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The buy-out barons say the worst is over. They would.
Economist Staff, The Economist
October 29, 2009
In the half-century since private equity first appeared, the industry has produced stretches of great profitability, culminating in a spectacular run from 2002-07. During that golden age, private equity was charmed. Investors poured record amounts into the industry. Bankers did their bit by relaxing standards on credit. Nine of the ten largest buy-outs in history occurred between 2006 and 2007, averaging $30 billion each. Four-fifths of that was borrowed. Can private equity ever regain those glory days?
As a result of the crash the industry faces four big obstacles to recovery. Thanks to frothy equity markets, the industry is closest to overcoming the first barrier — exiting current investments. TPG this week offloaded its remaining shares in Debenhams, a British department store. Blackstone is reportedly planning initial public offerings (IPOs) for as many as eight portfolio companies and trade sales for another five. Kohlberg Kravis Roberts (KKR) recently filed for an IPO of Dollar General, a discount retailer, amid reports that it plans to float six more companies.
If successful, these exits will provide welcome cash to distribute to investors, easing fresh fund-raising rounds. But there are big questions over how long the rally can last (shares have dipped since a high in mid-October). And rising markets do nothing to help the industry solve its second problem, making new investments. Political sensitivities about private-equity ownership run high — witness ill-thought-out European attempts to regulate private equity and hedge funds. And surging asset prices have made it harder to find bargains.
Before the crisis, higher prices were easily addressed: buy-out firms simply loaded up on debt. That is no longer an option. The banks are husbanding capital. Debt is more expensive. Demand from collateralised loan obligations (CLOs), specialist funds that hoovered up leveraged buy-out loans during the boom, has largely gone.
The industry has been here before. When Drexel Burnham Lambert, an investment bank, collapsed in 1990 the industry lost almost all its financing overnight. Managers focused on smaller deals and weaned themselves off debt. A similar scenario is playing out again now. Blackstone's $2.7 billion purchase of Anheuser-Busch's theme-park business in October reportedly included $1 billion of equity. Silver Lake recently led a consortium of private-equity and venture-capital firms to purchase Skype from eBay for roughly $2 billion, almost all of it equity.
These deals involved managers purchasing a business unit from a larger firm. "Private equity will return to basics: smaller deals with more cash upfront," says Brian Kaufman of Westridge Capital. That may help medium-sized specialist funds to shine. Managers have also set their sights on emerging markets, where their money goes further and growth is bubblier.
The private-equity industry does at least have plenty of cash to spend. Prolific fund-raising in the boom years has given firms more than $500 billion of committed but uninvested capital (or "dry powder"), the largest amount on record. But some of that money may no longer be available, as investors struggle to meet calls on their capital. And the industry's third problem, its relationship with investors, will make it harder for many firms to raise new money.
There are rumblings that Harvard's endowment plans to manage more of its money in-house after losses suffered by external managers, many in private equity. According to a new survey by Preqin, a research firm, 42% of the largest endowments are above their target allocation to private equity. Proposed regulations on placement agencies, firms that connect investors to smaller funds, are also likely to reduce cash flows to the industry.
Without leverage to juice up returns, the gap between the industry's best and worst performers will also become more apparent. Studies suggest that leverage accounts for between one-quarter and one-third of returns at private-equity-backed firms. Fees help, too. An influential study by Steven Kaplan of the University of Chicago and Antoinette Schoar of the Massachusetts Institute of Technology in 2005 that examined the performance of private-equity funds found that less than a third of managers consistently beat the S&P 500 after fees were accounted for.
Buy-out bosses are under pressure to revise the fee structures that made them rich. The standard "two-and-twenty" fee structure, whereby managers charge investors a fee of 2% of the money they manage and 20% of the profits they earn, is thought unlikely to change. But transaction fees, a 1-2% cut managers charged merely for consummating a deal, look indefensible now. So do fees for monitoring portfolio companies. Measures that prevent managers from charging management fees while capital sits idle (as now) may also surface: TPG is reportedly returning $20m in such fees to investors in its flagship fund.
The fourth threat facing the industry is its refinancing burden. Dealogic estimates that $378 billion of private-equity debt will need to be refinanced in the next four years. Generous loan covenants give managers more flexibility to work through their debt, and lenders are keen to extend the duration of loans rather than call them in and face more write-downs. By pumping more equity into investments and renegotiating terms with creditors — something that Blackstone is reportedly trying to do with its Hilton Hotels business — firms hope to manage their debt burden downward. But it won't work for everyone. On October 25th Capmark, a commercial-property lender controlled by a group of investors that includes KKR and Goldman Sachs, filed for bankruptcy. If the economy falters or if interest rates rise, more portfolio companies will come under strain.
The industry is poised for a significant contraction. Analysts at JPMorgan estimate that the number of firms will shrink by 30%. Others put the figure closer to 70%. Those with mediocre returns and short track-records will be the victims of an industry-wide reshuffle. Those that survive will have to get used to a diet of smaller deals and lower returns. Private equity is not dead. But its best days look behind it.