In finance, as in Greek tragedy, one of the commonest pairings is between hubris and sheer, toe-curling folly. In the boom years of 2006-07 nothing, it seemed, could constrain the leveraged buy-out (LBO) industry. In 24 months it pulled off deals with an enterprise value of $1.4 trillion, the equivalent, after adjusting for inflation, of about a third of all the buy-outs ever done. Thanks to the credit crunch, buy-outs have since become scarce: so far this year only $131 billion of deals have been announced, according to Dealogic. Yet those expecting private-equity executives to be cowering in fear of retribution will be disappointed. The mood remains one of almost hypnotic confidence.
Is this justified? On June 26th Chrysler, an American carmaker bought by Cerberus, a private-equity firm, in one of the highest profile deals of last year, felt obliged to deny it had filed for bankruptcy. Banks are selling loans made to LBOs at big discounts, reflecting wider fears of default. Other “mega-deals” that had not quite closed before credit markets froze last summer are suffering from a collective loss of nerve. Shareholders of Clear Channel Communications, an American media firm, will on July 24th vote on a revised offer with a lower price and debt level. The bidders for BCE, a Canadian telecoms operator, are still haggling over terms with their reluctant banks.
The Economist has examined ten of the biggest completed LBOs that were announced in 2006-07, accounting for a fifth of the total by value. Two are already home and dry. Blackstone, a private-equity firm, profitably sold on most of the property assets of Equity Office Properties within months of buying it. On June 5th buy-out funds run by TPG and Goldman Sachs sold Alltel, an American cellular operator to Verizon Wireless at a slight premium. But the condition of the eight others is less reassuring. In the latest quarter three of them suffered year-on-year declines in sales or underlying operating profits or both, mirroring the broader pressures on company profits. Under such conditions, the ability to make money for investors is one question; whether the biggest deals can survive with such huge debts is another.
Bankruptcy has been a feature of previous buy-out binges. Steven Kaplan, of the University of Chicago, reckons that about a quarter of the large deals struck between 1985-89 eventually defaulted. Today the eight mega-deals that are still in the hands of their original acquirers have balance-sheets that by any reasonable standard leave no margin for error. On a weighted-average basis, after allowing for capital expenditure, cashflow only just covers interest payments. Listed companies, even after excluding those in the booming energy and mining industries, have interest cover nearer to ten times, according to UBS’s World Inc database. If public firms are equipped to withstand a storm, LBO balance-sheets, it would seem, could barely cope with a summer shower.
Nonsense, say private-equity executives, who believe that they still have plenty of room for manoeuvre. Firstly, some of those firms bought in the big transactions have rapidly rising profits, allowing them to rebuild their interest-cover ratios. Hilton Hotels, for example, is performing ahead of its targets, buoyed by its exposure to growing markets outside America. Sales at Intelsat, a satellite operator, are rising at a double-digit pace. Alliance Boots, a European drugs retailer, confounded its critics by announcing a healthy rise in operating profits in June. Secondly, even those firms facing tougher trading conditions have flexibility, because they can cut capital expenditure. Were Harrah’s Entertainment, a casino operator, to cut capital spending to “maintenance” levels sufficient just to keep the business running, its interest coverage would rise from an estimated 0.8 times to a less sweaty-palmed 1.3 times. Freescale Semiconductor, an American firm, has already cut back investment.
Even more comforting, say private-equity executives, is the legacy of the extraordinarily generous credit terms they won before the credit crunch struck. Most of the eight remaining mega-deals have weak covenants and “payment-in-kind” arrangements that allow them to defer cash interest payments, in one case for up to one-fifth of the total. Some also have plenty of liquidity: Harrah’s has cash and unused bank facilities equivalent to two years of interest payments. If push comes to shove, buy-out funds could inject some of their “dry powder” (money raised but not yet spent) to pay down debt—providing the conflicts of interest between new and old investors could be managed. What is more, there is plenty of time before principal payments kick in: typically, five years or more. Stephen Schwarzman, chairman of Blackstone, argues that his firm’s acquisitions have “bomb proof” capital structures. By quoted company standards, that is an exaggeration. But at least the mega-deals do not look as if they are in imminent danger of going bust.
Survive but not prosper
If that is some comfort for their lenders, there is far less reassurance for investors in private-equity funds. Again, history is one reason for pessimism. Data from Cambridge Associates show that American private-equity funds raised during the previous boom years of 1987-88 and 1997-99 typically generated a median internal rate of return (IRR) of about 11%. That is poor given the high leverage that buy-out firms took on and well below the 20%-plus median returns for funds active in the dark days after the 2000 stockmarket crash.
Staggering under too much debt is bad for companies’ performance: capital-expenditure cuts can damage future growth and competitors may react by starting price wars (as Philip Morris, a rival tobacco company, did following the RJR Nabisco deal). And one of the tricks used to enhance IRRs in recent years, paying special dividends funded from even more borrowing, is no longer an option given credit-market conditions. Nor are valuations encouraging. The eight outstanding mega-deals were bought on a weighted-average price/earnings ratio of 24 times, well above where stockmarkets trade now. In some cases the share prices of quoted peers have tumbled as the outlook for profits has darkened.
Irrelevant, say some industry supporters. After all, investors in private-equity funds are typically locked in for at least five years and no one plans to sell now. Most of the mega-deals involved companies with high market shares and good brands: exactly the sort of businesses that can prosper in a downturn. What is more, it is argued, if mark-to-market losses do exist, they may not have to be recognised. Indeed, although notionally subject to accounting rules that require investments to be carried at fair value, private-equity firms seem to enjoy a degree of latitude that most bank executives would kill for. The disclosure remains hazy, but it appears that Freescale is the only one of the top-ten deals in which the carrying value has been written down much below cost.
Yet having a long time horizon does not make the present of negligible importance. Based on today’s outlook, just how bad might LBO losses be? One clue comes from two Dutch-listed entities, run by Apollo and KKR, that have invested part of their capital in their sponsors’ buy-outs. Their shares now trade at discounts of over 45% to the net asset values booked in the first quarter, suggesting deep scepticism that these investments are still worth what was paid for them.
That is not to say some private-equity firms will not have the last laugh. Historically the best time to invest in LBOs has been after what Mr Schwarzman calls “meltdown years”. Despite tricky markets private-equity firms have closed huge new funds in recent months. Investors must be hoping their cash is spent more wisely than in the recent past.