Soon
we'll see the New Yorker cartoon. A chic young businesswoman,
presumably an associate at a private equity firm, will be telling her
unhappy boyfriend over martinis: "I thought we were covenant-lite!" The
cartoon will appear, of course, amid strains in the secondary market
for buyout loans of that description and as Congress pursues its plans
to hike the tax rate on the type of income that made Blackstone's Steve
Schwarzman rich enough to hire Rod Stewart to sing at his birthday
party.
But filter out (if you can) some of the current noise around the
private equity phenomenon, and ignore for the moment the compelling
question of where we are in the M&A cycle. With a noisy initial
public offering for Blackstone Group LP, another one pending for
Kohlberg Kravis Roberts & Co. and a 35% share of deal activity in
the record-setting first half of 2007, the PE business looks mighty
frothy. Yet this is also an industry that has been decades in the
making, and has brought about major and enduring changes in the way
businesses are bought, sold and owned.
By now, most corporate dealmakers have had the experience of selling
to PE firms, buying from them, or both. In most industries they've
competed with them for assets. Still, many don't know private equity in
a depth befitting its significance in the deal world. So even if a
contraction in the debt markets should restore a bit of the edge
corporates traditionally enjoyed over PE firms, there are obvious
benefits to studying the way PE shops do the things they do, and trying
to see the world through their eyes.
For help on that front we turn to the most authoritative source
around: Our parent publication, The Deal. Over the past year, The Deal
newsweekly has produced a series of landmark articles showing in depth
what's really going on in PE land. You'll find three of them, in
slightly modified form, beginning on page 18. Taken together they
provide a sophisticated look at how PE firms transform companies, how
they use (and sometimes overuse) debt, and how they compensate--and
motivate--the executives that run their companies.
Before we get to those articles, though, some agenda setting is in
order. For corporate development folks, is studying the private equity
playbook largely a matter of knowing your competitor, the better to
outmaneuver him? Or is it more about learning from your counterparty
and perhaps finding ways to work together occasionally? Conversations
with a couple of dealmakers who have worked on both sides of the
fence--Dan Salliotte, vice president for strategy and business
development at Idex Corp., and Dan Pryor, managing director at the
Carlyle Group--indicate that it's a little of both.
Salliotte joined Northbrook, Ill.-based Idex, a diversified
engineered products company with about $1.1 billion in sales, in 2004.
He previously spent a couple of years with Oxford Investment Group, a
middle-market private equity firm in Detroit, and before that worked in
corporate development for manufacturer SPX Corp. Pryor, meanwhile,
joined Washington-based Carlyle in 2005, having previously worked as
vice president, strategic development, at Danaher Corp.
The two know each other and in their current roles have discussed
collaborating on deals, though nothing has come together yet. The
relationship came about because acquisition-minded Idex, a former KKR
portfolio company (it's now public), is led by former Danaher exec
Lawrence Kingsley. All of which may help to explain why, when comparing
the strategic and PE approaches to dealmaking in separate interviews,
Salliotte and Pryor found plenty of common ground.
As Pryor puts it: "Increasingly, I don't think there is a
difference. I think that there are best-in-class practices that anybody
can use."
One of those best practices has to do with the way
acquirers size up a target and the market it serves. This is an area
where a strategic buyer's strength--familiarity with the market--can
also be a weakness. When he was a corporate dealmaker, Pryor says,
"there were situations where we bought a business taking for granted
some basic understandings of the industry and then had them proved
wrong." Financial buyers, he says, "may look at things with fresh eyes
because they're outsiders to the industry."
Yet as Salliotte can attest, there's no reason strategic buyers
can't do the same kind of homework many financial buyers favor. That,
in fact, is what Idex did in its January acquisition of Quadro
Engineering LP, a small Canadian provider of particle-control solutions
for the pharma market. "We knew the Quadro space," Salliotte says. "But
we went out and found experts on the trends and characteristics of that
market to confirm what we were hearing from the Quadro team." Salliotte
says you don't see as much of that kind of research on the corporate
side. But that may change. Gerson Lehrman Group, the New York
consulting firm Idex used to find the experts, is expanding beyond its
core private equity clients to work more with corporates.
Of course, business managers who know a field are more fundamentally
an advantage for strategic buyers. At Idex, Salliotte runs a monthly
process where he asks each of the company's 15 business units to
identify logical targets. "We've got 15 management teams that can
easily come up with 20 or 30 targets apiece," he says, "so we start
with a large set of initial acquisition candidates that have a fair
amount of business logic behind them." In get-acquainted meetings with
acquisition candidates, the business unit executives bring credibility
as they clearly lay out the strategic rationale for a deal.
Here the best practice flows the other way, since bigger PE firms
can do something similar through their portfolio companies. In general,
though, the deployment of business managers is a key point of
differentiation between financial and strategic acquirers--and a source
of advantage corporate dealmakers may underestimate.
The PE firms' emphasis on attracting and rewarding executives is the
flip side of a vulnerability. "In a private equity diligence," says
Pryor, "looking at management is much more important. Because if the
CEO's a dud, I've got to figure out a solution to that before I buy the
business. As a strategic buyer, you care about management, but it's not
your paramount consideration, because you probably have some people you
can use as backups."
