Should We Welcome the PE Shakeout?

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Includes: DIA, QQQ, SPY
by: Prince of Wall Street

So the Street-wide forward pipeline of LBO related debt issuance has shrunk to around $70bn and in some weeks has actually increased.  Prices for LBO related bank loans and HY debt have slowly recovered.  This is no doubt because of the opportunistic hedge funds and even private equity firms that have bought up the debt of LBO credits seeing how undervalued these pieces of paper had become because of forced selling.  Granted prices in the secondary market for LBO related debt are still lower than they were before the credit crunch. And the largest former buyers of new paper, CLOs, are still mainly on the sidelines due to losses on mortgage related holdings.  In the face of this assessment, many private equity and banking pros still say that paper is available. (Albeit in smaller amounts than we saw during the boom.) It is still cheap compared to historical spreads. (Albeit it looks damn right usurious when we consider that banks are offering rates for new senior secured financing at a hundred basis points higher even in transactions that have moderate leverage than they did during the boom.)  The private equity landscape looks to be improving and the outlook is certainly more positive than it was at the start of 2008. 

Yet, with large attractively priced leveraged committed financings tough to attain and sellers still expecting premium pricing, the ability of the mega-private equity funds to deploy their immense funds looks mighty cloudy.  These players like Carlyle and Blackstone have been telling us since the crisis began that they already had a good chunk of their newest funds committed to deals before they stopped fundraising and closed their most recent funds.  They also tell us they will be doing more foreign transactions.  Never mind the fact that the concept of the LBO is still in its infancy in Asia and can not support enough activity to replace the drop in U.S. activity.  With high levels of government regulation and business cultures that are skeptical of the LBO model good luck doing large deals in China, Japan, or other parts of Asia.  In Europe financing is almost as difficult to come by as in the U.S.  When was the last time you heard a large European LBO printed?  Some private equity firms have drifted by making leveraged purchases of LBO debt.  Those who did this shortly after the credit crisis made a pretty good return.  The firms have also started making equity or hybrid investments in public companies.  Witness TPG’s recent forays into the financial sector to bargain hunt.  Many of the largest private equity firms have been trying to build themselves into diversified alternative asset managers for many years and branching out beyond private equity.  Blackstone is probably the farthest along in this process of diversification.  Even if these new activities by private equity firms are good strategic investments these activities will not be able to fill the hole left in revenues by doing fewer PE deals and earning less in carried interest as a result of poorly performing portfolio companies that were bought at the peak of boom.  So the great PE shakeout is coming and no amount of spin is going to convince The Prince otherwise.  There will be winners and losers but there are guaranteed to be fewer firms standing at the end of this downturn.  The private equity firms’ dance partners, the investment banks, are going through a rough patch right now.  We have already witnessed the collapse of one firm, the seeds of future regulation that will reduce earning potential, a decline in leverage which will reduce returns, and the raising of capital by most of the major banks.  So what does this downturn hold for the private equity industry?  What should we watch?

Many approach this question by looking to the past and comparing this downturn to the Internet bubble or the turmoil in the financial markets in the early 1990s epitomized by the collapse of Drexel.  The Prince thinks this is interesting but not very helpful.  The PE industry of today is unrecognizable compared to what it looked like over 15 years ago.  It has become a major part of the landscape.  Walk through a mall and you will have difficulty finding a company that has not been touched by private equity.  The number of employees and the size of revenues found in a large private equity firm’s portfolio is massive when we compare it to the miniscule private portfolios of the past.  This last boom saw 9 of the 10 largest LBO transactions ever, when adjusted for inflation.  Private equity is just a much larger part of the finance community than it was in the past.  Comparing this bust to previous downturns can only tell us that the industry will recover at some point and is not dead (as the New York Times and other news sources constantly try to suggest).  From such comparisons we could also possibly infer that the when the industry does return it will be larger but other predictions can not be made from comparing this boom and bust to previous cycles.  The private equity is just a different animal now.

We should welcome the shakeout because it will make distinctions between different private equity funds much more apparent.  The funds that claim they add value to operations will have to prove their claims.  Funds that have been getting by based mostly on leverage will be tarnished.  Funds that generate true alpha by picking the right companies to LBO will shine in this downturn and will be rewarded with more funds in the future.  Funds that make investments during the downturn at depressed prices for good assets will have some stellar numbers to put up.  Firms that bet on multiple expansion or picked the wrong industries to invest in will lose much of their luster.  The private equity funds will have to become more creative in how they find deals, structure them, and ultimately operate the companies they buy.  Great deals will have to be made and not just found among the companies that are being shopped by investment banks.  The best private equity firms will find new sources of financing for their activities and they will get creative in how they combine businesses.  For probably the first time in the private equity industry’s short history we will see how the largest firms perform on a relative basis during a downturn when plain vanilla LBOs can not be done.  For example, two firms that play heavily in the recently hard hit consumer discretionary sector, Golden Gate Capital and Leonard Green Capital Partners, will be differentiated.  Which of these firms will prove that it picked the right companies and did not just do deals because financing was available and the asset was for sale?  Which of these companies will be shown to bring value by meaningfully improving operations?  The shakeout will answer these questions.  The shakeout will allow us to judge the value of the mega-fund model employed by Blackstone, KKR, and Cerberus.  In a downturn can massive LBOs survive the storm better than smaller LBOs or even public companies?  The firms that have been claiming they have a differentiating edge will be proven right or wrong.  The victors will raise even more money for the next boom and the posers will be closed or reduced to a fraction of their former size.  Only the sharpest and the strongest will be rewarded after this winnowing.