PE’s Big Worry: Values Already Too High

Determined not to repeat the mistakes of 2005 to 2007, private-equity executives say they are being careful not to overvalue or overleverage target...
Vincent RyanFebruary 20, 2013

Debt is cheap, abundant, and free of stiff covenants. But private-equity executives say that if an M&A boom develops, it won’t be financial sponsors that are gorging on companies and piling debt on targets’ balance sheets as they did in 2005 to 2007.

At Columbia University Business School’s Private Equity and Venture Capital Conference last week, private-equity executives repeatedly struck a cautious note about the investing climate. Corporate valuations are headed higher and are beginning to make them wary. They are treading cautiously as the risks in financial markets increase. CFOs, especially acquirers, should take note.

“Prorisk behavior has made its way back into the markets in the last 15 months,” said Howard Marks, chairman of Oaktree Capital Management, which manages $80 billion in assets. Examples of that behavior include companies using debt to pay dividends to equity holders or buy back shares, and the recently announced leveraged buyout of Dell.

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While investors are not as “giddy” as they were prefinancial crisis, believing all risk is gone from the market, they are almost forced to give up some safety in order to earn decent yields, according to Marks, who called them “handcuffed volunteers.” Such investors “may not be thinking bullish but they are acting bullish,” he said.

The temptation for private-equity fund managers is that they have large amounts of “dry powder” built up in existing funds and their limited partners are anxious for healthy returns. At the same time, U.S. banks are easing lending standards and loosening terms for corporate loans, according to the Federal Reserve’s latest Senior Loan Officer Survey.

Taurie Zeitzer, a partner at Kirkland & Ellis, said the law firm saw more “covenant-lite” deals in 2012 than it did in 2007. “If a deal comes to market with covenants, people wonder what’s wrong with it,” said Mark Anderson, a managing director at GTCR.

The danger is that loose debt markets push up enterprise values more than they should, said Kevin Feinblum, a principal at Advent International. That can create a “perverse environment,” where the size of the loan a bank is willing to commit to affects how much the acquirer is willing to pay. “Just the fact that debt may be available doesn’t make a deal any better,” said Feinblum.

Said Adam Reinmann, a principal at Onex: “All of us are trying to buy businesses with a reasonable margin of safety. We price and value businesses so that not everything has to go right to make money. But valuations may have already gotten ahead of themselves.”

An example is China. Andy Rice, a senior vice president at The Jordan Co., said his firm has done 30 deals in China in the past few years. But that pace may slow, because Chinese investors have amassed massive funds in renminbi and are, in Rice’s opinion, overpaying for target companies. “They’re paying 10 times to 12 times EBITDA [earnings before interest, taxes, depreciation, and amortization]; we pay 4 times to 6 times,” he said. “We’re waiting for rational behavior to come back to the market.”

There are other elements that may keep financial sponsors from making the mistakes they did in 2005 to 2007. For one, limited partners are watching their private-equity partners’ investment performance more closely. Raising new funds, for example, is more time-consuming than it has ever been, said Jeffrey Barber, a managing director at TA Associates.

“LPs are asking more questions, and it’s increasingly difficult to get investors in at the early stages,” said Barber. “Some investors say they would rather see [the fund managers] do a couple of deals first.”

Second, while there is plenty of deal flow from private-equity funds trying to 1) exit investments they have held for seven or eight years and 2) put money to work before a fund’s life expires, corporate buying and divestiture activity is down.

Strategic buyers — through which private-equity sellers tend to generate the best returns — are scarce. “I’ve been surprised that there haven’t been more corporate buyers and shocked that there wasn’t a strategic bid for Heinz,” said Bob Juneja, senior managing director of Irving Place Capital.

On the sell side, “there is still reluctance on the part of companies to sell businesses earning a reasonable return when they are sitting on so much cash,” said Onex’s Reinmann. “They are hesitant to sell, and sit on more cash.”

Still, some fund managers are optimistic about closing deals in 2013. Thirty-six percent of the more than 100 private-equity fund managers surveyed by BDO USA last quarter said they expected to close more than four new deals in the subsequent 12 months, compared with 7% who expected to do so a year ago.

Still, private-equity firms are a long way from being in a state of overexuberance, when pricing and leverage begin to diverge from reality, says Oaktree’s Marks. “We haven’t reached the extremes that [Warren Buffett] would call nutty.”

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