Finance Ind III (Readings): Private Equity Futures - from Golden(Gilt) to Iron Age
A major and critical part of the financial frenzies of the last several years have been the LBO buyout and somewhat related buyback booms. As most of us know by now there's been a relative freeze on LBO activity since last summer, at least among the very large/large PE funds. Talking to my friends in the mid-size business that began to show up abruptly around the holidays and, judging from various statistics on mid-size deals, has spread there as well, if not as seriously. Yet at the same time the various PE firms have continued, successfully, to raise enormous amounts of investment dollars. Despite the fact that, if anything, the freeze continues and, if you believe our analysis, is likely to face much worse.
Part of it of course is that buyout funds have, over the years provided unusually good returns and part of it is that there have been few alternatives in this era of low returns...so why not ? And another part, how much we don't know, is that LBO activity, or more correctly Private Equity investing is actually facing several interesting opportunities. Thought not as business as usual. But let's backtrack a bit and start with this chart, slightly dated, of the cycle in buyout fund investments.
You'll have to update it a bit in your minds eye with the '06 and '07 data which was even larger than the illustrated '05. The catch is that buyout investment kept on during YTD for this year as well. As you can see historically there were pronounced cycles in the business accompanied by a general upward trend in the amount of funds raised. A trend that was non-linear. It'll be interesting to see what updated versions of this chart look like when they become available because if the news headlines are right fund raising hasn't busted so far even if investing has.
There's another interesting aspect of this, which is what do you do with the money. With so much of
it floating around there was not only an enormous increase in total funds but a lot of new firms and funds got started. Like the Hedge Fund industry though there are also enormous differences in performance. My suspicion is that these historical differences in fund performance and in performance over the years are about to get greatly exaggerated as we find out who's been swimming naked indeed. In the first sub-chart notice that the top firms enormously outperform the rest of the pack. And then bear in mind that all the newbies performance is not yet, and won't be for some time, reflected in those numbers. The second sub-chart suggests that there's also a big difference in performance over time that's worth looking at as well.
Take a careful look at this chart and notice that the years of great performance are years of significant downturn - that is investments made during '91 and '01 did exceptionally well. Why ? Well largely because they weren't made at extraordinarily high multiples with unusual leverage built into them. All of which is not true this last few years. This time around there were three things that were generally true. 1) Prices (EBITDA multiples) were exceptionally high - most likely as a friend of mine has pointed out historically unique and never to be repeated. 2) Funding was easy and cheap so the levels of leverage in deals was also unusually large - which is about to come back and haunt folks a great deal. And 3) the terms of that borrowing were extraordinarily lenient - what're called "covenant lite" in terms of re-payment, default and other loan terms. Which means a lot of deals got done at too high a price, with too much leverage and assuming that prices would keep going up. Stop me when this all sounds familiar.
Yet in these potential disasters lurks at least a couple of key alternatives. Actually several. First off all that debt is going to generate a lot more distressed debt than in previous cycles and the PE firms are going to be able to pick it up for half price, or perhaps better. Though they'll then face some serious workout problems. Which leads to the second major opportunity for those who kept some dry powder and their heads - as Wilbur Ross has shown in his beginning to buy up mortgage servicing firms. There'll be a lot of companies across many industries who used capital to buyback their own stock, are now leveraged at the beginning of a major downturn AND didn't make the operational improvements they should have with those funds. Judging from the historical cycles illustrated above that suggests that as we move into and thru the downturn, whatever it's length and depth, PE companies who focus on returning to their roots and have the skills and acumen to do so will be doing well in the years ahead.
By return to their roots we mean moving away from financial engineering, though not ignoring or neglecting the benefits of capital re-structuring. And moving toward what's been claimed as the major benefit, capability and strategy of PE firms. Putting in money, re-vamping operations, instilling good management and management practices and in general returing enterprises to high performance status. The firms that can do that in the next few years stand to do very well indeed and ought to be entering a new era. Not a golden one that turned out to be gilt. Rather an "Age of Iron". Look back at the second chart and the huge jump in performance between the top and restof the pack, especially during tough times.
As you go over the readings below you'll find a lot of these various aspects reflected from the section on the Strategic Outlook to indicators of current deals slowing and/or going bad. To my favorite section on the Mid-Markets. Now there's not a lot ever covered in the MSM on the mid-markets. So what you'll read there are the excerpts from various newsletters and seminar announcements which have come to my attention. Which aside from their intrinsic merits also are great indicators of the outlook - and they all are focused, one way or another, on the situation as we've sketched it. Life is about to get interesting indeed for the Private Equity industry.
