Troubled Credit Markets Have Impacted the Private Equity Industry in Recent Months

Focus /29 Structurally sound Troubled credit markets have impacted the private equity industry in recent months. Ross Butler assesses the strength of the sector’s business model throughout the economic cycle ast year mega buyout 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 Summer 08 – the markit magazine /30 Focus Focus /31 “ 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 the Blackstone Group, 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 buyouts – 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 the markit magazine – Summer 08 Summer 08 – the markit magazine /32 Focus Focus /33 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 The Carlyle Group, 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 institutional investor’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 growth capital 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.

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