What’s Going On?
The jury’s still out on how the market will respond to the credit freeze, so it’s unclear which LBO firm strategy will be the most successful in the coming years, said Hartley Rogers, chairman of funds-of-funds manager and advisor Hamilton Lane.
Opening the symposium, Rogers laid out three scenarios based on the three most recent occasions when the credit market seized up—in 1987 following the savings-and-loan collapse, in 1994 when mortgage-backed securities defaulted, and in 1998 after the Russian bond market cratered.
For Rogers, the current credit climate most resembles 1994, when the disruption was followed by a period of prolonged growth. That would favor quick exits and growth plays to take advantage of quickly rising equity prices, while big take-privates will still be too expensive and difficult to finance.
If the market turns out to resemble 1998—a probability Rogers estimated at 35 percent—that would be the worst possible environment. Large-market deals would still be difficult, hold periods would be longer and opportunities would flow principally to firms that specialize in turnarounds and deep operational improvements.
Lastly, if 1987 is the model—which Rogers pegged at a 20 percent probability—buyout pros can expect to scoop up companies at good prices, although investments will generally be harder to come by.
Nolan: The Contrarian View
When Leonard Green & Partners buys a company, the last thing the buyout shop wants is a distressed outfit or a turnaround opportunity. The firm would rather squire the belle of the ball.
“We marry well,” said Keynote Speaker Peter Nolan, a managing partner with the firm. “We pick companies that don’t need help when we get them.” Rather than blowing out a portfolio company’s management in favor of installing a new crew, Nolan said Leonard Green prefers to exit a company with the same CEO who was there at acquisition.
Nolan’s firm has carved out a contrarian place among the vast majority of shops that have tried to beef up their operating experience by hiring former CEOs and corporate division managers. Leonard Green also doesn’t send in a raft of consultants to micromanage the enterprise. “No CEO wants a 28-year-old kid from McKinsey coming in and telling them how to run their business. No one wants a former GE Six Sigma ninja who built jet engines coming in to tweak a retail shop,” Nolan told the audience at Buyouts West.
The firm’s sweet spot is retail companies and consumer and business services outfits. It tends to avoid companies that specialize in technology or telecommunications, Nolan said. Leonard Green has approximately $9 billion under management and is investing its fifth fund.
It’s Not Easy Lending Green
No one can escape blame for the dismal state of the credit market, according to debt specialists who participated in the symposium.
Even as the froth began to overflow, sponsors and underwriters alike kept adding to the pool of new issuances without thinking about how buyers of new debt would react.
“I believe the Street should have looked at a calendar,” said Mike McAdams of Four Corners Capital. “You suddenly drop a brick on one side of the scale.”
With the market pointing toward a downturn, it’s fair to expect a new round of defaults from LBO-backed companies. The coming cycle of workouts could be different from its predecessors because of the number and kinds of holders of paper. For example, the courts still haven’t sorted out the state of second-lien loans, and it’s unknown how patient hedge funds will be with troubled debt investments.
“Workouts consume the oxygen in the room,” said Thomas Klimmeck of Madison Capital Funding, and there will likely be more players drawing more air in the coming cycle.
Sharpening The Image
Finally, something the Service Employees International Union and a mega-firm can agree on: The buyout business hasn’t done a stellar job until now of presenting itself to the public.
John Adler of the SEIU, appearing at the Great Debates forum at Buyouts West, said Congress and others have pried into the dealings of buyout shops in part because they’re perceived as mysterious entities that generate big profits without returning much to the public.
Kelvin Davis, head of North American buyouts for TPG, agreed that the perception is real and said that’s a big reason his firm reached out to environment and labor groups before inking the deal to take Texas utility TXU Corp. private earlier this year. TPG didn’t want to run the risk of alienating an important constituency and wanted to prove that LBO firms can share the same outlook and interests with unaffiliated groups.
Monte Brem, of fund advisor StepStone Group, said that buyout firms have traditionally received a large portion of their fund commitments from pension funds that pay out to unionized workers. For that reason, LBO shops owe it to unions to make sure employees are better treated once their companies are taken over by buyout firms.
Deals Still Flowing In Tech
Going-private transactions have been one of the first casualties of the credit crunch, even in the technology space, according to buyout pros who participated in a panel covering trends in West Coast LBOs.
The panel consisted of a trio of tech investors—Chip Schorr of The Blackstone Group, Dipanjan Deb of Francisco Partners and Alex Slusky of Vector Capital—and a generalist, Frank Do of American Capital Strategies. As with most industry-related conversations these days, talk turned to leverage.
Despite the difficulty of taking a company private, buyout pros can still find value in public companies that have minimal analyst coverage, Deb said. Schorr said leverage is available, but that conditions in the marketplace look a lot more like 18 months ago, which he called “a very comfortable time.” Slusky mentioned that tech deals are somewhat immune to the credit freeze since they tend to be more heavily equitized; 40 percent of his firm’s deals, for instance, have used no leverage.
Resistance Meets Persistence
It’s easy to forget the many obstacles faced by early proponents of now-popular technologies—wireless e-mail, online shopping, Internet news, indoor plumbing. How could these pioneers tell that they were truly on to something worth sticking with? Just make sure the ultimate consumer sees value in the idea. That was one of the main messages delivered last month at Buyouts West by keynote speaker Barry Schuler, managing director, DFJ Growth Fund, and former chairman and CEO of AOL.
