Buyout firms surf wave of liquidity
Private equity has underpinned a boom for investment banks, but borrowing may be at dangerous levels
In a biography of the private equity industry, the chapter covering 2006 might be titled “The Year of Triumph”. Everything to do with private equity was bigger than before.
Fundraising set records, as did buyouts. The industry shed its label as an alternative asset class, not merely joining the mainstream but doing so with a splash
Investment banks took their share of the spoils, with buyout firms generating more than $12bn (€9bn) of fees in the first 11 months, according to data provider Dealogic. The size and activity of the top private equity firms made them arguably the most important clients for banks and many have been hiring aggressively for their financial sponsor coverage groups.
Globally, private equity is set to raise more than $400bn of new capital by the end of the year, a 40% increase on 2005 according to data provider Private Equity Intelligence. European funds raised more than $90bn.
This cash pile, geared at increasing levels, has been employed to complete buyouts of unprecedented size. In the first 11 months of the year, the largest 10 buyouts had a total value of more than $211bn. After a near 20-year wait for a deal to top Kohlberg Kravis Roberts’ $31bn acquisition of RJR Nabisco, 2006 saw the record broken twice.
Thomas Kubr, chief executive of Capital Dynamics, a Swiss-based private equity asset manager with more than $20bn of assets, described 2006 as the year private equity grew up. “I’m seeing a maturing industry beginning to hit its stride,” he said.
The roots of the private equity boom are easily identified. On the one hand, the attractive returns produced by the best funds over the past five years have encouraged investment to pour in.
Nick Ferguson, chairman of SVG Capital, a listed private equity investment vehicle, said: “Savings institutions round the world have come to the conclusion they ought to be exposed to private equity. It’s something everyone wants to do.”
Allied to that demand is a benign economic backdrop and historically low interest rates that have created deep and highly liquid debt markets. “These are the best borrowing conditions I’ve seen in my life,” said Ferguson.
Can it last? To most industry figures, the answer is a resounding yes. Richard Atterbury, head of financial sponsors for Europe at Lehman Brothers, said: “It has been a good year in the European private equity industry with no obvious signs of activity slowing down.”
But some observers fear the industry is unprepared for a downturn. Leverage has risen to dizzying heights and a tough period for credit markets could expose any number of highly geared companies. One industry figure predicted a rash of defaults next year, and the UK’s Financial Services Authority has suggested the failure of a highly geared buyout is inevitable.
Simon Henderson, managing director of European Capital, a €1.7bn ($2.2bn) buyout and mezzanine fund, said: “I would be surprised if either 2006 or 2007 does not in retrospect come to be seen as the high water mark of the current cycle.”
At investment banks, the big winners from the buyout boom have been mergers and acquisitions advisers and leveraged finance bankers. In the first three quarters, M&A led by financial sponsors totalled $570bn, a 50% increase on last year, and nearly a quarter of all announced M&A.
Leveraged loans, used to finance the buyout boom, have delivered banks handsome underwriting fees. In the first 11 months, more than $5.5bn, or nearly half of all investment banking fees earned from private equity, came from extending leveraged and highly leveraged loans. “We’ve been busy,” said Rommie Bhutani, head of leveraged debt capital markets and financial sponsors group for Europe, the Middle East and Africa at Bank of America.
Banks’ in-house private equity operations have become significant moneymakers. Goldman Sachs’ principal investment area achieved record net revenues of $2.8bn in the full year to November 24. Sanjay Patel, co-head of Goldman’s principal investment area in Europe, said: “For Goldman Sachs, private equity is a core part of the firm, and has grown in importance as it has become bigger.”
Goldman not only acts as a principal in deals, committing both debt and equity, but it also does agency work for other private equity houses including financing deals, acting as an adviser and selectively carrying out fundraising.
“The term that’s coming back into fashion is merchant services banking. It’s the part of the firm that brings together private equity, mezzanine financing and infrastructure and real estate investment solutions for clients. All of that activity is tied in with our investment banking franchise,” said Patel.
The growing firepower of the private equity firms, and their willingness to club together to do deals, means few companies are safe from the threat of a buyout. No one expects to have to wait another 20 years before the biggest buyout record is broken again. “I believe we will see a $100bn buyout in the next three years,” said Kubr.
