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— Analysis —
No one is predicting a return of the big-ticket leveraged buyout anytime soon, even if the banking industry recovers its footing. What Henry Kravis declared as "the golden era of private equity" barely a year ago in May 2007 now seems like so much ancient history. It will be a long time before banks stump up $20 billion or $30 billion in debt to finance a take-private. Indeed, with the prospect of several years of systemic deleveraging, it is anyone's guess when Kravis or his competitors will be able to propose with confidence even a $5 billion LBO. That day may be further off than it was just a month or two ago.
"So much dust has been thrown up in the last week and a half that it will take a long time for it to settle," says Christian Hess, head of the European financial sponsors group at UBS in London. Don't expect any major deals before the end of the year, he says, because banks won't risk offering commitments that bridge the December holiday season and extend into the new year. Middle-market dealmakers expect the markets to recover sooner, but they don't foresee much activity this year either. The pipeline of deals is nearly empty, says Diamond Castle Holdings LLC's Lawrence Schloss. "If you were a voluntary seller, would you want to sell now?" Meanwhile, if you're a banker, "you're going to want to have a smaller balance sheet by year-end. People are not looking to add to their commitments." No one is trying to win points in the bonus pool this year. To those with a long memory, the crunch looks eerily like that of 1989, when a correction after a decade of credit excess shut down the leveraged debt markets for years. LBOs returned in the mid-'90s, but it took 17 years before Kohlberg Kravis Roberts & Co. could match its own $31 billion, 1989 record for the biggest buyout ever -- RJR Nabisco Inc. -- with its $33 billion deal for HCA Inc. in 2006. And that was without adjusting for inflation. There is no law of nature mandating LBO activity at the levels of 2006 or early 2007. Some dealmakers who lived through that 1989 crash are optimistic credit markets will recover faster than they did in the early '90s. Leveraged lending and junk bonds were relatively new concepts when Drexel Burnham Lambert imploded, taking down the leveraged debt market with it. That market has expanded geometrically and become a much more integral part of the larger capital markets since. The experience and mistakes of Resolution Trust Corp.'s cleanup of the savings and loan industry will also come in handy. Still, one senior banker says he does not expect leverage to be a deal driver again for five or 10 years. Many in the buyout business profess to see the correction as healthy. "This return to sanity -- which is how I view this -- is good," says John Howard of Bear Stearns Merchant Banking. "There was a sense that if banks will lend at 6 to 8 times [Ebitda], then we'll pay 11 or 12 times. But we all know that's a fallacy." His firm, which specializes in the retail and consumer products sectors, didn't make a retail investment for two years because it thought valuations were too high. For the megafirms, however, it will take more than a return to rational pricing to restart the LBO engine. The search is now on for alternative ways to deploy their $10 billion and $20 billion funds. Apollo Management LP and Blackstone Group LP sank billions earlier in the year to buy up LBO debt at steep discounts, with 75% financing. (They had more flexibility in their buyout partnership agreements to invest in debt than some sponsors.) Other firms will be looking for large, capital-starved businesses. There are already examples: Warburg Pincus' two-tranche, $800 million investment in mortgage insurer MBIA Inc., announced last December; the $7 billion TPG Capital-led bailout of savings and loan Washington Mutual Inc.; and the unsolicited KKR- and TPG-backed bid by Electricité de France SA this month for Constellation Energy Group Inc., a struggling Maryland utility. JC Flowers & Co. LLC reportedly offered to buy or bail out American International Group Inc. earlier this month. One can quarrel with the timing and wisdom of the MBIA and WaMu investments, but they show the potential to match those with capital and an appetite for risk (private equity) with those at risk (a good slice of the financial sector). More money will go into growth-capital investments in places like India and East Asia, where the hope is that rapid expansion can make up for the lack of leverage. "Everyone is looking for the same thing, which is growth," says UBS' Hess. The dislocation ensures that there will be anomalous valuations. "At times like this, there are extraordinary opportunities for private equity players that have raised their fund," says Michael Ryan, a private equity partner at Cleary Gottlieb Steen & Hamilton LLP. "They can relax, they can sit and they can see what comes around." Some of the best buyout opportunities ever came in 2002 and 2003, when corporations -- telecoms, particularly -- were overextended and had to sell assets fast to repair their balance sheets. The financial sector may be churning up the equivalent opportunities now. If the federal government begins shaking loose $700 billion of real estate assets, there are bound to be some nuggets for private equity firms. Still, even if there are good deals to be had, investment holding times are likely to stretch out, and the rising tide of multiple expansion that has buoyed returns in this decade plainly is ebbing. Returns are thus likely to retreat as well. Limited partners can do the math, too, and may be reluctant to ante up the same levels of capital they have in recent years. With the fall in the public equity markets, pension funds and other limited partners may also find themselves overallocated to private equity. (Of course, their investment alternatives may be less appealing, too.) If there is any bright side on the fundraising side, it could be sovereign wealth funds and foreign state-owned enterprises. There are signs now that they may want to deploy more money through intermediaries or with partners. The SWFs simply have too much capital to effectively invest it all directly, and, in the U.S., they face political and legal scrutiny if they attempt to take control positions. Better to don the cloak of an American asset manager and deflect the political heat. The French state-controlled EdF appears to be doing something like that in tapping TPG and KKR for its bid for Constellation. Bain Capital LLC and Blackstone fulfilled a similar role for Chinese government-owned appliance maker Haier Group Co. when they teamed up with Haier to bid for Maytag Corp. in 2006. Blackstone reprised that role last year, when it took a stake in government-owned China National Chemical Corp. to help create a specialty chemicals subsidiary, China National Bluestar Group, and assist it in making overseas acquisitions. Playing the chaperone could be a lucrative new business line. Anyway you slice it, though, the private equity game is going to look very different for years to come. |
For a business like private equity, which lives on debt, the credit meltdown has been a chokehold. The guessing game now is just when the buyout world will breathe freely again. The bailout plans being cooked up in Washington do not make the answer any clearer. Even if Congress succeeds in putting a floor under the market, private equity faces the prospect of a long period without leverage.
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