From boom to bust, the private equity industry is attempting to reinvent itself for a much-changed world. Alex Aldridge assesses its chances of navigating the challenges ahead

A few weeks ago news got out that Bain Capital, one of the world's leading private equity firms, was holding interviews for junior investment professionals a month earlier than usual. Bain's competitors, which include Kohlberg Kravis Roberts & Co (KKR) and The Blackstone Group, moved quickly, bringing forward their pre-scheduled cocktail party recruiting events.

This was not a surprising development. Five years ago private equity houses often did their entry-level hiring in September. During the boom, such intakes kept drifting earlier into the year as rivals jostled to secure the best aspiring deal-doers.

Competition between applicants is fierce. When the industry was riding high, finance graduates would often aim to get their basic training at the likes of Goldman Sachs and Morgan Stanley before attempting to jump ship to the leading private equity houses, which were then drawing on huge amounts of cheap debt to pull off a series of increasingly ambitious deals.

Meanwhile, at the top international law firms, there was similar competition to secure places in City firms' private equity teams. With London well established as the leading centre for private equity in Europe, there is still no shortage of aspiring lawyers looking to practise in the fast-moving area, even after the deal slump of 2008 and 2009 when the banking crisis abruptly turned off the debt the industry had come to rely on. With private equity deals staging a modest but still substantial recovery in 2010, when deal values rose by 91% against the previous year, according to Mergermarket research, the sector remains a prime target for ambitious City lawyers.

"Private equity has become very popular among trainees. It's a growth area with excellent prospects," says Richard Youle, co-head of private equity at Linklaters. "These days private equity attracts very bright high achievers with great stamina," agrees Freshfields Bruckhaus Deringer practice head Chris Bown.

Barbarians emerge and the golden age

This marks a striking contrast with the not-so-distant birth of the sector. Indeed, back in the early 1980s the term 'private equity' was barely heard, with the fledgling industry simply known for what it did: leveraged buyouts (LBO). Having evolved out of the traditional venture capital business during the 1970s, in fusion with bankers experimenting with debt-driven deals, the LBO scene was initially made up of a handful of tiny firms staffed by mavericks who failed to fit into investment banks.

The industry's birth is, to a considerable extent, traced to the deals of Jerome Kohlberg, then a banker with the buccaneering Bear Stearns, itself the least conservative of the major Wall Street banks. Kohlberg was intent on using what became the LBO structure as a missing link to allow small owner-managed businesses to achieve a return on their investment. Working with a young George Roberts and his cousin Henry Kravis, the trio would in 1976 strike out on their own creating KKR, still the best-known name in private equity.

At first, it certainly wasn't the kind of place you would find the rising stars of the finance world, with many of those entering the industry hailing from unglamourous accountancy backgrounds.

Initially small deal sizes meant LBOs hardly registered on the radar of most of the large law firms. "There just wasn't much incentive to go into it because, relatively speaking, the sums in private equity at that point were so small. Basically, it was seen as fringe corporate stuff: a bit nouveau, complicated and document-intensive. In other words, a pretty hard way of earning your money," recalls Simon Beddow, European managing partner of corporate at Ashurst, one the first City firms to carve out a niche in the emerging area, alongside Clifford Turner (half of what would become Clifford Chance (CC)), SJ Berwin, Travers Smith, Macfarlanes and Dickson Minto.

The situation was somewhat different in the US, where the higher profile of the venture capital industry and rapid emergence of large LBO deals saw the country's leading law firms get involved much earlier on. The reason for this was obvious: from tiny unnoticed deals the private equity industry grew at an explosive pace, becoming by the 1980s a defining force on Wall Street as aggressively-structured $1bn (£621m)-plus deals became commonplace.

For example, white shoe outfit Simpson Thacher & Bartlett developed links with KKR as early as 1976 and would go on to represent the firm on its record-breaking $25bn (£15.6bn) buyout of RJR Nabisco in 1989, one of the most high-profile corporate takeovers of the era.

The rapid growth of this new industry echoed the changes sweeping corporate markets since the 1960s in the US in which hostile deals became commonplace. While Wall Street's traditional top-tier advisers had been slow to catch on to hostile takeovers – leaving the field to upstart firms like Skadden Arps Slate Meagher & Flom and Wachtell Lipton Rosen & Katz – they were determined not to make the same mistake this time, quickly moving in on the dynamic, if controversial, new breed of clients.