Bhutani added: “What’s changed in the last couple of years is that the size of a company is no longer an issue. Private equity no longer thinks simply because the asset is over a certain size it cannot be actionable. Now, all that matters is the quality of the investment and whether they can buy it at an attractive valuation and make a difference to the business.”
The private equity industry faces challenges. An economic downturn would hit the performance of portfolio companies, with the likelihood highly-geared businesses would struggle to generate the cash needed to meet interest payments on debt.
Ferguson said: “The market for private equity will remain cyclical. I don’t see anything to slow it, but if the markets crash next year, people will be scared and new investment will slow for a while.”
One investment banker said private equity’s fortunes would reflect those of the overall market: “The only thing that can muddy the water as far as private equity is concerned is the state of the M&A market, or the state of the equities market.
“There is only a concern if there’s a recession or the market backs up. In that case, everyone would suffer in the short term, but we’ve seen it before. The private equity industry would take a deep breath and start again,” he said.
Patel said a downturn might force dealmakers to be more conservative about transactions, but the industry would be more than able to weather it. “This is a cyclical business, and there are periods when credit gets squeezed. At some point, the market may slow but the broad direction of the industry is not changing – you are going to see larger transactions next year.
"Most people in the industry expect a downturn, but they will have planned for one over the course of their holding period and built their capital structure accordingly,” he said.
The industry is facing increased scrutiny. Last month, the UK’s Financial Services Authority published a 100-page report looking at the risks inherent in the industry and the possible regulatory response.
The report, described by Ferguson as “excellent, first rate”, concluded the industry posed no systemic risk and that private equity made a significant contribution to improving company competitiveness. It also said, however, a large private equity-backed company defaulting on its debt was “inevitable” and the number of advisers involved on large buyout deals made insider dealing more likely.
While committing to a light-touch regulatory regime, the FSA outlined a number of areas of risk – including excessive leverage, market access and conflicts of interest – which it planned to investigate further.
The European Central Bank is co-ordinating a task force of regulators looking at the risks to financial stability posed by the growth of private equity, which is expected to report in the spring of 2007.
In the US, the Department of Justice launched an informal inquiry, writing to firms such as KKR and Silver Lake Partners requesting documents relating to company auctions going back to 2003. The justice department was reportedly concerned about anti-competitive behaviour.
Several industry figures have said that private equity must adjust to its new size and prominence by being more transparent about what it does and how it does it. Ferguson said: “Private equity has got to change the way it views itself – it’s not private any more.”
He pointed out that Permira, the European buyout group, earns returns on behalf of pension fund clients with 30 million beneficiaries, and owns companies that employ tens of thousands of people. He added private equity will need to put more information in the public domain, and learn to make a case that it contributes to company competitiveness, jobs creation and economic growth.
Patel said: “Private equity has gone from a cottage industry to a mainstream asset class in the past five years, and there’s a lack of appreciation about what we do. It’s a small group of people for a large industry. It behoves the industry to be more open and more accepting of scrutiny.”
For many, the biggest worry about the buyout boom is the increasing levels of debt being used to fund deals. Greater competition for assets has pushed up prices, leaving private equity investors with little choice but to increase leverage if they want to hit return targets.
Credit has never been easier to come by with institutional investors, as well as banks, eager to lend to companies that will pay them a decent yield. High levels of borrowing magnify the returns achieved by equity investors, but also increase the risks should borrowing become more expensive or company cashflows decline.
One industry participant said: “Credit crunches happen, and they happen quickly.”
Figures from Standard & Poor’s leveraged commentary and data show the level of gearing has increased this year. The average ratio of debt to earnings before interest, tax, depreciation and amortisation in European buyouts this year was 5.46, up from 4.28 in 2001. The FSA found the average purchase price to ebitda multiple this year was 14, up from 11 last year.
Patel said: “Leverage is at its highest point to date and the cost of leverage is at a record low. Our cost of capital is as low as it has been in 20 years. That allows people to pay higher prices.”
The banking community is party to this risk. The FSA’s analysis found that in June this year, 13 surveyed banks had increased their combined exposure to leveraged buyouts to €68bn, a 17% increase on 2005.
Some think borrowing has reached dangerous levels. Jon Moulton, partner of Alchemy, a UK buyout group, said at a conference in November that “there is irresponsible leverage going on”, pointing out that some private equity-owned companies were saddled with as many as 11 layers of debt. “I think there will be a large number of defaults next year,” he said.
