Features : Adapting To Survive

SECTOR REPORT / PRIVATE EQUITY

Cash-heavy buyout firms are still looking for deals, but the rising cost of borrowing may result in their emulating their smaller private equity cousins.

Just a few months ago there were widespread fears that big buyout private equity firms were playing too large—and negative—a role in the corporate sector, most notably in the United States and Europe. Now, serious questions are being asked about their viability. Will they be able to change their business model sufficiently in order to survive?

The giants of the private equity world—buyout funds that do mega-deals such as Kohlberg Kravis Roberts’s $29 billion acquisition of electronic-payments processor First Data in October—have come under pressure because of how they are funded. Having long outgrown bank lending, they are funded mainly by the leveraged loan and bond markets.

In recent years buyout funds have enjoyed the good times. They have become increasingly aggressive in their use of leverage because strong institutional demand for loans and bonds has allowed them to do so. Whereas 18 months ago average leverage was just four or five times earnings before interest, taxes, depreciation and amortization (EBITDA), just before the summer crash deals had reached an average of more than seven times—and some mega-deals have been leveraged to double digits.

But now debt has become pricier and scarcer. As the credit crunch has deepened, the leveraged loan and public bond markets have slowed dramatically, according to Jonathan Blue, chairman and managing director of middle-market firm Blue Equity. Many of the loans extended to private equity firms have been impossible to sell on: Standard & Poor’s said in October that loans worth E76 billion in Europe alone remain undistributed.

Not surprisingly, investment banks’ appetite for new lending has shrunk and with it much of the financial basis of the mega-deal. “No one expects mega-deals, at least not in the short term,” says Katharina Lichtner, managing director and head of research at Capital Dynamics, one of the world’s largest private equity asset management firms.

Dipping Into New Markets
So with the public debt markets almost closed and mega-deals drying up—at least in the short term—are the huge buyout funds about to disappear? Not according to Lichtner. “There are managers that have raised funds of over $10 billion,” she says. “If mega-deals are not an option, then these firms will simply shift focus—deals of $1 billion to $5 billion are still taking place.” Lichtner says that deals of that scale would make sense even for very large buyout firms. “Mega-deals are usually done via syndicates, with individual equity involvement often not more then $2 billion,” she says. “With a focus on non-syndicated deals of up to $5 billion, a large buyout firm could, for example, invest in four to five deals. This would require $20 billion to $25 billion in debt a year, factoring in the expected decrease in leverage levels—the kind of money that doesn’t require bond or leveraged loan markets.”

Blue agrees that there could be some “dipping down into the small- and mid-cap and lower-middle markets.” However, he adds: “The issue for the top firms will be the need to deploy a record amount of capital, and those kinds of dollars have not traditionally been put to work in the lower market sectors. It is going to be a challenge for those firms.”

Such a shift could reduce potential returns, as leverage in smaller-capitalization markets is lower than for mega-deals. It could also mean changed expectations in terms of how long investment lasts. Until recently, buyout funds had a typical hold period of three years. But in the cheap debt bonanza of recent years—where it was possible to create returns simply by leveraging up an acquisition—that fell to as little as 18 months. Nevertheless, a move into the middle market could ensure the survival of buyout firms that would otherwise have to go into hibernation, if not close down.

If the buyout funds start to move into the middle market in a major way, rivalry for deals and funds will inevitably increase. Will small- and mid-capitalization-focused private equity houses—which range from venture capital firms that fund start-ups to those that can make $5 billion investments—be able to compete in this new environment?

Certainly, their finances are likely to be strong enough to put up a good fight. “It is taking longer to get credit approval, and pricing is tightening in terms of multiples,” says David MacLellan, chief executive at RJD Partners, a firm that makes investments in UK companies with a total value of up to £75 million ($155 million). Companies in the sectors in which RJD operates are typically bought at six to eight times EBITDA with leverage of up to four times. “That leverage figure is coming under pressure,” he adds.

However, crucially, middle-market firms have always been reliant on bank debt rather than public bond markets and so far continue to have access to funds, according to MacLellan. Moreover, Blue points out that commercial banks are most willing to lend to private equity houses because they are not perceived as a competitive threat. That could give small- and mid-capitalization-focused private equity houses a potential advantage over new entrants from the buyout market, which are sometimes seen as being in competition with investment banks for assets.

Meanwhile, from a deal perspective, there should be enough potential targets for both buyout firms and more traditional mid-capitalization firms, according to Lichtner. “Among US- and European-listed companies alone, the combined worth of firms with a market capitalization of $1 billion to $5 billion is $13 trillion,” she says. “Just in the S&P; 1500 in the US and S&P; 500 in the EU, there are about 1,500 companies of that size, not counting large privately held companies or large corporate spinouts.”

Moreover, a likely implication of the credit crunch, which has affected mainly the US and Europe to date, is an increased focus on emerging markets, expanding further the number of potential targets. “We are already active in India, China and Latin America and see huge opportunities for growth as consumer growth continues to accelerate,” says Patricia Hedley, senior vice president at General Atlantic, a leading global growth equity firm, which manages $15 billion.

The Wider Implications
So both buyout firms and small- and mid-capitalization-focused private equity houses look set to be able to continue to do deals. Money continues to pour into the sector: RJD Partners recently closed a £150 million fund at £180 million following strong demand, and MacLellan notes that “investors remain enthusiastic about the prospects for private equity. And, as we have seen, debt finance continues to be available from commercial banks.”

However, in addition to the changes the credit crunch has brought about in the types of deals getting done, it is also expected to change how private equity realizes its investments. Usually around 15% of exits by private equity firms are through the IPO market. But as the credit crunch has increasingly unnerved equity investors and raised fears of a recession in the US and a global slowdown, it has prompted a sharp reduction in IPO volumes. More than 80 IPOs in the US and Europe were pulled or postponed from October to the end of November. “That means that holding times are likely to drift out,” says MacLellan. “Secondaries [where a company is sold to another private equity firm] are also likely to increase,” he says.

Laurence Neville