Back To Basics
As private equity firms come to grips with new financing markets, deal structure undergoes dramatic change. Is financial engineering dead?
By Kelly Holman November 24, 2008
When Hellman & Friedman and Bain Capital Partners purchased Neuberger Berman from Lehman Brothers for $2.1 billion in September, the all-equity transaction illustrated more than just how private equity firms are adapting to the dearth of credit. It marked the end of the business model that has served as the buyout industry's cornerstone for more than two decades.
The traditional model for structuring leveraged buyouts with junk bonds, senior debt term loans and subordinated notes--known as "financial engineering" in the private equity business--has been swept away. And, some LBO veterans don't think the LBO deal will come back any time soon given the state of the credit market.
Rick Rickertsen, a managing partner at Washington private equity firm Pine Creek Partners, thinks it could be as long as three years before the debt capital markets recover. "The banks are going to have to work through their pain before they start aggressively lending again," he says.
Rickertsen has been through more than one busted business cycle, having worked for Los Angeles private equity firm Brentwood Associates when junk bond shop Drexel Burnham Lambert filed for bankruptcy in 1990. The author of the 2001 book Buyout: An Insider's Guide to Buying Your Own Company is adamant that "high leverage will come back."
In the meantime, financial sponsors are faced with creating transactions that aren't dependent on credit, or sitting on the sidelines until the debt markets rebound. Big league buyout houses that have raised multi-billion dollar funds can only hold off for so long before their investors ask questions.
For Kohlberg Kravis Roberts, which pioneered the use of debt securities, and a host of other financial sponsors such as Apollo Management, The Blackstone Group, Thomas H. Lee Partners and TPG that emulated KKR's reliance on big debt deals, the death of financial engineering is significant. Returns, in short, are expected to decline.
KKR, of course, has morphed into an asset management business with its own mezzanine fund since three former Bear Stearns bankers founded the firm in 1976. It is better positioned to navigate the tough M&A environment with other large buyout groups that have capital markets businesses such as Apollo, Bain, Blackstone and TPG than those with just equity funds, say industry observers.
"Given the lack of available leverage, buyouts in the near term will be over-equitized and sponsors with captive debt funds will have a leg up," says John Eydenberg, head of financial sponsors for the Americas at Deutsche Bank.
Setting the Stage
Investment bankers say Wesray Capital popularized the idea of debt-laden acquisitions with its $80 million purchase of Cincinnati greeting card company Gibson Greeting in 1982 from RCA Corp. An investment firm established by former Treasury Secretary William E. Simon, Wesray put up a mere $1 million of equity in Gibson's purchase, and borrowed the rest. Wesray subsequently took the business public in 1983, raising $290 million for Gibson and reaping a windfall profit in the process.
"It was the first time the world recognized that true financial engineering could multiply equity," says David Deutsch, president of New York investment banking firm David N. Deutsch & Co. "The magic of leverage produced astounding rates of returns," adds Deutsch, a former Drexel Burnham Lambert banker who says he coined and trademarked the term "leveraged finance" in 1993.
Not every big name private investor followed KKR's approach to leveraged dealmaking in the 1980s.
Theodore Forstmann of Forstmann Little & Co., for example, was against using high yield bonds in buyouts.
The interweaving of debt instruments in leveraged acquisitions was described eloquently by former Wall Street Journal editor George Anders in his 1992 book on KKR titled Merchants of Debt: "Senior debt, subordinated debt, and other types of loans were tied together with an intricacy and cleverness much like that of a mathematician solving simultaneous equations or an engineer designing bridges."
Debt occupied the bulk of deal capital structures in the last two decades.
"In the mid-to-late 1980s, the capital structures of the leveraged deal were on the order of 92% to 93% debt," says Josh Lerner, a professor specializing in private equity at Harvard Business School. "When you look at many of the early buyouts, they were very much dominated by high leverage," he adds.
But, the amount of leverage as a percentage of a buyout's capital structure has declined in the last two decades as the equity portion steadily increased. Banks began requiring financial sponsors to invest more equity.
"Whereas lending commitments in most LBOs done in the 1980s had exceptionally low sponsor equity requirements, capital structures over the last 15 years have generally trended towards a greater equity mix which resulted in more balanced capital structures," says Jonathan Lynch, a managing director of New York private equity firm CCMP Capital Advisors.
Transactions in the latest private equity boom from 2005 to 2007 generally didn't exceed 70% debt. In the first half of 2008, the average equity contribution amounted to 42%, compared with 32.1% in 2005, according to William Blair & Co.
Meanwhile, debt that LBO firms could borrow at a multiple to cash flow, driven by banks competing aggressively for fees, increased during the last three years with LBO debt multiples spiking to 6.2 times cash flow last year, according to William Blair.