As the 1980s wore on, some of those larger deals spread to Europe, with the 1989 acquisition of supermarket chain Gateway for $3.6bn (£2.2bn) by a specially-formed LBO firm, Isoceles, topping a list of several mega-deals. Still, with these buyouts dominated by LBO firms with their roots in the US – and often advised by New York-based teams from US investment banks and law firms – the industry remained focused outside the UK mainstream.

At this point the perception of LBOs was summed up by the title of Bryan Burrough and John Helyar's celebrated book about the RJR Nabisco takeover, Barbarians at the Gate. As underdogs with plenty to prove, the LBO firms quickly developed a reputation for aggressive tactics and were criticised for their controversial strategy of buying companies using increasingly large amounts of debt.

Critics argued this amounted to 'stealing' companies or financial engineering, where costs at successful companies were slashed to service huge debts, in some cases pushing acquired companies into restructuring or insolvency.

In her 1991 Pulitzer Prize-winning piece for The Wall Street Journal, The Reckoning: Safeway LBO Yields Vast Profits but Exacts a Heavy Human Toll, Susan Faludi explored the human cost of the 1986 Safeway LBO, which would see thousands of workers laid off.

Advocates of the industry have a very different take, arguing that in forcing bought-out companies to operate more efficiently, LBOs result in benefits to the wider economy, ultimately freeing up money for job-creating future investment. This school of thought also emphasises the strong alignment of ownership and management in private equity in contrast to the diffuse structure of public companies. Adherents argue that the discipline of private equity is far better at reshaping struggling companies than the consensus-driven governance model of a publicly-listed firm.

By the end of the 1980s, though, even this latter group mostly agreed that the level of debt being piled up on the largest buyouts was becoming unsustainable – in some cases exceeding 90% of the buyout purchase price. Ultimately, both the RJR Nabisco and Gateway deals would paralyse the respective companies and require a series of refinancings to resolve the mess. By the same token, the collapse in 1990 of Drexel Burnham Lambert, the Wall Street bank that was the most aggressive arranger of 'junk' bonds to back many of these deals, signalled a clear end of the first wave of the buyout industry.

The somewhat chastened LBO sector that emerged from the recession during the early to mid-1990s – characterised by lower leverage, smaller deals and the longer-term development of companies – operated under a new brand: private equity.

Its image was slowly being rehabilitated and European funds like Cinven, Candover and Schroder Ventures grew, helping to develop London into a genuine centre for the industry with a sizeable group of specialist advisers. "It was in the early 1990s when private equity really took off," recalls Travers Smith private equity head Philip Sanderson (pictured).

As deal sizes rose again – gradually at first, but then rapidly, culminating in the $1bn buyout of Generale de Sante healthcare – the City's traditional M&A leaders began sizing up the market. In particular, Freshfields recruited Chris Bown from Baker & McKenzie to spearhead a private equity team in 1998 in a push that was to prove extremely successful in the following decade. Linklaters followed with the 2001 hire of Graham White from SJ Berwin. A wave of US-based advisers were also looking at the London private equity market from the late 1990s as their domestic clients started to hunt for European acquisitions. Longtime Bain Capital adviser Kirkland & Ellis was among the early entrants, alongside Latham & Watkins, which has close ties to The Carlyle Group, with Weil Gotshal & Manges and Debevoise & Plimpton also active.

A steady momentum was already building at the end of the 1990s before the bursting of the dotcom bubble in 2001 and the 9/11 terrorist attacks in New York that same year would lead central banks to slash interest rates aggressively. A wave of cheap debt applied booster rockets to the industry, allowing buyout houses to soon hunt for assets of what would have once been an unthinkable size.

By the end of the 2004, The Economist famously – and not uncritically – dubbed private equity firms "the new kings of capitalism". So successful was the industry that it achieved the distinction of becoming a Hollywood villain, with a remake of The Manchurian Candidate including a shadowy finance house that many thought was loosely modelled on Carlyle.

