How the levers fell off the buyout machine
By Steven Rattner
Financial Times
Published: March 24 2008 18:39
Whither private equity, in the wake of its descent from a "golden age"
to the dog house in a handful of months? Few businesses or individuals
(save, perhaps, Bear Stearns or Eliot Spitzer, the former New York
governor) have fallen so far, so quickly.
Since July, not a single private equity deal has been hatched above
$4bn, and only $49bn of leveraged buyouts larger than $1bn have come
forth. That is less than half the amount achieved in June 2007 alone.
Not only are new deals scarce, a number of agreed deals that had not
yet closed have hit the rocks, spawning recriminations and litigation.
Still worse, after a long run of stellar performance, a clutch of
recent private equity investments are showing signs of cracking under
the strain of too much leverage and a weakening US economy.
Significant bankruptcies in private equity ****tfolios are a certainty,
as is the next round of bad press that will accompany them.
But just as private equity was never the killer asset class that its
most fervent proponents proclaimed, neither should it now be relegated
to the dustbin of financial history. Like other investment strategies,
private equity has a role to play in the financial world, although
whether it ever regains its Periclean glory of a year ago remains
questionable at best.
Amid last year's breathless coronation of the "buyout kings", private
equity acquired the lustre of mythology. In fact, reduced to its
essence, private equity is more prosaic - being simply leveraged
equity. As equity is more costly than debt, and because equity
generally appreciates over time, substituting generous dollops of
leverage for equity lowers an investor's cost of capital. That, in
turn, can raise the returns that public equity owners receive into
double digits.
Added to the benefits of financial leverage are the positive effects
of private equity's human capital - financial engineering, market
timing and the laser-like oversight of operating teams. Finally,
finance theory provides that investors accepting illiquidity (hence
the term "private") should receive higher returns than those able to
sell at any time in the public markets.
Summed up, over the long term, smart private equity investors should
produce returns meaningfully above the levels of those traded on stock
markets. But the froth of recent years - in which private equity firms
offered chest-thumping claims of outsized returns and leapfrogged each
other with ever larger megafunds - reflected, in large part, the fact
that never before had so much leverage been available at such low
cost.
In 2007, the average multiple of debt to cash flow in private equity
deals reached 6.5 - up from 4.7 only four years earlier. Meanwhile,
benign economic conditions and a worldwide liquidity glut pushed risk
premiums - the amount of interest that lenders demand over super-safe
Treasuries - down to record low levels.
Now, the tables have turned. The conditions that fuelled the private
equity boom - leverage - have, for the moment, eva****ated. Last year's
rash of giant deals overloaded a financing market that was
simultaneously reeling from the meltdown in the subprime mortgage
market.
With huge inventories of unsold paper sitting on dealers' books
($129bn at present, according to Bank of America estimates), new
commitments have virtually halted. So far in 2008, only $5bn in new
high-yield bonds have been issued, compared with $40bn for the same
period a year ago.
Meanwhile, holders of the leveraged debt sold as part of the buyout
binge are suffering acute buyers' remorse. Debt that has been released
to the market has traded down substantially. For example, bonds of
Univision, a Spanish broadcaster taken private a year ago for $13.7bn,
are now trading at 58, down from an issue price of 100, for a yield of
22 per cent - pretty remarkable in a world of 2.6 per cent Libor.
Certainly, the credit crunch and the return to more appropriate risk
premiums have contributed significantly to those trading levels. But
with recession worries mounting in the US, investors have also become
concerned that the default rate on high-yield paper - currently at a
record low - will rise.
In recent weeks, both Moody's and Standard & Poor's have issued
re****ts identifying an increasing number of debtors at risk of
default. Not surprisingly, many of those companies are private equity-
backed. S&P's list includes more than 50 worrisome private equity
****tfolio companies. "The day of reckoning has arrived," said Diane
Vazza, an S&P managing director.
Just as private equity's boom was finite, its bust will end, too, as a
more normal leverage environment takes hold. Logically, the return of
private equity will almost certainly come from the bottom up -
starting with smaller deals with less leverage and then, gradually,
larger ones.
But those less leveraged capital structures come at a significant
penalty. Private equity returns are much more sensitive to the amount
of leverage in a deal than to the cost of the leverage. That results
in either lower returns for investors or, more probably, a painful
ratcheting down of the prices attained by sellers.
Whether the largest, headline-grabbing deals ever re-emerge remains
questionable. More than likely, the past few years will be seen as the
aberration, rather than the decades before, or the nine months since
the music died.
The writer is a managing principal of Quadrangle Group, a private
investment firm. He will be speaking on the credit crunch and the US
economy at the London School of Economics on March 27
http://www.ft.com/cms/s/0/f72d31da-f9a6-11dc-9b7c-000077b07658.html
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