Peter Pfister, the newly appointed managing director of the Private Equity Group Asia Pacific for Private Wealth Management at Deutsche Bank discusses private equity as an asset class in the current market environment with Innovative Investor

How will private equity weather the current turmoil? Will the basic private equity model still work?

While the overall economic situation remains very challenging, we believe that the fundamentals for successful private equity investing remain intact: active ownership, full access to information, alignment of interests and a steady deal flow of under managed companies.

In addition, given the long-term nature of the asset class and the influence private equity managers exert over entry and exit decisions, private equity is better positioned to adapt investment decisions to changing market environments. In addition, private equity is one of the few asset classes that can thrive on the illiquidity that has caused significant problems for others. Private equity firms do not face the risk of investor redemptions, which means that they do not have to sell assets to meet fund redemptions, and it affords them the ability to step to the sidelines if market conditions are not attractive, and concentrate on improving the operations and profitability of existing portfolio investments.

Are institutional investors selling their private equity holdings?

It has been reported that a few large institutional investors such as pension funds, endowments and foundations are seeking to divest some of their private equity holdings in the secondary market. While this is true, it is not reflecting a general move to exit the asset class. Many sales in the secondary market are a response to liquidity needs, rather than an overall reduction of target allocations or an exodus from private equity as an asset class. As long-term investors, institutional investors need to continue to evaluate liquidity needs and rebalance allocations in light of the current financial crisis.

What are the prospects for private equity investing in the future?

Historically, private equity investments made during recessionary periods have delivered the best returns despite significantly reduced leverage. We believe that 2009 and 2010 will likely follow this pattern. Undoubtedly, leverage contributes to returns, but the notion that the highest returns in private equity are achieved primarily through leverage is misplaced. A study conducted by Boston Consulting Group in February 2008 shows that more than 50% of the value created by private equity firms came from improved sales and profit margins. Less than 25% came from the magnifying effect of leverage and a similar amount came from a rise in valuation multiples between purchase and sale.

Going forward, many deals will be done with little or no debt initially. These transactions can still deliver superior returns as a result of low entry prices which are expected to more than compensate for lower leverage and higher financing costs. The combination of low valuations and low levels of leverage could translate into transactions with improved risk-reward profiles relative to those before the credit crisis.

Private equity firms are by nature long-term value investors. The long-term investment horizon allows them to navigate through various market conditions. With approximately $1,000 billion of capital available across all private equity fund strategies and geographies, the private equity industry is well positioned to capitalize on the opportunities in the current market. Looking forward, we believe we are going to see a remarkable period in which private equity managers are going to make some of the best investments.

Furthermore, there are opportunities for private equity funds to deploy a significant amount of their available capital to participate in the necessary deleveraging of the economy.

Which private equity strategies are taking advantage of the current turmoil?

The current dislocation in the financial markets has created compelling opportunities for distressed and credit-driven, and mezzanine, investments. In the current market environment there is an unusual opportunity for mezzanine investments to generate equity-like returns by taking credit risk. Because of the scarcity of subordinated capital and the shift in negotiating power from borrowers to lenders, many current mezzanine transactions are priced to generate equity-like returns of 18% to 25% per annum.

As in the past down cycles, we expect a significant supply of distressed investment opportunities over the next 12 to 24 months, driven by an increase in default rates, significant corporate restructuring, and turnaround activity which typically accompanies periods of economic weakness.

How are private equity valuations of existing private equity in vestments impacted by the current financial crisis?

Difficult economic and financial market conditions combined with new mark-to-market accounting regulations (known as FAS 157) will result in continued downward pressure on interim valuations of existing private equity investments. FAS 157 requires private equity firms to mark-to-market unrealised investments based on an assumed exit price under current market conditions.

We expect the overall magnitude of the write-downs across private equity funds to be in the range of 20% to 35% for 2008, less severe than the decline in the global public equity markets as evidenced by the MSCI All Country World Index which was down 42%.

Due to the illiquid and long-term nature of the asset class, private equity managers are not under pressure to exit investments in the current environment. Many investments are likely to recover in value prior to exit and will have a good chance to generate attractive returns. Ultimately what counts in private equity are actual realisations (or 'cash-on-cash' returns) and not interim unrealised valuations. However, the implementation of the new accounting regulations will increase the volatility of unrealised values of private equity companies beyond what private equity investors have been accustomed to.

Unrealised mark-to-market valuations, while volatile, are expected to be transitory in nature and not necessarily reflective of portfolio companies' ultimate realisable values. Private equity is a long-term, investment, so quarterly mark-to-market is problematic.