Back in 1992, Schuler worked for a company, ultimately acquired by AOL, that had developed an online shopping network. “There wasn’t a real Internet yet, so it worked on a CD-ROM and dial-up, but it was very much representative of how you buy things today,” Schuler said. “It had a search engine, so you typed in ‘blouses’ or ‘slacks’ and then it would compose the catalog page.”
Working in partnership with Apple Inc., Schuler traveled around the country trying to convince catalog retailers to sell products through the system. But they hated the idea that their wares (including prices, no less!) would be displayed alongside those offered by rivals. “I was singularly thrown out by every one of them,” Schuler said.
As it turns out, the more accurate predictor of success was the reaction of shoppers. “When we would show that very same technology to consumers at the time … they loved it. To them it was highly convenient. And that’s the key word that I have followed my whole life—convenience. If technologies make things easier, faster, better for consumers, for businesses, generally they’ll win.”
Complexity Arbitrage
Investing at inflection points in the lives of companies has served many buyout firms well. Mere mortals fail to spot the same opportunity a buyout firm does—and, voila, millions of dollars are made.
Investment banking giant Morgan Stanley now sees the entire buyout business entering its own inflection point. Speaking on a forward-looking panel at Buyouts West, Mark Bradley, managing director and global head of the financial sponsors group at Morgan Stanley, predicted that with leverage harder to come by buyout shops are poised to return to an investment style last fashionable in the early 2000s.
“They’re going to look for complexity arbitrage,” predicted Bradley. “It used to be that most private equity deals were deals that had a high level of complexity,” he said. LBO shops “looked for companies that were at inflection points—where there had been fraud, there had been a CEO change, there had been a change in technology—something that caused less sophisticated public market investors to flee from a stock and allow valuations to get to a level where, with relatively low levels of leverage, you could generate attractive returns.”
Given these new market dynamics, Bradley said, Morgan Stanley is spending a lot of time searching for “rescue capital” opportunities on behalf of its financial sponsor clients. Such deals, he said, can be found in more volatile sectors of the economy, including home building, financial services and technology.
For Success, Separate Price, Leverage
That Tiger Woods avoids shooting bad rounds is one of the less heralded reasons for his success on the golf course. Much the same can be said, on the investment links, of Alec Gores, founder, chairman and CEO of The Gores Group.
His firm always goes into deals making sure that the worst case scenarios won’t be so bad. As a result, over more than two decades of buyouts, The Gores Group has never had to take a company into bankruptcy, and, out of more than 60 deals, has lost modest sums on just two.
For Gores,one of four keynote speakers at Buyouts West, a big way to guard against hitting investment shanks is to avoid overleveraging companies. The Gores Group has only been leveraging about 50 percent to 60 percent of the purchase price of the companies it has bought, Gores said. And the firm has been careful not to let the generosity of lenders influence the price it’s willing to pay. “Price has nothing to do with leverage,” Gores said. “You really have to make sure you separate the two. Because if you can leverage eight times, it doesn’t mean you pay 12 times.”
LPs Look Downstream
When it comes time to make their next round of capital commitments, limited partners will be looking for managers with a cohesive team and a clear investment strategy, according to a panel of limited partners. The LPs on the panel, who tend to invest in small and mid-market buyout funds, said they are also on the hunt for emerging fund managers and those that specialize in turnaround and distressed vehicles.
Pomona Capital Partner Tom Bradley said he expects his firm’s investments during 2008 to shift away from mega buyout funds and toward middle-market and distressed vehicles. Barry Gonder, a general partner with Grove Street Advisors, said his firm will maintain its focus on smaller buyout shops and continue its search for emerging managers.
Oak Hill Investment Management prefers to be the anchor investor in limited partnerships, according to James Hale, a partner. The firm wants a small, focused portfolio comprised of managers who have operational expertise, Hale said.
Peter Martenson, a director with Macquarie Funds Management, said he looks for general partners with a cohesive team, a solid track record and a clear investment thesis. “If it can’t be explained to us easily, it probably won’t work,” he said. The firm’s global private equity portfolio, which totals about $2.5 billion in assets, is invested 50 percent in North America, 25 percent in Europe, with the remainder spread across Asia and Australia.
Adjusting To A New Landscape
Four buyout pros brushed off their crystal balls to give a glimpse of the future to the audience at Buyouts West. Larger equity checks from buyout shops, a sluggish deal landscape for mega funds and the disappearance of covenant-light deals are just some of the developments taking shape in the wake of the credit crunch.
Banks that underwrite buyout deals will now insist on firm commitments and solid deal terms because they’ve been stuck holding the debt they used to syndicate out, said Mitchell Cohen, a managing director at Hellman & Friedman. That said, any bad blood between banks and the buyout firms that left them holding debt from highly levered deals seems to have been washed away. “Bankers are coin-operated,” Cohen said, quoting an earlier panelist. “People get over it quickly.”
It’s such a competitive environment that fee-reliant banks can’t afford to write off a firm permanently, but lenders will be more selective about the deals they work on, according to TA Associates Managing Director Jeffrey Chambers.
Hedge funds may also play a bigger role in providing liquidity, according to Kyle Ryland, a managing director at Silver Lake. He said we’ll see “a tale of two markets,” as middle-market deals continue to get done while mega-deals don’t. Steven Liff, a managing director at Sun Capital Partners, said he’s seeing a growing number of large buyout funds dipping down into the middle market. He also expects to see buyout firms write larger equity checks for deals since banks are scaling back on the amount of debt they’ll provide.
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