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If the globalisation of fund raising and investing is one of the defining themes for private equity at the start of this century, logic argues it should be manifest in the flow of funds and deals between the world’s two leading industry players, the US and the UK. These two countries, after all, share many of the features conducive to a strong buyouts industry: pro-business policies that encourage competition; a dynamic entrepreneurial culture; a broad range of investment opportunities; a stable legal and regulatory environment; and highly-evolved financial systems.

To assess the degree to which US and UK-based private equity firms have fertilised each other’s businesses and economies, we reviewed trends in UK/US fund raising, investments and club deals for the past six years, and looked at likely developments in the year to come.

Fund raising trends

Private equity funds have raised record amounts of capital in recent years. For the first three quarters of 2006, private equity funds worldwide raised $216bn. US and UK-based funds accounted for over 80% of this amount, with $138.4bn raised in the US and nearly $40bn in the UK. At this rate, fund raising in both countries should equal or exceed amounts raised last year.

Both countries are experiencing a flight to quality as the larger funds continue to deliver better results than the industry as a whole. A recent PwC/BVCA study showed that the three-year net internal rate of return for large UK-based buyout funds averaged 26%, compared with 21% for all private equity funds. Net returns on large US funds are even higher, with some of the biggest funds delivering cumulative returns of over 30%.

For this reason, mega-funds keep getting bigger on both sides of the pond. In the past year, fund raising almost doubled in the US, while nearly trebling in the UK, with half a dozen funds accounting for 40% of total capital raised this year. In July, Permira Advisors debuted Europe’s largest fund at $14bn, while a few weeks earlier, Blackstone launched the world’s largest fund ever at $15.6bn. While US firms derive 75 to 80% of their funds from US investors, UK investors have contributed less than 35% of funds raised by UK firms over the past three years. In fact, last year UK private equity raised 45% of its funds from North American investors, nearly all of them in the US.

Investment trends

With records amounts of cash and lending multiples not seen since 1999, private equity firms have also set investment records, as EBITDA multiples rose above 8.0 in the US and 5.5 in Europe. Global private equity deals announced through the third quarter totalled $570bn, up from $402bn during the first nine months of 2005. Private equity deals involving US targets stood at $270.7bn at the end of the third quarter, up 65% from the first nine months of 2005 and three times the value seen in 2004. Announced private equity investments in UK companies rose more steadily to $76.7bn from $67.7bn during the first three quarters of this year compared with last. However, private equity investments in UK companies doubled between 2000 and 2005 from $43.6bn to $86.8bn.

Assessing investments at the fund level is a more problematic undertaking because of the rise in crossborder club deals. In the US, one in every four private equity deals is a club deal, while the figure appears to be somewhat higher in the UK.

Cross-border club deals have become a major factor in large private equity transactions involving UK firms in the last six years. Six of the 10 largest UK private equity deals effective this year involved US firms as well. In contrast, in 2000, none of the top 10 deals involving UK private equity firms had a US private equity partner. In the US, large private equity deals are occurring in virtually all sectors, even those which private equity historically has shunned, such as technology and gaming. Hot sectors in the UK include consumer, healthcare, and real estate deals of all types, especially hotels. Private equity firms in the UK accounted for 41% of hotel deals last year, up from just 1% in 2000.

Outlook

UK and US firms will continue to have a growing impact on their respective economies. Private equity is largely credited with developing the service sector in the UK, and approximately 18% of private sector jobs are private equity-based. While the impact of private equity on the US economy is not nearly so great, its influence is growing rapidly with US mega-funds estimated to control companies with 700,000 employees and $122bn in sales. In both countries, private equity currently contributes 25 to 30% of M&A activity.

However, as the importance of the sector increases, private equity funds can expect increased government scrutiny as funds seek permanent sources of capital, club deals get bigger and bigger, and pension funds increase their private equity allocations. Add in a likely downturn in the US economy and tighter credit conditions over the next 12 to 24 months, and private equity could see some interesting times.

While some believe defaults will increase and a few large deals will fail, others contend that more sophisticated debt markets and products such as CDOs (collateralised debt obligations) and second-lien loans will reduce fallout from a possible credit crunch. In addition, large club deals are generally done at the most favourable rates, with structures that offer enough headroom to ride out a cyclical downturn.

An evolving market also offers intriguing opportunities. The BRIC countries – Brazil, Russia, India and China – with their significant labour rate arbitrage and increased consumer buying power will continue to offer strong fundamentals for private equity firms as the world’s economic centre of gravity moves eastward. Large private equity firms have already raised significant sums for investment in these countries. As they make acquisitions, private equity firms will have to pay special attention to accounting changes, especially as many countries segue from local GAAP to International Financial Reporting Standards.

Long a feature in the UK, infrastructure funds present a major opportunity for US firms. Fundamentals are strong in the transportation and water/wastewater sectors as demand for better public infrastructure increases. In its drive to reduce taxes, US federal and state governments have not spent sufficiently in these areas, and $920bn will be needed over the next five years for maintenance alone. The Australians, in particular, are looking to access this opportunity.

Privatisation offers state and local governments a means to pay for such projects, and affluent adults may consider a fee or toll a small price to pay for less crowded highways and transit systems. Twenty-two states have passed legislation supporting public to private partnerships, up from 17 last year.

Private equity is gaining more and more influence on both sides of the Atlantic, and challenges and new opportunities abound. Mega private equity firms have become major forces in the economy, and are wellpositioned to weather downturns and take advantage of the new opportunities a changing world presents.

For more information, contact:
Colin McKay
Tel: 001 646 471 5183
Website: www.pwc.com/ustransactionservices

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