Economic Outlook Q&A: Don Phillips of WP Global Partners

Economic Outlook Q&A: Don Phillips of WP Global Partners

January 13, 2009

CHICAGO - “ After the storms of 2008, what might be in store for private equity fund managers in 2009? The Illinois Venture Capital Association has interviewed fund-of-fund manager and private equity investor Don Phillips of WP Global Partners to get his forecast for 2009 and beyond.

Illinois Venture Capital Association: In an Illinois Venture Capital Association interview published in Dec. 2006, you were - œconcerned-  that the debt multiple in private equity transactions contributed to as much as $3 trillion in buying power in the marketplace. Is it safe to say these concerns were realized in 2008?
Don Phillips: If we got ourselves into a major market correction or catalyst to drive us into this marketplace, I thought it would have been money accumulated into mega funds. We got into a major market correction and this was not the driver.

The money today sitting on the shelves is interesting. I think you will see all this money being set aside is equity money. It will be very difficult for these guys to achieve the return expectations of their limited partners. I don't know whether the buyout market will come out in calendar-year 2009 or very late 2009.

When it does come back, you will see a lot more discipline in the marketplace. The banks will start lending money to these transactions again.

They will not, however, lend at the same levels of the past. Instead of getting deals done at high levels of EBITDA, they will be at more modest levels. You will see lower debt ratios set by the banks on the financing of transactions. The banks will not be offering interest rates as we have seen (3 percent to 4 percent higher than historically).

When you end up with lower debt and more equity and pay more money for the use of the debt, your return expectations drop. My guess is that this will be a 12 percent to 16 percent range over time. If you compare this historically, you will probably be within historical return expectations. The people who put this money up will not receive the 20 percent expectation.

This means you will see funds pare back in size.

The hedge funds are out of the business and one of the major players has gone. You will not see the frenzy of 2003 to 2006. That $3 trillion is not the issue it was before. There has been a major structure change in the large end of the marketplace that will not come back for at least five years before you see that potential. It will be five to 10 years.

IVCA: In WP Global's 2009 market outlook and review, private equity was described as - œa tale of two markets and a story of size- . Please elaborate.
DP: The flip side of this is that the other sectors of the marketplace never depended upon debt as the principal element of generating return. Those financings have been in the 25 percent to 40 percent range. Some of those are being financed today.

When the market comes back, there will continue to be money in the debt ratios as what has historically been there.

IVCA: Why is the venture capital space less immune to the credit bust?
DP: Venture capital has traditionally been an equity investment. Debt is only brought to the table when you get into - œC-  and - œD-  financing rounds. I define venture capital as when you're taking a product risk. At that stage, nobody is going to lend you money.

If I prove the fact that my product works now, is there truly a market to sell my product into? Most of your venture capital-backed companies have a long gestation period. There will be at least a full market cycle from where we are today. This won't be hurting as a structure by any means at all.

IVCA: Can you compare how private equity classes are responding to today's economic woes versus the dot-com shakeout of 2000 and 2001?
DP: When we speak of what occurred in 2000 and 2001, we're focusing on one sector of the asset class.

That was venture capital. That bubble was blown out of proportion when business plans went public. You didn't even need a product. The dislocation of capital was only at one end of the market. The economy was also going through a mild, 13-month recession. This was more of a correction and didn't cause any structural harm in the marketplace.

What you're looking at today are the systemic and structural changes of what's taking place in the marketplace (specifically in the large end). It all ties into the capital markets. Those capital markets tie in more directly and we will see a more systemic and long-term change. The magnitude of economic change is what's so significant at this point.

What makes it different is the return expectations people have on their money. Back in the dot-com boom, people literally had a return expectation that approached the three digits. As we got into this period of time in 2007, people were expecting returns in private equity that were in the 30 percent range. This was equally as unsustainable.

This will return to historical levels. The magnitude of the economic change is going to have systemic issues on the large end of the marketplace that will change the industry forever.

IVCA: As a fund-of-fund manager, what's keeping you up at night these days?
DP: We do fund-of-funds and direct investments.

Among the biggest issues right now that are pending is the commercial real estate market. If that market corrects itself to the magnitude of what we saw in 1990 (coupled with what we just saw in the residential markets), it's very difficult to think that even this $14 trillion national economy can absorb both a residential and commercial adjustment at the same time.

There is no question that we are going through a commercial adjustment right now. What is the magnitude of that adjustment? What is the direct impact of the banking system at the end of the day? We are down to four or five major commercial banks in the country. We know we have capital problems with major banks. Can we layer this on top of that?

For the venture capital marketplace, it is tax policy. If the new Congress comes in and increases taxation at the individual level, this will impact venture capital. Most of your venture-backed companies are set up as an LLC or - œS-  corporation. with individual tax rates. If individual tax rates increase, the majority of those increases go to the small companies in the U.S.

Something like 85 percent of the people in this country work for companies with less than 500 employees. These companies are either subchapter - œS-  corporations or LLCs. A tax policy that increases those rates will slow down those companies. That would worry me. The commercial marketplace would also prolong the recession, which would also hurt that space.

IVCA: Where are the biggest opportunities today in private equity?
DP: The U.S. is still 75 percent of the private equity marketplace. We will continue to be that percentage of the total investable opportunity for the next decade.

If you stay within the middle-market opportunities with private equity (funds in particular that might be $2 billion in size and smaller as well as the VC marketplace), even operating in that marketplace should have the opportunity to make returns within the historical norms of those asset classes.

You will probably have a middle-market return that is in the 15 percent  to 20 percent range.

Venture capital will probably be in the 18 percent to 22 percent range. When you compare those returns to other opportunities, these are very opportunistic returns. Opportunities are still strong. In comparing these relatively to other asset classes, there's no question that there will be very strong returns in an equity marketplace where there will be single digits for a while.

We see opportunities in other parts of the world. People always have to keep in mind with these opportunities the risk involved in investing in foreign companies. The risk around the world is mostly political risk. There are still places around the world where you can't repatriate your investment. While you should still have this exposure in your portfolio, you need to understand that risk. Over the next three to five years, the U.S. is still a very nice place to put your money.

IVCA: When do you think we will return to more stable economic times?
DP: Stable economic times will need to be redefined. As I mentioned, there are systemic changes in our financial systems. A return to any level of normalcy will take quite a while. I don't know if this will be two years, three years or five years. It's not measured in months. It's measured in years.

IVCA: What do you suggest for private equity fund managers to do in the interim?
DP: Do what you have been doing. Stick to your strategy and what you do well. Don't try to migrate up or down the investment spectrum. In some areas of the marketplace, patience will be the most important asset and virtue. In many cases, they will also have to adjust their return expectations.

I don't think you will see that being quite as lucrative. Back in the early part of this decade, people asked me the difference in investing in 2003 as compared to what it was between 1995 and 2001. My response was that we just came off a period that - “ in order to raise money - “ you had to have a good story and be a good storyteller.

Now what is needed is more fundamental: deal flow, deal flow and more deal flow. Patience and flexibility is the name of the game now.