Following the Era of Large Buyouts, Private Equity Funds Find New Ways to CompetePublished: May 06, 2008 in Knowledge@Wharton
Nothing symbolized the most recent private equity boom better than huge buyouts, deals so big that private equity sponsors teamed up to pull off the transactions in so-called consortium -- or "club" -- deals that spurred talk of $100 billion transactions.
Now that credit has dried up, the future of large private equity buyouts has become uncertain. Limited by the lack of available debt financing, 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. Not surprisingly, 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.
According to Jack Daly, a managing director at Goldman Sachs focusing on large-cap leveraged buyouts in the U.S. industrial sector, 2007 was a "tale of two markets." In the first half of the year, private equity sponsors enjoyed easy access to debt which led to previously unthinkable discussions about deals valued at up to $100 billion. By the end of the year, credit markets had contracted and the industry faced a $350 billion overhang. Lenders were unable to provide large financings and included extensive covenants on the loans they did write. "The next $10 billion deal feels years away," Daly said.
The only constant was sellers' high expectations about the value of their businesses, noted Daly, who participated in a panel discussion about large buyouts at the 2008 Wharton Private Equity Conference. In the face of the current economic turmoil, however, those expectations have begun to drop. The buyout business is cyclical, he added, noting other industry boom-and-bust periods -- in the late 1980s, the late 1990s and again from 2002 through the end of 2007. The public markets experience the same ups and downs, he said.
The latest boom came to an end in the usual way. "What happened was that people got out of hand with some of the valuations," he said. Add to that the subprime meltdown and it signaled the end of the industry's ability to digest deals like Blackstone Group's record $36 billion acquisition in 2006 of Equity Office, the Chicago-based commercial real estate investment trust.
One major difference in the most recent cycle was the amount of capital raised, Daly noted. The industry has raised about $750 billion since January 2006 -- an amount which, when levered, would be enough to finance deals worth a significant portion (15%-25%) of the Standard & Poor's 500. Buyout firms have remained relatively flush. "There's still a staggering amount of money sitting there," said Daly, who added that companies will find new ways to make deals work even if there is less debt financing available from lenders. "There is a tremendous amount of opportunity. There are still going to be a lot of ways to make that capital work."
A Return to Fundamentals
According to Perry Golkin, a partner at Kohlberg Kravis Roberts and a member of the firm's financial services industry team, the markets are clearly not deep enough to support huge private equity deals. Instead, sponsors should focus on smaller transactions, he said. PricewaterhouseCoopers research shows that the volume of large buyouts fell off sharply in the second half of 2007, but that middle-market deals, valued at up to $1 billion, totaled $355 billion, or 23% of U.S. transaction volume.
Lenders are demanding changes in covenants, Golkin said, which represents a return to more normal conditions after the boom period marked by easy loan terms. The revised covenants do not represent "radical change" but do restrict private equity firms' flexibility, he added. "We had some luxury for a little time, but the reality is we will not have the flexibility we were able to negotiate for the last couple of years."
According to Golkin, rising capital costs will reduce asset prices, and the diminished role of securitized debt funds will also affect private equity sponsors. "All of these things are going to make it a little more difficult for a buyer, or sponsor, to structure a deal in a way that's comfortable. You become more nervous." The industry will return to fundamentals that prevailed three or four years ago, he added. "We're not moving to the Stone Age."
The largest limiting factor now is that sellers' expectations have not caught up with the new pricing realities. Golkin noted that as deals collapse in the changing financial environment, the industry is wrestling with the question of what represents a material change in a business that might trigger a breakup fee. For example, is a 10% drop in earnings a material development? The Delaware court system is examining some of these issues, he said.
Other questions surround the value of a reverse breakup fee, which takes effect when a buyer walks away from an agreement before it is completed. Private equity sponsors will need to look at the structure of transactions to decide whether the breakup fee will cover the costs of terminating a deal. "I don't think when [breakup fees] were created, people would have predicted that financial markets would disappear," he said.
Greg Mondre, managing director of Silver Lake, the technology-focused buyout firm, pointed out that the downturn will make 2008 a more difficult year to exit from investments. Managers of recently acquired companies will need to pay close attention to operating fundamentals because those companies are carrying more leverage than in the past. One advantage for private equity sponsors in this cycle, he added, is that most large-cap buyout firms have built up substantial operating groups with in-house expertise to help companies move through the downturn. "Our ability to actually work with our costs, restructure operations and drive value is a huge added benefit going into a time of economic weakness."
Private equity sponsors also own better companies than they did in past downturns, Mondre noted. During the most recent period of private equity expansion, sponsors were able to acquire an increased number of large, stable companies with leading market positions than in the past. Those are the types of companies that are best able to weather a soft economy. "In any downturn, it is the leaders that come out with the highest market share and better margins," he said. "The weaker competitors fall by the wayside."
New Models and Markets
On the investing side of the business, a weak economy creates buying opportunities, Mondre said. "Historically, the best buyout investments have been made coming out of a recessionary period." In the last five years, capital had become a commodity; now, because much of that capital has dried up, private equity funds may play a new role, he noted. Previously, private equity sponsors used war chests raised from limited partners to buy out firms. In the future, that money may be a source of financing for companies that are struggling with balance-sheet problems but do not want to go along with a buyout. "We can structure minority investments, do acquisition finance and other types of structured transactions that are not the traditional 'going private' that we have seen in the last few years," Mondre said.
