The End
With little investor support, many PE firms face questionable survival prospects
February 2, 2009
Difficult times lie ahead for the buyout business: a lack of credit, portfolio company distress and the pullback in institutional funding for limited partnerships have created the private equity equivalent of the 1930s Dust Bowl. Indeed, many industry participants wonder whether some financial sponsors will go the way of Lehman Brothers.
Even investment titans known for their distressed dealmaking prowess like Apollo Management and Cerberus Capital Management, for example, will have to navigate what is expected to be a major contraction in private equity dealmaking. A number of global investment firms such as The Blackstone Group, The Carlyle Group and 3i Group have already taken steps to reduce the size of their staffs in recent months (3i chief executive Philip Yea is stepping down as CEO) in response to the comatose buyout business.
Experienced LBO executives and investment bankers alike think the industry’s ranks are about to be culled.
“I think there’s going to be some shaking out at every level [of the market],” says David Gellman, a managing director at New York private equity firm FdG Associates. “There are a lot of people in our business who haven’t been through a down cycle. Both lenders and LPs are going to be pretty focused on seeing how firms handle their companies when they get in a pickle.”
Gellman, a veteran buyout executive who spent 11 years at New York’s AEA Investors before FdG, notes his current firm will face much less of an impact than the large firms that purchased companies with huge amounts of debt in the go-go deal mania of the 2005 to 2007 period. Additionally, since FdG invests in smaller deals that require less debt, or companies valued between $40 million to $200 million, its holdings aren’t overly leveraged like the average mega buyout.
The FdG dealmaker isn’t alone in thinking the ranks of the buyout community, which number between 700 US-based firms or 1,300 firms globally by one estimate, will be winnowed.
The Boston Consulting Group (BCG) and IESE Business School of Munich recently published a report that estimates 20% to 40% of the 100 largest LBO firms could go out of business within the next two to three years. BCG and IESE analyzed 87 private equity firms and 79% of all LBO funds raised over the last decade, determining that a shakeout is inevitable based on several factors that leave private equity “in the middle of the perfect storm.”
The report noted that the drivers that fueled manic LBO dealmaking—booming debt markets, rising profitability across all industries, escalating asset prices and substantial investor allocations to private equity funds—have been curtailed by the financial market meltdown and economic crisis.
After all, at least 30% of buyout investment firms will survive, according to the report.
How Bad Is It?
Kelly DePonte, a partner at San Francisco alternative asset advisor Probitas Partners, isn’t sold on the idea that a mass collapse of financial sponsors is coming. “Anybody who thinks there is a spate of buyout firms going out of business in 2009 and 2010 doesn’t know how private equity works. To me, it seems ludicrous that 20% to 50% of all private equity firms will go away. It takes an awful long time for these firms to die.”
In the LBO business, shutting down a firm can take years since a limited partnership fund generally has a 10-year life. When the general partners of a buyout firm decide to close up shop, they are obliged to wind down their investment portfolio by selling the companies they own or realizing liquidity in some other fashion. The process is often carried out quietly.
It may take years before an LBO firm goes out of business, but all it takes to send an investment firm spiraling down the trail to dissolution is a few bad deals.
Take Forstmann Little & Co., the firm established by buyout deal icon Theodore “Teddy” Forstmann. The New York-based firm is perhaps the most famous of buyout groups to disappear from the deal scene. Known for the outsized personality of co-founder Forstmann, Forstmann Little had done fairly well after it was founded in 1978; that is, until a pair of bad telecommunication bets ultimately derailed the firm five years ago. The firm ran into trouble following large losses from a series of investments in telecommunications companies McLeod USA and XO Communications, which resulted in a lawsuit with the State of Connecticut in 2002.
The state’s pension fund claimed it lost $125 million from the two investments after Forstmann made investments that weren’t consistent with the terms of its contract. In 2004, Forstmann settled the suit with the State of Connecticut for $15 million—the same year it completed its acquisition of modeling agency IMG. By 2006, Forstmann ceased making new investments.
“A blow up doesn’t blow the fund up, it blows up your reputation,” says Probitas’ DePonte.
Forstmann’s firm wasn’t the only buyout group to have slipped from the vanguard of actively-investing private equity firms. McCown De Leeuw & Co. and Stonington Partners are two such firms, along with J.W. Childs Associates, that are largely involved with monitoring their portfolios.
Sometimes the wind-down of firms has been preceded by staff departures. Special situations private equity firm Questor Management, for instance, announced in December 2006 that it would close up shop after a host of dealmakers at the firm, including veteran buyout executive Michael Madden, left.
Fund Issues
The BCG and IESE report notes that a number of factors including a firm’s fundraising needs, long-term return performance, the timing of acquisitions and exits, along with exposure to default-prone industries, are the cards that will play into determining a buyout group’s hand. But, it is the ability to raise fresh capital from institutions such as banks, endowments and pension funds, which sets apart successful private equity firms from their peers.
For LBO firms that need to raise new money, the outlook is particularly tenuous. Firms seeking to raise capital will face an uphill climb because the asset allocations of institutional investors are out of balance, driving some investors need to sell their commitments in buyout funds or lower their alternative allocation limits.
