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Structurally
sound
Troubled credit markets have impacted the private
equity industry in recent months. Ross Butler
assesses the strength of the sector’s business model
throughout the economic cycle
Photo: Andy Paradise
L
ast year mega buyout firms had
the power to buy up massive
swathes of the corporate world.
Armies of lawyers and bankers
were on hand to advise them in their
latest assault. Then almost overnight, the
market for new mega deals shut down.
Private equity’s pivotal weapon –
leveraged loans – had been sucked
out of the market, following turbulence
during the summer of 2007 in a credit
market that has no underlying link to
private equity. Now, nearly a year after
the first signs of a credit crunch emerged,
there is still no indication that the
market for leveraged loans is returning.
The reasons for private equity’s
astonishing growth during the middle
part of this decade are well documented.
A benign economic environment was
coupled with an era of low inflation and
low interest rates, which in turn fed a
colossal appetite for high-yielding paper
such as leveraged loans. On top of that,
a period of low returns from both bonds
and equities encouraged institutional
investors to diversify their portfolios
into alternative asset classes that had a
record of out-performance – including
private equity.
As a result, private equity funds under
management swelled from $163m
in 2002 to $518bn last year, according
to private equity data provider Preqin.
Last year the industry passed a
landmark $2tr in total unrealised assets
under management.
This huge growth in funds under
management, combined with truckloads
of cheap credit meant deal sizes went
off the chart. In 2003, a $5bn buyout
was about the largest considered
Summer 08 – the markit magazine
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Photo: Andy Paradise
“ It is fair to say that the days of the big deals
are gone for the foreseeable future.”
the markit magazine – Summer 08
achievable. By 2005, the rules of the
game had completely changed.
A buyout consortium agreed to buy
Danish telecoms company TDC for
$15bn, the largest private equity deal for
a generation and a European record.
At the end of 2006, Blackstone singlehandedly set the new high watermark
with its $36bn acquisition of Equity
Office. Weeks later Kohlberg Kravis
Roberts and TPG Capital put the
finishing touches to their $45bn
purchase of utility TXU.
It wasn’t just the size of deals that
was going at break-neck speed. In
early 2006, Stephen Schwarzman, chief
executive of the Blackstone Group, said
that prices being paid for companies
were in “nose bleed territory”, and yet for
the next year, prices and gearing kept
rising, loan spreads tightened and debt
terms became ever looser.
To say that all the signs of a collapse
in the leveraged loans market were there
would be disingenuous, because when
it came it had very little to do with the
fundamental credit quality of buyout
targets. Everyone working in the industry
was waiting for the crippling levels of
leverage being placed into buyout
structures to initiate corporate defaults.
Even then, it was believed that the
huge liquidity in the loan market would
allow for a gentle slow-down and a
gradual de-gearing. Instead, the market
fell flat on its face, pushed by the fallout
in the US sub-prime housing market.
Many of the investors that got
pummelled by defaulting sub-prime
loans were also in the leveraged loans
market for buyouts – namely CLOs
and hedge funds.
As a result, underwriting banks have
been left with an estimated $40bn
of unsyndicated, or hung, debt on
their books that was arranged on what
are now considered toxic terms.
This has clogged up the system for
new issues. Worse still, pricing in the
secondary market has fallen like
a stone since November.
At the time of writing, the average
bid price for the 20 most liquid institutional term loans in the North American
and European secondary markets was
87.56% and 82.25% of face value
respectively, according to data
provider Markit. There is little sign of
the market stabilising.
In the face of a plummeting market
and huge write-downs, investment
banks refused to take on any new
mandates in the fear that they wouldn’t
be able to shift fast-depreciating debt on
to the institutional market and so private
equity’s so-called golden age came to
an ignominious end. “It is fair to say that
the days of the big deals are gone for
the foreseeable future,” says Annette
Kurdian, a partner in Linklaters banking
group. “So you aren’t going to see deals
of the order of KKR’s acquisition of
Alliance Boots, because clearly it is quite
impossible to raise that amount of debt.”
