According to the European Private Equity and Venture Capital Association (EVCA), a record $450 billion was invested in European and North American companies by private equity in 2006—an increase of 60% on 2005. Meanwhile, private-equity-sponsored companies were responsible for 40% of all US IPOs in 2006, and buyout funding represents a huge chunk of the high-yield bond and syndicated-loan markets.
Private equity’s importance has been growing since Kohlberg Kravis Roberts bought food and tobacco conglomerate RJR Nabisco for $25 billion 18 years ago. But in the past few years, the industry has achieved such a scale—and begun to employ so many people (in the United Kingdom alone, private-equity-owned companies now employ as many as 2.8 million people, a fifth of the workforce)—it has become impossible to ignore.
Private equity inevitably has attracted government attention, notes Jonathan Blue, CEO of US middle-market private equity firm Blue Equity. “Any industry that has success on the scale of private equity over the past several years can expect to receive scrutiny,” he says. Attention has largely focused on two issues: the level of tax paid by private equity partners, and how private equity companies generate returns.
On the issue of tax, public attention has unsurprisingly honed in on salacious details. UK legislators hung their attack on the industry on the claim that private equity partners pay less tax than the people who clean their houses. Meanwhile, in the United States, Blackstone Group’s CEO, Stephen Schwarzman, was criticized for his lavish lifestyle, which involved spending $3,000 a weekend on food—with the implication that he paid too little tax.
The Schwarzman episode inspired an orgy of self-righteousness and consequent calls from US legislators for higher taxes and more control of the sector. But many responses have focused on too narrow an agenda, according to Blue. “Many of the discussions have ignored the benefits that private equity brings to underlying portfolio companies and the overall economy,” he says.
Moreover, as Frank Morgan, president and COO of Coller Capital in the US, a company that buys private equity assets in the secondary market, points out, private equity firms are taxed just like any other partnership. “It would be unfair to discriminate against one type of partnership by taxing it differently just because it has proved to be successful,” he says. Despite the noise, Morgan says it is unlikely that any moves will be made in the US in the medium term that would curb returns, although in the UK the government’s pre-budget report in October signaled the end of some forms of tax relief for the private equity industry.
Kubr: Private equity firms also put their own money at risk.
The Perennial Question
The second question raised by regulators and legislators during hours of breast-beating hearings—how private equity makes its returns—is ultimately more important than levels of taxation.
Private equity is undoubtedly successful at creating value. A survey by consultancy Ernst & Young, which analyzed 200 private equity exits in the US and Europe in 2006, showed that the enterprise value of private-equity-owned companies grew at 33% a year compared to 11% for publicly listed companies. In Europe, private-equity-owned firms grew by 23% compared to 15% for public companies.
The real issue is whether private equity creates or exploits value. Does private equity produce growth from investment and improvements in operational performance, bringing long-term benefits? Or does it cut costs ruthlessly and pile on the debt, making a company briefly attractive in order to sell but destabilizing it in the long term?
The results of Ernst & Young’s survey strongly indicate the former. “There is convincing evidence that private equity creates real growth in enterprise value,” says Simon Perry, head of global private equity at Ernst & Young in London. “It is not the barbarian at the gate of legend.” The report shows that two-thirds of the growth in earnings before interest, tax, depreciation and amortization (ebitda) at private-equity-owned companies came from business expansion.
Perry says that the huge competition between private equity companies means that there is no possibility of buying a company cheap and then breaking it up for profit. Instead, as Blue of Blue Equity notes, the depth of experience, contacts and resources that a private equity buyer brings—combined with a proactive strategy for purchases and an understanding of the broader market context—leads to improved performance.
Perry: Sustainable growth can’t come from cost cutting.
While cost reduction is important for private equity, the focus is on efficiency rather than unsustainably cutting headcount. “Sustainable growth can’t come from cost cutting, which only benefits ebitda once,” explains Perry. With an average hold for private equity in the US of three years—or three and a half years in Europe—such a strategy wouldn’t work. Incidentally, such a hold period compares favorably to the public stocks, which are held for an average of just 10 months.
In addition to the “ability to ramp up revenues and reduce expenses potentially far more aggressively than a traditional operator” noted by Blue at Blue Equity, one of the most important elements of private equity’s return formula is the use of leverage. “Especially for large buyout firms, the cost of debt matters to returns,” says Morgan at Coller Capital.
Figures compiled by Bloomberg show that the four largest private equity firms in the world—Madison Dearborn Partners, Providence Equity, Blackstone Group and Thomas H. Lee—had leverage of more than 10 times the earnings of their target companies in the period from January 2005 to September 2007.
Morgan: The credit crunch hasn’t played out as badly as many feared.
Evidence suggests that as deal prices have risen, private equity firms have increased leverage in order to help maintain returns. In a prophetic report in December 2006, Standard & Poor’s credit strategist, Blaise Ganguin, warned that “debt leverage in buyouts has reached record levels, surpassing the peaks of the 1990s and suggesting bubble-like conditions.” She pointed out that “the average debt payment burden on outstanding leveraged buyout deals was four times above the normal safe level” and that there was “very little margin for error. Any hiccup, whether in currencies, commodity prices, or wage settlements, could push these companies over the brink.”
