Down but Not Out

Private equity may have lost some of its leverage, but it's still a force for companies looking to buy, sell, or just attract capital.
Vincent RyanDecember 1, 2007

The recent falloff in private-equity activity could hardly have been more precipitous. As credit markets tightened, the value of the leveraged buyouts (LBOs) done in the third quarter plunged nearly 80 percent, to $67 billion. Money-raising, meanwhile, fell by half, with PE firms closing only $91 billion of funds, according to industry researcher Private Equity Intelligence (PEI).

Since then, fund managers have been planning for a less ambitious 2008. “As an industry, we will invest fewer dollars over the next couple of years,” says David Donnini, a principal at GTCR Golder Rauner, a PE firm on its ninth fund. “That’s just a function of the math. We won’t be able to reach every seller’s asking price.”

But don’t cry for private equity just yet. Plenty of “uncalled” capital — about $496 billion, according to PEI — still sits in PE firms’ funds. In addition, secondary buyers of private-equity limited partnerships have raised $18 billion this year alone, more than double that raised in 2006.

Meanwhile, the more limited role of private equity in mergers and acquisitions will benefit strategic buyers, which were largely outbid by PE firms the past two years, says Tiff Armstrong, a partner at investment bank Harris Williams & Co. “The choppiness also creates opportunity,” he says. “It allows [firms] to reset expectations of valuation.”

On the receiving end, public companies and entrepreneurial concerns will find PE firms still willing to invest in them — under the right circumstances. “Growth equity” investments could become more popular, benefiting companies that need liquidity but not a controlling partner. PE firms, instead of sweating through negotiations over a $5 billion LBO, already are finding time to bring their operating expertise to bear on investments.

“While not looking at the mega-LBO transactions of the sort they did six to nine months ago, there’s no question my clients are still looking to invest,” says Jon Garcia, a director in McKinsey & Co.’s Washington, D.C., office.

Equity Resurgent

More deals could resemble Kohlberg Kravis Roberts’s (KKR) private investment in public equity (PiPE) involvement with Sun Microsystems last January. As of late October, there had been 1,069 announced PiPE deals worth $39.9 billion, up 41 percent over last year, according to Sagient Research Systems.

For the PE firm, “the negative is that it does not have complete control,” says Steven Kaplan, a professor at the University of Chicago’s Graduate School of Management. “The positive is they don’t pay a premium — they’re usually doing the deal at the market price.”

Originally PiPEs were designed to be last-resort funding. But Sun Microsystems had different aims when it entered discussions with KKR a year ago, says Sun CFO Michael Lehman. “We were emerging from a few tough years,” he says. “We were not profitable. The appeal was an endorsement by a very big, well-known investment firm.”

The deal also gave Sun new prospects. Chief information officers from the KKR stable have visited Sun’s headquarters in Mountain View, California, to explore Sun technology. In addition, the due-diligence process with KKR “was an acid test of our vision, strategy, and execution plans,” says Sun’s finance chief.

The potential downsides of PiPEs — dilution of shares is one — must be managed. The terms of Sun’s PiPE treat KKR like an insider; the firm is prohibited from shorting Sun’s shares, for example. Sun also designed hedging transactions to offset the common-stock dilution from the future conversion of the KKR notes, which carried a 25 percent premium over Sun’s share price when issued.

Avoiding Leverage

With credit still scarce, PE buyout deals are likely to involve far less borrowing and debt issuance, but firms are still not likely to put more equity at risk. Private-equity concern Sun Capital Partners (no relation to Sun Microsystems) found a prudent way to finance a takeover of Friendly Ice Cream Corp. in August. With an operating margin less than half that of its industry peers, the family-restaurant chain drew Sun Capital’s eye, says Gary Talarico, managing director of Boca Raton, Florida-based Sun Capital. With Friendly’s debt-to-cash-flow ratio at nearly six, its real estate proved critical to financing. Sun Capital bridged the $337 million purchase price on its own, then executed a sale-leaseback that included the $27.5 million sale of Friendly’s western Massachusetts headquarters.

Sun Capital’s bridging of the transaction gave the seller certainty that the deal would close on time and at the agreed-upon price — a comfort to sellers who have watched large LBOs unwind of late.

Fallout from the credit crisis could create some headaches for future deals that use bank financing. More “market flex” clauses — which give underwriting banks the unilateral right to change the price, terms, or structure of a loan — are showing up in commitment letters, says Jeffrey Saunders, a partner with Minneapolis-based law firm Dorsey & Whitney.

Banks could force sellers to live with greater risk that a deal won’t close. Sellers, meanwhile, have to worry about buyers walking away. Saunders says his team spent weeks adding contract “carve-outs” that deny buyers the right to withdraw from a deal for such reasons as changes in financial markets or industry regulation — even acts of terrorism.

For PE activity to rebound, firms need exit opportunities, which may be in short supply, at least for now. Secondary buyouts — one private-equity firm’s sale of a company to another — fell about 20 percent year-over-year in the third quarter. Forty initial public offerings came to market in that period, raising $11.3 billion, up 79 percent from a year earlier. But 34 companies also have withdrawn IPO registrations in 2007. And some firms that started trading during the credit crunch have been underwhelmed by their shares’ performance. “When the markets start to weaken, it hurts newly traded companies,” says Kathy Smith, a principal at Renaissance Capital.

Moreover, private-equity firms will have a harder time getting big interim returns through traditional dividend recapitalizations — cash paid to the PE owner with borrowed funds, according to a report by Standard & Poor’s. “It would not be easy for most companies to lever up further to take on a dividend,” says Robert Schulz, an S&P managing director. But if deals are less leveraged now, dividend recaps could increase in two years (the average time period between an original LBO and the subsequent dividend recap). So PE firms’ appetite for deals shouldn’t be affected by the current unfeasibility of recouping some of their investment midstream.

Most experts see private equity’s current condition as a cyclical, and temporary, adjustment. As banks begin to move the paper backing megadeals, private-equity firms will see it as a positive sign, and that trend could boost the overall health of the corporate debt market. Further interest-rate cuts from the Federal Reserve would also stoke activity.

“Some people might say private equity is dead or [will shrink] to a much smaller base,” says McKinsey’s Garcia. “Nothing could be further from the truth.”

Vincent Ryan is a senior editor at CFO.

How a lack of debt financing effected the value of private-equity buyouts in 2006–2007