The availability of debt and a thriving collateralized loan and debt obligation market fueled very large transactions like the $44.4 billion KKR- and TPG-led consortium acquisition of Dallas energy company TXU, now known as Energy Future Holdings.
Private equity buyers took advantage of strong debt capital markets and loans with attractive features such as covenant-lite terms and payment-in-kind toggle credits, which ultimately resulted in over-leveraged corporate balance sheets.
"If we review what happened in the buyout industry over the last cycle, prudent capital structures gave way to frequently excessive use of leverage," says CCMP's Lynch.
The Aftermath
Credit rating agencies have lowered their ratings on many LBO credits this year.
Last week, Standard & Poor's lowered its corporate credit rating on Harrah's Entertainment to "CC" from "B" in light of the Las Vegas casino operator's offer to exchange up to $2.1 billion in new senior second priority debt for its outstanding senior and mezzanine debt, which stemmed from its $27.4 billion buyout by Apollo and TPG in January. "We view the exchanges as being tantamount to default given the distressed financial condition of the company and our concerns around Harrah's' ability to service its current capital structure over the intermediate term absent this exchange offer," S&P said.
If the exchange is completed S&P plans to downgrade Harrah's notes to "D" and its corporate rating to "SD", or selective default. S&P also noted that the debt offering would reduce the company's debt load and help sustain it during the economic downturn.
LBO deals weren't the only financially-engineered deals fueled by strong debt markets. Leveraged recapitalizations where new debt was issued by a portfolio company was used by buyout firms to pay themselves a dividend. Numerous financial buyers like Apollo and CI Capital realized dividends through such deals, which allowed financial buyers to rake money from their holdings and boost their internal rates of returns temporarily.
But, like debt-hefty buyouts the recapitalizations have left some companies leveraged to the hilt. CI Capital's buffet restaurant operator, Buffets Holdings, went bankrupt and filed its reorganization plan on Oct. 31.
Middle market investment groups, meanwhile, also employed leverage in deals but often not at as high of multiples. Some such as Summit Partners, a 24-year-old Boston-based middle-market equity firm, eschewed the highly leveraged approach to investing from day one.
"We believe you can generate good returns based more on growth than financial engineering. Our business model has never required us to employ large amounts of leverage," says Joseph Trustey, a managing director at Summit Partners.
Trustey says the portfolio companies of Summit--a firm that raised $840 million for its fourth captive mezzanine fund this year--are conservatively leveraged compared with the debt arranged in larger deals.
New Structures
The change in how private equity firms will buy and sell companies presents new opportunities for private equity funds according to CCMP's Lynch. "What will come next is the correction of that excess, namely the provisioning of equity capital to help companies de-lever," he says.
Helping over-leveraged businesses is one area where CCMP is looking to invest equity from its $3.4 billion limited partnership, a fund raised in 2006 that is only 20% invested.
Greg Peterson, a partner in PricewaterhouseCoopers' transaction services group, says most private equity firms, including top-tier groups, have gravitated away from financial engineering over the last several years. Many investment firms have looked to generate returns through operational improvements in portfolio companies.
If a recent survey conducted by Celerant Consulting of 222 senior North American and European private equity executives offers any indication, some buyout firms will re-evaluate their deal models.
Twenty percent of respondents in the survey thought that financial sponsors would resort to using a different financing model, while 32% indicated they would make acquisitions without relying on debt.
"The idea is that you're not dependent on the debt markets," says Deutsche Bank's Eydenburg.
A move towards investing growth capital, buying into distressed companies and distressed credits, coupled with private investments in public equity and large minority stake purchases, will represent the next wave of dealmaking.
"Strategic sponsor partnerships will become more prevalent, and I think there is going to be a pretty significant increase in private investments in public equities, and sponsors putting equity into private companies," says Eydenberg.
Deutsche Bank participated as a lender in the sort of deal that Eydenberg sees as an example of the corporate partnership deal. The investment bank was part of a lending group that supported Bain Capital and Blackstone's $3.5 billion acquisition of The Weather Channel this year. The pair of financial sponsors teamed up with NBC Universal to buy the cable weather news business.
If recent deals offer any insights about the next chapter in the LBO industry's history, it's that some of the more successful private equity firms are plunging head long into the new post-financial-engineering deal world. Leonard Green & Partners, a Los Angeles buyout group that has completed its share of profitable LBOs, agreed to invest $425 million this month in Whole Foods Market for a 17% equity stake.
"I see private equity continuing to adapt to the parameters that the market sets," says Thomas King, a managing director in the financial sponsor group of KeyBanc Capital Markets.
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