There was plenty of work to go around as the market entered a period that KKR co-founder Henry Kravis dubbed the industry's "golden age". Until 2006 RJR Nabisco had stood as the largest-ever deal in the industry for 17 years, but as leverage soared, that record was beaten 14 times in an incredible 18-month period, culminating in the $45bn (£28bn) takeover of US energy firm TXU by KKR and Texas Pacific Group. Among the highlights of that period was the £12.4bn (£7.7bn) Alliance Boots deal in 2007, the first-ever take-private of an FTSE 100 company. A few months after it was concluded, the market turned.

2007 and all that

For obvious reasons, the credit crunch of 2007 and the banking crisis of 2008 were bad news for the buyout industry. Very bad news. With cheap debt gone, the problems facing the industry were stark and worth recounting. For one, sellers had become used to getting high valuations during the boom and were generally reluctant to downgrade their expectations. In addition, deals done at the boom were huge and had vast amounts of debt, which was now much harder to syndicate and refinance. According to research from Freshfields, there was total debt financing of $600.1bn (£374bn) across 1,460 deals globally in the peak year of 2006. By the trough of 2009, this had fallen to $43.3bn (£26.8bn) on 536 deals.

The US in particular in late 2007 and early 2008 saw a number of cases of buyout houses suffering buyer's remorse and then trying to get out of agreed deals as the financing environment worsened dramatically. If skirmishes over closing deals were quickly resolved – and not always happily – other problems were more lasting. Inability to do deals meant private equity houses couldn't return money to investors, use existing equity commitments for deals or raise new capital if needed.

The deal machine had ground to a halt. And in the meantime, many portfolio companies were struggling under debt, triggering a wave of restructurings, insolvencies and painful write-downs on assets. In the gloomy environment, there were widespread expectations that swathes of an industry that had grown rapidly would collapse or at least go into run-off.

In reality, those predictions have largely failed to materialise, though many leading private equity houses have slimmed down substantially. There were certainly some high-profile reverses, with Candover, one of the proudest brands in European private equity, announcing it would unwind some of its assets and return money to shareholders and investors last year. There were a number of high-profile restructurings and defaults of indebted companies in which banks seized control of assets or private equity houses were forced to inject more capital.

In Europe, arguably the most high-profile of these reverses was the music group EMI, which was bought by Terra Firma in 2007 in a deal worth £4.2bn. Almost immediately the group struggled under the debt used to back the deal, before Terra Firma founder Guy Hands engaged in a high-profile claim in the US courts, arguing that its main lender Citigroup had misled him over the acquisition. The case was dismissed by a US jury in 2010 while earlier this year Citigroup took full ownership of EMI, triggering a £1.7bn loss of the equity of Terra Firma and its backers, the highest-ever loss on a single private equity deal in Europe. (Terra Firma has said it will appeal the US verdict.) Despite such problems, banks' unwillingness to trigger more losses has meant that more organised restructurings and refinancings have generally been the order of the day.

Speaking earlier this month at SuperReturn International, the buyout conference in Berlin, Hands argued that a combination of the US troubled asset relief programme and central banks' decisions to keep interest rates low to help liquidity represented a set of "get-out-of-jail-free cards" while warning that considerable problems remain with private equity houses' portfolios.

His words are echoed by Macfarlanes partner Charles Meek: "Very early on in the credit turmoil the private equity community and the banks realised that there would be a lot of sorting out to do. With the help of what is now a very sophisticated secondary debt market the banks, and in some instances portfolio companies, have been able to reschedule, restructure or simply trade many of their difficult, underperforming loans; and to some extent that is why far fewer companies have been forced into administration than might have been expected."

Part of this general mood of emerging optimism relates to the fact that private equity firms hold so much unspent money – in excess of $400bn (£249bn), according to some estimates – thanks to a period of heavy fundraising in the run up to the financial crisis. But a continuing lack of availability of debt and a general sense of nervousness about the state of the economy have combined to limit deal sizes. "Although it's been two years now, we're still effectively coming off a boom, which requires a period of adjustment of expectations. Really we're still waiting for the establishment of that new paradigm," says Neel Sachdev (pictured), an acquisition finance partner at the London arm of Kirkland & Ellis.

The result is that the deals that have been done since the financial crisis have been characterised by their smaller size and lack of leverage. For example, last year KKR acquired Pets at Home for £955m, with a conservative £335m of senior debt and £120m of mezzanine debt.