The big question
Mega buyout houses, whose business
models are heavily dependent upon
being able to raise large quantities of
debt, are therefore now in a difficult
position. When the markets will return is
anybody’s guess – credit professionals
say it is unlikely to be before the third or
fourth quarter of this year. By that time,
many mega funds might have gone
more than a year without any prospect
of making new investments.
However, one of the beauties of
private equity is that funds are normally
structured as long-term locked-up
capital in the form of ten-year limited
partnerships, so sitting out of the market
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“ While the larger end is very difficult, in the
middle market there are banks lending
– admittedly not as much as before and at
higher margins – but the market is still
very open.”
for a while does not present any
structural problems. But, at the same
time, the economics of mega funds
means they cream off an enormous
amount in annual management fees.
Choosing to be patient with one’s
capital is one thing, but looking
impotent or at the mercy of events is not
great brand positioning. Cognisant of
this, large buyout groups are coy about
talking on the topic of private equity’s
sustainability. “To do so would make me
a hostage to fortune,” says one mega
buyout executive.
In reality, mega buyout groups have
several options open to them. The most
sensible course would be to wait for the
credit markets to unwind from their
current mess and spend the time
working out angles for future deals and
creating value in the current portfolio
of investments.
At the same time, the downturn is
bound to separate the boys from the
men. No longer able to reap giant
returns from multiple arbitrage and
rampant debt levels, this is a chance for
buyout groups to demonstrate their
ability to improve the operational
efficiency and quality of earnings in the
businesses they acquire.
Another option is to fish in those
emerging markets – outside of the US
and western Europe – where financing
is still available for buyouts and control
positions are politically acceptable.
For instance, BC Partners recently
completed the $3.2bn acquisition of
Turkish supermarket chain Migros.
The deal was financed purely by
the markit magazine – Summer 08
Turkish banks, which appear to be
relatively insulated from the worldwide
credit turmoil.
“We focused on financing the transaction with local banks,” says Nikos
Stathopoulos, a senior partner at BC
Partners. “The reason we approached
them is that they knew and understood
the business very well because it is a
very strong brand in Turkey; but also my
sense is that they were less hit by the
overall credit crunch, so they had more
appetite, more liquidity and were able to
be more competitive.”
This certainty of local funding is
believed to have been a key factor in the
vendor’s decision to sell. BC Partners
and its co-investors, TurkVen Private
Equity and DeA Capital, acquired the
business in a heated auction that
included both trade and private equity
bidders. Several competing bids, such
as Blackstone and Croatian retailer
Agrokor’s, were not financed out
of Turkey.
Investment opportunities in the
Middle East and Asia are also possible
alternatives, where the penetration of
private equity remains very limited and
the potential is huge. Japan – an emerging market in terms of private equity – is
seen as particularly attractive by mega
funds. Permira has been active in the
region for sometime, while earlier this
year Dubai International Capital recently
earmarked part of a $5bn Asian investment plan to the country.
Putting large sums to work elsewhere
in other parts of Asia can prove more
difficult. No foreign buyout group has
yet managed to close a large LBO in
mainland China.
The Carlyle Group, which has three
offices in China, was frustrated by the
government in its attempts to acquire a
controlling stake in Chinese engineering
equipment group Xugong Group
Construction Machinery and now
focuses on growth capital in the region.
In a similar way, India will no doubt
provide rich pickings for private equity
firms interested in venture and growth
capital investments, but the number of
control LBOs are likely to be minimal for
many years to come.
Some credit-constrained mega
buyout groups believe that more creative
investment strategies could allow them
to put money to work. So called PIPE
deals, or private investment in public
equity, have been a standard part of the
US mid-market for a long time, and over
the past two years the investment
technique began to gain credence in
Europe, for reasons unrelated to the
credit crunch. Larger PIPE deals
remained unusual on either side of
the Atlantic.
But since the start of the credit
crunch, the number of such deals has
jumped to 364, representing $29.9bn,
according to data from Dealogic. This
represents an increase of 73% on the
preceding seven-month period.
