An interesting column from the Globe & Mail.
jwm
Why LBOs will be the next thing to go pop
ERIC REGULY
October 3, 2008
ROME -- Five months ago, J.C. Flowers, one of Wall Street's best-known private equity firms, figured Germany's banks had been sufficiently beaten up. It was time to buy.
A Flowers-led group plowed €1.1-billion ($1.68-billion) into the country's second-biggest commercial property lender, Hypo Real Estate Holding, in exchange for a 24.9-per-cent stake.
Talk about bad timing. On Monday, the financial crisis swamped Hypo and the German government tossed it a €35-billion lifeline. Flowers had paid €22.50 a share for Hypo. The value yesterday: Less than €6.
While Hypo was the private equity industry's highest-profile dud of the week, it may not be the last. The reason: Leveraged buyouts, the lifeblood of the private equity industry, are set to unravel. Even private equity says so. "There will certainly be dozens of LBOs that won't make it and it doesn't take a lot of imagination to get into the hundreds," said John Moulton, founder and managing partner of Alchemy, a London-based private equity firm.
Like real estate in the United States and Britain, private equity and LBOs were bubbles waiting to burst. Highly leveraged deals, in which a pebble of equity was buried under a mountain of debt, are already a thing of the past; thanks to the credit crisis, banks have no appetite for risky lending. The new world of lower leverage will inevitably translate into lower returns. In the meantime, more than a few top-of-the-market LBOs are cracking.
The traded debt on the deals (where there is traded debt) tells the story.
Take Realogy, formerly Cendant, the world's largest real estate franchisor, whose businesses include Century 21, Coldwell Banker and Sotheby's International Realty. Its debt trades at about 75 cents (U.S.) on the dollar, a level that implies a fairly high chance of default.
This is bad news for Leon Black's Apollo Management, one of the world's biggest private equity firms. Its purchase of Realogy, completed in the spring of 2007, when the buyout frenzy was at its height, valued the company at $8.5-billion. It's safe to assume Realogy is worth considerably less today as real estate values go into the tank.
While the partners of private equity firms were built up as swashbuckling captains of capitalism, the reality is that their business model was dead simple: Goose investment returns by buying an asset with as little equity as possible.
They could do so because loans were cheap and plentiful, and rising markets kept the credit spigot open. Typically, private equity firms financed LBOs with one-quarter equity and three-quarters debt, though many were done with much thinner equity layers.
As the good times rolled, the LBOs, measured by their cash flow cushions, became riskier. A strategic buyer would make sure the target company's debt was no more than three times EBITDA - earnings before interest, taxation, depreciation and amortization. The first wave of private equity deals were done with debt equivalent to five times EBITDA. During the credit boom of the past two or three years, that multiple rose to eight times or higher.
The higher the ratio, the higher the risk, because cash flow is used to pay down debt. "If your operating profit goes down even a fraction in these highly leveraged deals, you're up [a] creek, to use the technical term," said Alchemy's Mr. Moulton.
Up the creek, so to speak, is casino operator Harrah's Entertainment. Its equity investors, Apollo and Texas Pacific Group (now called TPG Capital), larded Harrah's with debt equivalent to an astounding 10 times EBITDA. Harrah's cash flow is sinking, taking the bonds down with it. A month ago, the junior debt traded at about 40 cents on the dollar. By the end of September, the price was about 25 cents. The money raised by the private equity funds has been phenomenal. Andre Sawyer, the managing editor of Mergermarket, a London research firm that covers the mergers and acquisitions market, said about $400-billion came in the door in 2006 alone. According to Private Equity International magazine, the top 20 private equity firms (including Ontario Teachers' Private Capital) each raised between $10-billion and $32-billion in capital in the five years to 2007. The top five were Carlyle Group, Kohlberg Kravis Roberts (KKR), Goldman Sachs Principal Investment, Blackstone Group and TPG.
Some private equity funds probably wish their takeover victories had come less often because asset values are coming down. For evidence, just check the stock market. Sinking values create all manner of problems for the funds. In some cases, depending on the lending covenants, they will have to inject more equity into the companies they bought. More equity equals less return.