There are signs, however, that the market could be on the verge of a comeback. European buyouts more than doubled in 2010, the total value of deals done rising to €50.3bn (£44.1bn), from €20.2bn (£17.7bn) in 2009 – in part a result of the recent strong performance of the high-yield bond market. With pressure from investors for returns growing, a further wave of activity is expected, say lawyers. "Funds' investors, who pay a yearly management charge, are going to start demanding a return on their investment," argues Beddow. "I expect a considerable upturn in the number of deals being done in the next 18 months."

Meanwhile, the success this month of BC Partners in raising €4bn (£3.5bn) for a buyout fund – one of the largest of its kind since the financial crisis – is being cited as a bellwether for the industry: "People had been watching that fundraising carefully, and its successful outcome shows an encouraging willingness on the part of [investors] to continue to support the market," says Macfarlanes' Meek.

Indeed, there is a growing feeling that the industry has enjoyed a surprisingly good recession, with private equity as a proportion of the M&A market actually increasing over the last year, according to the Centre for Management Buyout Research. This corresponds with the pattern of previous dips in the cycle: "Downturns have not always been bad for private equity," continues Meek. "Private equity houses' access to committed, and therefore available, capital has allowed them to do some very good deals at the bottom of the market, and in some instances the returns generated on those deals have helped the industry as a whole to emerge into a new era in better shape."

The maturity wall

If there are a number of reasons for relative cheer for the private equity industry, a major challenge will be dealing with the so-called 'maturity wall', the huge amounts of sponsor-friendly debt backing deals done during the boom that will need to be refinanced between now and 2016. An analysis by Freshfields using data from Dealogic estimated that $814bn (£507bn) of maturing debt needs to be refinanced within the next five years. Managing this will be relatively doable over the next two years but will become considerably more challenging in 2013 and 2014 when the debt on the largest boom-time deals will need to be refinanced. Freshfields calculates that while there will be $80.2bn (£50bn) refinanced this year, up from $43.4bn (£27bn) in 2010, this will peak at just under $200bn (£124.6bn) in 2014.

Options will be further constrained by the number of banks withdrawing from the leveraged finance market and new standards on bank capital. This will be most pressing in North America and Europe, where the vast bulk of these deals have been done. There are, however, a number of means to break down the wall. Advisers expect a renewed rash of 'amend and extend' deals, whereby creditors gain better terms in exchange for extending the maturity of existing debt. Other approaches include forward start facilities, which were deployed by many portfolio companies during 2008 and 2009. The model sees existing lenders commit in advance to new reserve facilities than can be used to repay existing debt in exchange for a fee.

The rapid expansion of the market for European high-yield bonds during 2010 is another alternative means of refinancing. The recent popularity of such bonds in part reflects the willingness of investors to take over some of the commitments of retrenching banks. The use of such bonds, already common in US buyouts, is also becoming increasingly common in new acquisitions.

However, the ability of the industry to manage this mountain of debt will in part rest on its ability to exit its investments. The outlook for initial public offerings (IPO), a traditional exit for private equity investors, has shown signs of recovery, with more than 15 floats in Europe in excess of ‚Ǩ1bn (£878m) between the fourth quarter of 2009 and the end of 2010. There is also a strong pipeline of companies looking to float in 2011 but, with a series of planned IPOs already postponed this year due to volatile conditions, the outlook remains uncertain. (Such conditions also explain the current popularity of secondary buyouts – where private equity houses sell companies to other private equity houses.)

The turbulent environment also explains why many believe that the private equity industry could generate more litigation in future. Potential areas of dispute involve high-profile investment professionals leaving, banks in disputes with sponsors or lenders trying to push through restructurings.

It appears that a more risk-conscious industry will expect its lawyers to anticipate more problems, help it through longer negotiations and produce more stress-based, document-intensive deals. It also partly explains the vogue for private equity houses to hire veteran partners for general counsel roles to handle increased regulatory workload, particularly in view of the European Union's Alternative Investment Fund Managers (AIFM) directive. Recent months have seen Apollo Global Management hire O'Melveny & Myers private equity partner Paul Loynes as its first European head of legal and Apax hire Goldman Sachs counsel Simon Cresswell as legal head. Bain Capital is also currently looking to recruit an experienced partner as its first European general counsel.

The next generation

If the March recruiting round illustrates the industry's continuing ambition, the recent acquisition by various private equity houses of alternative asset divisions from investment banks suggests there is an evolution of sorts going on. In October last year Goldman Sachs' proprietary trading desk joined KKR. The move follows Apollo's acquisition of Citigroup's real estate investment division and Blackstone's takeover of Bank of America's Asian property business.