The survival chances for buyout groups that can’t raise new money aren’t good. “If you can’t raise a follow-on fund, that is the beginning of a danger sign,” says Probitas’ DePonte.
Institutional funds, which typically have a five-year investment horizon, generally command a 2% annual management fee on committed capital. The fee is used to fund the overhead and salaries of a firm’s investment staff.
Private equity firms that are sitting on plenty of “dry powder,” or un-invested capital, are best positioned to ride out the storm. The fact that there is some $450 billion in funds available to invest indicates a good number of buyout groups will do just that.
Apollo is one such firm that’s well positioned, having completed the raising of $14.8 billion for its seventh private equity fund in December. So, too, are TPG, which closed on $19.8 billion last year, and Blackstone’s raise of its $21.7 billion fund in 2007. Cerberus, meanwhile, reportedly closed on $7.5 billion last year for a recent fund.
The amount of capital that buyout firms garner for new funds this year, however, isn’t expected to mirror the behemoth-size funds raised in previous years. Declining returns are expected to reduce investor appetite for private equity funds along with allocation issues.
Dealmakers say the issue of how much capital a firm put to work in the last bustling M&A environment, when transactions commanded lofty purchase multiples and large amounts of debt, is one factor that may determine a firm’s future. So, too, is the amount of capital that was returned to investors through sales of portfolio companies or partial harvests via leveraged recapitalizations and secondary offerings.
“If you raised money in 2005 and came out in 2006, firms that got rewarded were the quick flippers that pulled out their initial investments,” says Paul Weisbrich, a senior managing director at McGladrey Capital Markets.
BCG’s Meerkatt agrees. “There are a significant number of funds that got their timing right and divested their [holdings] during the latest bubble.”
Weisbrich says the opposite is true for the limited partnerships raised in the last two years. “If your latest fund came out in 2007 and 2008, you’re likely in double trouble for paying high prices fueled with plentiful debt; meanwhile you are stuck with awful mark-to-market values reflecting the disturbances in the stock market.”
The Default Scent
The excessive debt that sponsors obtained in the last two years has created a slew of potential restructuring headaches for financial sponsors. Some well-known private equity houses like Apollo and Sun Capital have taken it on the chin with the bankruptcies of portfolio companies. Apollo’s Linens ‘n Things has liquidated and Sun companies Wickes Furniture, Sharper Image and Lillian Vernon went into Chapter 11 last year.
BCG and IESE expect that defaults of private equity-backed companies will balloon, especially those with debt that trades at more than 1,000 basis points. The organizations’ report expects that as many 50% of the businesses owned by financial sponsors will default on debt at spreads of 10 percentage points or greater, which is considered “distressed.” Companies with these distressed credits are likely to default within three years, posting some $300 billion in losses.
In November 2008, BCG determined that 60% of the debt of 328 private equity portfolio companies was trading at distressed levels. Still, whether a good portion of the deals financed in recent years will trigger defaults depends on whether the debt was structured with covenant-lite terms, which can delay defaulting.
“You’re going to see some firms that relied too heavily on leverage through this cycle with troubled portfolios that they can’t recover,” says Monte Brem, chief executive of the StepStone Group, a La Jolla, Calif.-based private equity advisor.
The cracking of the debt market that fueled the mega-deal boom over the last two years, though, will make it tougher for buyout firms to earn the same returns they garnered in previous years.
A decline in the big, highly leveraged buyout amounting to $2 billion or more was reflected in deal data last year. Transactions that were greater than $2 billion generated $86.5 billion of volume in 2008, accounting for the more than a 70% decline in private equity investments made from 2007 to 2008, according to private equity data provider PitchBook Data.
Market Segment
FdG’s Gellman thinks the outlook for larger firms with a more diverse base of investors is better in the face of a shakeout. These groups will be less susceptible to the fallout than smaller funds, especially those that haven’t been through a tough business cycle and relied on one or a small number of principal investors, he says. Industry participants don’t expect large firms with a wide range of businesses apart from private equity like real estate, alternative asset management and lending to disappear from the deal landscape. The diverse business lines of firms like Blackstone, Carlyle, Cerberus and Kohlberg Kravis Roberts is expected to help them better weather the retrenchment that’s befallen buyout dealmaking, according to observers.
“You have seen the big firms diversifying away from a pure LBO play, which has been harder for the middle market to get that level of diversification,” says Steve Smith, global head of leveraged finance and Americas head of financial sponsors banking at UBS.
Probitas’ DePonte takes another view: “They may not go away, but when you’re talking about firms that built their success on the control-buyout model they may not be as successful in those other areas,” he says.
By contrast, the middle-market buyout firms that make up the vast majority of the private equity industry have relied on straight forward LBOs as their bread and butter for years. But, by the same token many of these firms relied less on highly leveraged transactions to generate returns, choosing instead to earn their capital through less debt-structured transactions and operational improvements.
The outlook for the industry isn’t entirely bad. A decline in asset prices means companies can be bought at cheaper purchase prices. “Those that can do deals in the next one to two years are going to be looking at very interesting opportunities,” says Oliver Gottschalg, a professor at Paris’ HEC School of Management.
(c) 2009 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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