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  • 01.27.10

Paradoxes in PE: IPO’s, LBO’s and M+A

Shawn Baldwin from CMG discusses the paradigm shift in Private Equity and the implications going forward

The Private Equity industry roots began with a governmental impetus in the 1940’s when a firm called the American Research and Development Corporation (ARDC) under the leadership of George Doriot began to raise money from institutional investors to hire soldiers returning from the war in manufacturing jobs. ARDC went onto greater heights in the 1950’s when it realized over $350mm from and investment in the Digital Equipment Corporation for less than $100,000.00.  During the 1960’s the ties to the private equity and government were aligned as the Russians successfully launched a dog into space in its’ Sputnik program, so President Kennedy challenged the country into action while shoveling dollars into firms with the simple objective of using cash carrots and asset flow to reach a goal of getting a US man on the moon–first. These actions lay the groundwork for institutional investor involvement in the private equity industry. The pioneer who dramatically expanded the notion of institutional investor particpation was Lionel Pincus, he realized that regulations were important and strove to create the legal opportunities for pension funds to invest in the new funds. The firm he started, Warburg Pincus, with Eric Warburg the German banker became the first private equity group to raise $100mm. The team exceeded their own expectations and dramatically surpassed that amount by raising $1B 5 years later. The birth of the institutional investor, cash chocked mega fund was now complete to the future delights of Mssrs. Kravis and Schwarzman alike.

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Expect the opposite to happen in the coming months, as the government seeks to reduce the size and power of the private equity industry. Concurrently, many institutional investors will press for distributions and seek exits from the illiquid investments that they are currently in. The two key words in the private equity industry will be the same as the keywords were for the hedge fund industry last year: consolidation and contraction. Firms will be looking to exit and return cash to investors so that they will not be caught in the ensuing wave of contraction and viably pursue what will be some of the best returns ever due to current market valuations. Everyone will be rushing to the door–but everyone isn’t going to make it.

The typical PE investment is 10 years with capital commitments, many of those commitments are currently unfunded and will remain so due to a lack of allocation capacity–this need for cash will create opportunites in the secondary markets which are unregulated and extremely opaque. This will allow the institutional investors interested in buying these investments from previous fund investors the opportunity to do so–approximately $75b to $100b in PE assets will change hands during these transactions. This process is highly attractive to the institutional investors because the general guideline will be to go into an existing fund cheaply versus going into another fund at a higher price. Approximately half of institutional investors and sovereign funds have indicated great interest in the secondary market–expect it to be hot for the next 2 years. These discounted assets will have high appeal and offer the much needed liquidity to managers and investors alike as everyone waits to get more comfortable with valuations. High yield default rates resulting due to the dearth of debt, greatly reduces the viabilty of many shops ability to do deals. Credit constraints caused by lower amounts of leverage will put returns under pressure since the industry was built on leverage–this is what has stymied the mega buyouts. There is currently $470B of committed but unused funds. Close to $800b to $1t has to be refinanced over the next few years–the combination of these factors will mean that it will take much longer to raise capital for new funds from institutional investors in the system that Lionel Pincus originated. 

In terms of governmental interaction, President Obama took a slightly different track to get returns: he unleashed taxes against sponsor companies that own US companies with foreign subsidiaries set initially at $210b, this will create a layer of taxes for onshore multi-national organizations further constraining profitability–which will most likely result in funds being raised overseas to make investments in offshore vehicles that won’t be taxed in this country to take advantage of the hot emerging markets. The EU has been increasing taxes and regulations has been active in taxing the “locusts as well”. To be fair to our President, he has addressed the other aisle by essentially creating a stimulus for private equity through the American Recovery and Reinvestment Act of 2009 which allows businesses to pursue the cancellation of debt transactions and defer tax payments on the income until 2014–a date far beyond the wall of debt. There are far too many nuances and regulations to explain here that tie into what are know as “Applicable High-Yield Debt Obligations” or more affectionately known as the AHYDO rules. These rules applied can give companies additional breathing room before becoming distressed or bankrupt, ultimately as the wall of debt approaches and refinancing becomes critical–it might be what assists PE portfolio companies getting over the goal line. Rest assured that an additional wrinkle the government will give the industry is more regulation. A highly politicized environment is going to spur all types of new regulations which will undoubtedly require more transparency from the institutional investors and create expansive needs for more personnel and the costs that come with them. A few have already been outlined under the “Volcker Rule”–the main one being that banks can no longer make investments with their own money, which will cause further capital constraints. Another agenda item on the drawing board is the possible jettisoning of private equity arms from banks that own them—forcibly by the government. The main theory is to stop the conversion of debt into equity in the event of a bankruptcy and exposing the public. Continue to stay tuned, this will get very interesting…

