Yesterday’s Bloomberg article, “Buyout Funds Face Elusive Returns as Debt Costs Rise,” covered the declining state of the private equity market.
Not unlike real estate speculators of 2 years ago, it looks like private equity funds are holding over-priced merchandise financed by cheap credit during the boom:
Buyout firms relied on cheap debt in the past two years to finance the biggest deals of all time, often paying premiums of more than 30 percent for companies. Now, as the subprime mortgage meltdown rattles credit markets, firms will have to sell their companies to buyers who no longer have access to low-cost loans. That will cut the sale prices of the companies and slash the buyout funds’ returns, billionaire financier Wilbur Ross says.
“When it comes time to resell these investments, we’ll likely be in a very different rate environment,” says Ross, whose New York-based WL Ross & Co. focuses on distressed assets such as auto parts makers. “The implications for returns could be substantial.”
And quite a boom it was:
In 2005, buyout firms began to show a swagger rarely seen in the industry’s 30-year history. In the first half of this year, mega deals for TXU Corp., First Data Corp. and Equity Office Properties Trust — all topping $20 billion — were part of a record $616 billion in announced purchases. That’s just shy of 2006’s all-time-high total of $701.5 billion, data compiled by Bloomberg show.
Cheap credit fueled the frenzy. The extra interest that investors demanded to own high-yield, high-risk debt rather than U.S. Treasuries fell to 2.41 percentage points in June, the lowest on record. The rates enabled buyout firms, which use credit to finance about two-thirds of a company’s purchase price, to ratchet up their bids.
Premiums for U.S. companies, or the percentage offered above the target’s stock price, soared to 39 percent in June compared with 23 percent a year earlier, Bloomberg data show. Gavin MacDonald, Morgan Stanley’s head of European mergers and acquisitions, said in April that a $100 billion leveraged buyout was possible.
The boom hit a brick wall in August:
By July, the appetite for deals, especially record-breaking ones, had evaporated. Investors, surprised by their level of exposure to the subprime debacle, saw greater risk in the approximately $330 billion of loans and bonds that banks had slated to fund LBOs. Investors balked at credit terms that allowed companies to pay off debt by issuing more bonds. Lenders had to rework or cancel at least 45 loan and bond offerings since the beginning of July, including debt to pay for Cerberus Capital Management LP’s acquisition of Auburn Hills, Michigan-based automaker Chrysler LLC.
Buyout firms and sellers are also renegotiating deals in order to get financing and keep them alive. On Aug. 26, Home Depot Inc., the world’s biggest home-improvement retailer, agreed to sell its construction supply unit to Bain Capital LLC, Clayton Dubilier & Rice and Carlyle Group for $8.5 billion. That’s 18 percent less than the price negotiated in June, Home Depot said in a statement today.
Many other deals aren’t getting done. The value of announced buyouts dropped to $18 billion from Aug. 1 to 26. That compares with $87.4 billion last month and $131.1 billion in June, Bloomberg data show.
Yet hope springs eternal:
The severity of the drop depends on whether the U.S. economy flags further, says Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business in Hanover, New Hampshire. Growth will slow to a pace of 2.6 percent in the second half of the year, according to a Bloomberg News survey of economists taken from Aug. 1 to 8.
Blaydon says that sluggish expansion, which crimps companies’ ability to pay back debt, may push down annual returns to as low as 10 percent in the next three years. “The question is how harsh it’s going to be,” says Blaydon, who examined returns during the economic slump in 2001 to produce his forecast.
Still, investors won’t flee private equity funds as long as they outperform the Standard & Poor’s 500 Index by several percentage points, says Warren Hellman, who co-founded Hellman & Friedman in 1984. The private equity investments by the California Public Employees’ Retirement System in 2001 returned 17 percent through the end of 2006, according to its Web site. The S&P 500 returned about 15 percent over that same period.
“Returns are relative,” Hellman says.
And money continues to pour in from investors longing for the outsized gains of the past:
Investors in Blackstone Group LP, whose shares fell 23 percent to $23.80 on Aug. 27 from its initial public offering in June, haven’t lost all of their faith in private equity. In August, the firm said it had raised $21.7 billion to establish the world’s biggest buyout fund.
- This is nothing like the 2001-2002 speed bump for private equity. a) There was no mega-boom that preceded that downturn, save the tech bubble. b) Value-oriented stocks that buyout firms seek were actually depressed in 2000 because people unloaded their Old Economy furniture to own more tech. c) The 2002 “recession” was one of the mildest in history. d) The conditions – cheap valuations and ultra-cheap credit of 2001-2002 lit the fuse for the buyout boom of 2005-2007.
- With all the leverage the private equity shops employ, outperforming the S&P 500 by 2% during the greatest buyout boom in history is hardly impressive.
- Returns aren’t going to 10%; they’re going negative.
- Pension funds were snookered into “diversifying” into this new “alternative investments” asset class. What they’re stuck with is overpriced merchandise, levered to the gills, assembled by grossly overpaid managers, going into a brutal recession.
- Without the light of liquid public markets for these holdings, it will be interesting to see how long bagholders – er, shareholders – are left in the dark over pricing.