Private Equity in 2008
The End of the Golden Age?
Managing Director, Pacific Equity Partners
In April 2007, Henry Kravis stated that private equity (PE) was in its “Golden Age”. This is perhaps not surprising. Notwithstanding Kravis’ experience in an industry which he helped create over 30 years ago as a founder of KKR, the first half of 2007 was an extraordinary period. The market was awash with cheap debt. Banks were so keen to lend into leveraged buy-outs (LBOs) that covenants were dispensed with (and thereby the warning lights which signal when a deal is turning sour in time for remedial action to be taken). And the private equity firms were flush with more equity capital than they had ever had. There seemed to be no company that was immune from the attentions of individual, or clubs of, private equity firms. In the UK, Boots was purchased for £11 billion in the largest ever European buyout; in the US, TXU was at the centre of a US$32 billion bid; and in Australia, an A$11 billion takeover was launched for the national airline Qantas. That was then….
Within a few short months, the US credit markets were shuddering in response to rising default rates in the sub-prime mortgage market. Payment stops on low quality mortgages which had been re-packaged and re-sold several times over affected hedge funds, pension funds and banks alike. In the months that followed, tens of billions of dollars of write-downs were taken. By March 2008, one bank alone, UBS, had written down US$37 billion. The debt markets were paralysed. The secondary market for securitized debt and leveraged loans dried up. Loans that were in syndication became ‘stuck’ and underwriters were forced to carry them on their balance sheets. Banks were unable to determine the scale of losses they were carrying because there was no real market for these ‘assets’. They went into ‘capital preservation’ mode and new lending more or less stopped. What lending was happening was being priced at significantly expanded spreads. For private equity firms, even deals that were signed and committed were at risk. In the first quarter of 2008, the Clear Channel deal in the US was ‘pulled’ - the argument about who pays the break costs is just beginning. And the credit crisis doesn’t seem to be getting any better. Some sources estimate that there is US$1 trillion of write-downs to be taken, of which only about US$150 billion have been taken to date. And this does not take into account a whole new category of credit instruments called Credit Default Swaps (CDS) which could dwarf the sub-prime and leveraged loan exposures of some of the major banks around the world.
As if this wasn’t bad enough, the effect of the credit crisis is only now starting to be felt in the real economy. If, as the IMF is predicting, a recession in the US economy causes a global slowdown, the impact on companies’ earnings will be felt the world over. For deals that took advantage of the heady credit conditions of recent years and loaded up on debt, this is not good news.
From the “Golden Age” in April 2007, it seemed as if the private equity industry may have regressed to the Dark Ages.
Or had it? Whilst the ability of private equity firms to do new deals in the current environment is limited, and whilst the headwinds of a potential global slowdown are chill, the performance of leading PE firms has proven remarkably robust through economic cycles. This is because the ‘traditional’ LBO model is built on business fundamentals and the top quartile PE managers have generally applied their craft with discipline and focus. Furthermore, the highest PE returns over nearly twenty years have been recorded in times of financial ‘crisis’.
The Traditional LBO Model
At one level, the classic LBO is pretty uncomplicated. A business is identified with a strong and defensible market position in a structurally attractive industry with a resultant high quality of earnings and steady cashflows. Based on a rigorously researched view of the future prospects of the business, debt (of different forms) is raised to support the funding of the purchase. Equity from the funds managed by the PE firm makes up the balance of the purchase price. Over the course of the investment period (typically three to five years), the business is managed with intense oversight from the PE firm through the Board with the objective of delivering performance at or better than the initial investment case. Equity value is created for investors (which typically include the managers of the business) as the result of profit improvement and the use of free cashflow to pay down debt. And if things go particularly well, the eventual purchaser of the business may pay a higher multiple of earnings than the PE firm did when it bought the business, further enhancing equity value.
Of course this is a simplistic view and there are many things which contribute to the broad spread of actual returns that are experienced across the PE industry. Poor asset selection, over-gearing, over-paying, poor due diligence, bad management and so on all contribute to disappointing and sometimes catastrophic investment performance. But top PE managers have demonstrated surprisingly strong performance over a long period and through economic cycles. Cambridge Associates data show that between 1986 and 2004, top quartile performing funds have delivered an average 25% Internal Rate of Return (IRR). Returns by fund vintage (the year in which a fund is formed) vary between 11% and 41%, indicating that there is volatility through cycles but that the worst returns over an 18 year period are still in double digits. The best performing vintages are those funds raised in ‘crisis’ years. The highest return vintages in this data set were 1991 (41%) and 2001 (39%). It may be that 2008 vintage funds are actually looking pretty good!
