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The Changing Face of Private Equity

The credit crunch has resulted in fewer financing options for big buyout firms. Now they’re having to reinvent themselves.

What a difference a year makes for private equity.

About this time last year, the industry was inking deals at a dizzying pace and raking in massive profits, making it the hottest game on Wall Street.

While private equity shops are still raising massive amounts of money, tight credit market conditions are forcing large buyout shops to rethink the business model that brought them so much success in years past.

“It is clear they are going through the process of reinventing themselves,” said Josh Lerner, a professor who specializes in the study of private equity at Harvard Business School.

Private equity firms buy companies – mostly with borrowed money – with the aim of overhauling their businesses and selling them at a profit or taking them public, usually within three to five years.

Some things stay the same, but changes underway

Big investors like pension funds and foreign wealth funds seeking sky-high returns are still flocking to private equity.

During the first three months of the year, buyout shops raised nearly $164 billion – the second biggest quarterly haul on record, according to the London-based research house Private Equity Intelligence.

But in order to finance their deals, private equity firms still have to secure funding from banks. That has proved difficult in recent months as lenders have been unable to find investors willing to take on the risky loans these deals entail.

So far this year, buyout deal volume has reached just $82 billion worldwide, according to deal tracker Dealogic. That’s down 68% from nearly $261 billion during the same period in 2007.

“Sales are down, margins are [lower] and costs are up – everything is being squeezed,” said Paul Schaye, managing director of Chestnut Hill Partners, a boutique investment bank in New York that works with private equity firms.

In addition to turmoil in the credit markets, getting sellers and buyers to commit to a deal is now layered with challenges, experts say.

Many companies are less willing to accept buyout offers. “People still have in their mind – ‘Two years ago I was offered X for my business’ – so there is that residual frothiness in the market,” Schaye said.

At the same time, there is a reluctance by some private equity shops to go shopping – even with the number of undervalued firms seemingly on the upswing, said Howard Spilko, a partner and head of the private equity group at the law firm Kramer Levin Naftalis & Frankel LLP.

“Just because something is cheap or cheaper than it was six months ago doesn’t mean it’s a value,” said Spilko. “They might be catching a falling knife.”

Adjusting their game

As a result, private equity heavyweights like Blackstone Group (BX), the Carlyle Group and KKR are having to adapt.

For instance, since late last year, buyout firms have increasingly targeted smaller acquisitions, experts like David Brophy, a finance professor at the University of Michigan’s Ross School of Business, said.

“The drum that keeps beating steadily is the middle market,” said Brophy, who also directs the school’s Center for Venture Capital and Private Equity Finance.

In January, Bain Capital announced plans to buy Bright Horizons Family Solutions, a provider of employer-sponsored child care, for $1.3 billion. That same month, an affiliate of Blackstone announced plans to partner with Wellspring Capital Management to purchase the food distributor Performance Food Group for $1.3 billion.

The size of those deals pales in comparison to last year’s blockbuster deals, such as the take-private of utility firm TXU Corp. by KKR, TPG and the private equity arm of Goldman Sachs for $44 billion, or Blackstone’s acquisition of Hilton Hotels for $26 billion.

In fact, buyouts announced worldwide so far this year have averaged $210 million in size, according to Dealogic, less than half of what the average was in 2007.

Private equity firms are also increasingly considering alternative investment options like acquiring stakes in public companies.

Last month, an investment group led by the private equity giant TPG acquired a $7 billion stake in Washington Mutual (WM, Fortune 500). In a similar move, National City (NCC, Fortune 500), another bank hit hard by the meltdown in the housing market, sold off a chunk of the firm to a group of outside investors led by the New York-based private equity firm Corsair Capital in exchange for a $7 billion cash infusion.

At the same time, the big private equity players are increasingly scouring the globe for investment opportunities, said Paul Schnell, a partner in the U.S. and international mergers and acquisitions group at the law firm Skadden, Arps, Slate, Meagher & Flom LLP.

Firms like the Carlyle Group have ramped up staffing in emerging markets like India, China and Latin America as part of an industry-wide push to find companies with strong growth prospects, he said.

“Increasingly private equity funds are looking outside the U.S. because they are finding a lot of companies with much greater prospects of significant growth,” said Schnell. “They can do these deals with less leverage but with significant returns.”