Many media headlines have been dedicated to the ability of private equity to buy just about any company, almost regardless of size these days as private equity firms have raised ever-increasing amounts of money. Last year alone there were 17 buyouts funds that raised more than US$2bn and combined those 17 raised US$78bn. While a staggering amount of money in itself, the leverage that large buyouts, as highly cash generative businesses, are generally able to cope with means the equity component put up by the buyout firms will range from 20% to 35%, so the money on the table to spend could be as much as €390bn.
Even given these staggering figures, to buy a €1bn plus business, and €3bn, €4bn up to €17bn as we have seen last year, requires that large buyout funds club together with other large buyout funds. If they didn’t they’d be flouting the terms of their limited partner agreements, which, like any good fund investment strategy, places a limit on individual investments within the fund so the fund has a good chance of being appropriately diversified. “The size of buyouts being done today, where there is €1bn equity on the table, means it’s quite likely you will have a club, just for the risk management of any fund,” says Serge Raicher of Pantheon.
But buyout funds are used to calling the shots on investments. Every investment agreement places stringent restraints on what management can or cannot do with a business while under the ownership of the private equity firm, capex controls, voting rights and so forth are always tied up in venture capitalists favour.
Given the absolute nature of that control, and the nature of the people wielding it (typically highly intelligent, creative individualists) it’s hard to believe sharing that control will be easy and easy to see how fraught this situation could become once control is divided. Divided by two might seem simple enough, although logjams are just as severe when two parties disagree as when three, four or five or more come to an impasse. (See table on next page for details of the number of buyouts in the €1bn+ range in Europe announced last year that attracted more than one private equity backer.)
“What’s the difference between a club deal and having LP co-investors? Do I want to bring LPs alongside me who are more passive or another GP who can help in the work?” says Raicher. This is an important question, one that some firms have made clear decisions on and established relationships with some of the larger private equity groups within pension funds and other institutional investors who have the ability to work to tight deadlines and have the appetite for direct investments. But in truth having both the qualified staff and the appetite are fairly rare so these relationships don’t crop up often. It suits the more individualist buyout firms since the limited partner while investing on the same terms is a follower rather than a leader and so will comply with the strategy set by the buyout firm from everything up to and including exit routes.
But assuming things don’t go wrong, the returns for these deals should materialise, but it’s too early to say whether they will be enough to justify the considerable capital allocated to them. What you pay going into a mega buyout deal as a private equity club or consortium member is a topic for heated debate. Some argue that by clubbing together the private equity firms allow themselves to be bid up on price as the (commission focused) investment banks start salivating about the increasingly large pot the combined firms have to drawn on. The buyout firms that have participated in these deals argue that by clubbing together on these deals, they are ensuring the exact opposite in that they quickly eliminate the competition, and with reduced competition for a deal, auctions run out of steam in terms of their ability to elevate price.
Surprisingly, given that a lot of information about these mega bids enters the public domain, it’s actually quite difficult to prove who is right on this one. Entry multiples would seem an obvious place to start, looking at whether higher multiples are paid at entry for club deals than for non-club deals. But this could prove to be a moot point if you don’t have many deals in the sector of that size happening in a year. Plus there are always different dynamics that can be pointed to in order to explain why certain outcomes prevailed. And is there a case for only including deals that involved some private equity bidders, regardless of whether or not they were actually the successful bidder?
Equally frustrating is the issue of whether these deals will make the buyout firms’ limited partner investors money. It’s not just a matter for debate what sort of criteria to include, but impossible information to get hold of because all private equity returns are disclosed on a non-disaggregated basis specifically so that individual investments can’t be identified. While this is laudable when an investment is active and ongoing, evidenced by the numerous cross state rumpuses caused by Freedom of Information Acts in the US, after the fact, the private equity industry shouldn’t really go in for these sort of self protectionist measures.
This is because they are essentially denying their investors the opportunity to debate what worked and what didn’t so they can decide how to allocate their funds in the future. Anecdotally, for instance, many point to the last time European private equity firms clubbed together to do larger deals than they would otherwise have been able to do in the early 1990s. “Primarily [club deals in the early 1990s] were done for scale. They add operational efficiency, and different leads taken by different groups,” said Jesse Reyes, private equity consultant, prior to his joining Crane Capital Associates late last year.
The general view that it was a disaster sometimes from an operational point of view and in many instances from a financial returns perspective too. Unfortunately lessons, if there are lessons you can take away from such complex and individualistic cases, weren’t learned because the private equity industry suffered a downturn in fund raising and economic slump during the mid 1990s that meant these deals weren’t repeated until the last two years or so. “Ultimately none of this is about money. It winds up being how do you run the shop afterwards. In the late 1980s and early 1990s there was a lot about unlocking value, whereas it’s about financial engineering in the late 1990s,” says Reyes.
“The current club deals remind me of piranhas in the Amazon; everyone taking a chunk no real clear strategy. But they are not doomed to failure if there is an alignment of vision and interest,” says one market observer. Many have tried to examine the club or consortium deal in the venture capital space, which has proved both fruitful and an accepted standard in the way young companies are run.
“Clubbing in venture is different because it’s a means of validation of interim rounds’ pricing,” says Raicher. Others point out that the issue of why people draw together in the venture space is clear, usually driven by a particular expertise in growing young companies within a specific technology or life sciences niche, money being almost a secondary consideration. And perhaps it’s fair to argue that if you invest in young companies you expect a bumpy road ahead and that there may be several projections and versions of business plans produced in a each year that the investment is held as the company responds to the challenges it faces in its particular market. The same is probably not true of huge multinational enterprises being bought by buyout firms. The investee companies face heavy interest repayment schedules, endless banking covenants to avoid breaching and any change in the market significant enough to cause a business plan to be rewritten is likely to be the subject of much debate among its private equity investors.