So why have the top performing PE firms delivered such high average returns over time, and how have they managed to deliver attractive returns even in the face of significant economic downturns? The answer lies in the fact that, as an ownership model, private equity has a number of advantages over public and, in some cases, other forms of private ownership. Private equity funds tend to have an intense focus on sustainable value creation. Partners in a PE firm are paid a ‘carried interest’ on the profit they make for their investors. PE firms are often accused of being cost-cutters, asset-strippers and “quick flick artists”. In Germany, they have even been described as “locusts”. But a firm that has been in business over a number of years cannot have achieved this by exhibiting those sorts of behaviours. Sellers must want to continue to sell to them, buyers must want to continue to buy from them, and investors must believe that they have a model that will deliver value for years to come. Cost-cutting alone is not a long term value creation strategy. It is overwhelmingly in a PE firm’s self-interest to focus on growth-based value creation. Only growth which is perceived to be sustainable will be highly valued by a purchaser of the business. There are many models of how PE firms do this, but the common themes are a focus on top line growth and on one or two big and actionable initiatives. PE firms also create a ‘partnership’ with their management teams, inviting them to invest alongside them and providing performance-based upside through an attractive options package. Versus public companies, there is no quarterly performance pressure so businesses genuinely can invest for the medium term without worrying about the impact on quarterly results. And versus private companies, there exists an effectively unconstrained ability to invest behind initiatives which will add value to the investment in a present value sense. Together with a judicious amount of debt to gear the equity returns and create capital efficiency and cash management disciplines, these are the ingredients which set the PE ownership model apart.
Adapt or Die?
But in a world where debt funding has all but dried up and an economic downturn is likely to affect business performance, what is the future for private equity? History would seem to support the view that news of its demise is much overstated. At the same time, an element of adaptation to the new environment will be necessary.
As has been discussed above, the PE model has demonstrated resilience of performance through previous economic downturns. This should not be surprising if one accepts the strength of its ownership model. But not all practitioners excel and, notwithstanding the excellence of the model, 75% of PE firms fall outside top quartile performance. Some of these will fail in the current downturn. In previous downturns, even some of the stalwarts of the industry ran into heavy seas by straying from the tried and tested. A number of large US firms have burnt their fingers in PIPE (Private Investment in Public Equity) investments, and New York buy-out firm Forstmann Little was sued by one of its investors, accused of straying beyond its fund mandate by making significant investments in newly formed telecoms companies at the height of the dotcom boom between 1999 and 2001.
Winners and Losers
It is likely that there will be some sifting of winners and losers over the next couple of years. Asset selection disciplines of the recent past will be tested and those portfolio companies with business models found wanting will face significant performance pressure. All PE firms will be tested in terms of their capacity to support and manage their portfolio businesses through volatile times. But it will be particularly challenging for those firms who have overvalued and/or poorly positioned investments on their books. Investors and banks will respond to the successes and failures of PE firms. The effect of this may not be immediately apparent, but
greater selectivity on the part of debt and equity providers is likely to drive some firms from the industry.
Winners will be characterized by investment discipline and patience. They will also be characterized by a willingness to innovate without losing a focus on the core business of private equity investing. If debt is hard to source, leading firms will find new ways to finance. Already the leading global firms, names like KKR, TPG, Bain Capital, Carlyle and Blackstone, have raised over US$10 billion of funds to invest both in secondary debt, which is trading at a discount to face value, but also to finance mezzanine and subordinated loans into new deals. If the banks remain closed for new business for an extended period, PE firms are likely to seek alternative sources of senior debt from pension funds, non-bank institutions and sovereign wealth funds. The turmoil of the public markets and the pressures in the real economy will ultimately create attractive buying opportunities as pricing expectations adjust and even strong businesses are affected by the economic slowdown.
Is The “Golden Age” Yet To Dawn?
Where does this all lead? If one believes that the private equity ownership model has some inherent advantages over other forms of ownership, then it must necessarily have longevity. The near term environment presents undoubted challenges. But history has shown that PE firms have weathered the adversity of economic crisis well on average, and the top performing firms have actually profited handsomely from it. It may be a bold prediction to say that the Golden Age of private equity is yet to dawn, but for those firms who are patient, disciplined and innovative, and who have strong financing relationships in place, returns on investments made over the next two years could far surpass what has been experienced in recent history.