The advantages of the technique are
clear. There is no need to tap the flighty
credit markets because, as a public
company, the target’s tolerance of
leverage does not compare with that of
an LBO. To an extent this also mitigates
the advantageous effects of gearing.
But there are other drawbacks.
Private equity’s other main weapon of
value creation is control. If a portfolio
company starts underperforming,
loss-making arms can be shed and
managers can be fired at a moment’s
notice. Not so with PIPE deals, where
private equity executives are one voice
among many around the board table.
Just look at Blackstone’s $3.3bn
acquisition of 4.5% of Deutsche
Telekom. The share price performance
since investment hardly compares with
promised buyout returns. And if private
equity firms continue to move into
PIPE investing in a big way, they had
better be very certain of success
because, from an institutional investor’s
perspective, investing in public
equities through private equity limited
partnerships is a very expensive model.
Opportunistic diversification is
another strategy being considered in the
offices of Europe and America’s largest
groups. As banks face write-downs on
their leveraged loan exposures and face
breaching their capital ratios, there
will almost certainly be attractive
buying opportunities.
Carlyle launched a synthetic CDO
in early 2008, based on credit default
swaps that commit to covering senior
debt losses in LBOs. But, while Carlyle
waited until the market was in its
favour, others such as Kohlberg Kravis
Roberts diversified too soon. Its listed
KKR Financial Holding has deferred
several repayments of debt related to
mortgage-backed securities and is now
undergoing a restructuring process with
its creditors.
But the most talked-about strategy by
far is that of mega funds jumping down
into the thriving and highly competitive
mid-market, where financing is still
available, albeit on much less attractive
terms that before.
London-listed waste company
Biffa is one mid-cap to have attracted
the attention of the mega funds.
The company was put into play by two
mid-market firms, Montagu Private
Equity and Hg Capital. Hg subsequently
dropped out and so Montagu teamed up
with infrastructure fund GIC. Then mega
fund CVC Capital Partners was reported
to be circling the company, alongside
Australian investment bank Macquarie.
The dangers of big funds investing in
the mid-market are clear. Firstly, mega
funds are not mandated to invest in midmarket deals. Sophisticated institutional
investors don’t take kindly to their
portfolio diversification being tampered
with and will remember the fact. In
addition, the portfolios of mega funds
would quickly become unwieldy, given
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Photo: Andy Paradise
the larger volume of deals that would
have to be undertaken.
A more immediate threat is that the
mid-market on both sides of the Atlantic
is already heavily populated with professional funds that will give any mega fund
a run for its money. “I can see how mega
funds might be tempted to invest in midmarket deals. But it would be a tactic
rather than a strategy. They are not set
up to do these types of deals,” says one
mid-market investor.
Mid-market stability
Whatever the fate of the mega funds,
in volume terms at least they are merely
a thin top layer of a deep and vibrant
buyout industry that, in the teeth of the
credit crunch, continues to thrive.
“While the larger end is very difficult,
in the middle market there are banks
lending – admittedly not as much as
before and at higher margins – but the
market is still very open,” says Alastair
Gibbons, partner at Bridgepoint, an
upper mid-market firm that invests
across Europe.
Inevitably, debt terms have changed
even in the mid-market. The levels of
gearing are much reduced, with equity
components of 40% to 50% or more
being commonplace. For upper midmarket deals, pricing across the debt
structure has hit record levels, particularly
in the US, as the plummeting secondary
market feeds into primary syndication.
Perhaps the biggest change has been
the need to put together banking clubs in
order to underwrite even modestly-sized
buyouts. This is partly because the few
underwriting banks that are still open
for business are extremely cautious of
syndication risk, but clubs also give
sponsors a great comfort factor.
“The more that the debt is spread
among market lead arrangers, the more
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confidence the sponsor has in terms of
safety in numbers, because there is less
risk on syndication and less risk that
debt will be flexed,” says Kurdian. “That
is becoming a very common feature of
the market.”
