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Structurally sound

Troubled credit markets have impacted the industry in recent months. Ross Butler assesses the strength of the sector’s business model throughout the economic cycle

ast year mega firms had low interest rates, which in turn fed a the power to buy up massive colossal appetite for high-yielding paper swathes of the corporate world. such as leveraged loans. On top of that, L Armies of lawyers and bankers a period of low returns from both bonds were on hand to advise them in their and equities encouraged institutional latest assault. Then almost overnight, the investors to diversify their portfolios market for new mega deals shut down. into alternative asset classes that had a Private equity’s pivotal weapon – record of out-performance – including leveraged loans – had been sucked private equity. out of the market, following turbulence As a result, private equity funds under during the summer of 2007 in a credit management swelled from $163m market that has no underlying link to in 2002 to $518bn last year, according private equity. Now, nearly a year after to private equity data provider Preqin. the first signs of a credit crunch emerged, Last year the industry passed a there is still no indication that the landmark $2tr in total unrealised assets market for leveraged loans is returning. under management. The reasons for private equity’s This huge growth in funds under astonishing growth during the middle management, combined with truckloads part of this decade are well documented. of cheap credit meant deal sizes went A benign economic environment was off the chart. In 2003, a $5bn buyout

Photo:Andy Paradise coupled with an era of low inflation and was about the largest considered

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“ It is fair to say that the days of the big deals are gone for the foreseeable future.”

achievable. By 2005, the rules of the are now considered toxic terms. game had completely changed. This has clogged up the system for A buyout consortium agreed to buy new issues. Worse still, pricing in the Danish telecoms company TDC for secondary market has fallen like $15bn, the largest private equity deal for a stone since November. a generation and a European record. At the time of writing, the average At the end of 2006, Blackstone single- bid price for the 20 most liquid institu- handedly set the new high watermark tional term loans in the North American with its $36bn acquisition of Equity and European secondary markets was Office. Weeks later Kohlberg Kravis 87.56% and 82.25% of face value Roberts and TPG Capital put the respectively, according to data finishing touches to their $45bn provider Markit. There is little sign of purchase of utility TXU. the market stabilising. It wasn’t just the size of deals that In the face of a plummeting market was going at break-neck speed. In and huge write-downs, investment early 2006, Stephen Schwarzman, chief banks refused to take on any new executive of , said mandates in the fear that they wouldn’t that prices being paid for companies be able to shift fast-depreciating debt on were in “nose bleed territory”, and yet for to the institutional market and so private the next year, prices and gearing kept equity’s so-called golden age came to rising, loan spreads tightened and debt an ignominious end. “It is fair to say that terms became ever looser. the days of the big deals are gone for To say that all the signs of a collapse the foreseeable future,” says Annette in the leveraged loans market were there Kurdian, a partner in Linklaters banking would be disingenuous, because when group. “So you aren’t going to see deals it came it had very little to do with the of the order of KKR’s acquisition of fundamental credit quality of buyout Alliance Boots, because clearly it is quite targets. Everyone working in the industry impossible to raise that amount of debt.” was waiting for the crippling levels of leverage being placed into buyout The big question structures to initiate corporate defaults. Mega buyout houses, whose business Even then, it was believed that the models are heavily dependent upon huge liquidity in the loan market would being able to raise large quantities of allow for a gentle slow-down and a debt, are therefore now in a difficult gradual de-gearing. Instead, the market position. When the markets will return is fell flat on its face, pushed by the fallout anybody’s guess – credit professionals in the US sub-prime housing market. say it is unlikely to be before the third or Many of the investors that got fourth quarter of this year. By that time, pummelled by defaulting sub-prime many mega funds might have gone loans were also in the leveraged loans more than a year without any prospect market for – namely CLOs of making new investments. and hedge funds. However, one of the beauties of As a result, underwriting banks have private equity is that funds are normally been left with an estimated $40bn structured as long-term locked-up of unsyndicated, or hung, debt on capital in the form of ten-year limited Photo:Andy Paradise their books that was arranged on what partnerships, so sitting out of the market

