“The buyout party is over, but the funds continue to flow,” as the FT put it. The credit crunch has seen new buyout deals dive, but investors are still pumping money into the business in the hope of a revival: private-equity funds raised some $323bn in the first half of this year, says Private Equity Intelligence, little changed on 2007. The boom has been great for fund managers, whose management and bonus fees only grew bigger as their funds grew. But even in the good times, was the buyout boom ever really much of a party for investors?
The case for buyouts is simple. By going private, a company removes itself from the short-term pressures of the equity market. Instead, it has a relationship with just one shareholder. This can be helpful for troubled firms that need to restructure or turn around in some way: the new owners can give the company the time it needs and provide expertise. They also keep the management disciplined and on course: often, they’ll parachute in a new, experienced management team. Once leaner and meaner, the firm can be floated on the stockmarket, sold to a trade buyer or another private investor, and investors in the buyout funds can collect a fat return (and the manager a large fee).
Private equity’s big secret: debt
So that’s the theory. Does the reality match up? Well, in the ten years to 2006, buyout funds made an average annual return of 14.3%, comfortably beating the FTSE All Share’s 7.9%, according to a 2006 Citigroup study. So, chalk one up for superior management? Maybe not. There’s less to this wizardry than meets the eye, say Citigroup.
Gearing up a portfolio of shares – that is, buying them with borrowed money – using the same proportion of borrowed money to equity as a typical buyout fund (75% debt to 25% equity) would have outperformed buyouts handily over the same period. A portfolio of 25 mid-cap, high-cash-flow, low-debt stocks (the kind that buyout firms generally invest in) from the UK or European markets would have returned an average 38% a year over the ten years. And that doesn’t just beat the average buyout – it beats more than 75% of them.
The analysis is “simplistic”, says Citigroup. But it raises big questions about buyouts, because it strongly suggests that most funds’ performance is a result of raising debt levels, not investment and management brilliance. Gearing up is a key part of buyout funds’ strategy: they buy firms using as much debt and as little equity as possible, and then after the purchase, often pile on more debt and extract equity, in the form of large dividends payments. Gearing up a quoted portfolio mimics this. But if there was any advantage to private ownership and the buyout firms’ turnaround skills, we should expect the buyout funds to outperform the geared portfolio, since they would still have this extra ingredient for success. The fact that they don’t implies that these supposed skills add nothing to the process.
Indeed, buyout funds’ main impact may be to undermine the companies they buy by overloading them with debts that are unsustainable in a downturn. While the Citigroup analysis is based on a 75%/25% debt/equity split, by the peak of the boom, buyouts were being loaded with higher ratios (and increasingly high levels of debt relative to their cashflow). Now that economic conditions are worsening and refinancing loans is becoming ever harder, some buyouts are starting to tip over the end.
In the US, a slew of deals, including retailer Linens ‘n Things, casino operator Harrah’s and media group Clear Channel, are starting to hit trouble. Some are complaining about the extra debt burden placed on them by the buyout funds. Sooner or later, some firms are likely to need a new equity injection from the buyout funds or will have to be sold on cheaply. That could be a severe blow to returns for buyout funds – they may well struggle to deliver those 14% returns over the next few years.
Rich pickings for vultures
It’s no surprise, then, that the secondary market – in which the underlying investors in buyout funds can buy and sell their interests stakes – is becoming increasingly active. Experienced investors suspect that the tide has turned and want to get out of funds that they think will do badly. Many listed private-equity managers, such as Blackstone, are down heavily over the past year, on the prospect of much lower performance fees.
Still, one man’s problem is another man’s opportunity. One reason that private-equity fundraising has held up so well is that distressed debt or ‘vulture’ funds are taking in record amounts of money, with $33bn raised since the start of the year. These funds buy up the debt of troubled firms, aiming to gain control and either turn them around or break them up and sell off the assets. With the buyout boom having created plenty of deals that will struggle in tough times, the next few years could mean very rich pickings for the vultures.