NEW YORK–(BUSINESS WIRE)–Private equity (PE) is poised for a comeback in 2011, with increased optimism for a steady revival of deal, fundraising and exit activity–but a fragile economy and credit market hangover could derail PE's recovery; this, according to the 'Global Private Equity 2011 Report,' released today by Bain & Company, the world's leading advisor to the PE industry.

Signs point to a healthy surge in demand for PE deals in 2011, according to the report, including:

• GPs still sit on nearly a trillion dollar stockpile of uninvested capital, i.e. 'dry powder.' This dry powder will help fuel a predicted surge in deal volume in 2011, given the inclination by many GPs to 'put money to work.' This positive trend is somewhat tempered by the fact that approximately one-quarter of the $434 billion of the dry powder targeted for buyouts is 'pressured capital'–committed capital in the hands of GPs with powerful incentives to return profits to limited partners (LPs) and extend the life of their firms–which may cause some pressured firms to overreach in their deal-making efforts and potentially drive up deal prices as a result.
• GPs will benefit from more stable debt markets. Major improvements in the dynamics of the debt markets increased the amount of leverage–a ratio of five times EBITDA by the end of 2010–that PE investors were able to bring to the financing of LBOs and the softer covenants attached to it in 2010 should continue into 2011, provided investor demand remains buoyant.

“PE firms are hungry to do deals,” said Hugh MacArthur, global head of Bain's Private Equity Practice. “But that hunger can quickly translate into heartburn for firms that ignore the new realities of PE value creation.”

On the supply-side of the deal-making equation, Bain estimates that the supply–and range–of PE deals should increase in 2011. Strong public valuations and buyers' willingness to pay healthy premiums on acquisitions during 2010 will continue to draw sellers of high-quality assets into the market over the coming year. Two additional key factors are likely to anchor an increase of potential PE targets:

• Bull market continues for secondary buyouts. Sponsor-to-sponsor deals, aka secondary buyouts, will remain popular in 2011 for several reasons: they can be completed more expeditiously than an IPO or a sale to a strategic buyer can, there are more PE-owned companies available for purchase following 30 years of deal-making, the fact that some companies are simply better suited for private ownership–given that these businesses are stable, enjoy predictable cash flows, require low capital expenditures and need limited working capital–and the relative performance of secondary buyouts which recent research shows is only slightly lower than primary buyouts, yet with a lower risk profile.
• A thaw in public-to-private deals. Robust public-to-private deal-making activity drove the last PE boom and will be essential for powering a healthy recovery going forward. Bain's proprietary analysis of 1,400 larger US public nonfinancial companies concludes that more than 400 companies with a combined market capitalization in excess of $1 trillion appear to have valuation and cash flow characteristics that could support a public-to-private transaction.

Other key findings from the report include:

• Pressures are building for increased exits in 2011. Unrealized investments for all PE funds swelled to $1.5 trillion by the end of the second quarter of 2010–$663 billion for buyout funds alone–a figure 50% higher than their holdings of dry powder and approaching 60% of total capital under PE fund management, the highest ratio in years. Seventy-percent of unrealized buyout investments are concentrated in buyout funds of vintages between 2005 and 2008 and virtually no buyout fund with a vintage after 2004 has yet to return paid-in capital to its LPs.
• Signs point to a fund-raising rebound, but a supply-demand imbalance will challenge GPs. Based on past patterns, fund-raising, which historically lags investment and exit activity, has reached a cyclical low and is poised for a recovery. Even as LPs increase their new commitments in 2011, the number of new PE fund opportunities will continue to outpace demand–making for a crowded and challenging fund-raising environment for GPs.
• Brazil is hot. China, India and the other hot-growth economies of Southeast Asia continue to top the list of markets where PE firms and LPs see the most promising PE opportunities. But Central and Eastern Europe and Brazil particularly are attracting increased PE attention. After Asia-Pacific, Latin America is today the second most-attractive emerging region, attracting nearly 25 percent of the PE funds raised for investment in emerging markets in 2010.

The report reveals that without market 'beta'–i.e. factors related directly to market performance–in the form of strong GDP growth, expanding multiples and abundant leverage to drive returns, average PE returns will be more modest over the next few years. Bain believes future PE returns will be shaped more by 'alpha,'–i.e. actions taken by GPs themselves, versus market beta–which will be created by four interrelated factors:

1. Develop an adaptive investment strategy built on core strengths. PE firms need to keep in step with LPs' changing tastes, but they cannot pursue diversification for diversification's sake. Bain analysis has found little correlation between the number of fund types or geographies in which a firm invests and its overall performance. Bain interviews with LPs reveal that many do not place a premium on firms that bridge several fund types or geographies; LPs evaluate each fund opportunity on its own merits.
2. Strengthen and professionalize the organization. PE firms need to attend to their organizational health and continually seek ways to professionalize, with a focus on four key areas–talent management, full-time investor relations, resources to support repeatable value-creation processes and the firm's general management, because the business of running a PE firm has never been more complex.
3. Have truly proprietary investment theses and beef up due diligence. Firms that are best in class recognize that strengthening their due diligence and investment-committee processes helps them avoid losers and develop the proprietary insights required to stretch for winners in the higher-than-ever competitive environment.
4. Build repeatable value-creation processes. Top GPs set themselves apart by their ability to add alpha to their portfolio returns through their distinctive portfolio-management strengths. They build processes that can be customized to the unique needs of each portfolio company and flexed to run through each portfolio company's life cycle.

“Top quartile PE firms must 'up their alpha game' now more than ever,” concluded MacArthur. “They won't rely on the market to do the work for them.”