Strategic Outlook
Private equity: Year of the vulture While the days of the brainless megabuyout are over (at least for now), private equity has not gone away. It has just retreated. Veteran dealsters say they welcome the current separation of the men from the boys, of the serious players from those who merely surfed on waves of cheap debt but have now wiped out. What's different in private equity now from its last meltdown, in the late 1980s? Answer: It's become part of the landscape in a way that it wasn't 20 years ago. If you get coffee at Dunkin' Donuts, stay at a Hilton, or drive a Chrysler, private equity is part of your life. If your pension fund has money invested in buyouts, these guys' performance will have a say on whether your golden years are spent eating caviar or cat food. Many public-employee pension funds have a piece of buyout action (or soon will), and if they don't make their projected returns, governments will turn to taxpayers to make up the shortfall. So what do smart people do when they're confronted with violent change in the markets? For starters, they're engaging in what we'll call "double cropping," which we'll explain in a minute. Second, they're making grand plans to profit off the next boom by becoming publicly traded companies. That's the same transformation that a previous generation witnessed when a handful of brokerage houses began going public in the 1970s.
Following the Era of Large Buyouts, Private Equity Funds Find New Ways to Compete Now that credit has dried up, the future of large private equity buyouts has become uncertain. Today, buyout firms are looking to compete in middle-market and foreign deals and, in many cases, are teaming up with strategic buyers and corporations in new types of transactions. According to PE firm partners and other industry experts, the economic downturn has also paved the way for a resurgence in distressed investing, as lenders and investors alike begin to adjust to new pricing realities.
Carlyle Says Game Is Set to Restart Carlyle's David Rubenstein expects more $2 billion to $4 billion deals in coming months as companies begin to adapt to life beyond the era of megabuyouts. Early last year, private-equity firms struck deals that were as large as $45 billion, fueled by easy credit. Later in the year, as credit markets seized up, deal making ground to a halt and some of those buyouts collapsed. Now, as credit markets show signs of thawing, Mr. Rubenstein says, private-equity firms will cast their nets wider and close more deals ranging in value from $2 billion to $4 billion and that require less debt. One example is Carlyle's recent purchase of a majority stake in the U.S. government-consulting business of Booz Allen Hamilton Inc. for $2.54 billion
French Boardrooms Are All Shook Up as Private-Equity Funds End `Beffa Era' Investor activism is shaking up French boardrooms as funds buy stakes in listed companies following a credit shortage that dried up financing for leveraged buyouts. The confrontations are breaking down links between executives and directors who attended the same schools and sat on each other's boards, making managers more accountable. The cozy relationship between companies and the state left France behind the U.S. and the U.K. in adopting shareholder- friendly policies, he said. In the 1980s, 12 of France's top 20 industrial groups and most banks were state-owned. Even after the government sold companies from Saint-Gobain to Renault SA, shareholder protests were rare. A new generation of executives is more receptive to investors, he said. Half the CEOs of companies in the CAC 40 Index, including Lafarge SA's Bruno Lafont, were appointed less than five years ago. Many, such as Schneider Electric SA's Jean- Pascal Tricoire, never held government jobs. Funds such as Los Angeles-based Colony Capital LLC and private-equity firm Eurazeo in Paris have built stakes in four CAC 40 companies, including hotelier Accor SA and retailer Carrefour SA, and are demanding better returns.
Deal Problems
M&A Deals in the Industrial Manufacturing Sector Drop A total of 39 deals (disclosed value at or above $50 million) were announced in the first quarter of 2008, a 17% decline from the 47 deals announced in the first quarter of 2007, according to PricewaterhouseCoopers. Total deal value for industrial manufacturing transactions totaled $7 billion, a 46% decline from the $13 billion announced in the first quarter of 2007 and a 78% decline from the $31 billion announced in the first quarter of 2006. At this rate, projected total deal value for 2008 is set to fall far short of the levels set in 2007 ($88 billion) and 2006 ($92 billion). "A shortage of large industrial manufacturing deals took a toll on deal values during the first quarter of 2008 and will likely impact deal values for the remainder of the year," said Barry Misthal, U.S. industrial manufacturing leader at PricewaterhouseCoopers. "Financial investors are playing a lesser role due to higher risk premiums and a decline in debt market liquidity, and it is unlikely that total and average deal values will rise to previous levels until the financing environment improves."