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yet managed to close a large LBO in promised buyout returns. And if private “ While the larger end is very difficult, in the mainland China. equity firms continue to move into middle market there are banks lending , which has three PIPE investing in a big way, they had offices in China, was frustrated by the better be very certain of success – admittedly not as much as before and at government in its attempts to acquire a because, from an ’s higher margins – but the market is still controlling stake in Chinese engineering perspective, investing in public equipment group Xugong Group equities through private equity limited very open.” Construction Machinery and now partnerships is a very expensive model. focuses on in the region. Opportunistic diversification is In a similar way, India will no doubt another strategy being considered in the provide rich pickings for private equity offices of Europe and America’s largest firms interested in venture and growth groups. As banks face write-downs on capital investments, but the number of their leveraged loan exposures and face control LBOs are likely to be minimal for breaching their capital ratios, there for a while does not present any Turkish banks, which appear to be many years to come. will almost certainly be attractive structural problems. But, at the same relatively insulated from the worldwide Some credit-constrained mega buying opportunities. time, the economics of mega funds credit turmoil. buyout groups believe that more creative Carlyle launched a synthetic CDO means they cream off an enormous “We focused on financing the trans- investment strategies could allow them in early 2008, based on credit default amount in annual management fees. action with local banks,” says Nikos to put money to work. So called PIPE swaps that commit to covering senior Choosing to be patient with one’s Stathopoulos, a senior partner at BC deals, or private investment in public debt losses in LBOs. But, while Carlyle capital is one thing, but looking Partners. “The reason we approached equity, have been a standard part of the waited until the market was in its impotent or at the mercy of events is not them is that they knew and understood US mid-market for a long time, and over favour, others such as Kohlberg Kravis great brand positioning. Cognisant of the business very well because it is a the past two years the investment Roberts diversified too soon. Its listed this, large buyout groups are coy about very strong brand in Turkey; but also my technique began to gain credence in KKR Financial Holding has deferred talking on the topic of private equity’s sense is that they were less hit by the Europe, for reasons unrelated to the several repayments of debt related to sustainability. “To do so would make me overall credit crunch, so they had more credit crunch. Larger PIPE deals mortgage-backed securities and is now a hostage to fortune,” says one mega appetite, more liquidity and were able to remained unusual on either side of undergoing a restructuring process with buyout executive. be more competitive.” the Atlantic. its creditors. In reality, mega buyout groups have This certainty of local funding is But since the start of the credit But the most talked-about strategy by several options open to them. The most believed to have been a key factor in the crunch, the number of such deals has far is that of mega funds jumping down Photo: Andy Paradise sensible course would be to wait for the vendor’s decision to sell. BC Partners jumped to 364, representing $29.9bn, into the thriving and highly competitive credit markets to unwind from their and its co-investors, TurkVen Private according to data from Dealogic. This mid-market, where financing is still the larger volume of deals that would market is still very open,” says Alastair current mess and spend the time Equity and DeA Capital, acquired the represents an increase of 73% on the available, albeit on much less attractive have to be undertaken. Gibbons, partner at Bridgepoint, an working out angles for future deals and business in a heated auction that preceding seven-month period. terms that before. A more immediate threat is that the upper mid-market firm that invests creating value in the current portfolio included both trade and private equity The advantages of the technique are London-listed waste company mid-market on both sides of the Atlantic across Europe. of investments. bidders. Several competing bids, such clear. There is no need to tap the flighty Biffa is one mid-cap to have attracted is already heavily populated with profes- Inevitably, debt terms have changed At the same time, the downturn is as Blackstone and Croatian retailer credit markets because, as a public the attention of the mega funds. sional funds that will give any mega fund even in the mid-market. The levels of bound to separate the boys from the Agrokor’s, were not financed out company, the target’s tolerance of The company was put into play by two a run for its money. “I can see how mega gearing are much reduced, with equity men. No longer able to reap giant of Turkey. leverage does not compare with that of mid-market firms, Montagu Private funds might be tempted to invest in mid- components of 40% to 50% or more returns from multiple arbitrage and Investment opportunities in the an LBO. To an extent this also mitigates Equity and Hg Capital. Hg subsequently market deals. But it would be a tactic being commonplace. For upper mid- rampant debt levels, this is a chance for Middle East and Asia are also possible the advantageous effects of gearing. dropped out and so Montagu teamed up rather than a strategy. They are not set market deals, pricing across the debt buyout groups to demonstrate their alternatives, where the penetration of But there are other drawbacks. with infrastructure fund GIC. Then mega up to do these types of deals,” says one structure has hit record levels, particularly ability to improve the operational private equity remains very limited and Private equity’s other main weapon of fund CVC Capital Partners was reported mid-market investor. in the US, as the plummeting secondary efficiency and quality of earnings in the the potential is huge. Japan – an emerg- value creation is control. If a portfolio to be circling the company, alongside market feeds into primary syndication. businesses they acquire. ing market in terms of private equity – is company starts underperforming, Australian investment bank Macquarie. Mid-market stability Perhaps the biggest change has been Another option is to fish in those seen as particularly attractive by mega loss-making arms can be shed and The dangers of big funds investing in Whatever the fate of the mega funds, the need to put together banking clubs in emerging markets – outside of the US funds. Permira has been active in the managers can be fired at a moment’s the mid-market are clear. Firstly, mega in volume terms at least they are merely order to underwrite even modestly-sized and western Europe – where financing region for sometime, while earlier this notice. Not so with PIPE deals, where funds are not mandated to invest in mid- a thin top layer of a deep and vibrant buyouts. This is partly because the few is still available for buyouts and control year Dubai International Capital recently private equity executives are one voice market deals. Sophisticated institutional buyout industry that, in the teeth of the underwriting banks that are still open positions are politically acceptable. earmarked part of a $5bn Asian invest- among many around the board table. investors don’t take kindly to their credit crunch, continues to thrive. for business are extremely cautious of For instance, BC Partners recently ment plan to the country. Just look at Blackstone’s $3.3bn portfolio diversification being tampered “While the larger end is very difficult, syndication risk, but clubs also give completed the $3.2bn acquisition of Putting large sums to work elsewhere acquisition of 4.5% of Deutsche with and will remember the fact. In in the middle market there are banks sponsors a great comfort factor. Turkish supermarket chain Migros. in other parts of Asia can prove more Telekom. The share price performance addition, the portfolios of mega funds lending – admittedly not as much as “The more that the debt is spread The deal was financed purely by difficult. No foreign buyout group has since investment hardly compares with would quickly become unwieldy, given before and at higher margins – but the among market lead arrangers, the more