Henderson said: “The growth in the market has been fuelled by outrageous levels of debt financing, in excess of any previous cycle.” He argued the availability of debt was allowing buyout firms to pay excessive amounts for poor companies. “Ebitda multiples for mediocre businesses have crept towards the multiples you would expect to pay for a high quality business.
"There should be more of a gap. It is perhaps the debt people who have lost their discipline more than the equity investors. Some lending banks would appear to have got their risk/reward mathematics wrong. A default has to happen. It doesn’t need an economic downturn, just a bit of bad luck because everything is so finely tuned.” Patel added: “The credit markets are pricing risk too low.”
Jane Welsh, an investment consultant at Watson Wyatt who advises pension funds on private equity investments, said: “I’m sure there will be some blow ups, that is part of the nature of the asset class. You do need to go into this with your eyes open.”
Others in the industry are more sanguine. Ferguson said: “I don’t see much sign of excess.” Although leverage levels are high by recent standards, he said they are below the levels seen in the buyout boom of the late 1980s. He added that debt coverage ratios, the extent to which debt repayments are met by a company’s earnings, are in good shape and that current borrowing takes account of low interest rates.
The fact buyout groups are acquiring larger companies, with more diverse and predictable cash flows, also supports the case that higher borrowing can be sustained. Bhutani said: “Have the debt multiples gone up compared to historical levels? Broadly speaking, yes, but the quality of assets the private equity industry is going after is top notch.”
Patel said the terms and conditions attached to loans meant companies had room to manoeuvre if conditions worsened. “The flexibility we’re getting from lenders is extraordinary. Because we can build flexibility into our capital structure, we can feel reasonably confident about our ability to weather a downturn,” he said.
Many in the industry bristled at the suggestion they had not contemplated the implications of increased borrowing. “It’s not as if the private equity industry is insensitive to these risks. Firms aren’t wildly trying to get their hands on every dollar they can,” said one source.
An investment banker added that private equity firms are aware of the risks posed by a downturn because, as holders of equity in any transaction, they are last to get their money back.
“They will suffer most, so they are more concerned than anyone else,” he said.
Ferguson added: “Private equity funds know one really bad deal can scupper the business. No one wants to do that, and so discipline is very good. The main risks to the industry are that the discipline slips and people overpay.”
But there are those in the industry who suggest this is exactly what is happening. A private equity manager said: “It seems like some of the big deals lately have been done for the sake of it. There are some people who look to be in a rush to put money to work, and there are people paying more than they should for businesses.”
Private equity goes public
The private equity industry didn’t just grow this year, it adapted. In the typical business model, a firm raises a series of funds which are invested and redeemed over five to seven years.
The cycle has grown shorter, however, and firms have become frustrated by the time and effort that fundraising absorbs and the conditions investors can place on strategy, for example, by not allowing hostile bids. Listing individual funds offers a solution. It removes the need for fundraising rounds and gives private equity investors access to permanent capital with no strings attached.
Kohlberg Kravis Roberts pioneered the concept in Europe this year, listing a $5bn (€3.8bn) fund on Euronext Amsterdam in May. Apollo followed a month later with a $2bn listing. However, the share price of both funds struggled and Doughty Hanson subsequently cancelled a planned €1bn float.
There is nothing new about listed private equity companies: UK group 3i went public in 1994 and SVG followed in 1996. Nick Ferguson, chairman of SVG, expected the public model to become increasingly popular, despite the poor performance of this year’s crop of private equity listings. “A lot of the industry in 10 years’ time will be public in one form or another,” he said.
As well as giving the industry more flexibility, Ferguson said the listing of private equity vehicles would answer the charge that too many companies are abandoning the public markets in favour of the less transparent private sphere.
“There’s an argument that it’s somehow a bad thing for the stock market to be smaller. The obvious response to that is to make it easier for private equity vehicles to list. If the private equity industry is doing something right, then it should be made easier for investors to access the asset class,” said Ferguson.
If private equity is learning lessons from the public markets, then the reverse is also true. David Lis, head of UK equities at Morley Fund Management, said listed companies, and their institutional investor owners, were borrowing some of private equity’s value-enhancing techniques.
“We are running more concentrated portfolios and focusing on our investments more sharply. You’ll see that as a trend across the industry. It gives us a seat at the table in terms of influencing the business, and gives us the opportunity to look at companies in the same way as private equity, to spot growth potential and work with management to deliver enhanced returns,” he said.