Bell Canada buyout in trouble Closing the biggest deal ever just got a little more complicated. According to Monday's The New York Times, the banks providing financing in the takeover of Bell Canada parent BCE, are seeking to renegotiate terms of that deal. Providence Equity Partners, Ontario Teachers' Pension Plan and Madison Dearborn are seeking to take BCE private for nearly $52 billion. The reason for the financing snafu? Banks are feeling squeezed because of losses from the subprime crisis, and their stomach for financing leveraged buyouts has diminished from even a year ago, when the Bell Canada sale was brokered. In interviews earlier this month, Providence Equity Partners CEO Jonathan Nelson told Fortune that he expects the banks and other partners to honor their commitments to the deal.Still, Providence has shown a willingness to sue its lenders: Earlier this year it countersued lender Wachovia (WB, Fortune 500) when that bank tried to extract itself from providing financing for a $1 billion buyout of Clear Channel's television group. That deal was separate from the acquisition of Clear Channel's radio stations, a deal that also found itself in litigation as lenders sought to renegotiate terms of the deal. In both Clear Channel (CCU, Fortune 500) cases, the deals ultimately got done. In March Clear Channel's television group and Providence agreed to a reduced price and announced the closing of the deal, and last week Clear Channel lowered its takeover price of its radio assets in order to get the $18 billion transaction financed. Indeed, three of the four lenders involved in the Clear Channel radio buyout are also involved in the BCE buyout, and the street had been speculating for months that those banks would "pull a Clear Channel" on BCE. BCE's buyers, though, seem eager to close on the transaction. It is a deal that is very much in Providence's wheelhouse: A big, national telephone company with strong cash flow. Providence likes these kinds of companies, adding to the likelihood that it is unlikely to let this one get away. · Inside a record-breaking $51 billion... More
Owner of Bill Blass Faces Cash Shortage After Acquisition The fast-growing buyout firm that owns the fashion house Bill Blass, the retailer Athlete’s Foot and the ice cream chain MaggieMoo’s appears to be on the verge of collapse.NexCen Brands, a little known firm that owns many high-profile brands, said on Monday that it faced a severe cash squeeze and warned that there is “substantial doubt” that it will remain in business. The company, which dismissed its chief financial officer two months ago, said that its 2007 financial statements could no longer be relied upon and that it was investigating its financial reporting practices. NexCen, which earns revenue from 1,900 franchised stores, said it might try to sell off some, if not all, of its brands. That could put eight chains — including Marble Slab Creamery, Pretzel Time, Pretzelmaker, Great American Cookies, Shoebox New York and Waverly home furnishings — up for grabs. And it could put the future of Bill Blass, an influential clothing label sold at high-end stores like Saks Fifth Avenue, in doubt.
Mid-Market Situation
The Big Picture: the Fate of Leveraged Deals (Capital Roundtable Seminar) Last summer, the credit market drama dealt private-equity mega-deals a losing hand. But what the credit meltdown has in store for middle-market (LBOs) deals is still something of a mystery. Even though leveraged deals in the middle-market seem to be holding off the downstream spread of credit upheaval for now, everybody, it seems, is watching for tell-tale cracks in the dam and asking:Is the credit infection spreading? If so, who’s more at risk – equity or debt investors? What new funding opportunities are emerging? Is there another shoe still left to drop? To answer these questions and learn what underlying factors will shape the murky credit markets and deal-making in all parts of the middle market for the remainder of the year and beyond, we invite you to an important new MasterForum -- and cocktail reception -- on Wednesday, July 16, called “the fate of leveraged deal financing,” featuring Ed Altman, Peter DeMaria, and James H.M. SprayregenTheir high-level discussion and lively Q&A session will be moderated by leveraged-finance investment banker John Miscione, himself a former commercial lender and current Managing Director at Duff & Phelps LLC. Come hear how these top minds view the erosion of confidence in the credit markets -- and what they predict will happen next for middle-market buyouts and the larger economy. They’ve given leveraged investing a lot of study -- and their well-considered recommendations for how best to proceed amid hemorrhaging valuations and liquidity demand our attention. And if you’re active in middle-market deals during these volatile times, then you need to hear what these three wise men are saying.