Regardless of any tools or regulations, PE firms will need liquidity to return capital to investors, so that they can raise new funds in this environment (which will do incredibly well thanks to extremely low valuations). So the liquidation of investments, manifesting of profits and the returning of cash to investors is the top priority. This will most likely occur through the incredibly back-logged IPO market. The capital markets are a prime channel for the monetization for what we call private equity sponsor firm deals. Private equity sponsors IPO portfolio companies as well as IPO themselves, as we have seen with Blackstone and KKR. Sometimes they take parts of themselves out in carve outs as we saw with Greenhill after the successful IPO of the investment bank–in any case, returning cash back to investors is the top priority. Recently Texas Pacific Group (TPG) offerred investors the opportunity to reduce commitments and quietly cut their fund from $6bn to $4.6b–due to lack of deal flow. In the Middle East, Abraaj conducted a rights offerring for $375mm from existing share holders and having fortuitously returned $1b to investors before the crisis hit in 2008–additional exits through the M+A process are likely as long as the market conditions will bear them. The Birds Eye sale of $1.3B to Pinnacle , a division of Blackstone, was initially thought to be the thawing of the market as it had $1B of debt accompanying the $300mm equity from Blackstone. That deal was done at 9 times earnings before interest taxes depreciation and amortization (EBITDA). The driver for the deal was that-Pinnacle had sundry brands that would work in combination with Birdseye and create $2.6b in global sales with synergies–look for more of that in the future. These deals make great public companies. 😉

The absence of leverage is considerable in that there is over $400bn of PE debt coming due within the next 6- months (in tandem with the $2.7T wall of real estate debt)–unfortunately these loans were made at much higher valuations making the returns from these investments dismal causing those funds to not be in the first quartile and reducing their viability to to raise additional capital–and because PE is a lot like Ms.”What have you done for me late-ly?” Jackson (that should be the theme song for PE)–expect contraction as institutional investors don’t dance– but vote with their feet (and dollars). Private equity detractors have often decried that PE firms can only generate returns through the use of ridiculous amounts of leverage to enhance their performance returns, not unlike an athlete improving his performance on steroids, the onus is now on them to prove that they can generate returns without “the juice” i.e. read leverage. They will also have to show that the returns are due to their prowess as managers. This will be no mean feat–cunning as they are, this will send dealmakers to initially negotiating terms and the due date of maturities so that the exits can be more favorable making the likelihood of defaults highly unlikely for the savvy firms–in combination with saving their performance records. The less successful will find that their portfolio companies high debt levels will render them distressed assets. Making their firms sought after by institutional investors as much people are currently seeking the Janet Jackson’s 1986 “Control” album that spun the aforementioned private equity theme song–possibly regulating them to the dustbins of history. C’est la vie!

In short, the considerable dearth of leverage will translate into consolidation and contraction. The limited partner (LP) asset allocation scarcity in combination with declines will dramatically exacerbate consolidation in the industry. Experts estimate approximately 20-23 percent will go out of business in the next few years per a study by conducted in NY and London by a private equity london based firm — Coller Capital, a firm that specializes in buying unfunded partnership commitments.

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These factors will greatly affect fundraising on a blind pool basis. Further hampering asset raising is that one of the greatest sources of sponsors were the endowment foundations. The dry powder capital in these organizations has been greatly reduced in the US from $26b to $13b. This was mainly due to a combination of bets in equities and and the illiquid PE firms–their interest will be focused on the bond markets in the near term as they desparately need liquidity. Blackstone has been raising its latest fund for over 2 years with KKR making the rounds as well, rest assure that Permira, the U.K. fund will begin shortly in earnest too, effectively crowding the street with private placement memorandums–the average time to close a fund is 18 months– be prepared to see it stretched longer. Due to the conundrum, rest assure that limited partners (LP’s) will carefully consider deal fees, management services agreements (which can be quite lucrative to the PE firm) and sundry transaction fees as these fees are in addition to fees are going to the firm GP’s who are already compensated.

LP’s will also carefully consider reinvestments into new funds with most selling off their interests in current investments prior to dismal distributions. Such was the case of Harvard Management Company sale of $1.5b of it’s partnership portfolio..most don’t believe that the much needed exits in the IPO or M+A markets will occur soon enough–this will create longer exit times for GP’s and recapitalization will not be available to most companies due to greatly reduced market valuations. Over 84% have declined to give new capital to their funds, almost one quarter of the plan sponsors are reducing their allocations as they rebalance their respective portfolios. The recipients polled believe that their resources will be constrained along with their ability to invest–given the recent article in Institutional Investor and the firestorm over the role of 3rd party investors.

Investors in the Middle East have stopped to review all of their investments–as they begin to sell off investments, while calling due a number of the loans that they previously made through private bankers. Many sovereign funds are demanding more favorable terms for investments which go beyond being simply an LP–furthermore most institutional investors are looking for reasons to escape the unfunded commitments that they can no longer allocate for due to their portfolio imbalances and much neeeded rebalancing-that in combination with the outsized allocations of private equity stakes will stymie fundraising considerably. These conditions have caused a perfect storm. Firms such as Permira, Blackstone and TPG have dramatically reduced the size of their next funds. This has caused the previous 12 months to close a fund in 2007 to be pushed up to 18 months in 2009–which was the lowest fundraisng year in the past 6 years.

