Leveraged Buyout Specialists Find Ways to Prosper amid Global UncertaintyPublished in Knowledge@Wharton
Panelists at the 2012 Wharton Private Equity & Venture Capital Conference saw clear paths for the leveraged buyout industry to prosper despite slow economic growth in the U.S., uncertainty over the upcoming presidential election and major global financial threats from Europe. Among the reasons for optimism: new energy resources in the U.S. and new private equity models.
Global uncertainty produces challenges for all businesses -- but also opportunities. How can the leveraged buyout (LBO) industry prosper as major economies struggle to emerge from the financial crisis?
In a wide-ranging discussion at the conference, five panelists discussed market conditions that could affect their firms' LBO strategies for 2012. The consensus: Difficult times can produce attractive opportunities for LBO firms that are nimble enough to adapt.
The panelists believe the U.S. economy will continue to strengthen slowly, though debt issues and the presidential campaign cloud the future. Europe, the panelists agreed, has bigger problems, though none of the speakers predicted a broad economic collapse.
LBO firms, like all private equity (PE) firms, must look for new types of investments as the market changes, the panelists concluded. Over the past 15 to 20 years, for example, big-box retailers have provided some attractive buys in the U.S., but now those opportunities are hard to find, said Sanjay Banker, a principal at Bain Capital Private Equity. Today's retail plays are more likely to be found with smaller companies that have more room to grow.
Change is also occurring in the energy industry, added Sam Oh, partner at Apollo Global Management. "There's really a renaissance occurring in the U.S." he said, describing new gas and oil fields opened up by "fracking," which uses water pressure to break up underground formations and release hydrocarbons. "We've opened up massive horizons of natural gas, crude oil and other hydrocarbons. We don't think 2012 will be any slower than 2011. In fact, we think the opposite."
North America, with its cheap natural gas resources, may well have an economic edge on emerging markets that rely on exports, as rising oil prices boost shipping costs, said Andrew Marino, managing director at The Carlyle Group. "It will give us a bit of a shield to grow our base."
Health care reform could create some LBO opportunities in the U.S. too, but at this early stage LBO firms must be very careful in placing bets, said Ali Satvat, director of KKR & Co. "The idea of being able to predict what health care will look like 10 or 12 years in the future is very hard." The U.S. Supreme court will rule, probably in June, on the constitutionality of a key health care reform feature requiring most people to buy medical insurance if they don't get it through their employer, and Republicans are campaigning hard on promises to repeal the new health care law.
Amid the uncertainty, Satvat said, KKR tries to focus on what is knowable: that the pace of growth in health care spending is unsustainable over the long term. KKR therefore looks for "companies that solve the problem," such as firms that can bring more efficiency to the system, like providing care in the home, which is cheaper than care in hospitals or nursing homes.
Europe--Serious, but Not a Surprise
Government debt and economic problems in Europe are worrisome, but some panelists felt that LBO funds can still find opportunities on the continent. The worst outcome, said John Maldanado, managing director of Advent International, would be a complete collapse of the euro. But "we're hopeful that the [eurozone] does stay together."
"I'm generally confident when it comes to Europe," Marino added, noting that the region's government-debt problems, while serious, are not a surprise, which would be more disruptive. Austerity programs may cause difficulties in some countries, but are not likely to do serious damage to the zone as a whole. "I believe -- and we believe as a firm -- that global growth will continue."
The ongoing deleveraging process in Western countries "is painful," added Oh. "We're in early innings. It is by no means over, but we're making progress."
If the developed economies do resolve their problems and return to economic health, commodity prices will move higher, he noted, suggesting that this would be "good for producers, bad for consumers." That could change the landscape for LBO firms.
Marino and Oh both expect high commodity prices to be a long-term feature of world markets given that the supplies of some commodities are being depleted. "The difference between today and 10 years ago is that we are bumping into spare-capacity issues, Oh said.
But in the short term, Marino added, low natural gas prices will help boost the U.S. economy, creating LBO opportunities. Credit issues, however, remain a problem in Europe and the U.S., Oh warned, predicting that tight-credit conditions will persist, making LBO financing difficult.
Unpredictability in the U.S.
What are the biggest factors facing the U.S. economy in 2012? Unpredictability, said Banker, pointing out that it is far from clear how the government will address its debt problems. It is also not clear when consumers, who remain over-leveraged, will increase spending, which is key to economic growth.
"It's jobs," added Oh. "The jobs issue in this country is a big problem. Apollo surveyed CEOs in its portfolio companies and found that most are very reluctant to hire. "It still doesn't feel like we're out of the woods." The unemployment situation varies dramatically around the country, and economic conditions -- notably in the distressed housing market -- exacerbate the macro problems, leaving workers less mobile and thus less able to take advantages of distant opportunities. "I think until we [solve] that, it's going to be tough." Marino agrees: "I think we're far away from being out of the woods in the economy. To me, it feels like we are just starting to get on with things."
In the U.S., the presidential election creates another layer of uncertainty, Maldanado pointed out. Slow economic conditions, tight credit and investors' heightened sensitivity to risk are causing some changes in the LBO industry, including the relationship between general and limited partners, the panelists said.
Marino noted, for example, that in recent years many PE firms have developed closer relationships with limited partners and are making special efforts to comply with specific requests. A number of pension funds, for instance, want their PE investments to respect issues important to pension plan participants, such as environmental, worker-safety and corporate-governance practices. "All the big firms have adopted ways of dealing with what I would call those 'softer issues,'" Marino said.
Limited partners have also become more attentive to their overall risk exposure, said Oh, explaining that pension plans, which often invest in multiple PE funds, are now more likely to look at whether overlaps in the portfolios create too much concentration. "There's definitely a movement toward more transparency."
In addition, fees are a bigger issue for limited partners than they were a few years ago, added Maldanado, noting that PE firms must be more responsive to this issue, because finding investors is harder today than a few years ago. Furthermore, PE firms are placing less emphasis on once-popular strategies like boosting returns through high leverage, or flipping target firms that can be bought cheaply, held briefly and sold at a high multiple. Instead, PE firms strive to improve their portfolio firms' operating results. "Eight-five percent of [PE] returns to investors have been from earnings growth," Maldanado stated.
While economic uncertainties are significant, several panelists noted that private equity is in an especially good position to deal with uncertainty because PE firms can hold a steady course. As a group, the panelists believed there can still be a bright future for LBO funds, though market-beating gains may be harder to come by than in the past.
"I think we have the ability to think longer-term," said Satvat. "That's one of the great advantages of this industry."