More Money Than They Know What to Do With

It is a $1 trillion game: Use It or Lose It.

The private equity world is sitting on that 13-figure sum. It’s what the industry calls dry powder. If they don’t spend their cash pile snapping up acquisitions soon, they may have to return it to their investors.
Nearly $200 billion from funds raised in 2007 and 2008 alone needs to be spent in the next 12 months or it must be given back.

Private equity executives, after spending the last several years largely on the sidelines amid the economic uncertainty — often proclaiming “patience” as an explanation — have begun to be anxious that they may need to go on a shopping spree. At least two major private equity firms, according to two executives involved in the discussions, have held internal strategy sessions in recent weeks about how to approach the looming deadline.

Some private equity firms have put the word out to Wall Street banks that they want to go “elephant hunting” — seeking big deals worth as much as $10 billion — and are willing to pay a special bounty for bringing them acquisition targets.

At least one firm has gone so far as to begin contemplating asking its investors, which include the nation’s largest pension funds, to extend the deadline for the money to be spent in return for certain concessions on fees. (Of course, they don’t return the fees that have been collected thus far).

“The clock is ticking loudly for these funds,” Hugh MacArthur, the head of Bain & Company’s private equity practice, wrote as the lead author of a report on the state of the industry.

So the race is on.

But, of course, there is a problem: “Burning off the aging dry powder will likely result in too much capital chasing too few deals throughout 2012,” according to Mr. MacArthur.

That means it is possible we could see a series of bad deals with even worse returns.

Already, private equity firms have been quietly spending lots of cash. In the third quarter alone, private equity firms in the United States burned through $45 billion, up from $17.1 billion in the previous quarter, according to Capital IQ, which tracks deals data. Carlyle Group, which had its initial public offering in May, has been the busiest firm this year: it has done 11 deals worth almost $12 billion.

Acquisition prices are also likely to balloon because of “lots of firms bidding for the same obvious deals,” Alastair Gibbons, a senior partner at Bridgepoint Capital, told Triago, a fund-raising services firm that publishes a widely read quarterly newsletter. “Since there is near record dry powder globally, it’s entirely plausible that we’ll see increasingly overcrowded bidding processes.”

Richard Peterson, an analyst for S&P Capital IQ’s Global Markets Intelligence group, said that private equity firms are already paying multiples of Ebitda — earnings before interest, taxes, depreciation and amortization — of 10.6 this year, up from 10.3 last year. It’s worth remembering that many of the most successful deals in the private equity industry were bought for six to eight times Ebitda, he said.

He noted, however, that since firms were able to borrow at unheard-of low rates today “it may give them more confidence to pay a little bit more.”

Perhaps in a sign of desperation, many private equity firms have been increasingly engaged in a game of “hot potato” with one firm selling a business to another — known as a secondary deal. Mr. Peterson said that at the current pace, the industry was expected to spend a record-breaking $22.3 billion this year simply buying companies from each other rather than buying businesses from the public markets or from private owners outside the private equity industry.

Mr. Peterson also raised a question that is often being whispered about but rarely said aloud: “A lot of these firms are publicly traded now. So to what degree are the transactions being driven by earnings objectives?”
Many of the big private equity firms — Apollo Group, Kohlberg Kravis Roberts, Blackstone Group and Carlyle Group, among them — are public. And for the first time, it is possible that the interests of the public shareholders could diverge from the interests of the investors in the buyout funds, at least in the short term.
If the private equity firms don’t spend the money that they have already raised, it is unlikely they will be able to raise even more in coming years. And increasingly, the private equity firms have become dependent on the management fees not just to keep the lights on but to expand their businesses into other areas, in part to diversify, which has been part of the pitch to public investors. The biggest firms have become asset gatherers.

“In a nutshell, 95 percent of funds would be affected and see a big drop in fee income based on not investing all of the committed capital,” according to Tim Friedman, director of North America for Preqin, which tracks private equity fund-raising and deals. He said that he did not expect firms to do deals simply “for the sake of it,” but he also cautioned that the firms were “under a lot of pressure.”

So keep an eye out for megadeal headlines — and whether they command the same prices when the companies are sold.

Source: http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-to-do-with/

Private equity turns to commodities

The newly found enthusiasm among private equity groups such as KKR, Blackstone, Carlyle and others towards commodities trading is an interesting development, but they all face critical balance sheet challenges before such deals can be considered.

Private equity groups have deep pockets to buy the commodities trading businesses of Wall Street banks, which face new regulation potentially hampering their ability to trade raw materials. For example, several private equity groups have approached Morgan Stanley to discuss a deal involving the bank’s commodities division. Morgan Stanley said the business was not for sale.

But many industry insiders believe the idea of a sale was a non-starter.

The challenge in running a day to day commodities business is access to credit at competitive rates. This is particularly true in the oil sector where prices have risen over the past decade.

In 2002, a trader could buy enough oil to fill a supertanker with less than $50m in credit lines. Today, it needs more than $200m. The same applies to derivatives trading in the oil sector.

