The Buyout Binge

Private-equity firms are gobbling up everything in sight. How long can it last?
Joseph McCaffertyApril 1, 2007

Seated 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.”

New Targets

Avoiding bad deals will depend on the supply of good targets, and there is plenty of debate regarding how many of those remain. Some observers contend that most of the low-hanging fruit — solid middle-market companies with low debt and healthy cash flow, but in need of some TLC — have already been picked. “There is so much money and so many firms chasing deals that finding [good targets] has gotten much harder,” says Greg Peterson, transaction-services partner at PricewaterhouseCoopers.

The counterargument, advanced by numerous private-equity partners and industry watchers, is that the universe of viable buyout targets is expanding. That’s because deep-pocketed buyout firms have the resources to go after bigger companies, and because they are increasingly looking overseas for new possibilities.

If you accept the notion that there is more value to operating as a private company than as a publicly traded one, then the number of potential targets increases still more. Talk to almost any private-equity manager these days and you will hear how difficult it is to be a public company. “Where we come from, we think the public model is broken from a governance and capital-structure standpoint,” says Michael Goss, CFO of private-equity firm Bain Capital. At 2004’s Private Equity Analyst Outlook Conference, KKR’s Henry Kravis spoke of the disadvantages to public-company regulation. “To the extent that Sarbanes-Oxley causes public companies to be less competitive, there is an opportunity for the private-equity industry in taking these businesses private and putting some energy back into growing them,” he said.

Private-company proponents also say that public-company shareholders are too focused on the short term and have little patience with long-term strategies. “Public-company managers are measured by a different standard,” says Hamilton “Tony” James, president of Blackstone. “We make decisions that might not pay off for three to five years. You would get crucified as an executive if you did that in the public market.” Adds Peter Jeton, chief operating officer of private-equity firm Apax Partners: “There are all kinds of things that can be done in a private-company setting that [managers] wouldn’t dare do, or couldn’t afford to do, in a public environment.”

By this logic, virtually any public company could be a buyout target — meaning that the private-equity boom could continue indefinitely. And, in fact, private-equity firms are considering companies and industries they wouldn’t have consider five years ago. “I can’t think of even a modest swath of the economy that would be off-limits for private equity,” says Jeton.

“They will not exclude anything,” agrees Saikat Chaudhuri, an assistant professor of management at the University of Pennsylvania’s Wharton School. “PE firms are looking at every company under the sun.”

For example, big technology companies were once considered poor candidates for buyouts. They were thought to be too capital intensive, with cash streams that could be unpredictable. But in September 2006, Freescale Semiconductor agreed to a $17.6 billion buyout by a consortium led by Blackstone, Carlyle, and TPG (formerly Texas Pacific Group). And when TPG, along with KKR and Goldman Sachs, announced an agreement last February to acquire Texas utility TXU, conventional wisdom was dealt another blow — not just because the deal would be the largest LBO ever at $45 billion, but also because many figured that buying a large utility was unthinkable because of operational constraints imposed by state regulators. “God knows what is coming next,” says Charles Ames, vice chairman at private-equity firm Clayton, Dubilier & Rice.

The typical buyout model of targeting companies with low debt, lots of cash flow, and plenty of fat to be trimmed is no longer the only one. “There are so many different models now,” says PwC’s Peterson. “It’s all over the place, and it’s surprising some of the things that people are looking at.” He notes that buyout firms are looking at every opportunity, whether it’s a turnaround, a growth opportunity, a real-estate-based transaction, or a bolt-on transaction.

Blackstone’s February buyout of Equity Office Properties for $39 billion, including assumed debt, could signal the return of another model: the bust-up. Shortly after the deal closed, Blackstone immediately began to sell off parts of the real estate portfolio. “They had a lot of [resale] deals lined up before they were even done buying it,” says Peterson.

Monster Deals

Whether or not such bust-up deals herald the return of corporate raiders and the hostile bids associated with them is unclear. But the recognition that no single type of transaction rules the day and that almost no company is too big to be bought out has created a wave of speculation on Wall Street over what will be next. The list includes prey as large as Home Depot, Dell Computer, Gap, Texas Instruments, and Chrysler. Such rumors can make life difficult for CFOs. In November, when word circulated that Home Depot could be an imminent buyout target, the price of the retailer’s bonds dropped, which could negatively affect its credit rating.

Five of the six largest buyouts were announced last year, including Equity Office; Freescale Semiconductor; HCA, with a price tag of $33 billion; Kinder Morgan, for $22 billion; and Harrah’s Entertainment, for $27 billion. Even without including assumed debt, the proposed TXU buyout at $32 would top KKR’s $31 billion acquisition of RJR Nabisco in 1988 as the largest LBO in history.

While such monster deals capture the imagination of Wall Street, making them pay off could be difficult. Even though few firms can play in the megadeal space, competition is still fierce, says Jeton. “We all gulp at the prices we have to pay, especially for these larger companies,” he says. While Jeton insists that the inherent risk of a large deal going bad is lower due to the stability of such companies, the returns will also be diminished.

To make such deals work, private-equity firms know they need to do more than financial engineering. “Everyone will be able to get the same leverage we will, so people in our shoes have to say, ‘What angle do we have, given the high price?’” says Jeton. That’s why the buzzword among buyout firms these days is operations: winning bidders must have strategies that will create value by improving operations.

For this reason, the biggest private-equity firms are adding operations and strategy talent at a rapid pace. And it’s not just Harvard MBAs they’re pursuing. Celebrated CEOs and business leaders are becoming a fixture at buyout firms. Carlyle tapped former IBM CEO Louis Gerstner as chairman in 2003. The firm also lists former Securities and Exchange Commission chairman Arthur Levitt as an adviser. Clayton, Dubilier & Rice lists former General Electric guru Jack Welch as “special partner.” Apax Partners went overseas for its rock star when it hired former BP CEO Lord John Browne.

