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: One careful owner?

DISCOUNTED prices, outdated models and a glut of inventory. Customers can tell plenty about the state of the auto industry while kicking tyres at a used-car dealership. The same is true for the second-hand market for private-equity stakes. What used to be a tiny part of the industry has flourished (see chart).

“Secondary” stakes change hands when investors, who typically agree to lock up their money for a decade, decide to sell early. Triago, a firm that arranges secondary transactions, reckons that deals worth $25 billion will take place in 2011, up by 25% from last year’s record.

Banks and insurers are largely responsible, since they need to sell their investments in private equity and free capital to comply with an onslaught of new regulations, such as Basel 3 and Solvency II in Europe, and the Volcker rule in America. Cash-strapped European banks are also eager to peddle their private-equity investments. In August HSH Nordbank, a German bank, sold a €620m ($1 billion) portfolio that included stakes in well-known firms such as Carlyle and KKR.

A flurry of secondary activity has been predicted for years. But until recently only the most desperate investors wanted to offload their stakes at rock-bottom prices. Transactions have picked up because sellers can now get better prices. Neil Campbell of Tullett Prebon, an interdealer broker, says that investors today can expect around 95 cents on the dollar for many of their stakes, compared with only 60 cents in 2009. Some assets have doubled in price in the past year.

Prices have risen because of a glut of capital that firms specialising in the secondary market, such as Coller Capital and Harbourvest, have raised to take advantage of the opportunity to buy. These firms aren’t the only ones shopping. Some pensions and funds of funds have begun to use the secondary market to invest in promising funds or regions.

Some say that the secondary market’s growth shows that institutional investors are becoming more familiar with private equity as an asset class—and are becoming more aware of its attractions. It helps that secondaries can be bought and sold more easily than ever before. But transactions in them are still more arduous to complete, not to mention more opaque, than other investments. Unlike face-to-face bargaining over a dodgy motor, deals are negotiated through an intermediary. Attempts to launch exchanges and derivative products, which would make for more transparent pricing, have not taken off.

Mathieu Dréan of Triago predicts that by 2015 the annual tally will be $75 billion-worth of secondary transactions annually. The struggles of the private-equity industry will partly fuel this growth. Buy-out firms bought too many companies at top prices. They must now wait until the economy improves to sell or float them and return money to impatient investors. Private-equity firms are now holding on to companies for five years on average, compared with three-and-a-half years in 2007. Some investors don’t want to wait that long to pocket returns. They are turning to the secondary market to hand in the keys for their old model and grab what cash they can.

Source: http://www.economist.com/node/21541430

Pulling for the home team

IT CANNOT be pleasant to start a new job with a continent’s fate resting on your shoulders. On November 1st, Mario Draghi’s first day as president of the European Central Bank (ECB), peripheral-government bond yields shot up and stockmarkets sank on fears that Greeks might reject a rescue plan agreed days earlier.

On November 3rd, as The Economist went to press, Mr Draghi was presiding over his first policy meeting. Much is riding on what the ECB decides then and in coming weeks because it alone currently has the means to stem the intensifying crisis. It has bought Greek, Portuguese and Irish debt; since early August, it has also purchased Spanish and Italian bonds. But its purchases have been intermittent and begrudging. Without a firm commitment to buy as much as needed to prevent yields on Italian and Spanish bonds rising so high that both countries become insolvent, investors have less incentive to return.

The ECB’s reluctance to make such a commitment is understandable: its legal mandate and doctrinal persuasion bar it from directly supporting governments. Yet throughout history central banks have been lenders of last resort to their governments. In 1694 the English monarchy was broke and in need of a loan so that it could wage war with France. A group of financiers agreed to lend the crown £1.2m in return for a partial monopoly on the issue of currency. Thus was born the Bank of England.