Worse, they face big losses when they attempt to book gains on the LBO by selling the company or floating it on the stock market through an initial public offering. Private equity firms are not long-term investors. In this market, it would be next to impossible to sell a company for a profit, unless it had been bought many years ago.
The share prices of the private equity market's few publicly traded names says as much. In the past year, Blackstone has gone from a high of almost $30 a share to less than $15. The shares of KKR Private Equity Investors, which trades in Amsterdam on the Euronext bourse and invests alongside KKR's buyout funds, have lost more than half their value in the past year (KKR planned to go public by merging with KKR Private Equity Investors).
Of course, sinking values and investment returns mean the private equity funds will have trouble raising new buyout money.
Private equity buyouts of consumer companies, such as retailers, appear especially vulnerable as economies slip into recession and consumer confidence evaporates. Blackstone learned this the hard way in May, when Linens 'n Things, the American big-box retailer of home textiles and housewares, filed for Chapter 11 bankruptcy protection and closed 120 stores.
As companies given the LBO treatment lose value or go bankrupt in the worst cases, some private equity funds will wind down and disappear. But there will be survivors. They just won't look like today's funds; they look like old-style merchant banks, or "private equity without the debt," as Mr. Moulton put it.
Merchant banking would involve far more than buying a company and flipping it in a couple of years to another buyer who might tack even more leverage on it. It would, essentially, see the private equity firms become long-term partners in the companies in which they invest. The firm's partners would get involved in restructurings, financings, acquisitions, management recruitment and the like.
Two of the biggest LBOs of the decade have run into trouble. Tribune Co., the media company taken private last year by real estate magnate Sam Zell, has $1.4-billion in debt coming due next year, and is seeking to sell the Chicago Cubs baseball team in a bid to raise $1-billion. Cerberus Capital Management LP bought control of Chrysler LLC last year for about $7-billion, but has not been able to stanch the company's losses.
Private equity managers say things will get a lot worse before they get better. Some truly big LBOs could blow up, spreading wreckage everywhere. For investors such as Cerberus and Mr. Zell, the golden age of private equity - all three or four years of it - has come to an end.
jwm
Why LBOs will be the next thing to go pop
ERIC REGULY
October 3, 2008
ROME -- Five months ago, J.C. Flowers, one of Wall Street's best-known private equity firms, figured Germany's banks had been sufficiently beaten up. It was time to buy.
A Flowers-led group plowed €1.1-billion ($1.68-billion) into the country's second-biggest commercial property lender, Hypo Real Estate Holding, in exchange for a 24.9-per-cent stake.
Talk about bad timing. On Monday, the financial crisis swamped Hypo and the German government tossed it a €35-billion lifeline. Flowers had paid €22.50 a share for Hypo. The value yesterday: Less than €6.
While Hypo was the private equity industry's highest-profile dud of the week, it may not be the last. The reason: Leveraged buyouts, the lifeblood of the private equity industry, are set to unravel. Even private equity says so. "There will certainly be dozens of LBOs that won't make it and it doesn't take a lot of imagination to get into the hundreds," said John Moulton, founder and managing partner of Alchemy, a London-based private equity firm.
Like real estate in the United States and Britain, private equity and LBOs were bubbles waiting to burst. Highly leveraged deals, in which a pebble of equity was buried under a mountain of debt, are already a thing of the past; thanks to the credit crisis, banks have no appetite for risky lending. The new world of lower leverage will inevitably translate into lower returns. In the meantime, more than a few top-of-the-market LBOs are cracking.
The traded debt on the deals (where there is traded debt) tells the story.
Take Realogy, formerly Cendant, the world's largest real estate franchisor, whose businesses include Century 21, Coldwell Banker and Sotheby's International Realty. Its debt trades at about 75 cents (U.S.) on the dollar, a level that implies a fairly high chance of default.
This is bad news for Leon Black's Apollo Management, one of the world's biggest private equity firms. Its purchase of Realogy, completed in the spring of 2007, when the buyout frenzy was at its height, valued the company at $8.5-billion. It's safe to assume Realogy is worth considerably less today as real estate values go into the tank.
