For PE Firms, Liquidity Remains the Key IssuePublished: January 12, 2011 in Knowledge@Wharton
With easy access to financing, large leveraged buyout firms grew to massive sizes during the private equity boom between 2005 and 2008, often with shares in deals valued in the billions. Now, following the global economic meltdown, speakers explored how the industry is faring during a panel discussion titled, "Leveraged Buyouts: Generating Returns in a Challenging Climate," during the Wharton Private Equity and Venture Capital Conference.
The moderator, Wharton finance professor N. Bulent Gultekin, asked the panelists what they have learned since the collapse and how they are managing portfolio companies through the current cycle.
Jacqueline Reses, head of Apax Partners' U.S. media business, said private equity is focused on helping CEOs and providing additional resources to support portfolio firms. Like many large, leveraged buyout firms, she said, Apax has a team of former executives and specialists with skills in areas such as cost control, sales and consumer use of the Internet, who can help portfolio companies with specific problems.
At the same time, the firm is also focused on managing costs throughout its operations. Apax was ahead of some other firms at the beginning of the financial crisis in 2007 and made sure its portfolio firms were positioned to support themselves through the downturn, Reses said. "I'm not sure anyone predicted it would be as bad as it was at the depths of 2008 and 2009," noted Reses, "but we did our best to focus our CEOs so they would be proactive rather than reactive."
Jim Neary, co-head of global technology, media and telecommunications at Warburg Pincus, said his firm, too, has an institutional infrastructure build up over decades in which the firm has owned more than 500 companies in many parts of the world. As a result, the company's staff had enough experience to adjust as the downturn took hold. "To say we had seen it all is quite true," he said. "[The economic crisis of] 1975 was horrible. 9/11 was horrible. This is horrible, but all those lessons [are] learned over time [and] our industry, which was very young in the late 1960s and early 1970s, has matured in recent years. Bringing resources aggressively to bear on the business is something we were able to do in this crisis."
Neary said executives in his firm always spent a lot of time talking to the management of portfolio companies but are doing so more often now. Perhaps some of the added attention is possible because there is little new business to distract the partners, he added. The most important issue, for the companies is liquidity. "You can get through a crisis if you have liquidity," according to Neary. "So we are making sure our companies are well capitalized and not overleveraged, or if there is leverage that it is benign or long-dated. We are shoring up balance sheets where needed."
Greg Mondre, co-head of Silver Lake's North American business, said that if a buyout firm buys good businesses, then it must stand by those businesses in a tough period and remain ready to invest more capital to maintain growth. If on balance it makes sense to consolidate, then a decision based on that judgment should be made more quickly today than in a different economic climate. "We've done a lot of portfolio pruning as well as major acquisitions and consolidations," he said. "We focus on core consolidation where necessary and on having much stronger companies coming through the other side of this crisis."
Perry Golkin, a partner at Kohlberg, Kravis, Roberts & Co., said that in a tough economy buyout firms should become proactive in working with the boards of the companies they own to help them make the difficult decisions. He used the example of a semiconductor company in the KKR portfolio. The industry's dire condition in the crisis became a reason to override traditional obstacles to making changes in production. "When selling falls off a cliff you have the opportunity to consolidate factories," he pointed out. "You can take a very bad environment and do some important things to set the stage for future success."
Gultekin also asked the panelists about expectations for returns in private equity going forward.
Reses said that in the past two years many provocative statements have been made about the death of private equity. "It was a great storyline at the depth of the crisis, but I don't think you will see firms failing by the wayside," she noted. "You will see the resilience of the industry as a whole. Some of the larger firms will be a bellwether for that resilience."
She said many of the major buyout firms acquired large, market-leading companies with "many levers to pull even in the worst times." As a result, she pointed out, there are many ways for these portfolio companies to survive. One upside of the boom years is that much of the private equity financing in place has few or no covenants, allowing more breathing room for companies to make it through the cycle.
Neary told the audience that private equity is in the business of pricing risk. He said Warburg Pincus has varied investments by size and, in the smaller companies, leverage is not an issue. He said he is working closely with growth companies -- which is what the firm's investors pay it to do. Private equity will continue to pay investors superior returns compared to alternative investments, he predicted. "Whether that's 500 to 1,000 basis points better than the overall market -- we try to do better than that -- but if we deliver a premium that's great." Neary's firm works on a broad range of companies and in some cases can generate a rate of return of 50% to 60% while "bond-like" leverage buyouts provide rates in the low 20 percents.
Mondre said his firm has not had any companies enter bankruptcy, and a few highly successful deals will emerge as the economy recovers, although overall it will take longer for returns to come in than they have historically. Private equity takes longer to determine returns compared to hedge funds or other types of investments because capital is typically locked up for six to 10 years.