He added that the consortium, or club, structure may still be valuable in smaller transactions because private equity sponsors can prosper from one another's strengths. "We benefit from some level of humility. We don't think our firm knows everything there is to know," he said. "Having one or two other firms as part of a deal going in from a diligence standpoint, and after the deal's closed for shared governance and shared knowledge, is a very valuable thing for bigger transactions. We actually are happy and okay with taking a little smaller investment to bring in those added skills."
Richard Schifter, a partner at Texas Pacific Group (TPG) with expertise in bankruptcy law and corporate restructuring, noted that during the recent private equity boom corporate executives turned to private equity because it could supply capital at lower cost than public financing and allowed management to escape the "limelight" in the post-Enron era of public scrutiny and regulatory reform.
Now, he said, those trends no longer shape the market, but private equity can still play a role in corporate financing. "You will see more situations where there is a need for capital, and that's something private equity can provide." Transactions could involve private equity partnerships with strategic buyers, or deals in which companies seek out leverage to avoid giving up equity. "It may be very opportunistic in light of what's going on both in the economy and the financial markets," he said.
In fact, some novel transactions have already emerged: In mid-April, Citigroup confirmed a sale of $12 billion in leveraged loans to TPG, the Blackstone Group and Apollo Management -- an attempt by the bank to insulate itself from further writedowns on debt, including loans it made previously to fund transactions at all three private equity firms.
Recently, sovereign wealth funds, or state-owned investment funds, have begun stepping in to provide capital for struggling companies like Citigroup: In November, the Abu Dhabi Investment Authority, flush with cash thanks to high oil prices, bought a nearly 5% stake in Citigroup to help cover losses from subprime loans and related securities. But while sovereign funds are clearly on the rise, Jordan Hitch, managing director at Bain Capital, said he does not view them as significant competitors for private equity. "They do have capital and certain people who look for investment opportunities," he said, "but not the same capabilities as private equity funds in expertise and global reach."
In addition to new transaction structures, buyout firms are looking toward new geographies to cope with the credit crunch. "All the major firms are spending time and energy building investment teams in Asia," said Hitch, who noted that many firms had begun to focus on Europe several years ago. Firms would also likely turn to emerging markets like India, South Africa and Turkey, he added.
A Boom for Distressed Investors
While the current down cycle has demanded out-of-the-box approaches from buyout firms, it has also created ample opportunity for distressed investors seeking to buy up the securities of troubled companies.
"There's not enough money out there to deal with all the problems," said Marc Lasry, chairman and chief executive of Avenue Capital Group in New York, who joined a panel discussion on distressed investing at the Wharton conference. "[People] are panicking, and things are getting worse -- and the more people who believe that, the better it is for us."
In fact, the situation is "unprecedented," according to Maria Boyazny, a New York-based managing director with Siguler Guff. "Over the next year, $500 billion in subprime mortgages are maturing. The cash-debt market gets a lot of press, but even scarier is the $1 trillion in [corporate] leveraged loans that are maturing."
Lenders and investors alike are only beginning to grasp the new pricing realities that have resulted from the downturn. Recent chaos in the market has been complicating analysis, Boyanzny said, but some firms may be ignoring the market's signals because they don't like what they're hearing. "Banks are complaining that there are no bids for securities that they have to mark to market," she said. (Under generally accepted accounting principles, publicly traded companies must estimate the market value of their tradable securities each quarter and record that value on their books.) "I'm being told that you can get bids, but you might not like where the bid is. Banks are marking things at 60 [cents on the dollar], where the active bids are 20. People are bidding 50 cents on the dollar for Triple A debt."
Many investors are facing rude awakenings when they try to refinance debts or unload downgraded bonds. Lasry recalled one investor who got angry upon being told that the discount he was offering Lasry to buy his bonds wasn't steep enough. "I had to remind him that the market price is what someone will pay you, not what you want to sell for."
Partly, investors are working through the necessary but painful process of squeezing out the excesses of the recent real estate and credit bubble, when lenders offered a variety of new types of loans without fully appreciating the risks. Subprime mortgages, the majority of which went to riskier-than-usual borrowers, were among them. So were so-called "covenant-light" loans, which placed few restrictions on corporate borrowers.
"The market discounts that lack of covenants," Lasry said. "Those bonds are now trading at huge discounts. Without covenants, I'll pay you 40 or 60 [cents on the dollar] instead of 80."
Banks in Europe and Asia were just as loose with their lending standards and equally willing to try unproven products, Boyazny added. As a result, their reckoning could come soon, too. Asian banks might be protected, at least partly, by Asia's economic boom, she noted. A surging economy and rising corporate cash flows can make a banker's rashness look like prudent risk-taking.
For buyout firms, though, the rapid downturn in credit markets remains unsettling. "There is a desire by private equity investors to capitalize on the major dislocation," Hitch from Bain Capital said, "but also a fear of not really knowing where the bottom is."