VideoSeated on the stage of the Empire State Ballroom in New York's Grand Hyatt Hotel, Bill Conway talked of missed opportunities. A featured speaker at January's Private Equity Analyst Outlook Conference, the cofounder and managing director of The Carlyle Group told the assembled bankers and private-equity partners that he wished he'd done more. "We should have done every single deal, everywhere in the world," lamented Conway. "Every deal worked."
Although it may sound as if Conway were channeling Gordon Gekko, he was hardly exaggerating: nearly every Carlyle deal in recent years has worked. The private-equity firm's recent purchases of Hertz, Dunkin' Brands, and other companies have outperformed all but the most optimistic projections. What's more, Carlyle isn't the only one with the Midas touch. Private-equity firms are enjoying a success that eclipses that of the Michael Milken era of the 1980s, when leveraged buyouts (LBOs) came into vogue. Through the first three quarters of 2006, private-equity funds yielded an average 12-month return of 23.6 percent, versus 9.7 percent for the S&P 500, according to Thomson Financial. Over the past three years, buyout firms have averaged a 15.6 percent return, compared with 9.9 percent for the index.
As private-equity funds have consistently beaten the markets, money has poured in by the billions. In 2007, according to industry professionals, U.S. private-equity firms could raise well more than last year's record $215 billion. Among the biggest firms, Kohlberg Kravis Roberts (KKR) recently closed a $16 billion fund, Goldman Sachs Capital Partners is rumored to be raising a $19 billion fund, and The Blackstone Group is said to be building a stockpile of more than $20 billion. Currently, by some estimates, private-equity firms are collectively sitting on a $400 billion war chest.
Combine that cash with leverage, and private equity's buying power increases four- or fivefold. So while 2006 was a banner year for private equity — more than 27 percent of all acquisitions were made by financial buyers, according to investment-banking specialist Dealogic — 2007 and 2008 promise to be even bigger in terms of deal volume.
Meanwhile, the private-equity phenomenon has caught the attention of CFOs, many of whom yearn for freedom from the pressures of earnings calls and audit committees — not to mention more pay. So far this year, the finance chiefs at AOL, Circuit City, and H.B. Fuller have left to join private-equity firms or companies owned by them. When Alvaro De Molina left Bank of America as CFO at the end of 2006, he told reporters that he wanted to go to a private-equity firm.
It may seem as though the private-equity party could go on indefinitely, but some observers are wondering if the boom has already peaked. "The most money always comes in at the end of the cycle, when the big returns have already been achieved," says Bruce Evans, a managing partner in the Boston office of private-equity firm Summit Partners. Others think private-equity firms are destined to overreach, emboldened by their financial strength to strike increasingly dubious deals.
If that happens, the consequences might not become apparent for years. Most private-equity firms have an investment horizon for the companies they buy of about five to seven years. That lag could allow ample time for a bubble to grow, fueled by cheap credit and a continuing inflow of investor capital.
Easy Money
Indeed, credit terms for LBOs have never been easier. Banks, hedge funds, and other lenders have been willing to bankroll buyouts at historically low rates. Nor are they attaching many strings to the deals. Many loans have been structured with "covenant lite" agreements that put few restrictions or triggers on the terms.
Rumors circulate on Wall Street that buyout firms now have so much clout that they can blacklist potential creditors, directing bankers not to syndicate loans to certain buyers. That typically means hedge funds, which private-equity firms fear could be too aggressive in calling in loans after a default.
Some industry watchers worry that credit is getting too loose. They point, for example, to recent deals that have included so-called PIK (payment in kind) toggle loans, which give the lender the option of postponing repayment by paying more interest. One company, General Nutrition Centers, issued $300 million of floating-rate PIK toggle notes in March to finance a buyout. The notes give the issuer the ability to skip interest payments when cash is tight, in exchange for a higher interest rate on what is skipped, usually about 75 basis points. Critics compare the potential effect of the notes to the so-called death spirals of convertible bonds with a floating conversion rate, suggesting the notes may only delay inevitable defaults while causing more investor pain in the process.
"Typically, the music would stop if credit got tighter due to rising default rates," says Brian Conway, a managing director at private-equity firm TA Associates. "But in some cases, these natural governors are being removed."
"When that stuff [such as PIK toggle loans] comes on the marketplace, then you need to taker a closer look," agrees G. Bennett Stewart, CEO of EVA Dimensions. "A lot of bad deals are going to get done because of [those loose terms]." Stewart says he is always surprised when he hears private-equity managers claim that the boom will last as long as debt terms are good. "The debt market is more of a reflection of the deals being done than a cause," he says. "It's not like the debt [terms] go bad first and then the deals go bad. Debt terms go bad because of the bad deals getting done."
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