Morgan Stanley – the second biggest commodities dealer in Wall Street after Goldman Sachs – requires something like $20bn or so of credit support to make money. Morgan Stanley’s commodities arm gets the financing directly from the bank, but if a private equity group were to buy it, it would need different credit terms. Most likely, credit costs will rise, and profitability will decline.

Industry executives and bankers are not even debating whether a buyout firm could provide enough credit at competitive prices to support the needs of a major commodities trading operation. The consensus is that the private equity groups will struggle.

There is already an example where the credit challenge has hampered a deal. When Credit Suisse and Glencore discussed two years ago forming a joint venture that was, in effect, a spin-off of the bank’s commodities business, both soon realised that the deal did not make financial sense.

The problem? The joint venture would have taken the relatively small Credit Suisse commodities business out of the bank’s balance sheet, depriving it access to cheap credit. As soon as the business needed to finance itself on commercial rates, the business ceased to make financial sense.

Other examples confirm the need of deep pockets to finance the commodities operations at competitive rates. Take Phibro, the former oil trading arm of Citigroup. The bank spun off its subsidiary and sold it to Occidental Petroleum in 2009. The oil company then leveraged its balance sheet to continue providing Phibro with plenty of access to credit.

But there have been success stories of private equity firms and hedge funds owning commodities business too. Hedge funds Ospraie Management and Soros Fund Management and the buyout firm General Atlantic bought out the trading arm of ConAgra Foods – which later they renamed Gavilon – in a $2.8bn deal in 2008. After operating the business for four years, the trio sold the commodities trading business last month to Japanese trading house Marubeni for more than $5bn, including debt.

The examples suggest the key for private equity success in commodities trading would be size, and the “place of birth”. Small to medium-size operations such as Gavilon are within the groups’ reach. Moreover, commodities traders from the non-financial sector are likely to be an easier target than operations from the banking sector.

Source: http://www.ft.com/intl/cms/s/0/939df770-b082-11e1-a79b-00144feabdc0.html?ftcamp=published_links%2Frss%2Fmarkets%2Ffeed%2F%2Fproduct#axzz1x3LcONGX

Waves from slowing China to break our shores

On November 18, the great and good of the New York financial community flocked to the drawing room of the NY Palace Hotel to attend a lunch given by Chinese brokerage CICC in honour of the former vice-prime minister, Zeng Peiyan, and a senior delegation of Chinese leaders such as Lou Jiwei, chairman of China Investment Corp.

Facing the Chinese were senior executives from the buy-out world including Henry Kravis of KKR and Blackstone’s Jonathan Gray while the hedge fund contingent included Maverick’s Lee Ainslie, Eric Mindich of Eton Park, John Paulson, and Dinakar Singh of TPG-Axon. Wall Street was represented by Ken Wilson, the former Treasury official who is now at BlackRock and Lazard’s Gary Parr. There were a few chief executives as well, such as Klaus Kleinfeld of Alcoa.

The Chinese message was stark according to multiple guests: if your Congress passes a bill labelling us as currency manipulators, we will crush you. And because we find your government rather difficult to deal with, please convey that message on our behalf.

As economic growth slows both in Europe and Asia, the search for an edge becomes ever more critical and one of the more obvious ways to grow is to export, which depends at least partly on a relatively cheap currency.

The Chinese take great exception to the suggestion that they are the only ones trying to keep their currency cheap when, in their eyes, most of the world is playing that game. Many Chinese believe that any “quantitative easing” from the Federal Reserve is merely an indirect way of putting downward pressure on the dollar. They believe the euro was designed as a way to keep German industry competitive because if there was no euro, the D-Mark would have appreciated and Greeks and Italians (and Chinese) would no longer have been able to afford to drive sleek Mercedes and BMW cars.

The Chinese sense of resentment is also fuelled by a growing sense of confidence in the government’s own macro-management skills. The rest of the world frets that China may face a hard landing as its manufacturing index drops into negative territory. China’s export machine has been slowing, as labour costs rise, forcing many makers of cheap goods to shut down. The residential property market is plummeting.

That sense of concern is not evident in Beijing. China has seen the emerging markets of Asia seize up in the late nineties, with little impact on its own well-being. Japan has been losing ground for two decades. The global financial crisis of 2008 suggested that the US model was deeply flawed, its growth dependent on debt that came largely from Beijing itself. Now, with Europe in recession, many Chinese feel that their system has proved far superior to those of any of its competitors.

In the past, slower growth in China would have been a problem. In the last ten years, China needed growth of 8 per cent to generate jobs for about 115m people joining its labour force. But the demographic change as its population ages as a result of the one child policy means that in the coming decade less than 20m people will join the labour force. That means a slower rate of growth will not be calamitous for China.

China is beginning to reverse its tight monetary policy by cutting the reserves banks have to post with the central bank for the first time in three years. Now, because of the combination of those demographics and a slowing in Europe, China’s biggest export market, China needs to continue to shift to a more domestic demand led economy.