In response to the challenges in fundraising, PE firms have begun lowering the entry bar from midnight blue chip to commitments as low as $2mm by Goldman Sachs themselves in their Capital Partners V (with the caveat that you were already a GS, client of course). Citigroup in their Private Equity Partners II, a fund of funds dropped to as low as $250k–a far cry from headier days..look to see more of this flexibility as firms seek to draw more SHNW investors to deal with the illiquidity by tagging new sources creatively.

To be truly competitive in the global markets–PE firms will need international distribution and deal flow as emerging markets offer higher returns with research and diligence into these areas–this will greatly affect risk. This is why the 34% stake that Morgan Stanley held from their investment in (CICC) China International Capital Corp was being eyed avariciously by seven bidders which included the likes of TPG, Carlyle and Bain. Morgan Stanley reportedly paid about $37mm for the stake 13 years ago–that is now valued in the $1B range. In response to that CIC has been making partnerships with firms in the UK like APAX partners in which it made a $1.2b investment–in that deal Apax offered investors the opportunity to transfer unfunded commitments to CIC. CIC owns 10 percent of Blackstone in which it paid $10B–it’s all getting inter-linked again. The myth of de-coupling should be clear to everyone at this point..it is a complete fantasy markets are inextricably linked.

NEW PARADIGM

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The new leverage challenged, post financial crisis world has created a need for new strategies that compensate for the absence of debt. This has caused some PE shops to focus on deal structures that have built in leverage due to prior banking relationships, in these deals they buy some equity with existing terms for leverage and negotiate to restructure the balance sheet–the existing relationship and knowledge of the business greatly enhances the negotiations of loan modification for the business that the banks have already been serving. This can be done with a preferred equity injection in the form of a payment-in kind (PIK) with warrants. This defers interest payments tax advantages through a limited liability corp structure for pass through tax treatment. These will be highly desirable given then combination of reduced debt capacity and easing by the government which will assuredly bring higher taxes and the desire for relief by investors.

The need for substaintial equity injections brought on the advent of the Equity Buy Outs (EBO’s). These deals in comparison to the miniscule amounts equity during the easy credit, covenant lite days represent a stark contrast in dealmaking. Some deals due to the absence of senior debt will most likely cause more collaboration of shops through EBO’s-this will return the notion of the club deal, as more equity is needed for investing since financial sponsors in most funds are restricted to only 10 to 20% of their funds committed capital into any singular investment. Deals like TXU at $44B and HCA at $32B were done through clubs which included firms like KKR, Texas Pacific Group (TPG), Bain and the like. These deals will create stronger ties between buyers and lenders with common interests and limited resources.

Another strategy that has arisen due to the small deal flow, is that some PE shops (along with a number of hedge funds) focused on debtor-in-possession deals (DIP’s) in bankruptcy courts. this a strategy which has yielded up to 30% returns for shops such as Apollo Management, Centerbridge, and Angelo Gordon–it is however quite risky.

Look to see acquisitions of smaller shops as the well capitalized firms like Blackstone with over $27b for investments and an evergreen publicly traded capital markets structure seeks to take advantage of their balance sheet. Firms with strong balance sheets will focus on PE and hedge fund acquisitions, with lending at 4 to 5 times balance sheets (far less than the previous 8 to 10 times) they are penultimately positioned to be a great consolidator. KKR and Blackstone will also benefit from their public traded structures through rising market values (KKR merged with its publicly traded unit in Amsterdam while Blackstone IPO’d)–while Fortress listed in the height of the capital market boom, Apollo Management took advantage of the market recovery through an unconventional deal in an institutional exchange. 

The consolidation and lack of leverage will mandate that in this new era returns will be driven by more managers. PE firms will look to increase their respective benches in corporate talent to drive returns as the focus will shift from gathering assets to generating high earnings before interest taxes depreciation and amortization (EBITDA).

These factors will generate more strength for investors versus the managers who simply dictated terms in prior years. The wooing and swaying of investors during this period will be fairly difficult. The total funds raised in 2009 were roughly $250b–a paltry sum in PE and arguably the least amount since 2004. A far cry from the so called “Golden Age”. The positive to be noted is that the funds raised now will create tremendous returns. One of the largest institutional investors in the United States, the $187B CalPERS, clealry believes that this trend will occur and they voted with their dollars by ramping up their asset allocation from 11.7 % to 14%. A clear nod to expected higher returns.

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The hot areas for investments will be infrastructure assets, renewable energy-clean tech (with as much as $6b available), technology, healthcare and luxury. There will be a particular focus on medical and bio technologies. We will examine those next along with the technical aspects driving them.

 

 

 

(L) Jay W. Ireland the President & CEO of GE Asset Management one of the largest alternative investment managers in Private Equity and Hedge Funds; (R)Shawn Baldwin from CMG

About the author

Shawn D. Baldwin is Chairman of the AIA Group (AIA), an alternative investment and advisory firm based in Chicago.

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