That hiccup occurred in the first quarter of 2007 with the US subprime mortgage crisis. By the summer it had become a global credit crunch that not only shut down debt markets—causing banks such as UK mortgage lender Northern Rock to come close to failing—but was resulting in dramatic swings on equity markets and raising concerns about the sustainability of global economic growth.
For private equity, the effect was dramatic and immediate. “It was a rabbit-in-the-headlights situation when the credit crunch first broke,” says Morgan. Institutional investors that had been eager buyers of syndicated loans resulting from leveraged buyouts simply disappeared overnight. By some estimates as much as $300 billion of leveraged debt remained unsyndicated at the beginning of October—including a £9 billion loan to finance the £11.1 billion acquisition of UK pharmacy chain Alliance Boots by Kohlberg Kravis Roberts.
Just a Blip
With banks unable to shift debt from their balance sheets, their ability to lend further to private equity funds is currently severely restricted. But while private equity firms’ room for maneuver is currently constrained by the closure of some areas of the debt markets, no one in the industry believes that the current market turmoil is anything other than a temporary problem for private equity. “The lack of availability of debt will work itself out,” says Kubr at Capital Dynamics.
Morgan at Coller Capital says that the adaptability of the financial markets to the credit crunch has reassured the private equity market. “It’s far from an ideal situation, but it hasn’t played out as badly as many feared,” he says. “Initially, there were concerns that mega-deals such as the $29 billion acquisition of electronic-payments processor First Data by Kohlberg Kravis Roberts would have to be renegotiated or even reneged upon. But, instead, we’ve seen all the parties involved take a pragmatic approach and get the deal done.” Similarly, at the beginning of October, reports emerged that the eight banks holding the £9 billion Alliance Boots leveraged loan had agreed to continue to hold onto it until February next year.
Blue: Many of the discussions ignore the benefits that private equity brings.
More generally, no one questions the continuing role of leverage in private equity. While leverage may have reached high levels, the general strategy of increasing leverage at acquired companies to increase returns remains valid. “Private equity—most obviously buyout funds—increase leverage because it is in a position to do so,” notes Kubr. “That increase in leverage is offset by the fact that private-equity-owned companies are managed to maximize cashflow so that any additional debt can be sustained.” He adds: “Private equity firms also put their own money at risk, and it would be shortsighted to leverage an acquisition to unsustainable levels.”
Speaking off the record, other industry observers say that private equity firms simply took advantage of huge demand among investors for higher-yielding debt. “Private equity firms didn’t create that appetite,” says one industry veteran. “And it would have been negligent to a firm’s shareholders not to take advantage of the availability of cheap credit when it was available. But if debt does become more expensive, it doesn’t mean private equity returns disappear.”
Moreover, while some markets are currently almost closed to new deals, underlying trends indicate that when confidence returns to the market, borrowing costs could be very attractive. The 50-basis-point cut in rates by the Federal Reserve on September 18 has driven the expectation that the trajectory of interest rates in the US, Europe and possibly the UK will now be downward—likely cutting the cost of debt. And while credit spreads have widened out, they are still only at the level of 18 to 24 months ago, notes Kubr.
It is one of the paradoxes of the contemporary financial markets that amid a clamor for transparency and liquidity there is a shift among investors toward alternative assets such as private equity and hedge funds.
Private equity investments are usually extremely illiquid: Many funds have five- or 10-year investment periods, and exiting before maturity is extremely costly. Consequently, observers report next to no redemptions during the choppy summer and autumn months. However, what is more surprising is that there is no evidence that the trend of increased allocation toward private equity has stalled following the events of the summer, according to Morgan at Coller Capital.
Figures from research group Private Equity Intelligence show that a record $260 billion went into buyout funds in the first half of 2007. That scale of inflows is unlikely to be sustained into the second half of 2007, but the raising of €5.4 billion to fund acquisitions in Europe by buyout firm Carlyle Group at the beginning of September—more than the €5 billion it was aiming for—indicates that enthusiasm for the sector is far from diminished.
The reason for the continued shift of money into private equity is simple: The returns are attractive. “That trend is likely to continue regardless of market conditions because it is a straightforward reflection of the fact that returns are higher in private than public equity,” says Perry at Ernst & Young. Morgan says that the expectation of institutional investors in private equity—of roughly 500 basis points more than the S&P 500—will be achievable even in a tougher debt climate.
Moreover, even without the influx of new money, private equity is a force to be reckoned with given the huge resources it has. “The sums amassed are such that private equity will continue to be a significant component of M&A activity,” says Morgan. Makis Kaketsis, manager of the F&C UK Dynamic Fund in London, agrees that leveraged buyouts driven by private equity “are still awash with cash,” but, he cautions, “such deals will have to be done at more reasonable prices.”
The irony is that if deals are done at more reasonable prices—and assuming the debt markets return to some semblance of normality—private equity firms are best placed to benefit. As one industry observer notes, “The credit crunch may end up being a godsend for the industry. It has stalled the prospect of increased tax because legislators don’t want to upset the economy at a crucial time. And while the cost of debt has increased, that will likely be reflected in prices paid for companies. In all likelihood, private equity’s involvement in the economy will end up stronger following this episode.”