When it comes to new deals, Neary said his firm is using its large institutional footprint to find new opportunities overseas and in emerging industries. Successful private equity firms do not wait around for a banker to come to them with a company that needs new equity. Instead, private equity firms must continually look for new areas of growth and be opportunity driven by identifying dislocations in existing markets, as well as nurturing networks to generate deal flow, according to Mondre. The current environment is an "interesting time" for deals. "It's exciting in some ways and dangerous in others." He explained that prices for businesses should be good as the economy comes up from the bottom of the business cycle. "Historically, the best deals are done coming out of a crisis. "Leverage is lower, growth is higher. Leverage and the purchase price are aligned. So this could be a good period."
However, he continued, private equity managers remain concerned about the broader global economic environment. Investors are sitting on a lot of capital and pressure is building to find places to invest that money. "I'm a little concerned that leverage has come up too quickly, and with the pressure to get deals done, some multiples don't reflect what has gone on in the past couple years," said Neary. His firm's investment approach is like a barbell. On one side are investments in growth properties that may be higher multiple and lower leverage but with the potential for growth that is not cyclically driven. For example, the company joined other private equity firms to acquire Skype, the Internet communications firm. He said the company is well-established, but has tremendous opportunity for more growth worldwide. On the other side of the barbell, he said, are underperforming companies that can benefit from Warburg Pincus' in-house operational capabilities. "What we are not going to do now in this environment is pay a high multiple for a business that is growing at a slightly higher rate than GDP. That's a scary place and we will see some auctions now that look a lot like that."
Gultekin said that it seems clear that 2010 will be a slow-growth year and asked what strategies large leveraged buyout firms will use to adapt.
"You look for the best opportunities you can," said Golkin, "but there are times when the best strategy is to accept where you are in the cycle, run your business as tightly as you can and wait for the cycle to turn."
Reses said that her area of specialty, media, is a "tale of two worlds." She is bearish on parts of the industry facing structural challenges, such as consumer magazines, books, radio and network television. At the same time, there are emerging parts of the business -- such as information service and digital media -- that are consuming a lot of her time. "In those businesses you can see a path for the next 10 years," she said, pointing to online education as an example.
Neary, too, said his firm has been negative on traditional media in the United States for a decade. Most of the portfolio companies in his fold are actually what he considers to be data and information services businesses, or new media companies linked to the Internet. He said Warburg Pincus also has an online education business that's been successful in the current cycle.
Mondre said there are often good companies in out-of-favor industries that can generate returns if private equity's timing is right. He noted that investors would have made a lot of money purchasing debt securities for traditional radio in the past few months. "It's all a question of your horizon," he added, "although it is helpful to have the industry trend behind you, not ahead of you."
Lessons from the Crunch
Finally Gultekin asked what lessons leverage buyout firms had learned as a result of the crisis.
Golkin said the most important lesson is that the past repeats itself. "Nothing is new about this crisis, but people tend to forget the lessons of the past," he said. Private equity investors need to pay attention to their capital structure and liquidity, he warned. "You have to be prepared for what you don't know is around the corner. If you remember the past -- which will repeat itself -- you are better prepared for macro things that you can't control. But if you work hard on the things you can control, you will do better."
Mondre said the crisis has made the dangers of "vintage risk" more apparent. Vintage risk occurs when firms invest too much capital in a year that could be the peak of the cycle. Indeed, 2007 was a strong vintage with $575 billion in capital invested in private equity. By contrast, $43 billion was invested in 2009. Most 10-year funds invest over five to six years and should try to diversify over that time.
Another lesson private equity firms have now learned is that it is harder to make decisions when multiple firms are involved in a deal, according to Mondre. At the peak of the private equity boom large firms combined in so-called "club deals" to amass billions of dollars to take major firms private at premium prices. "Decision-making is easy when everything is going well and a little more difficult when things are not going well." When a business is deteriorating, decisions must often be made to change management or take other actions quickly to preserve value. "What people have found is that a smaller number of firms in a given deal make the decision-making easier."
Neary said his firm tried to "stick to our knitting and resist the temptation of the loose capital and becoming something that we fundamentally weren't." The company's basic model is to find good businesses, understand their pricing and risk and then make a decision about an acquisition. "We shouldn't let too many externalities change that fundamental premise and get in the situation where capital markets are throwing more capital at you [and] you begin to change the way you think about risk and reward. Leverage is risk," he continued, "and [it] adds more risk when you add more leverage. I think there was a moment in time that our industry forgot that we have to pay every penny of that debt. That it's not free capital."
The most important lesson, according to Reses, is to "know your partners." Complex private equity transactions today involve a wide range of people, from underwriters to investors, who may have different motives. "One observation I have from this period is that you should understand the incentive of your investors and make sure you are aligned and thinking about the long term." She said that her firm tried to preserve long-term relationships, while others in the business "took the short-term view of getting the last dollar." A long-term approach, she said, is important to riding out down times like the current market.
"Private equity did a lot of things right," she continued. "As an industry we were very focused on giving management the tools to succeed in the crisis and focused on cost control. I think that served us well as an industry and that's not something that should be forgotten."