Central banks routinely serve as their government’s agent: they accept payments, disburse outlays, auction and redeem their bonds. Most buy and sell government bonds to carry out monetary policy. At times they have done so to finance government, especially in wartime. The Bank of England suspended the convertibility of its notes to gold from 1797 to 1821 to enable it to better finance Britain’s wars with France. In the 1930s the Bank of Japan was compelled to buy the government’s bonds, and from 1942 to 1951 the Federal Reserve agreed, at the Treasury’s request, to hold Treasury yields to 2.5% or below.

The risks are obvious: bond purchases expand the money supply, potentially leading to inflation. Virtually all hyperinflations begin with such monetisation of budget deficits, including Germany’s in 1920-24, which explains the Bundesbank’s, and now the ECB’s, reluctance to lend to governments.

The mere possibility of inflation can force governments with weak central banks to pay punitive interest rates. But as Chris Sims of Princeton University, who shared this year’s Nobel prize for economics, notes in a recent presentation, there is another side to the story. Bonds of a country with its own central bank are simply a promise to repay one government obligation (ie, debt) with another (ie, currency). The owner of such a bond is confident he can always sell or redeem it, and thus does not demand a higher yield to compensate for counterparty risk.

A country that gives up its monetary sovereignty by dollarising or adopting the euro may gain greater credibility on inflation but may have to pay more to compensate investors for counterparty risk. This may seem like a good idea when counterparty risk is low, but that can change abruptly and dramatically. Mr Sims, in a 2002 paper, says the option of using inflation to repay debt is a valuable fiscal-shock absorber that over time may be less expensive than the risk, or fact, of default.

This can be seen starkly by comparing Britain with Spain (see chart). Based on debts, deficits and inflation, Britain should be the riskier credit. But British bonds yield around 2.3% whereas Spain’s yield around 5.5%. One reason is that Britain can still devalue to boost growth; Spain can’t. Another is that it has a lender of last resort; Spain doesn’t. Paul De Grauwe of the University of Leuven says that if Britain couldn’t roll over its debt at acceptable interest rates, it could ultimately force the Bank of England to buy it. “This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default.”

No central bank wants to be put in that position, of course, and institutional arrangements have sprung up to prevent it. The most common is to require that bonds be purchased only at market prices. The Federal Reserve is prohibited from buying bonds directly from the government, except to roll over a maturing issue in its portfolio. It can buy bonds on the secondary market, which is how it enforced the yield ceiling during the second world war, but its accord with the Treasury in 1951 ended that obligation. The Bank of Japan can buy bonds on the secondary market, but not directly from the government unless the Japanese Parliament votes to require it. The Chilean central bank may not buy government securities while Israel, Argentina, Canada and South Korea impose limits on how much the central bank may purchase.

The European Union’s Maastricht treaty is in keeping with these arrangements: it prohibits the ECB from buying bonds directly from member governments, but not from buying them on the secondary market. The ECB claims it buys only to ensure its monetary policy is transmitted to interest rates.

How could the ECB be enticed into becoming lender of last resort? Mr Sims says the ECB needs to be reassured its own balance-sheet has sound fiscal backing. That is because it may deplete its capital by selling assets at a loss or paying interest on reserves to prevent bond purchases from fuelling inflation. He suggests empowering the European Financial Stability Facility, Europe’s bail-out fund, both to issue euro-denominated bonds (backed by a euro-zone-wide tax) which the ECB could buy during open-market operations, and to recapitalise the ECB if needed.

But the ECB may not have time to await such arrangements. Brad DeLong of the University of California, Berkeley, notes that central banks have taken liberties with their mandates when financial stability was at stake. The Bank of England lent aggressively during the financial crisis of 1825-26, for example, despite lacking the legal authority. Sir Robert Peel, First Lord of the Treasury, later said: “If it be necessary to assume a grave responsibility, I dare say men will be willing to assume such a responsibility.” Whether Mr Draghi does so may determine the euro’s fate.

Source: http://www.economist.com/node/21536567