Banks have also become much more
cautious about who they lend to. “The
banks have a very clear preference as to
who they want to work with,” says
Gibbons. “In times of turmoil, people
tend to cut the relationships that aren’t
long term or close and focus on their
core. So banks are choosing deals on
the basis of the sponsor firm, rather than
getting into bed with just anybody.”
But, essentially, mid-market investors
view the credit crunch as a cyclical
retrenchment rather than a structural
barrier. “It is not affecting fundamentally
what we are doing at Advent International,” says Fred Wakeman, managing
director at the firm. “We have been in
business for more than 20 years and
we focus on five growth sectors. The
requirement of leverage in those sectors
to generate attractive financial returns is
typically not as high as in stable,
non-growth industries.”
Over that time, Advent has built a
global office network, which is well
placed to help strong domestic
companies internationalise. This infrastructure has also enabled the firm to
build up a pipeline of deals. It is also why
Wakeman is not worried about mega
buyout firms descending into the midmarket. “This type of investment requires
a lot of manpower, a local presence and
it is complex. We are geared up for it.”
In addition, while mega funds might
be looking for emerging market
transactions, it is widely spread
mid-market firms such as Advent that
are geared up for them. The firm has
the largest Latin America fund and it has
been in central Europe since the
mid-1990s.
As a result, when mega fund BC
Partners acquired Migros, it did so
alongside Advent’s Turkish affiliate
Turkven for on-the-ground assistance.
“TurkVen was a good partner for us,
as it allowed us to have a local partner
the markit magazine – Summer 08
“ The dislocation in the banking markets and
the fact that some companies are starting
to struggle, and have a need for capital or
to divest subsidiaries, creates opportunities
for financial sponsors.”
who is on the ground, speaks the
language and understands the local
dynamics,” says Stathopoulos.
The downturn in the markets also
presents opportunities. “The dislocation
in the banking markets and the fact
that some companies are starting
to struggle, and have a need for capital
or to divest subsidiaries, creates
opportunities for financial sponsors
such as ourselves,” says Wakeman.
Take-privates are another area
where a downturn could benefit private
equity firms. “I think take-privates are
looking potentially very attractive,” says
Bridgepoint’s Gibbons.
“Certainly, multiples have come back
quite some way, so the issue is whether
earnings will also come back. At the
moment the equity markets are taking
the view that earnings will fall, so you
aren’t seeing representative multiples.
All such deals must be looked at case by
case, but I would expect an increase in
the level of take-private activity over the
next 12 months,” he adds.
Long-term viability
At the World Economic Forum in 2006,
Apax Partners chief executive Martin
Halusa famously predicted $100bn
private equity funds “within 10 years”.
At the time, many scoffed, and with the
onslaught of the credit crunch, even
fewer would give the idea credence. But a
recent poll by private equity research firm
Preqin found that, while Limited Partners
had understandably become more
cautious following the credit crunch, over
half said their basic objective was to
increase their exposure to private equity,
while just under half intended to keep
their allocations in place.
Whether the top end of the market
will continue growing at pace seems less
certain, but there is little doubt among
mid-market firms – some of whom are
starting to raise funds of several billions
of euros – that private equity will
continue to grow through the cycles.
The private equity business is still
small when compared with global stock
market capitalisation. However, Mark
O’Hare, managing director of Preqin,
says: “The potential to grow further
is enormous: we’re predicting a $5tr
industry over the next five to
seven years.”
For now, the fact remains that private
equity’s troubles are not connected to its
performance or the underlying performance of portfolio companies, and default
rates continue to run at extremely low
levels of below 1%. However, if business
failures do start to climb over the
coming year – as most rating agencies
are predicting – the market could take
much longer to get back on its feet.
Such a scenario would increase the
chance of a shake-out in the private
equity market. Scores of new entrants
have set up over the past few years.
If all they have to show for themselves
are top of the market highly leveraged
deals that start to unwind, it will be very
difficult for them to raise new funds.
But for the majority of players the
credit crunch should be welcomed as a
sensible correction in leverage levels. It
may seem painful now, but structurally,
private equity firms are ideally placed to
make the most of their downtime.