Credit market turmoil is altering the global playing field in buyouts and acquisitions, a field rife with complaints in recent years about too much money chasing too few good deals. The credit shortage puts pressure on pricing and transactional quality, while also giving public companies a better shot at acquisitions that the more aggressive private equity firms might previously have snatched away.
These are some practical implications of a paper presented at a recent Wharton conference sponsored by the Weiss Center for International Financial Research whose theme was “A Global Perspective on Alternative Investments.” The paper, titled “Leverage and Pricing in Buyouts: An Empirical Analysis,” documents the pricing anomalies that have characterized private equity transactions in recent years. Chief among them: The greater the leverage applied to a deal, the greater the price it has tended to command.
Acquisition by private equity firms has become increasingly common in recent years in both the U.S. and Europe, with deals growing rapidly in both number and size, notes Michael S. Weisbach, from the University of Illinois at Urbana-Champaign. Weisbach presented the paper on behalf of his co-authors, Ulf Axelson, from the Stockholm School of Economics; Tim Jenkinson, Saïd Business School, Oxford University; and Per Strömberg, Stockholm School of Economics.
As recently as 2002, Weisbach noted, total deal value hovered around $30 billion a year. In 2006, buyout transactions totaled around $233 billion in the U.S. and $151 billion in Europe. Private equity deals now account for some 20% of worldwide M&A, up from 3.1% in 2000. Moreover, with a current overhang of some $250 billion in buyout funds that are committed but uninvested, the buyout trend is unlikely to stop — although it does appear to be taking a rest.
Not surprisingly, the spectacular growth in private equity transactions has been matched by equally strong growth among firms that specialize in them. The paper’s authors compiled and analyzed an extensive list of deals sponsored by some of the largest, best-known private equity houses — Bain Capital, Blackstone, CVC Capital Partners, Kohlberg Kravis Roberts, Madison Dearborn and Permira — admittedly, a sampling with built-in bias toward large-scale transactions.
These and other private equity firms have raised large amounts of equity capital from their limited partners and even larger sums of debt capital from the syndicated loan market, using the capital to buy public corporations and business units as well as family-owned firms and companies previously owned by other private equity concerns. Most of the earlier studies focused on the 1980s buyout wave, when leverage ratios were lower.
Today, the financial structures that private equity firms choose for their portfolio companies turn out to be radically different from those that public corporations use when making acquisitions. In fact, they are almost the inverse of one another. Extensive use of leverage has long been a distinguishing characteristic of the LBO firms, whose equity typically comprises just 20% to 30% of total capital, a ratio that has steadily declined. For public corporations, by contrast, equity is more likely to comprise 70% to 89% of the total.
As the authors found, the availability of credit in recent years and the ability to structure deals with greater leverage resulted in ever-higher purchase prices. Buyout firms learned to price transactions, first, by borrowing as much capital as possible and then, by factoring in the extent of the debt obligation and tacking on an additional multiple of, say, three times the target company’s earnings.
Price Escalation
How did the availability of debt capital become equated with higher purchase prices? Because, notes Weisbach, to borrow less and bid less would have meant losing a prime buyout target to a competing fund. Ask a gathering of corporate treasurers to explain how their companies determine the pricing and leverage appropriate for a given acquisition, and their answers will be shaped by predictable considerations like projected returns, corporate tax rates, borrowing capacity and so forth.
But put that question to a room full of private equity fund managers, and the response will be short and simple: “If the banks will lend it, we’ll take it!” Indeed, a private equity firm that appeared reluctant to borrow and spend aggressively might have difficulty pooling investors for its next fund launch.
Until recently, the cycle of hyper-competitive borrowing and bidding meant that even the largest and shrewdest private equity firms found it difficult to negotiate a buyout in private. Instead, businesses of varying shapes and sizes were auctioned off at ever-escalating prices that required ever larger amounts of leverage. As prices and debt levels continued to rise, these transactions became less profitable for the funds’ general and limited partners, although hugely profitable for owners of the properties being acquired.
For now, that cycle has ended. “The excitement over leverage is clearly gone,” says Weisbach. With credit both scarce and expensive, he thinks the focus must inevitably shift — from deals that command the highest leverage and that can be flipped the fastest to those where investors see real opportunity for adding value.
As recently as a year ago, buyout firms tended to buy and hold a business for as short a term as possible — typically one year — before flipping it to another private equity buyer, not unlike speculators in Florida or Las Vegas real estate. Both of these games came to a screeching halt last summer when lending evaporated, putting a sudden break on the number of available buyers.
From the value investor’s perspective, the best deals are more likely to be those that are done during a cyclical trough like the present one. Not surprisingly, notes Weisbach, some of the most successful private equity firms, Blackstone for one, built their reputations on the deals they did in the last down-cycle, which occurred in the early years of this decade.
The field of buyout funds remains crowded, but the firms themselves are nervous. The scarcity of credit inhibits their ability to structure appealing transactions. For them, the payoff from a good deal comes as much from the momentum it creates for launching their next buyout fund as it does from improving the results of the acquired business. For the same reason, the effects of cutting a deal that goes wrong can be lethal.
For now, these factors should make it easier for public companies looking to make strategic acquisitions — because the standards they apply are vastly different. Public companies might also need to borrow and leverage in order to make acquisitions, but for them, acquiring a business is always a value play. No matter how much or how little leverage they apply in structuring a transaction, the only reasons for making it in the first place lie in the potential cost savings and synergies and in the access that the acquisition will afford to new customers and new markets.
The buyout market is hardly dead and buried, Weisbach believes. Private ownership has gained broad acceptance in recent years, especially among CEOs and other senior executives who can make more money while escaping the harsh glare of scrutiny imposed by Sarbanes Oxley and compensation disclosure requirements.
All the same, says Weisbach, leveraged buyouts are and will remain an inherently temporary form of organization, if only because private equity buyers have fiduciary obligations to exit their deals expeditiously — once they can realize targeted returns.
No such constraints apply when a company acquires another for strategic purposes. So as long as tight credit keeps a damper on the private equity buying frenzy, corporations ought to stand a far better chance of bidding competitively for businesses they covet.
