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’s mega-deals: Too big to veil

CRITICS predicted the largest private-equity deals would end up like the giant python in Florida, which exploded in 2005 after it hungrily devoured an alligator. During the 2006-07 bubble, buy-out firms hunted iconic companies at sky-high prices with oodles of borrowed money. Then the economy turned. Boston Consulting Group forecast in 2008 that the majority of companies owned by private equity would default on their debts.

A look at the 20 largest deals, however, shows that most will turn out better than predicted. In June KKR agreed to sell a 45% stake in Alliance Boots, a British pharmacy chain, for $6.7 billion to Walgreens, which has the option to buy the rest in three years. If this happens, KKR will make 2.2 times its money. Kinder Morgan, a pipeline operator owned by Carlyle and three others, did an initial public offering (IPO) last year; the owners may triple their money. Even Hilton, a hotel chain bought by Blackstone at the peak of the bubble, could defy the doomsayers. The investment could be worth 2.5 times the initial value when Hilton goes public.

There are, of course, some carcasses. The 2007 leveraged buy-out of Archstone, a property company, by Lehman Brothers and Tishman Speyer was a disaster and is partly blamed for Lehman’s demise. The biggest buy-out in history is a spectacular failure: TXU, a Texan utility owned by KKR, TPG and Goldman Sachs, has suffered from a huge debt load and falling gas prices. The question is when, not if, it will file for bankruptcy.

What determined whether these deals flew or flopped? Companies in recession-resistant industries performed better. So did deals done before the peak of the bubble in 2007, says Colin Blaydon of Dartmouth’s Tuck School of Business: they were cheaper and had less debt. Swift pay-outs were key too. Blackstone sold most of Equity Office Properties immediately after its 2007 buy-out, which helped it pay down debt. When possible, private-equity firms piled on more debt to pay themselves early. By the time HCA, a health-care firm, went public in March 2011, its buy-out owners had taken out nearly enough in dividends to recoup their investment.

Low interest rates, however, are why most deals have avoided bankruptcy. Private-equity firms have been able to refinance, and yield-starved investors have given some of these deals a second life.

Two boom-era phenomena, “covenant-lite” debt and “payment in kind” loans, also helped. The former made it hard for creditors to force the company into bankruptcy, and the latter enabled firms to pay off creditors with new debt instead of cash. Private-equity firms have managed to push back the “wall of debt” that critics thought would crush them this year or next. Many do not see significant debt maturities until 2016 or later. With any luck they will already have offloaded their companies onto the public market by then.

 

Several companies have technically defaulted but restructured behind closed doors. TXU, Caesars, Clear Channel and Freescale did “distressed exchanges”, in which creditors accept losses in return for new debt. Buy-out firms also protected themselves by aggressively buying back bank debt at distressed prices when they could. Creditors will be the ones to suffer most from private equity’s exuberance.

Caveat investor

Amazingly, most private-equity firms’ returns will be fine if the IPO market stabilises enough to list their companies. Even KKR, which invested in nine of the 20 largest buy-outs and will have to write off its $2 billion investment in TXU, may see its 2006 fund make money. TPG, which invested in seven of the 20, is one of the worst performers, with exposure to TXU, Caesars and Freescale (the latter two have lost 60% of their value). At the least TPG will probably return money to investors when the fund winds up. But that takes ten years, a long wait for a small return.

How will private-equity firms have managed to turn a profit, when they overleveraged and overpaid? Typically they do not invest more than 10% of a fund in any one deal, so diversification helped. So did perverse “deal” fees. Buy-out firms charge the firm they are acquiring around 1-2% of the deal for the privilege of being purchased. TXU paid its sponsors $300m at acquisition and at least $35m a year to be managed and advised.

Whereas private-equity firms may be toasting catastrophe averted, investors have less to celebrate. Most mega-deals were done by “clubs” of firms, so investors have multiple exposures to some of the worst deals. How the companies themselves will fare is a separate consideration. Their debts may leave a lasting scar.

Private equity’s reputation should be bruised a bit too. The techniques many firms used to keep their companies alive amount to little more than financial engineering, says Peter Morris, the author of “Private Equity, Public Loss?”. The industry’s boasts of value creation may look hollow, at least for many of the mega-deals.

Source: http://www.economist.com/node/21559957