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Mirror, Mirror on The Wall

By Marc Raybin, Editor in Chief

PrivateEquityCentral.net / HedgeFund.net / Alternative Universe

With the book quickly closing on 2006, a year that will certainly go down in history as the time of the mega-deal and mega-fund, it is only natural to turn the page to next year. Considering the amount of money pouring into private equity, a long-term asset class, chances are business will be pretty good for the near future. The question, however, is at what price?

Paul Schaye, a managing director of Chestnut Hill Partners, predicts private equity will continue to prosper at the expense of hedge funds.

If you look at what hedge funds have become, it is the Wild, Wild West, says Schaye. It does not have the same kind of discipline that you have when you look at private equity.

Schaye speculates a shakeout will hit the hedge fund market at some point relatively soon. Should that happen, he believes investors in alternatives will move their money toward private equity and away from hedge funds, with the implication being the former is more stable than the latter. Schaye likens the current state of hedge funds to the atmosphere of what private equity was 20 years ago. If he is correct, that means what is bad for hedge funds could be good for private equity.

As far as specific sectors are concerned, Schaye believes healthcare and financial services will continue to flourish next year. He thinks investment will gravitate to these industries, taking away from money that would usually be allocated for classic manufacturing. Schaye points toward the margins in healthcare and financial services as being much greater than the margins found in manufacturing.

Whoever thought Ford Motor would be leveraging their assets, asks Schaye. They have never done that in their 104-year history.

Schaye is not alone in this belief. John Sinnenberg, a managing partner at Key Principal Partners, echoes these sentiments, saying healthcare works in a long-term, secular, trend. KPP does not invest in financial services, due to the firms connection with banking company KeyCorp.

When it comes to looking at the automotive industry, Sinnenberg disagrees with Schaye, saying there will ultimately be money to be made in that space.

The question is how far down have things gone, says Sinnenberg. There are going to be firms out there supplying the OEM and [that begs] the question of whether it is this round of financing or the next round [that will be profitable].

Sinnenberg also points toward the possible benefits an economic slowdown for restructurings. Firms that specialize in this sort of transaction could find themselves in the middle of a windfall if the market loses steam in 2007. Sinnenberg predicts a number of companies will need to refinance in light of slowing economy combined with the amount of leverage taken against the company. These businesses need a reasonable amount of growth in order to make the leverage work and if the growth is not there, odds are the companies will have to redo their deals.

You will end up with companies that are defaulting and probably investors who are not prepared to work through those issues, explains Sinnenberg.

Both Schaye and Sinnenberg are in agreement about the future of the building sector in the United States. Schaye acknowledges the space has taken a hit recently and thinks the trend will continue. He says it is not so much private equity investing in real estate that could be in trouble, but rather, the related industries that are at risk. Building materials and distribution are two areas that he noted specifically. Sinnenberg says the multiples that are being asked for by potential sellers in construction would seem attractive at their face value, but considering the downward trend that he suspects will continue into the New Year, the numbers do not add up. In fact, he thinks the sector will not reach rock bottom until after next year. Sinnenberg anticipates a gradual decline through all of 2007.

Predicting the future is always a tricky proposition and seeing that neither Schaye nor Sinnenberg has a time machine, we will have to cut them some slack if their prognostications do not come out exactly as they say.

Considering the amount of capital flooding the asset class and the need to get deals done, perhaps next year at this time private equity investors will be putting their money in fortune telling.

You never know.