.
6 See Viral Acharya, Conor Kehoe, and Michael
Reyner, The voice of experience: Public versus
private equity, in this issue.

A relatively new class of private-equity

investorsovereign-wealth fundsneeds
particularly careful nurturing. These longterm investors constitute a very large group
in the aggregate, with $3 trillion in total
assets in 2007 and a projected $8 trillion in
the next decade. By the end of 2007,
they had committed about $300 billion to the
private-equity sector, but they can bypass it

By and large, the sector is well prepared

for these challenges. Active ownership is its
biggest competitive advantage over
companies in the quoted market: the best
private-equity firms are more effective
because of their stronger strategic leadership
and performance oversight, as well as their
ability to manage key stakeholders.6 Firms
must continue to hone these skills and
to ensure that they are applied consistently.
Even the better firms have a great deal of
opportunity for improvementparticularly
in attracting partners with the right operating
skills, getting a better balance between
financiers and active owners, adding people
who have experience in downturns, and
reviewing the current portfolio with the rigor
traditionally devoted to new investments.
Finding new ways to invest

In the long term, the math of deploying the

industrys $470 billion in committed but
uninvested capital looks challenging. Forty
percent (about $240 billion) of the equity
capital that private-equity firms invested
from 2004 to 2007 financed 55 megadeals
(2 percent of all private-equity deals).
It could take a long time for megadeals to
reemerge if recently completed ones
perform less well than quoted companies

14

7 After the late-1980s collapse of the junk-

bond market, the $25 billion (enterprise value)

RJR Nabisco deal of 1998, at more than
90 percent leverage, wasnt topped until 2006.
8 The purchase of stock, at a discount to the
current market value per share, by a privateinvestment firm, mutual fund, or other
qualified investor for the purpose of raising
capital for the issuing company. The
discount is needed when companies seek to
raise significant capital or when there
is an illiquidity provision in the agreement.

McKinsey on Finance

Spring 2009

do.7 And even if the core midmarket leveraged

buyout comes back quickly, it probably
wont absorb all the available capital, so the
sector must look for new investment
opportunities. Given its current market
sharethe value of the capital that private
equity controls equals only some 2 to 3 percent of the total value of all the equity
quoted on public marketsmore opportunities for active owners exist, though
few are proven.

Developing markets
Companies in developing markets enjoy
favorable demographics and are opening
up to the global economy. Nonetheless,
immature regulatory and legal systems, along
with a lack of transparency, can bedevil
outside investors who lack connections to
the companies in which they invest.
Although those companies may have local
sources of new money, they often lack
the value-adding capital that experienced
private-equity firms can offer. In particular,
family-controlled companies that aim to excel
internationally see them as a way to
gain expertise previously available only from
multinationals. Private-equity firms can
deploy their managerial and sectoral knowhow to help such companies, family
owned or otherwise, and to provide close
local supervision on behalf of the firms
international investors. These companies are
a very important long-term outlet for
private-equity firms, though from 2003 to
2007 their investments outside Europe
and North America accounted for only
around 5 percent of their $630 billion of
invested equity.

Private investment in public equity

One way for private-equity firms to use their
ownership expertise would be to channel
some of the capital under their control into
public companies through private investment
in public equity (PIPE)8 and to assert
themselves, even without complete control,
on the boards of those companies. The
benefit to a public companys executives
besides quick access to capitalwould
be the commitment of a shareholder that will
be stable in the medium term and perhaps
provide them with private equitystyle
incentives to ensure that the company acts in
the interest of shareholders. Private-equity
firms will need to learn how to operate in
public companies, however. Private-equity
board members can help a public company
focus on shareholder value, as well as offer
their own time and the resources of their
firms and networks. But they have much to
learn from their public-market colleagues
about communicating with a dispersed body
of stakeholders and compliance with
public-market regulation.

Financial institutions
In the past, private-equity firms seldom
invested in financial institutions, like banks
and insurance companies, which are
already leveraged to very high levels set by
regulators, as the current banking crisis
has clearly demonstrated. Yet today such
institutions provide a fascinating opportunity: they may be cheap, their productivity
varies widely, and recent events show that
they clearly need more intense governance
and will face demands that they obtain it.
The board of an average bank, for example,
could add considerable value by resolving
to use a private equitylike approach
to improve the banks operational and riskmanagement practices. Measuring the
value of so-called toxic assets presents real

15

The future of private equity

9 Allocations to newcomers in emerging

markets may offset this concentration in the

developed world.

difficulties to a private-equity transaction,

however, and these risks may be too
great unless the authorities hive off such
assets to a bad bank. Private-equity
firms might then be tempted to infuse the
good institutions with much-needed
private capitaland $470 billion of it gives
the authorities a strong incentive to
explore this route.

that private equity has persistent outperformers and underperformers has been
analytically substantiated and taken root.
We therefore expect that the more discriminating limited partners will concentrate European and US investments in
fewer private-equity firms and that many
firms will disappear when they cant
raise their next round of funds.9

The alternative
If the private-equity sector cant identify
new channels for investment, it may have to
contract. In any event, it will probably
concentrate. The top ten firms controlled
30 percent of the sectors capital in 2008,
just as they did in 1998. Since then, the idea

Private equitys core value proposition

superior representation to maximize returns
for the long-term investorremains sound.
But private-equity firms that hope to survive
must adapt to a new world. MoF

Conor Kehoe ([email protected]) is a partner in McKinseys London office, and Robert Palter
([email protected]) is a partner in the Toronto office. Copyright 2009 McKinsey & Company.
All rights reserved.