The way they finance deals is another obvious difference between the
two sides. But here again its significance may be underappreciated by
corporate buyers--especially in middle-market transactions, which are
often harder to finance than bigger ones. In Salliotte's view,
corporate dealmakers are getting more knowledgeable about the models
that PE competitors employ. To really gauge where a bid from a
financial rival is likely to come in, though,you need to stay current
on the debt markets (senior, mezzanine, second-lien) that a rival is
tapping.
"Some of the rules that corporate development people apply are still
too general," Salliotte says. "You really have to figure out
specifically, for every property, the amount and terms of the debt
structure that a private equity bidder will realistically be able to
secure." Salliotte factors in a host of other variables as well: the
amount of equity the PE bidder will be willing to put up; the
percentage of equity proceeds upon exit required by mezzanine lenders
or the management team; the likely entry and exit transaction multiples
that financial sponsors are assuming; plus the minimum
internal-rate-of-return parameters the sponsors are likely targeting.
Clearly, corporate and financial dealmakers can compete more
effectively against each other by learning more about each other. A
more complicated question is whether mutual understanding will give
rise to more collaborations. According to both Pryor and Salliotte,
partnering is an interesting idea that's tough to execute.
Pryor lists five kinds of deals that a strategic and a
financial buyer might work together on: a spinoff from a strategic to a
PE buyer, with the strategic retaining a stake; a partnership to carve
up a business; a partnership whereby a financial buyer would warehouse
and improve an asset, for later sale to a strategic; a partial-stake,
capital-infusion deal such as Kohlberg Kravis Roberts' investment in
Sun Microsystems Inc. in January (see box); and a transaction where a
strategic folds a business unit into a company that a PE firm is buying
in exchange for an equity stake in the new entity.
Aside from spinoffs, which are common, Pryor says all have
considerable complexities. In a carve-up, for example, the fact that
one partner must be the initial buyer and then on-sell some of the
assets creates unwanted tax burdens as well as complications with the
representations and warranties in the sales agreement. Collaborations
remain an interest for Pryor, given his corporate background. But in
general, he says, "I'm not sure you're going to see a lot more
partnerships."
Would a big change in the financing markets alter the dynamic? We'll
have to wait and see. But for the rest of this cycle and long into
future ones, a few points will remain fixed. "We're all trying to buy
companies," says Pryor, "but we're doing it for different reasons, and
we have different financial measurements. There are some very good
acquirers in the world and some very bad acquirers in the world. Some
of the great acquirers are corporations, and some of the great
acquirers are PE firms." - Kenneth Klee
A new kind of private equity deal in the tech industry
Under new management and on the mend following a prolonged period of
difficulty, computer hardware maker Sun Microsystems Inc. has plenty of
cash and little in common with struggling handset maker Palm Inc.
But both companies recently employed a new and unconventional
approach to raising money from private equity investors: a so-called
PIPE deal, or private investment in a public entity. While the terms
and purposes of the transactions are different, they both point to the
same broader trend: private equity firms seeking innovative ways to put
their huge piles of capital to work.
The move by Palm, maker of the Treo, came in June after months of
efforts to sell the company as a whole. Instead, Palm sold a 25% stake
in its business to Elevation Partners for $325 million. The company
also announced that former Apple Inc. executive Jon Rubenstein would
come in as executive chairman and try to lead a turnaround
Sun announced its PIPE in January. It took the form of $700 million
in convertible senior notes purchased by KKR Private Equity Investors
LP, the Amsterdam-listed unit of Kohlberg Kravis Roberts & Co. As
Sun CEO Jonathan Schwartz put it on his blog, "They loan us money at an
extremely low interest rate, in exchange for the right to buy our
shares if they rise above 25% of their original price."
If Palm's deal represented a bet by Elevation on a turnaround, Sun's
was an endorsement by KKR of the company's current course. Bret
Schaefer, Sun's vice president of shareholder value finance, says that
Schwartz (who took over as CEO from Scott McNealy in 2006) pushed to do
the deal largely to signal to Wall Street that Sun is as serious about
its finances as it is about developing groundbreaking technology.
"KKR is very well respected and a fairly hard-nosed investor, and
the idea of someone of that ilk investing in Sun sends a strong
message," Schaefer says. "Perception is a huge part of this."
How will Sun use the money? Acquisitions are one possibility. The
company's last big deal was the 2005 purchase of Storage Technology
Corp. for $4.1 billion. At the time of the PIPE, KKR's George Roberts
cited Sun's "substantial growth potential," and Schwartz said his
company would use the proceeds to pursue "strategic opportunities for
growth."
A complete buyout, it seems, is out of the question, since KKR
signed a standstill agreement. The PE firm also took a board seat, and
Schwartz says he's looking forward to introductions that could help Sun
sell to KKR portfolio companies.
Craig Norris, who worked on the deal as Sun's vice president of
corporate law, says he thinks it's likely that more deals of this sort
will get done in the future. "I think private equity firms are looking
for other ways to spend their money," he says. -- Andrea Orr
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