1 You spent six years as an investment professional at Citicorp and DLJ Bankers Trust Co. in the 1980s. What are the biggest differences in the market now compared to your time as an investor?
The market is a very different place than it was 20 years ago. The first thing that’s different is that the amount of leverage in transactions is significantly lower than leverage in buyout deals during the late 80s. During the late 80s, these transactions were financed with almost 90% debt and 10% equity and today there is much lower leverage used in a typical buyout transaction. The other thing that’s dramatically different is the amount of equity that’s pooled and available for transactions today. In the late 80s there were many, but compared to today there were relatively few sophisticated participants in the buyout market. Today it’s just a crowded space with many, many people with very deep levels of experience. The debt markets have changed as well. Financing for leveraged buyouts today is really coming from a number of places, but especially from hedge funds, which are providing debt for private, asset-based loan transactions and for syndicated leveraged loan transactions. Hedge funds didn’t play in the debt markets at all 20 years ago.
2 To what extent are you participating in club deals?
I participate in a number of transactions that are structured as club deals, where multiple groups participate in an acquisition transaction. What’s difficult about them is that, in some cases, rather than all of the investors participating in the same security, we wind up structuring out deals with a layer of securities. That leads to negotiations between the providers of capital as they jockey for position within the capital structure. And so they’re paying increasing attention to governance rights, not only as it relates to the company itself but as it relates to the rights of the other co-investors, both from a governance perspective and a financial perspective.
3 What is the most disturbing trend you’re seeing in buyout transactions today?
So much capital has come into the market, both on the debt side and the equity side, that the prices of targets have just been bid up and bid up. Someone recently said that “nine is the new six” and “eleven is the new eight,” referring to transaction multiples, and that’s really true. Transaction multiples have expanded very significantly. That means buyout firms have to chase deals and ultimately accept lower returns on their investment while at the same time using increasing leverage. The higher multiples result directly in higher leverage and higher leverage results in increased risk to the safety of transactions over time. While we haven’t seen a downturn or any bankruptcies or real losses that have come along with that of late, it’s a possibility, especially if we have interest rate inflation over time. It just hasn’t happened as of yet.
4 What is the most positive trend you’re seeing in buyout transactions today?
A positive outcome of the bidding wars has been the recognition by buyout firms that in order to be successful they need to manage risk. Ultimately the best tool to manage risk is to spend the effort and energy on improving the performance of the portfolio companies. Many buyout funds have taken a very hands-on approach, hiring operating executives and others with managerial skills to provide their expertise to portfolio businesses. What ultimately comes from that is an increasingly stronger underlying business.
5 What do private equity sponsors need to know most about the increasingly complex nature of buyout transactions?
Competition requires specialization, particularly in the middle market. Buyout firms need to know how to do certain things and do them well. And that often requires either industry specialization or, in some areas, specialization in a particular kind of financing. It’s hard to really succeed as a generalist. Ultimately private equity firms are using their specialized knowledge to find businesses where they can do two things. One is improving the performance of the business over time because that ultimately translates into higher returns. Then, based on that demonstrable ability to improve performance of companies, they’re able to obtain attractive financing so that, again, they’re able to generate better returns. That financing is critical. There are so many participants in the market, but to the extent that the private equity sponsor is able to demonstrate a reason why they’re the best owner for a businesses the financing will come with better terms. v