Fidelity Investments
A whitepaper written for Fidelity Investments in 2008

The Private Equity Market: Past Performance is an Indicator of Future Performance

If we’ve learned anything from an historical perspective, when it comes to the private equity market, it’s accurate to say that past performance is a good barometer of future performance.

With that premise in mind, let’s consider the four distinct time periods of the last several decades and what they mean for 2008:
• The expansion period from late 90s to 2000
• The contraction period from 2001-2002, when the high tech bubble burst and the 9/11 event occurred
• The recovery period from 2002 to 2003
• And the expansion period, or the M&A market expansion, from 2003 to 2007

There are three major drivers and critical components to market activity: consumer sentiment and psychology; liquidity (both equity and debt); and economic outlook.

Let’s begin with psychology and consumer sentiment. The psychology aspect encompasses how consumers, businesses, and private equity investors are feeling about the market. Consumer sentiment is a core driver, and consumer spending is critical to the underlying economy. Likewise, it is also critical to a lot of middle market deals. In addition, consumer sentiment affects private equity investors. Each of us is a consumer and how we view the economic outlook will personally impact how we view our own investments.

According to consumer sentiment, the down cycle in the market began at the end of 2007. Prior to that, the overall market ─ thanks to stable housing trends, low interest rates, inflation, and a robust stock market ─ was strong. Today, much of that is dissipating.

But, does the consumer feel wealthy and secure and do companies feel the same? If, in fact, indices are an indicator, we’re potentially in a downward trend. During 2001 and 2002, the market suffered a decline, followed by a positive recovery and expansion through 2007. Today, it appears we are on a downward orientation and another decline is eminent.

A decline in the market is often a signal that corporations need to lower spending. It is also a signal as to how companies perceive their value. Let’s look at CFO optimism as a proxy. In general, CFOs tend to be conservative, so as the expansion period extended, there was concern that, during the past year, the optimism was going to end. A key indicator is that the model reflects what you believe the business will do. Obviously, CFOs believe businesses are going to under perform going forward. In private equity, this can lead to a herd mentality, which, if times are good and models are great, companies will out perform. When times are bad, generally models become more conservative and companies, in turn, under perform. This kind of scenario drives lower valuations, which tends to make people cautious and wary, going forward.

Recently, there has been a fundamental shift in the market. In fact, the market has experienced a complete sea change in terms of who is providing capital to middle market Leveraged Buy Outs(LBOs). Originally, banks and finance companies were providing the majority of the credit to the middle markets. However, by the end of 2007, that equation changed and institutional investors and Collateralized Loan Obligations (CLOs) were providing the “lion’s share” of the credit to the middle market. Today, business has dried up and consequently, the easy money has disappeared.

From a debt multiples perspective, leverage was very high in the late 90’s and again in 2007, creating a barbell effect. Essentially creditors were lending less money, and in 2007, second lien loans became prevalent. Because of this, credit quality improved dramatically. In addition, an interesting underlying dynamic occurred: loans no longer amortized, and higher and higher levels of debt were achievable because a down payment was no longer required. This, in turn, enabled the borrower to meet coverages which were previously unattainable.

A corollary is equity requirements. In 2007, equity contributions dropped to a low, mirroring the late 90’s. Alternately, during the 2001-2002, deals had lower leverage and higher equity contributions. In 2008, it appears the numbers are trending upward again.

Despite all of these loose lending practices, levels of bankruptcies are historically low. Slide not necessary here? This is driven by the fact that it's hard to default. In the middle market, there are some covenant-light packages, although not quite as much as in the larger deal markets. At times, interest payments were not required, which meant no defaults. The downside of this scenario is that the abundant availability of loose credit was masking the fact that even if a company was doing poorly, it could recap and get more funding. In addition, through credit expansion, many companies could be financed, and could be recapped even if they were in trouble.

As most know, there are two ways to fund a company: through debt and equity. Up to this point, we’ve been discussing debt. Now, let’s address the other funding source, equity raised ─ which is where we come in. Approximately $560 billion was raised in 2006 and 2007, combined. This is a substantial amount and a strong trend, even as compared to the “go-go” years of the late 90’s. We can expect this upward trend to counter balance the current decline in the market. In other words, if you consider how much money is being raised through private equity, it is a substantial amount of capital and can replace debt as a counterbalance to credit – or the easy money ─ which is drying up.

We’ve discussed the first two key drivers to the market of consumer psychology and liquidity. Now, let’s talk about the third driver – the market outlook – and how it affects the overall investment landscape. In terms of GDP (Gross Domestic Product), there’s a strong downward trend. The GDP is dropping below 10 year averages, and the question becomes, are we in a recession?

When considering inflation over a 25-year period, it appears tame during the last 10 years, driven primarily by commodity prices. Certainly, it is more difficult to understand where companies are headed in these kinds of environments, but essentially, there was a strong trend of relatively benign underlying economic terms during the expansion period of the late 90’s. These terms are now changing.

So, what does this mean for underlying business performance? Let’s look at employment numbers as a measure. Employment numbers are a mixed bag when considering that some believe the 2007 results showed the effects of the globalization of the workforce with many “blue collar” jobs moving off shore.