While the partners of private equity firms were built up as swashbuckling captains of capitalism, the reality is that their business model was dead simple: Goose investment returns by buying an asset with as little equity as possible.
They could do so because loans were cheap and plentiful, and rising markets kept the credit spigot open. Typically, private equity firms financed LBOs with one-quarter equity and three-quarters debt, though many were done with much thinner equity layers.
As the good times rolled, the LBOs, measured by their cash flow cushions, became riskier. A strategic buyer would make sure the target company's debt was no more than three times EBITDA - earnings before interest, taxation, depreciation and amortization. The first wave of private equity deals were done with debt equivalent to five times EBITDA. During the credit boom of the past two or three years, that multiple rose to eight times or higher.
The higher the ratio, the higher the risk, because cash flow is used to pay down debt. "If your operating profit goes down even a fraction in these highly leveraged deals, you're up [a] creek, to use the technical term," said Alchemy's Mr. Moulton.
Up the creek, so to speak, is casino operator Harrah's Entertainment. Its equity investors, Apollo and Texas Pacific Group (now called TPG Capital), larded Harrah's with debt equivalent to an astounding 10 times EBITDA. Harrah's cash flow is sinking, taking the bonds down with it. A month ago, the junior debt traded at about 40 cents on the dollar. By the end of September, the price was about 25 cents. The money raised by the private equity funds has been phenomenal. Andre Sawyer, the managing editor of Mergermarket, a London research firm that covers the mergers and acquisitions market, said about $400-billion came in the door in 2006 alone. According to Private Equity International magazine, the top 20 private equity firms (including Ontario Teachers' Private Capital) each raised between $10-billion and $32-billion in capital in the five years to 2007. The top five were Carlyle Group, Kohlberg Kravis Roberts (KKR), Goldman Sachs Principal Investment, Blackstone Group and TPG.
Some private equity funds probably wish their takeover victories had come less often because asset values are coming down. For evidence, just check the stock market. Sinking values create all manner of problems for the funds. In some cases, depending on the lending covenants, they will have to inject more equity into the companies they bought. More equity equals less return.
Worse, they face big losses when they attempt to book gains on the LBO by selling the company or floating it on the stock market through an initial public offering. Private equity firms are not long-term investors. In this market, it would be next to impossible to sell a company for a profit, unless it had been bought many years ago.
The share prices of the private equity market's few publicly traded names says as much. In the past year, Blackstone has gone from a high of almost $30 a share to less than $15. The shares of KKR Private Equity Investors, which trades in Amsterdam on the Euronext bourse and invests alongside KKR's buyout funds, have lost more than half their value in the past year (KKR planned to go public by merging with KKR Private Equity Investors).
Of course, sinking values and investment returns mean the private equity funds will have trouble raising new buyout money.
Private equity buyouts of consumer companies, such as retailers, appear especially vulnerable as economies slip into recession and consumer confidence evaporates. Blackstone learned this the hard way in May, when Linens 'n Things, the American big-box retailer of home textiles and housewares, filed for Chapter 11 bankruptcy protection and closed 120 stores.
As companies given the LBO treatment lose value or go bankrupt in the worst cases, some private equity funds will wind down and disappear. But there will be survivors. They just won't look like today's funds; they look like old-style merchant banks, or "private equity without the debt," as Mr. Moulton put it.
Merchant banking would involve far more than buying a company and flipping it in a couple of years to another buyer who might tack even more leverage on it. It would, essentially, see the private equity firms become long-term partners in the companies in which they invest. The firm's partners would get involved in restructurings, financings, acquisitions, management recruitment and the like.
Two of the biggest LBOs of the decade have run into trouble. Tribune Co., the media company taken private last year by real estate magnate Sam Zell, has $1.4-billion in debt coming due next year, and is seeking to sell the Chicago Cubs baseball team in a bid to raise $1-billion. Cerberus Capital Management LP bought control of Chrysler LLC last year for about $7-billion, but has not been able to stanch the company's losses.
Private equity managers say things will get a lot worse before they get better. Some truly big LBOs could blow up, spreading wreckage everywhere. For investors such as Cerberus and Mr. Zell, the golden age of private equity - all three or four years of it - has come to an end.
