Private Equity: Down, But Not Out

Includes: BX, CS, GS, JPM, UBS
by: Prince of Wall Street

A diamond is forever even if it spends years in a drawer only to periodically emerge for moments of brilliance. Business cycles continue but the existence/relevance of private equity should not be doubted. This downturn will pass and private equity will come roaring back with the largest war chest it has ever possessed and more brazen tactics. This will pass, and it seems like many institutional investors agree, as they continue to pour money into all the new mega-funds the PE firms are closing each passing day. Alison Mass, co-head of Goldman Sachs’ (NYSE:GS) financial sponsors group, speaking at the 20th Annual Buyouts East conference last week in New York, had this to say, "Private equity is not a new business." She went on to say that, "It consists of firms that have been in business for decades. But it’s a cyclical business. [They] have seen these cycles before."Indeed, some of the best returns the industry has recorded came from down years, she said. In the downturn from 2000 to 2002, the best-performing firms generated annualized compound return rates of more than 10%, according to Mass (This seems to fit with The Prince’s suggestion to buy when there is blood in the streets).

Mass also saw equity checks continuing to rise in the current turmoil in the market. However, she emphasized that this is a trend that has been underway for quite some time. She provided the example of KKR’s takeover of Safeway Stores in the late 1980s which was a $5bn buyout with only $130m in equity from KKR. Today 30-35% equity is assumed for most buyouts even at the peak of the buyout book last spring. Mass said that percentage could rise to as high as 50%. This will obviously dampen returns for private equity firms since the impact of lower leverage will be lower returns. Remember that there are essentially three ways to make money in an LBO. First, the PE shop can improve operating performance by improving margins through rising revenues and/or cutting costs. This would serve to improve the EBITDA of a company that has been taken private by a PE firm. The second strategy is to depend on multiple expansion, that is, buy companies in industries that are out of favor, at low multiples, and resell them when the industry cycle hits its peak for a higher multiple. The final way to make money in an LBO is through leverage. The best firms employ all three strategies effectively but some firms specialize in one in particular.

This exit is blocked, try over there

Now all this is fine and dandy when it comes to creating value at a company that has been taken private, but it doesn’t mean anything if the PE shop cannot exit its investment and realize its gains. In the past this was done through an IPO, a sale to another private entity, sale to a strategic partner, or a dividend recapitalization where the PE shop paid itself a special dividend with the proceeds of newly issued debt. The leveraged bank loan and high yield markets are shut to new issuance, so the dividend recapitalization option is off the table (not to mention new LBOs but that is another story). Furthermore, the IPO market for an over-leveraged sponsor-owned company looks very weak right now. Finally, selling the company to another private entity doesn’t seem likely since the other private equity shops are all facing an inability to get financing for new acquisitions. So basically, the only option that is left for PE firms to exit their investments is a sale to a strategic partner. Many investment grade strategic partners have record amounts of cash on their balance sheets. However, many are going to be hesitant to invest, given the gloomy forward outlook for the economy and technology. So selling a sponsor-owned company to a strategic partner will also probably prove to be a tall order.

This is not to say that these four options for realization will not eventually become available again. It just means that PE firms cannot rely on them right now. Mass doesn’t see a huge problem with this since she points to the fact that many large PE firms, which are sitting on record amounts of cash, are holding their investments longer or are diversifying into other asset classes like real estate, hedge funds, mezzanine and distressed debt. Others are doing smaller deals. Mass said she is getting calls from clients looking to do deals in the $800 million range, which, just a year ago, the same firms couldn’t even afford to spend time on. Having bought up $1.9 trillion of companies from 2005 to 2007, private owners are now confronting how to monetize their investments. The doors look shut right now. The M&A markets are shut, as potential buyers wait for asset prices to decline.

For an example of this process of value creation followed by realization The Prince turns to an example highlighted by Dennis Berman at the WSJ.

Dex Media Inc. was one of the greatest private-equity trades of the decade. And that is precisely why it is important to take note of its deep failings in public-company life.
For four years, buyout shops Carlyle Group LLC and Welsh, Carson, Anderson & Stowe played the yellow-pages firm, Dex, with a maestro’s aplomb. They paid themselves special dividends. They took the company public in 2004, cashing in part of their stake. The capper came in the 2006 merger with fellow publisher R.H. Donnelley Corp. (RHD), creating the nation’s third-largest phone-book outfit by total volumes published. By the time it was all over, the $1.6 billion Dex investment had yielded a $2.6 billion profit.
As sold to the public, the yellow-pages story was always about faith. Faith that the pen-and-ink business would hold up despite lower margins from Internet offerings. Faith that directories were like oil wells, monotonously pumping cash.
Over the past 12 months, Donnelley shares have shed 77%. Shares in the Verizon Communications directories spinoff, Idearc Inc. (IAR), are off 80%. The Internet is more irrepressible than first thought, which is why phone books are making for nifty computer-monitor stands.
"Timing is everything," is how Carlyle Group managing director James Attwood put it at a recent conference, explaining how the firm had exited from its position by November 2006. "What we did see over time is [the directory business] can be disintermediated partly, if not fully, by the Internet."

It's getting harder

The next cycle of private equity portfolio company IPOs will struggle. Mainly because the prices originally paid for targets were so high. Purchase multiples reached their highest prices in 10 years during the first half of 2007. There is little doubt that if Clear Channel Communications Inc. or Freescale Semiconductor Inc. or Equity Office Properties Trust were bought today they would receive much lower valuations. Using the power of leverage, private-equity buyers still can turn a profit even if their assets don’t grow in value. But that assumes some of these valuations aren’t deeply underwater already. Statements from PE executives now suggest that some investments will have to be held for as long as seven years to make back a middling return.

This suggests that valuations are swimming with the fishes already on some of the mega-buyouts. The other problem for prospective IPOs is the nature of the companies that went through LBOs. The vast majority of them were not traditional buyout targets that required substantial refurbishing. The PE shops pursued healthier businesses, which were expected to grow along with the world’s economy. If that growth does not materialize, there may be little that the owners can do to get an edge. These dynamics will certainly work to the advantage of buyers who bring significant operating improvements to their holdings or who purchased companies with high amounts of leverage (so long as the cash flows from the company continue to grow or become constant). Firms that rely more on multiple expansion will probably take the most pain now that multiple expansion exits look unlikely.

So how should Wall Street firms respond to the "purgatory" that PE shops are in right now? These clients were extremely valuable to Wall Street banks for the last five years. For example in 2007 Carlyle dolled out $300m in fees to Wall Street and this number was dwarfed by Blackstone (NYSE:BX). Sponsor clients that the public had never heard of paid the street far more in fees than GE (NYSE:GE), Verizon (NYSE:VZ), Apple (NASDAQ:AAPL), etc. While the smaller deals (those less than $1bn in aggregate value) will be pursued by the larger private equity firms and these deals will generate some level of fees to support staff in sponsors, the blockbuster fees earned from PE firms will take a while to return. Some of the top banks in leveraged loans and financial sponsors like Credit Suisse (NYSE:CS), UBS (NYSE:UBS), JP Morgan (NYSE:JPM), etc. have been pairing down these groups since this fall when it became clear that the music had stopped for LBOs. Dealbreaker drew attention to the plight of some sponsors analysts who were told to speed up their jumps to PE firms but were not fired. While some cuts are probably necessary at the banks that have large groups devoted to servicing private equity firms, key relationship managers should be kept in place. Private equity will reemerge from its hibernation, and the bankers who have strengthened their relationships with the PE firms during this lull will be rewarded.