Sticking-Plasters of the Universe

The buy-out barons say the worst is over. They would.

In the half-century since private equity first appeared, the industry has produced stretches of great profitability, culminating in a spectacular run from 2002-07. During that golden age, private equity was charmed. Investors poured record amounts into the industry. Bankers did their bit by relaxing standards on credit. Nine of the ten largest buy-outs in history occurred between 2006 and 2007, averaging $30 billion each. Four-fifths of that was borrowed. Can private equity ever regain those glory days?

As a result of the crash the industry faces four big obstacles to recovery. Thanks to frothy equity markets, the industry is closest to overcoming the first barrier — exiting current investments. TPG this week offloaded its remaining shares in Debenhams, a British department store. Blackstone is reportedly planning initial public offerings (IPOs) for as many as eight portfolio companies and trade sales for another five. Kohlberg Kravis Roberts (KKR) recently filed for an IPO of Dollar General, a discount retailer, amid reports that it plans to float six more companies.

If successful, these exits will provide welcome cash to distribute to investors, easing fresh fund-raising rounds. But there are big questions over how long the rally can last (shares have dipped since a high in mid-October). And rising markets do nothing to help the industry solve its second problem, making new investments. Political sensitivities about private-equity ownership run high — witness ill-thought-out European attempts to regulate private equity and hedge funds. And surging asset prices have made it harder to find bargains.

Before the crisis, higher prices were easily addressed: buy-out firms simply loaded up on debt. That is no longer an option. The banks are husbanding capital. Debt is more expensive. Demand from collateralised loan obligations (CLOs), specialist funds that hoovered up leveraged buy-out loans during the boom, has largely gone.

The industry has been here before. When Drexel Burnham Lambert, an investment bank, collapsed in 1990 the industry lost almost all its financing overnight. Managers focused on smaller deals and weaned themselves off debt. A similar scenario is playing out again now. Blackstone’s $2.7 billion purchase of Anheuser-Busch’s theme-park business in October reportedly included $1 billion of equity. Silver Lake recently led a consortium of private-equity and venture-capital firms to purchase Skype from eBay for roughly $2 billion, almost all of it equity.

These deals involved managers purchasing a business unit from a larger firm. “Private equity will return to basics: smaller deals with more cash upfront,” says Brian Kaufman of Westridge Capital. That may help medium-sized specialist funds to shine. Managers have also set their sights on emerging markets, where their money goes further and growth is bubblier.

The private-equity industry does at least have plenty of cash to spend. Prolific fund-raising in the boom years has given firms more than $500 billion of committed but uninvested capital (or “dry powder”), the largest amount on record. But some of that money may no longer be available, as investors struggle to meet calls on their capital. And the industry’s third problem, its relationship with investors, will make it harder for many firms to raise new money.

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