Management star power is a key advantage of large private-equity firms, says Blackstone’s James. “We’re bringing a lot more than capital to the table,” he says. According to James, Blackstone hires top specialists in different management disciplines to help out in nearly every situation. Few if any companies “could afford to have that kind of management talent at their beck and call,” he says.

Jonathan Coslet, a senior partner at TPG, says that roughly a quarter of the firm’s partners are on the operations side, and that number is growing. But he doesn’t think the industry has as much operational expertise as advertised. “Only a handful of top firms really have that capability,” he says.

Moreover, buyout firms may lack the operational expertise to fix the companies they buy. “In some cases, buyout firms count on changing the complacent culture of the company they buy,” says Peter Morici, a professor at the University of Maryland. “But some of these companies are just too big to change.” Morici adds that private-equity firms can easily overextend themselves: “PE firms run the risk of falling into the arrogant [belief] that they can make anything work.”

A Quick Unraveling?

Most experts expect to see the trend toward larger deals continue — although the so-called club deal, in which buyout firms team up to buy a company, is currently under informal investigation by the Justice Department for possible antitrust violations. Going forward, it will be harder to make every deal work — even for a Carlyle. “We are going to have PE firms that lose all kinds of money,” predicts Morici. “With the big successes will come a few huge failures.”

For all the talk of the benefits to being private versus public, you won’t hear many private-equity managers talk about a paradigm shift. “This is a cyclical business,” says Bain Capital’s Goss. “The best private-equity firms realize that and will deal with it accordingly. They are the ones that are in it for the long haul.”

Some private-equity firms are looking to diversify beyond the buyout arena. Carlyle, for example, has investments in venture capital and real estate. Carlyle and Blackstone unveiled their first hedge funds in 2004, while KKR launched its first in February 2006. Many private-equity firms have also opened advisory businesses that help companies with restructuring or with their own deals. The firms hope that these businesses will provide a cushion during a downturn in the buyout cycle.

That’s not to say that a bust is imminent. “I don’t think there is a bubble,” says James. “We are creating value in the economy for many different constituencies. As long as we continue to do that, [private equity] will continue to be robust.” But even James doesn’t think the party can last forever. “It’s hard not to feel that life won’t be this good forever,” he says.

There are signs that shareholders, tired of watching private-equity firms flip companies for a 30 to 50 percent profit in one year, want to turn out the lights. In March, when Clear Channel management accepted a buyout offer from Bain Capital and Thomas H. Lee Partners for $18.7 billion, shareholders, notably Fidelity Investments, threatened to vote against the deal. In January, an offer to take Cablevision private by the controlling Dolan family and private-equity investors was rejected by independent directors, even after the offer was raised from $27 a share to $30.

“More shareholders are extracting their pounds of flesh, and multiples are increasing,” says Raphael Newman, a managing director in the due-diligence practice at Duff & Phelps. “It’s becoming a sellers’ market, and more sellers are willing to walk away if they don’t get their price.”

Josh Lerner, a professor of investment banking at Harvard University, says that conditions bode well for private equity for the foreseeable future. But he doesn’t think that it can escape its cyclical nature. “It will continue to remain cyclical, but it will likely operate from a higher base,” he says, meaning a return to the dormant days of the early part of this decade is improbable.

Others foresee anything but a soft landing. EVA’s Stewart says that a slow normalization into a downward cycle is unlikely. “Engines that get going that fast are hard to slow down. They put together lots of infrastructure to do deals and they keep doing deals until they do bad deals,” he says. “It’s going to be a quick unraveling. They always overshoot.”

Joseph McCafferty is departments editor at CFO.

Imitating the Masters

The perception that buyout firms are gobbling up undervalued companies on the cheap may be prompting some companies to leverage themselves preemptively. For example, Health Management Associates announced last January that it would take on $2.4 billion in new debt to finance a one-time $10-per-share dividend. While the move will lower HMA’s credit rating from investment grade to junk levels, CFO Robert Farnham noted in a conference call that it would drop the company’s cost of capital from the low teens to 7.5 to 8 percent. The move makes a private-equity buyout nearly impossible. Anheuser-Busch signaled that it was pursuing a similar strategy when it announced in December that it was moving to an “aggressive leverage target.”

But such instances are few. “It’s really shocking how difficult it is for Corporate America to repeat what private-equity firms have done,” says Josh Lerner, a professor of investment banking at Harvard University. He says that while observers have long predicted that public companies would adopt plays from the private-equity playbook, such as using more leverage, they have been slow to do so. “They just don’t seem to get it,” says Lerner. — J.McC.

Supersized Buys
Nine of the 10 largest private-equity deals of all time are recent.
Target Price* Date Acquirer
TXU $43.8 2/2007 KKR, TPG, Goldman Sachs
Equity Office Properties $38.9 11/2006 Blackstone
HCA $32.7 7/2006 Bain, KKR, Merrill Lynch
RJR Nabisco $31.1 10/1988 KKR
Clear Channel $27.5 11/2006 Bain, Thomas H. Lee
Harrah’s Entertainment $27.4 10/2006 Apollo, TPG
Kinder Morgan $21.6 5/2006 Goldman Sachs, AIG, Carlyle, Riverstone
Freescale Semiconductor $17.6 9/2006 Blackstone, Carlyle, Permira, TPG
Albertson’s $17.4 1/2006 SuperValu, CVS, Cerberus Capital, Kimco Realty
Hertz $15 9/2005 Carlyle, Clayton Dubilier & Rice, Merrill Lynch
* In $ billions. Price includes amount of assumed debt.
Source: Dealogic