Mega funds, mega changes

It’s been a torrid two years for private equity’s top players. After debt started drying up for deals at the end of 2007 and then almost completely disappeared following the fall of Lehman Brothers, the ability to buy large businesses and leverage them up to provide the kind of turbo-charged returns their limited partners had become accustomed to also dissipated.

Coupled with this, exits vanished overnight. The fall-out from a lack of distributions struck the industry immediately, as many LPs found they had their own over-allocation and over-commitment issues to deal with: the crisis at SVG Advisers prompted a fund reduction at Permira (where SVG was by far the largest LP), Candover saw its listed vehicle funding model savaged and TPG took the pre-emptive step of cutting the size of its latest funds.

Then came the problem portfolio companies. With many saddled with way too much leverage, private equity houses have spent the last year working through their portfolios, cutting costs, rationalising and attempting to refinance where possible.

One of the biggest European casualties has been PAI Partners, an establishment name in France that most in the market thought was solid as a rock. Faced with a number of problem children in its portfolio – such as property company Kaufman & Broad, as well as its disastrous negotiations with lenders to roofing specialist Monier, which resulted in PAI having to walk away from its investment – plus the departure of two key figures Dominique Mégret and Bertrand Meunier, LPs have lost patience. The latest news on the firm is that LPs have demanded a 70% reduction of its latest €5.4bn fund.

It’s all a world away from 2007 when Carlyle co-founder David Rubenstien was predicting that the US$100bn buyout was just around the corner.

Yet, given the difficulties that firms of all sizes have faced, it’s surprising that there haven’t been more bust-ups. Clearly, there have been changes at the top of many firms as the old guard have either decided to step down to make way for fresh blood or have been pushed – Guy Hands is no longer at the helm of Terra Firma, Damon Buffini has relinquished his chairman’s role at Permira and Candover’s Colin Buffin has left, for example. But the industry as a whole has survived relatively intact.


So, now they have had the chance to review and regroup, what’s next for the big guys? Well, still a lot of sifting through portfolio issues. “Large funds are generally extremely busy with their existing portfolios,” says Ralph Aerni, chief investment officer at SCM. “I wouldn’t be surprised if we saw more reductions in investment personnel and increases in the number of operational partners. The US houses are generally better than the European ones in this respect – they have a long way to go before they reach US standards.”

The prospect of smaller fund sizes also looms large. Hellman & Friedman has recently raised US$8.8bn – an impressive amount in the light of market conditions, but substantially lower than the US$13bn it had originally raised in provisional commitments before the crisis hit. And many others may not be quite so lucky. “Larger firms will come down in deal size, but many will argue that they still need as much capital because they will have to put more in – the debt isn’t available,” says Nigel McConnell, managing partner at Cognetas. “But the reality is that they are unlikely to raise as much capital as they did in the recent past.”

“My assumption is that most of the large buyout firms will raise half the amount of capital for their next fund that they raised in 2005 and 2006,” says Aerni. “This has as much to do with LP constraints as it has opportunities on the ground and the availability of leverage. A large commitment three years ago was US$1.5bn; now it’s more like US$500m. Very few LPs can write a cheque above US$100m now.”

It is probably just as well. Few see the debt markets coming back any time soon, so larger deals will continue to be thin on the ground for private equity. “It’s hard to make confident predictions right now,” says Neil MacDougall, managing partner at Silverfleet Capital, which backed German sausage skin casings maker Kalle for €212.5m – a not inconsiderable deal size for private equity in today’s market. “The regulators haven’t yet decided what the right amount of regulatory capital is that banks should hold. As a result, banks don’t know what their cost of capital will be and so it’s hard for them to make big lending decisions.”

There are also now fewer banks with leveraged finance teams and many of these are taking the view that there is little point in dedicating resources and effort to working on mega deals when they probably won’t get past the start line. “The banks that are left in the market are not saying that they won’t fund large buyouts, but larger deals have a lower likelihood of getting completed due to overall liquidity restrictions in the market,” says Nick Soper, head of debt advisory at Investec.

