What is Happening?
No question the buyout industry has been suffering. Symptoms of ill health in this otherwise popular asset class were clearly visible about 24 months ago. Actual rates of return on invested capital began to dissipate by early 2000. By mid-2000 the broader private equity boom began to decline of its own weight, a downdraft further accelerated by monetary policy, credit rationing, higher labor costs, a faltering stock market, higher energy prices and a collapse of the high yield market.
Deal volume for the middle market (companies valued at $25 – $500 million) is down 40% year over year. Market-wide, 2001 figures indicate a 25% drop in LBO transactions compared with the same period in 2000 and a 48% decline compared with 1999 results. Measured by dollar volume for the same period, the decline was 37% compared with 2001 and 65% compared with 1999. Just 23 leveraged investments totaling $1 billion occurred between July and September of 2001 -arguably the lowest level of activity ever recorded on a quarterly basis. In 1999, the average corporate merger or acquisition was valued at $454 million. That figure, at the height of the industry’s prosperity, compares with an average deal size of just $61.3 million in the second half of 2001. And finally, the total value of all corporate mergers and acquisitions for last year totaled $1.6 trillion versus $3.4 trillion for all of 2000. Most startling is that we find that no more than seven-to-eight investments have been made over the last 18 months by a group of leading buyout firms that include Fox Paine, Behrman Capital, The Carlyle Group, KKR, Cortec, CDR and Thomas H. Lee.
Performance data from the buyout community is turning downward and will worsen as accounting rules necessitate write downs and buyout shops reconcile themselves to incurable portfolio problems. Many of the country’s leading buyout firms disclose, sometimes proudly, that they haven’t done a deal in 12 to 18 months. That may be good for limited partners, but profit margins for general partners have shrunk under the combined effects of less deal making, diminished asset values, and fewer realizations. Capital deployed from buyout funds over the past 2 and a half years and current economic hardships badgering investments made in prior timeframes will support substandard LBO returns for the next few years. Fundraising hardships will result in the disappearance or consolidation of marginal buyout platforms in the lower and middle marketplaces especially.
Why is it Happening?
Years from now industry observers will point to 2000 and 2001 as a reminder that private equity is, in fact, a long-term investment strategy. Dealmaking is increasingly scarce because of a widening spread between seller expectations and valuations that make economic sense to buyout investors. Declining stock prices discourage public companies from using stock as currency for acquisitions. Fewer quality investment products are coming to market, and once secure exit strategies are in disarray.
The economy is weaker than anytime since 1982. Of particular concern to buyout investors is that the commercial default rate has approached 4%, consistent with conditions at the peak of the last recession. More significantly, loan defaults will total $100 billion in 2001 more than doubling the prior year’s total and nearly four times the $23.6 billion in defaults at the peak of the last recession. A disproportionate number of these “busts” featured leveraged capitalizations. The manufacturing sector has been in a deep recession for 24 months and other segments of the economy are following suit, most notably the technology, telecommunications, transportation and hospitality industries. Credit rationing at the behest of the Comptroller of the Currency is having a devastating effect on an industry whose life’s blood is rooted in liquidity. We have witnessed an extraordinary consolidation of 50 major U.S. banks to just seven banks over the last 10 years. All this is adding up to a credit crunch of record proportions for buyout investors as they unsuccessfully grasp for leverage geometry, which is essential for heightening returns and mitigating risk for investors.
The sharpest drop in industrial output in 20 years has occurred because the liquidity squeeze has forced companies to shrink inventories, layoff workers and extend accounts payable. Traditional sources of equity are defecting from the buyout landscape because of an uncertain economic outlook, allocation imbalances wrought by a stock market devaluation, and safe harbor instincts deriving from the varied implications of the Trade Center tragedy. A deep high-yield market is but a wistful memory. Taken as a whole, these factors add up to an LBO nightmare.
Today’s Private Equity Challenge
Buyout investing is a less certain and more complex investment discipline than ever before because franchise profiles over a broad front are inherently less durable. Moreover, investment managers and banks fret over “earnings visibility.” What, indeed, are investors to do as they perspire over what level of earnings to apply anemic credit multiples to? Punishing waves of disintermediation continue to roil over markets once considered secure because of breakneck technological change and global competition. Product cycles and pricing power are hard to measure, placing a premium on portfolio managers with acute operating experience.
We believe the buyout market is coming back. Predicting comebacks that are sure to materialize is less important than calling the timing of the comeback. There are mountains of “dry powder” out there as valuations continue to decline and sellers appear more motivated. The only missing piece of the puzzle is a lending market for which the party must wait.
Timing the Bottom
What will cause the senior debt market to open up? Encouragement from the Comptroller of the Currency and Alan Greenspan wouldn’t hurt. Watch for the revival of the high yield market and more particularly the prosperity of high yield mutual funds as investors recognize the economy is near bottom and that high yield credit is less likely to jeopardize their principal. When this happens, investors will hand over considerable amounts of capital to high yield investment managers, which in turn will arouse the competitive juices of senior lenders. Watch carefully through the pipeline to the revival of B-rated credits. This development would foretell a shift in risk tolerance that would classically result in a competitive response from senior lenders.
Finally the climate may be turning. Historically the very best LBO and private equity returns originated from investments occurring in the wake of recessionary pressures and a concomitant liquidity crisis. We believe that we are finally approaching a time frame in which promising franchise opportunities will be captured on the basis of attractive valuations and sensible terms.
Here are a few recent changes on the horizon, which suggest the bottom may be near. Remember though that investors should care less about timing a bottom just right than about avoiding timing it just wrong:
– Senior lending practices have conclusively migrated from cash flow to an asset-based basis as banks lose faith in earnings projections. This phenomenon usually signals the base of a trough.
– Companies are coming to buyout players directly and more often than any time in the last
two and a half years. Reluctant sellers once content to wait out the return of a surging stock market to support higher valuations are concluding that lower prices may be around for a long time. As a consequence, seller psychology is changing. Buyout players are seeing more value in growth markets, which comes as a result of capital needs to address various liquidity objectives that cannot wait any longer. Most often this is a sure sign of an emerging buyers’ market.
– Earnings visibility will improve along with the economy. In this regard it is hard to ignore the positive effects of a massive inventory liquidation occurring throughout 2001. Also hard to ignore are the highest consumer sentiment figures in 12 months and a dramatic decline in new unemployment claims in December and January. Rate cuts and massive government spending initiatives in 2001 are about to leave their mark.
– An increasing number of anecdotal factors have begun to warrant attention. There is more talk than ever about “creative deal structure.” Usually just about the time when dealmakers are taking bows for “creative deal structures,” they’re not needed any longer. Furthermore, it has been our experience that the best deals are made in the worst of times just before an upturn. And finally, consider the “Porsche factor.” Four times over the past month I have heard of cases where a 30-something CEO-entrepreneur, usually leading a mid to late stage venture or development deal, has finally resigned himself or herself to a sale of the Porsche. Experience tells us that when the Porsches start flying rising fortunes in private equity are never far behind. Alas, on this final cornerstone of statistical probability, we are betting on buyout recovery sometime soon. P.S. We are not yet betting “the farm.”