Private Equity Risks for 2013

December 17, 2012

At this time last year, private equity was recovering modestly, with around $1 trillion in dry powder and another $2 trillion in assets still held on general partners’ books.  Bain & Company described the outlook as highly uncertain, with the general spread between the valuations of buyers and sellers as some of the highest in history.

We now stand a year later, and it’s hard to argue that the economy is making deal making any easier – the fiscal cliff, which includes the likelihood of much higher tax rates for investment professionals, the tax side of Obamacare, a politically unstable European Union, and teetering BRICs (Brazil, Russia, India, China) provide much more political and economic risk than has been the case over the past three years.

But, as every good investment professional knows, out of crisis springs either lifetime opportunities or sad losers.  What are professionals saying about the 2013 outlook for the private equity industry?  Well, not surprisingly, there’s no real consensus (private equity professionals are much like economists when it comes to the wide range of opinions on the industry outlook).

With that said, there appears to be general agreement on a few things.

First, U.S. and European political risk represent by far the most dangerous forms of risk in the upcoming year, with U.S. political risk occupying the top position in the near term and European political risk representing the most dangerous long term political risk.  How important are the two political risks and how are they likely to affect the private equity sector in the upcoming year?

The U.S. political situation is likely to provide only downside risk on a post-tax deal making perspective.  On the flip side, once it is certain what the tax situation will look like over the rest of Obama’s term in office, the higher tax rates side of the political risk disappears, leaving only industry meddling (such as what happened with the Affordable Care Act) as the remaining U.S. political risk.  The uncertainty over the tax code is likely to provide support for a narrowing of the valuation spreads, not only because of the increased certainty in calculating after tax returns, but also due to the effect certainty may have on overall economic growth.  Of course, eliminating the tax rates uncertainty of the political risk issue is also likely to worsen, assuming tax rates increase the private equity exit markets.

The European side of the issue is a little more complicated given the political risk associated with the longer term outlook.  There is certainly the potential for huge profits for individuals that survive where others fear to tread, such as InvestIndustrial’s or Bain Capital’s recent European acquisitions.  But, has the longer term political risk (policy risk) bottomed out in European countries ranging from the periphery to the core?  Probably not.

Overall, political risks will likely to continue to put downward pressure on private equity deal making in the coming year.

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