Private equity: Maybe down, but not out

NEW YORK (Fortune) -- Despite turmoil in the credit markets, a string of broken deals, and a dramatic slowdown in M&A this quarter, the private equity deal machine is still humming, says a report released Friday.

According to Ernst & Young, buyout fund deal flow should remain strong in 2008 - even above 2004 and 2005 levels - because private equity firms still have a lot of unspent capital that they have to put to work. There are 150 private equity-sponsored funds with more than $1 billion, compared with only 14 in 1995, and managers at private equity firms tell Fortune fundraising remains strong.

Of course, just because money must be invested doesn't mean that the results will be spectacular. David Rubenstein, head of buyout titan the Carlyle Group, said last month that private equity funds will likely see lower returns in the years to come as it grapples with a tougher debt market. The report acknowledged the fact that the credit crunch will have an tempering effect on buyout activity. "It is expected that new deals will be done on more traditional terms," Ernst & Young predicts, signaling an end to the unusually generous financing agreements in the past few years, including sky-high debt multiples and loan contracts with few or no covenants.

However, the accounting firm still believes that private equity will be a significant force in next year's deal landscape. With sovereign wealth funds and other non-traditional sources of capital in the mix (i.e. hedge funds), the market will still be flush with liquidity, says the report. Other macro factors that should fuel private equity activity in 2008 include a weak dollar that will attract overseas investment to the U.S., and hopes that the Federal Reserve will keep short-1term interest rates - and thus borrowing costs - low.

One major source of deals is likely to come from opportunistic distressed investing funds that have raised huge sums of capital to buy beaten-down securities. And the three sectors that should continue to see activity in 2008 include financial services, media and entertainment, and energy. "Out of the $1.5 trillion in announced 2007 U.S. deal volume, almost a third was from deals in these three sectors," says the report. The researchers believe that buyers will scoop up badly battered financial services assets in the months ahead. They also say that the great wave of changes roiling the media industry will keep consolidation and spin-offs going in that sector. And high commodities prices, cost pressures, and international wealth funds should drive deals in the energy sector.

"Assuming that stability returns to the credit markets during the near term, expectations are that the slowdown in mega-PE deals will be temporary," the report says.