When the credit bubble burst, many industries and companies went from irrational exuberance to abject despair. With credit markets still mangled, private equity firms now face a dire and uncertain near-term future, since their industry is largely based on the availability of credit and raising capital. Fools should not be surprised to hear that private equity won't be investing as avidly this year as it did in 2006 and 2007.

The losing side of leverage
Many private equity firms are in the business of leveraged buyouts, or LBO's. They raise equity capital for an internal fund from outside investors, including pension funds, endowment funds, sovereign wealth funds, and institutional investors. The firm then uses capital from that fund, in conjunction with debt, to purchase a company. The company is taken private, restructured, and monetized through an outright sale or IPO, which hopefully pays off the debt the firm incurred to make the purchase in the first place, with enough left over for a tidy profit. That debt makes up most of the purchase price, thus putting the "leverage" in "leveraged buyout."

Several private equity firms found themselves unable able to close previously made deals after the credit markets froze over. Some well-publicized deals have begun to unravel based on financing and market conditions, including J.C. Flowers's venture for Sallie Mae (NYSE:SLM), Cerberus's deal for United Rentals (NYSE:URI), and Blackstone's (NYSE:BX) deal for Alliance Data Systems (NYSE:ADS).

"It's tough to do an LBO without 'L,'" said Greg Ledford, managing director at private equity firm The Carlyle Group. "Along with the industry, Carlyle is spending a lot of time just on our portfolios to make sure they can ride out the economic slump."

The credit drought
Carlyle had better luck than many of its struggling peers. "Fortunately, we were able to complete every deal that was in the works, though some deal terms were changed late in 2007," said Ledford. Carlyle closed a buyout of consulting firm Booz Allen last year, which was announced after the credit crunch began and became one of the larger deals made in 2008. Additionally, despite the tough environment, Ledford says Carlyle hasn't rethought target returns on deals.

Falling asset prices may make for attractive valuations, but they might not serve as an impetus to launch more deals, since the heart of the problem remains dried-up credit. "I've done this for more than 20 years and gone through cycles, but nothing like this credit crunch," said Ledford. "In terms of valuation, it takes a while for it to shake out to where people's expectations meet the market's demand, and that's now occurring. So I don't think the valuation is so much the issue, as it's just the lack of credit to allow the normal types of transactions to get done in this market. "

Diversification won't salvage the situation, either. Unlike hedge funds and others, which have methods of diversifying investments to stay afloat in the current environment, it's difficult for private equity firms to diversify investments. Funds are raised for a specific purpose; as a result, it's difficult to change the type of investment based on the partnership agreements they've entered.

Not all is lost

While 2009 will be a tough year, it should still provide restructuring opportunities and places to put equity to work. The industry's deals probably won't be quite as grand as those seen in the past decade, but there's still $760 billion of capital in private equity hands to fund potential deals. "I think you'll see smaller deals than those done in the 2006 time frame, and I think we'll see more deals in the emerging markets of India, China and the like," said Ledford.

Deals could also sprout from the carnage of the banking industry and its different "toxic" assets. Private equity funds such as Carlyle or Blackstone could capitalize in conjunction with tarnished banking assets. "They're talking about private money coming in, so there might be a role for private equity there," he said.

The future of the industry

The industry has evolved over time, and if the credit markets come back -- as expected -- the buyout business should return to normal. The difference is that the deal size most likely will not be the same as in 2006 or 2007, because the credit markets probably won't return to its frothy pre-crunch heights. Also, regulators could crack down on the industry, resulting in more oversight.

"I'm not sure I'll see that in my career again," Ledford said of previous years' boom times. "In terms of returns of getting deals done and being part of capital markets I think that's near term. But again, it really depends on the credit markets."

Take a lesson from private equity
If nothing else, the current state of the private equity industry illustrates credit's importance -- it's as vital as oxygen for businesses. For individual investors on the prowl for lucrative investments, it's important to remain focused on companies with strong balance sheets and manageable debt positions. Beware of companies that need constant access to credit, and favor companies that can finance their own activities. Search for companies with low debt, strong cash positions, and positive free cash flow.  Among other companies that fit the bill (and may merit further research), consider Cisco (NASDAQ:CSCO) and Johnson & Johnson (NYSE:JNJ).

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Fool contributor Jennifer Schonberger owns shares of Johnson & Johnson, but does not own shares in any of the other companies mentioned in this article. J&J is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.