“How big can deals get?” says MacDougall. “Can you get together a £300m facility? Probably not for a purely domestic business. In the UK, for example, you only have around six banks that are active and each of them will only want to hold a maximum of £30m.”

There’s also little prospect of the institutional money, which flooded the market before the crisis, coming back – in Europe, at least. “I’m not hopeful of a return of institutional investors to the debt market.,” says Cognetas’ McConnell. “CDOs and securitisations have now gone and won’t be back for a decent chunk of time. Private equity is going to have to live with the amount of debt that banks are comfortable holding.”

It may be that we see a return to larger deals over the Atlantic long before it happens in Europe. Over the summer, the high yield bond markets started stuttering back to life in the US, for example. No sign of that here. “Larger buyout transactions will get completed, although this is more likely to happen in the US than Europe because funds there are able to tap capital markets for finance (as opposed to banks in Europe),” says Aerni.

Tooling up

So where does that leave Europe’s large houses? There are still deals that can get done, say some. “What we’re seeing now is a cyclical trend that has happened before,” says an insider at a large European buyout house. “We’ve had debt crashes in the past, albeit not of this severity, when leverage has been highly constrained. The point to bear in mind is that large LBOs are simply one kind of deal – there are plenty of other tools in the private equity kit.”

All-equity deals have already made an appearance and some observers believe we will see more of them, particularly now that it seems that the worst of the crisis has passed and there is greater visibility on many companies’ performance.

“We’ll see more vendor-financed deals and more all-equity deals that can be refinanced at a later date when markets re-open,” says SCM’s Aerni. “We saw these in the last downturn in 2002 and they have performed well on the whole.”

However, many will proceed with caution. “You need to be able to make reasonably strong growth assumptions to make all-equity deals work,” warns McConnell. “We have seen some, but not as many as there could be. You’re seeing that people like the idea based on a back of the envelope calculation, but when they investigate further and factor in refinancing risk, the numbers just don’t stack up.”

And then there is the strategy of buying into companies that already have debt. In some instances, these may be privately-owned businesses, but it may be that we start seeing more large secondary buyouts in which incumbent banks decide to roll over their debt partly because they will get better terms and also because a new injection of equity will improve the balance sheet position of the business. The announcement by players such as Permira that they are looking at floating a number of their portfolio companies is, as one observer put it, “tantamount to putting up a for sale notice outside. They know that other houses will be interested in these companies and, while they may end up floating some of them, a number of them could well go to private equity.”

Some are taking the build-up approach in which equity (and possibly leverage) can be deployed over years. It could be a smart approach in an environment like today’s when valuations are down. “The larger buyout houses are looking at deals in the £200m-plus category now on the premise that they can expand them using a significant M&A strategy,” says Gareth Taylor, director at Investec’s private equity practice.

In a similar vein would be the idea of working with companies in a kind of joint venture arrangement. “There is a role for private equity houses to partner with listed and unlisted companies to take advantage of depressed valuations and weak competitors by making acquisitions,” says the large buyout house insider.

The other option, of course, is to offer LPs co-investment opportunities as a means of financing larger transactions. And it may be that we see some deals get financed this way. But as long as there is an issue with LP liquidity, a raft of co-investments seems unlikely.

All of these options hark back to a time well before the heady excesses of 2006 to 2007, when the capital available to the industry was scarce, as it is now. They are predicated on transforming business (and buying cheaply) rather than relying on leverage. As a result, some believe that private equity across the deal size spectrum is going back to its roots.

“We’re seeing a return to what private equity is supposed to be – a strategy of driving businesses operationally, rather than buying companies, leveraging them up and relying on financial engineering,” says Taylor. “It’s not that the model is broken, just that it is returning to its core values.”

Until the next time, that is. “There is an expectation in the firm that larger deals will get done with leverage – these represent good business for banks, after all,” says the insider. “When confidence starts returning, banks will start coming in aggressively for the right deals.”