Checks and Balances (Merger Mogul Newsletter)This year, as the credit markets struggle to regain their feet, I imagine it can be pretty difficult for some to smile through the adversity. Nevertheless, I’m still a believer that a good soak can wash the toxins out. In our latest issue of Mergers & Acquisitions Journal, due out in June, Danielle Fugazy wrote the cover story on due diligence. The central theme of the article was that during the hysteria that engulfed the deal market from 2005 to the first half of 2007, buyers were giving short shrift to their homework. It’s not that they didn’t want to perform due diligence, it’s just that the pace of the market didn’t allow for it. The sell-side advisers pushed the PE firms, who pushed the lenders, who pushed someone else, until nobody knew even who was pushing whom. If anyone even thought to push back, someone else would step in to take their place in the daisy chain of “investors” unwilling to say no. Today, however, everyone seems to be pushing back – buyers, sellers, lenders, advisers, consultants, you name it. I’d argue that even us reporters are asking more of the right questions lately. On one hand, the collective pushback probably makes dealmakers feel even more squeezed in an already tight market. But these are the checks and balances that are necessary to truly thrive. Experienced buyers often tell me that their best deals were made during the last economic downturn at the beginning of the decade. While some of that success had to do with buying low and selling at the high end of a cycle, one has to believe that the increased focus on due diligence, and perhaps the fear of doing a bad transaction, played just as important a role.
Post-Crunch M&A (Merger Mogul Newsletter) No matter how challenging the deal market becomes, it’s a sure bet there will be folks, funds and firms who find ways to benefit from the down cycle. (In fact, you can hear from some of them at our June event on Post-Crunch M&A.) Restructuring firms are chief on the list of beneficiaries, since economic slowdowns tend to expand their pool of potential clients. Talk to firms like Alvarez & Marsal and FTI Consulting, and they’ll tell you they have more clients than they can handle these days, which is a problem most of us would love to have. Among the list of not-so obvious beneficiaries—at least within the mid-market—are private equity firms willing to increase their equity contributions. History has shown, and conventional wisdom would support that firms who are willing to invest in down cycles generally come out of those cycles in better shape than counterparts who sit on the sidelines. Of course, it’s tough to know how long the current downturn will last, but a financial buyer who buys now and can afford to be patient has a good shot at turning a big profit a few years down the road. Small companies who price their assets to sell should also do well in the current market. My numerous talks with small market participants at the recent ACG InterGrowth conference only confirmed what most people had been telling me leading up to the event: The smaller the deal, the less impacted it is by Scrooge-like lenders. Another thing helping small deals is the creep down market by mid-market buyers who can’t get bigger deals done as easily anymore but still need to put money to work.But without question, getting deals done post-credit crunch is no easy task. Due diligence is going the way of the tortoise, limited partners are asking more questions of their GPs, and even some strategic buyers are more gun-shy, wondering how long the current downturn with last. Meanwhile, anyone who bought a company before Fall 2007 is now dealing with a new set of rules, forecasts and expectations. PE buyers have to determine whether to invest in their companies, stay ultra-lean until the downturn is over or, despite the blow to ego, cut their losses. More than deal sourcing, portfolio management is arguably the most important skill of any M&A buyer. Only those who can manage effectively through the current storm will circumvent the crunch.
Creating Value in PE Portfolio Companies – Strategies for Catalyzing Operational Success (Capital Roundtable) Facing greater competition and limited financing, private equity investors recognize that gone are the days when they could achieve good returns just by buying low, leveraging up, and selling high. Busy GPs who used to “pinch hit” between deals by helping improve portfolio company performance are seeing that this work takes a specialized skill set, quite different from what it takes to source and finance a deal. So today, some GPs are themselves becoming deeply enmeshed in portfolio company operations, while others are relying on the services of “hired gun” consultants – or increasingly are developing in-house operations teams. As a result, to differentiate their firms in today’s competitive and recessionary markets, many GPs have entered an operational “arms race,” struggling to develop or access capabilities to enhance the performance of their investments. If you’re interested in comparing notes on these trends with 20 of your peers who are testing out different operational strategies, then please join us for The Capital Roundtable’s first MasterClass on “Creating Value in P.E. Portfolio Companies,” being held Wednesday, May 21, in midtown Manhattan. Come see how some of the best-managed private equity firms are -- …conducting rigorous pre-investment operational assessment and planning… achieving 360° company and sector awareness…analyzing executive talents needed to manage and coach portfolio companies …pushing their companies’ management outside of their comfort zones to boost returns