How are all of these drivers impacting the health of the private equity marketplace? First, let’s consider the U.S. M&A activity for the middle market. During the past 10-plus years, there has been a core middle market of approximately 3,000 deals. Significantly, at the end of the 90’s there was a spike of deals less than $100 million, which were mostly technology related. In essence, in the late 90’s there was a plethora of technology companies, which resulted in a high volume of deals. However, these deals, though numerous, were lower priced.. In 2007, these kinds of deals were trending upward, but many were leverage-driven deals, because most of these companies were acquired by debt. Therefore, the aggregate value increased.

The lesson learned here is that there is a risk of potentially paying too much for a company that might be mediocre. In addition, it points to the fact that leverage can be dangerous and can drive prices up, which is what occurred in 2007.

To put this in context, let’s look at deal volume and value compared to GDP and market cap. In the late 90s, M&A activity, as a percentage of GDP and market cap, was higher. Conversely, 2007 ─ which was a self-proclaimed healthy private equity environment ─ in actuality, wasn’t as robust. In reality, 2007 M&A activity was less in terms of number of deals, but on a par in terms of value of the deals. But in terms of GDP and market cap, M&A activity in 2007 was less as a percentage.

However, today the “sweet spot” for the private equity market is the middle market. When considering purchase price multiples, in 2007 with the leverage gains, they reached a peak of 11.4 times EBITDA, far outstripping the last high water mark in 1997. Then there was a decline in 2001, 2002, which basically means by the end of this last cycle, we were paying the highest prices we’ve seen in 10 years.

The interesting question becomes what is the right time to invest? Let’s recap: in 2000/2001, there was a downturn in the market, followed by a leveraged come down, and a relatively unhealthy economy. However, at the same time, the market experienced the best private equity returns in years. Case in point: the vintage years of 2000 through 2003 represent approximately 24 to 33 percent above the median.

So, where are we today in the cycle? If, volume, leverage, and prices are declining, is this, in fact, an opportune time to start to invest money? Yes, now is a good time to invest, but investors should proceed with caution. Essentially, given that the 2007 market looks a lot like the 2001 market ─ which enjoyed very good returns ─ it makes good business sense to consider investing in today’s market.

Additionally, if investors believe the S&P 500, then they also believe the overall economic picture will improve by year-end. Still, given that near term growth is flat and leverages are lower, investors may want to be conservative. Translation? You may have to write bigger equity checks and think about restructuring transactions to potentially use seller paper, earn-outs, or deferred compensation, to get the flexibility needed to get the deal done. Because prices have remained fairly “sticky” while underlying economic fundamentals remain problematic, business owners continue to want high prices for their companies, despite the underlying deterioration of specifics in any given deal.

Today, when considering the middle market as an investment strategy, it’s important to be creative but proceed with caution, given that it is a diverse, flexible market. Finally, it’s important to remember that smaller companies have sold for lower multiples of earnings, which is an opportunity for the small market. Certainly, there can be higher levels of risk when buying smaller companies, but there is also multiple arbitrage that can be gained when buying these businesses ─ professionalizing the companies, doing add-on acquisitions, and helping them to grow organically, with the ultimate goal to sell them, and, reap the benefits of that sale.

At Fidelity, our focus and value proposition is really toward the low end of the middle market. In our experience, smaller companies have sold for lower multiples due to more risk in doing transactions through all different cycles over the past decade.


Adams, Harkness and Hill (Cannacord) - An internal communication prepared for employee program

Teamed for Success email notice

At Adams, Harkness, & Hill, we believe we are “Teamed for Success.”

It’s illustrated in the innovative way in which we conduct our business every day with our internal clients as well as our external customers. It’s demonstrated in the winning solutions that make us just a little bit better than the best. And, it’s exemplified in the way we work together as partners --- partners with out colleagues and partners with our customers --- that defines the essence of Adams, Harness and Hill.

Now, here’s a chance to experience what it means to be teamed for success through our new quarterly rewards program. Through this program we’ll celebrate efforts above and beyond the norm, whether it be through relationship management, teamwork, or leadership endeavors.

The program is simple: it recognizes those individuals or teams that exemplify what it means to be teamed for success and rewards them for their efforts. How do you define success in an arena that is already filled with the best and brightest? Here are some examples:

• Someone who identifies a new business opportunity or a change in the way we manage a particular activity
• Someone who has developed a special relationship with a client that results in multiple referrals
• A team effort that would not have happened without the team
• Someone who forfeits personal time to take part in events that position AH&H as a leader in the marketplace

Here’s how the program works: nominations will be submitted to the President and CEO, who will select one winner or a team winner, and two honorable mentions, each quarter. Announcements will be made at our quarterly meetings where the winners will present a short slide summary of their winning effort, detailing what worked, what they do differently, and how they will implement next steps.

At Adams, Harkness & Hill, we know we are teamed for success. Now, we want to be sure you know it, too. As Chairman of the Board, John W. Adams has stated numerous times: “Everyone looks for the best. We think we actually have them.”

Watch this space for more details about our Teamed for Success Rewards Program.