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confidence the sponsor has in terms of safety in numbers, because there is less “ The dislocation in the banking markets and risk on syndication and less risk that the fact that some companies are starting debt will be flexed,” says Kurdian. “That is becoming a very common feature of to struggle, and have a need for capital or the market.” to divest subsidiaries, creates opportunities Banks have also become much more cautious about who they lend to. “The for financial sponsors.” banks have a very clear preference as to who they want to work with,” says Gibbons. “In times of turmoil, people tend to cut the relationships that aren’t long term or close and focus on their core. So banks are choosing deals on who is on the ground, speaks the while just under half intended to keep the basis of the sponsor firm, rather than language and understands the local their allocations in place. getting into bed with just anybody.” dynamics,” says Stathopoulos. Whether the top end of the market But, essentially, mid-market investors The downturn in the markets also will continue growing at pace seems less view the credit crunch as a cyclical presents opportunities. “The dislocation certain, but there is little doubt among retrenchment rather than a structural in the banking markets and the fact mid-market firms – some of whom are barrier. “It is not affecting fundamentally that some companies are starting starting to raise funds of several billions what we are doing at Advent Interna- to struggle, and have a need for capital of euros – that private equity will tional,” says Fred Wakeman, managing or to divest subsidiaries, creates continue to grow through the cycles. director at the firm. “We have been in opportunities for financial sponsors The private equity business is still business for more than 20 years and such as ourselves,” says Wakeman. small when compared with global stock we focus on five growth sectors. The Take-privates are another area market capitalisation. However, Mark requirement of leverage in those sectors where a downturn could benefit private O’Hare, managing director of Preqin, to generate attractive financial returns is equity firms. “I think take-privates are says: “The potential to grow further typically not as high as in stable, looking potentially very attractive,” says is enormous: we’re predicting a $5tr non-growth industries.” Bridgepoint’s Gibbons. industry over the next five to Over that time, Advent has built a “Certainly, multiples have come back seven years.” global office network, which is well quite some way, so the issue is whether For now, the fact remains that private placed to help strong domestic earnings will also come back. At the equity’s troubles are not connected to its companies internationalise. This infra- moment the equity markets are taking performance or the underlying perform- structure has also enabled the firm to the view that earnings will fall, so you ance of portfolio companies, and default build up a pipeline of deals. It is also why aren’t seeing representative multiples. rates continue to run at extremely low Wakeman is not worried about mega All such deals must be looked at case by levels of below 1%. However, if business buyout firms descending into the mid- case, but I would expect an increase in failures do start to climb over the market. “This type of investment requires the level of take-private activity over the coming year – as most rating agencies a lot of manpower, a local presence and next 12 months,” he adds. are predicting – the market could take it is complex. We are geared up for it.” much longer to get back on its feet. In addition, while mega funds might Long-term viability Such a scenario would increase the be looking for emerging market At the World Economic Forum in 2006, chance of a shake-out in the private transactions, it is widely spread Apax Partners chief executive Martin equity market. Scores of new entrants mid-market firms such as Advent that Halusa famously predicted $100bn have set up over the past few years. are geared up for them. The firm has private equity funds “within 10 years”. If all they have to show for themselves the largest Latin America fund and it has At the time, many scoffed, and with the are top of the market highly leveraged been in central Europe since the onslaught of the credit crunch, even deals that start to unwind, it will be very mid-1990s. fewer would give the idea credence. But a difficult for them to raise new funds. As a result, when mega fund BC recent poll by private equity research firm But for the majority of players the Partners acquired Migros, it did so Preqin found that, while Limited Partners credit crunch should be welcomed as a alongside Advent’s Turkish affiliate had understandably become more sensible correction in leverage levels. It Turkven for on-the-ground assistance. cautious following the credit crunch, over may seem painful now, but structurally, “TurkVen was a good partner for us, half said their basic objective was to private equity firms are ideally placed to as it allowed us to have a local partner increase their exposure to private equity, make the most of their downtime.

the markit magazine – Summer 08