In recent weeks, data show a bipolar world in which the strongest bloc is the US, rather than emerging markets or (obviously) Europe. JPMorgan, for example, cut its forecast for Chinese growth and expects GDP to expand 7.4 per cent on an annualised basis this quarter and by 7.2 per cent next quarter. It forecasts emerging markets to grow this quarter and next by a mere 4 per cent, the lowest in the past decade outside the Great Recession, according to its economists.

One reason the US has been doing better than Europe and Asia is because exports have been stronger than expected. It has benefited from the fact the euro remains relatively high, a reflection of the fact that monetary, fiscal and regulatory policies have all been tighter than they should be, despite the expectation that at some point European governments will reverse those policies and the euro will ultimately go to parity with the dollar.

Still, the world should not take too much pleasure from a slowing China. A slowing China means less export orders for the rest of the world and (as officials later suggested in private meetings around that lunch) fewer buy orders for the rest of the world’s debt. If China slows, it may well be more of a problem for the rest of the world than for China itself.

Source: http://www.ft.com/intl/cms/s/0/d07ac0ce-20ea-11e1-816d-00144feabdc0.html#axzz1iUVbDoKd

Hedge funds and deleveraging: Waiting to turn trash into treasure

“THIS is going to be the next great trade,” one American hedge-fund executive effused early this year. For more than two years funds have been salivating over the slew of assets that Europe’s banks will have to sell. Many have been opening offices in London and hiring to prepare for this “tidal wave” of opportunities.

Up for grabs will be distressed corporate loans, property debt and non-core businesses as European banks shrink their balance-sheets to meet stricter capital requirements. Huw Van Steenis of Morgan Stanley estimates that banks will have to downsize their balance-sheets by €1.5 trillion-2.5 trillion ($2 trillion-3.4 trillion) over the next 18 months. Funds have only about $150 billion to spend on distressed debt in Europe, he reckons, which means they should have their pick of assets.

For now the “next great trade” is not looking that good, mainly because there have been no fire sales. Most banks that are selling assets have priced them close to face value, providing little to entice buyers.

Even where sales are agreed, financing is scarce. In July Blackstone, a large alternative-asset manager, agreed to buy a £1.4 billion ($2.2 billion) real-estate loan portfolio from Royal Bank of Scotland, but has yet to raise an estimated £600m to pay for it. Worse still, many banks may not be able to sell assets cheaply even if they wanted to, because it would force them to take losses that would erode scarce capital.

“We’ve been lying in wait for this opportunity since 2008. But it will come piecemeal. It will take years and years and years,” says Joe Baratta, head of European private equity at Blackstone. Some predict that Europe could go the way of Japan’s glacial deleveraging and take a decade or more to clean up its banks. Politics play a role too. European politicians, no hedge-fund lovers, won’t want to see them buying up assets at truly distressed prices and profiting from Europe’s gloom. It may even be “politically impossible” for banks that got a government bail-out to write down assets significantly, says Jonathan Berger, the president of Stone Tower, a $20 billion alternative-asset firm.

What could turn things around? Some fund managers hope a plan to recapitalise Europe’s banks to the tune of €106 billion by next June will at last force disposals at banks. So too may the introduction of Basel 3 rules that will require banks to hold more high-quality capital. Marc Lasry, the boss of Avenue Capital, a distressed-debt hedge fund, wants to buy from these “forced sellers”, because they will offer lower prices.

Banks aren’t the only prey that funds are hunting. A wave of refinancing that will hit private-equity-owned firms over the next few years may prove profitable for distressed-debt funds. And plans by some European governments to privatise infrastructure assets may also be enticing.

In the meantime, inventive fund managers are figuring out other ways to do deals. Some, such as Highbridge, a large American hedge fund that is owned by JPMorgan, and KKR are scaling up their lending operations as banks cut back. They are able to charge high interest rates, because companies are desperate for cash.

Banks are being inventive too. Unable to sell assets, they have come up with a compromise of sorts, and have started agreeing to “synthetic risk transfer” arrangements with hedge funds. For example, BlueMountain Capital, an American hedge fund, has agreed to take on some risks on a credit-default swap portfolio from Crédit Agricole, a French bank. Another hedge fund, Cheyne Capital, has reached an arrangement with two big banks in Europe to take the first 4% or so of losses from a securitised portfolio of loans, in exchange for a very healthy return.

Funds’ investors may need convincing, given that “synthetic” became a dirty word after 2008. The deals can also be risky, says Galia Velimukhametova of GLG Partners, a European hedge fund. “You could lose 80-90% of your capital if things go very wrong, but make 10-15% if everything goes right,” she says.

Robert Koenigsberger of Gramercy, an emerging-market hedge fund focused on distressed investing, insists it is best to look elsewhere. “The best distressed opportunities created by Europe are now outside of Europe,” he says. He believes opportunities are particularly bright in emerging markets. Many of them are undervalued because investors are selling everywhere as a result of worries about the stability of the euro zone.

For those hedge funds set on playing Europe, the main dilemma they face is how long to wait before buying. Steve Schwarzman, the boss of Blackstone, insists that it is important to stay put. “It’s like dating someone,” he says. “You can say let’s wait two years. But she probably won’t be around then.”

Source: http://www.economist.com/node/21538739