Private Equity’s New Challenge

A changed competitive landscape calls for a different business model.

Privileged access is less important. Discussions with fund managers and investors indicate that the privileged deal is a thing of the past. Historically, the relatively limited number of fund managers (primarily experienced investment bankers) had unique networks of relationships that provided access to investment opportunities that other, less well-connected buyers couldn’t match. Indeed, fund managers could sometimes consummate buyouts without a competitive bid process.

This situation has changed gradually over the years; today there are many more well-networked participants with much better information. Almost all significant deals today are subject to a visible and public auction process as sellers seek the maximum price. In many large deals, the number of bidders, both alone and in consortia, can reach double digits. The recent auction of a U.S. newspaper publishing business, for example, attracted almost all of the large active U.S. buyout funds.

Commodity financial-engineering skills. For years, the ability to create value through financial engineering was important. At its simplest level, a buyout fund would restructure and increase the debt of companies with too much equity. In this way, the fund reduced the companies’ exposure to corporate-income tax, used heavy interest payments to manage cash flows, and encouraged management performance with levered equity-based incentives.

Such skills remain important, but today they are broadly available. Vendors are beginning to use so-called stapled finance, where assets and businesses are auctioned with aggressive buyout leverage already in place or preapproved by the financing banks, for instance. Even the sales of businesses with lower leverage tend to attract multiple bidders, each with its own access to similar sources of debt through the financial sponsors’ groups of large investment and commercial banks. Acquisition prices therefore tend to reflect most of the upside from leverage.

Cyclical difficulties in ensuring attractive exit. Particularly during the 1990s, strong equity markets frequently permitted buyout firms to use initial public offerings (IPOs) to divest their interests. Beginning in 2000 that became more difficult, as markets plummeted, and even today this approach is a harder sell. As a result, buyout firms increasingly are changing their divestment strategies. Some are selling via secondary buyouts, while others are holding onto their investments longer. Indeed, Initiative Europe has reported that average holding periods increased from 37 months in 2002 to 52 months in 2003. (Founded in 1988, Initiative Europe is a leading independent provider of specialist and in-depth information focused purely on European private equity and venture capital markets.)

While some will argue that the current situation merely reflects the cyclical nature of the IPO market, it may well signal a fundamental change in the way that investors, markets, and regulators think about the characteristics of an IPO as well as the track record necessary for a successful listing.

Emergence of new types of competitors. Several categories of new competitors have emerged, further complicating the buyout world. An increasing number of buyout firms now raise funds for each individual transaction from investors who can choose to participate on a case-by-case basis, for example. A few have used this model for years, but others are attempting to copy it. Such funds may be more flexible in responding to market conditions than those that engage in significant fund-raising activities only every few years and may feel less pressure to rapidly put money to work. Another example involves the accelerated IPO, whereby businesses being auctioned are offered a rapid route to IPO, circumventing the typical intermediate step of buyout-fund ownership for a three- to seven-year period. Undoubtedly, we will see additional categories of competitors, further increasing the competition for available transactions.

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