"The big private equity firms are diversifying," says a leading partner at a US firm in London. "They are becoming, if you like, the new investment banks."

The changes are partly a response to rules imposed by the US Dodd-Frank Act, which limit the involvement of banks in riskier investments. Nothing so draconian has been passed in the UK – in part thanks to the British Private Equity and Venture Capital Association's successful lobbying last year against the harsher elements of the AIFM directive.

SJ Berwin partner Simon Wittney comments: "There is no question that the AIFM directive will have a major impact on the European private equity industry. But we are in a crucial phase at the moment, and to a large extent the Level 2 measures will determine how dramatic the impact will be."

But the implementation of new capital requirements under the upcoming Basel III standards on bank capital, which is designed to force lenders to increase their financial strength and limit risky lending, is likely to prompt some similar acquisitions on these shores. "Given their proven ability to raise large amounts of money, private equity houses are the natural homes for any alternative asset divisions that banks want to sell. Many corporates will not be able to raise the sort of money BC Partners has just raised," says Beddow.

A related factor is the trend among private equity houses to go public – KKR joined Blackstone as a New York Stock Exchange-listed company in July, with Apollo and Carlyle also exploring public listings. The responsibility to shareholders is adding to pressure to spread risk by moving into new areas, as well as making the larger houses more 'corporate' in governance. Others argue the diversification will only go so far, pointing out that risk is what defines the industry. Weil Gotshal private equity partner Marco Compagnoni (pictured) comments: "If you diversify too much you'll create a disincentive to invest. Risk is attractive because it can lead to spectacular returns. In any case, private equity investments are almost always part of a diversified risk portfolio."

Still, there's little doubt that the atmosphere within the private equity industry is changing. "Many private equity houses started independent life as very close-knit, entrepreneurial partnerships. Some of the houses are now very large indeed, and maintaining that ethos in a big environment is, I suspect, one of the challenges those houses face," says Macfarlanes' Meek.

This means institutional relationships are becoming more important – a process which comes at the expense of the individual connections private equity has long been famous for. "With even the smaller private equity firms employing general counsel and initiating panels, the atmosphere is clearly changing," says Sachdev.

However, the personalised nature of the industry is still one reason why law firms have continued hiring senior private equity specialists, as partners frequently take clients with them when they move. "Private equity advisory work remains highly relationship-focused. As some of the large private equity houses grow larger that will evolve to an extent, but at its core the industry is joined together by relationships, and that is the real draw to many of those that work within the industry," says Sanderson.

Notable hires last year include Kirkland bringing in rising-star Ashurst partners Gavin Gordon and David Arnold – reputedly offering the pair £1.4m and £800,000, respectively – while Debevoise & Plimpton hired Travers Smith partner David Innes.

Also closely watched is the City arm of Simpson Thacher & Bartlett, New York's top private adviser, which last year hired highly-rated CC funds head Jason Glover. The move followed up its much-touted hire of CC corporate veteran Adam Signy in 2009. Weil Gotshal, meanwhile, also remains an aggressive competitor in the European buyout market, boasting high-profile lawyers like Compagnoni and Mike Francies.

UK advisers continue to battle it out for dominance, with traditional frontrunners CC and Freshfields taking the lead on international deals, while Travers is generally regarded as the strongest player in the quality mid-market space.

In this competitive market, many American advisers are hoping that the rise in popularity of US financing techniques like high-yield can give them an edge (though UK firms, having made a series of investments in the practice in recent years, argue that they are breaking down the dominance of US rivals). Kirkland's Gordon comments: "It is an interesting time because the pecking order, which was well established, is seeing some changes."

These teams are increasingly being led by a new generation of private equity lawyers who have only known private equity in the mainstream manifestation it has occupied in the last 10 to 15 years. "Quite a lot of people in private equity are on the verge of retirement. Soon a new generation who have only known private equity at the heart of M&A will take over," says Freshfields' Bown.

As a new generation emerges it appears that a more corporate incarnation of the private equity industry will be rising to prominence, even if it will have evolved considerably from its previous form. Despite being written off so recently, the barbarians appear to be once more looking for opportunities to storm the gates.

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