The Buyout Industry: The Going Gets Tough –

Battered by portfolio problems, fundraising impediments, management fee criticism, a general decline in investor confidence and shrinking expectations, buyout players have seen better days. Unfortunately, an objective assessment of changes to the LBO investment landscape, many of them permanent, suggests that the conditions and performance results underlying the industry’s once-fabled distinction as an asset class now belong to the ages. In truth, the buyout business has probably delivered 12 consecutive quarters of deal making, which on average, will yield negative returns to their investors. Rolling, 3-year capital returns have declined from 18% in 1998 to less than 0% today.

The sheer scope and magnitude of challenges facing the buyout industry include, but are not limited to, heightened operating risk, declining leverage geometry, savage forms of disintermediation and a backdrop of economic factors less promising to risk adjusted returns than anytime in recent memory.

First and foremost are prevailing leverage dynamics. According to S&P’s Portfolio Management Data, LBO transactions in 1993 garnered a purchase price multiple of around 7.0x EBITDA with average debt/EBITDA of 5.2x. So a $500 million acquisition in 1993 would require an equity stake of 25%, and a 2.7% annual growth in EBITDA in order to generate a 25% IRR assuming the exit multiple remained at 7.0x. The same $500 million acquisition in 2003 would price out at 6.3x EBITDA and require a 41% equity stake necessitating EBITDA growth of 9.1% per year to achieve a 25% IRR. Consequently, fund managers in today’s market must embrace higher capital risk and engineer more than three times the rate of intervening EBITDA growth necessary to generate the same IRR as in 1993. From a theoretical perspective, future IRRs can be gleaned from prevailing market conditions. EBITDA growth aside, LBO returns are simply a function of transaction leverage, or average debt as a percentage of purchase price. In any investment year, this number offers a good indication of future IRR, assuming no multiple expansion. Over the past decade, average transaction leverage has fallen from 75% in 1993 to around 59% today.

Going forward, LBO equity growth must be achieved without exit valuations facilitated by a riveting tailwind in the form of an explosion in GDP growth, skyrocketing productivity gains, stable-to-declining interest rates, burgeoning consumer confidence, high levels of industrial production and a stock market gone mad. Before leaving the subject of interest rates it is worth noting that we haven’t seen interest rates at current levels since the early 1960s before the advent of the buyout business as we know it. The industry is presently operating in parallel with the lowest interest rate environment in its history. If the coupon on the 10-year note rises to the higher end of a recent Wall Street Journal survey to 6.70%, it will constitute the most rapid increase on record since 1984. In any event, it is reasonable to assume that very few buyout executives are experienced with the percentage gain in interest rates which promises to unfold over the next 36 months. If rates don’t rise to anticipated levels, it will only be as a result of disappointing growth in GDP and/or conditions resulting in a dysfunctional economy.

This time around, there is no bounty of lumbering under leveraged balance sheets to prey on. There are very few outwardly dumb operating models resulting from a gross lack of corporate discipline, and a short supply of low lying fruit associated with unspent consolidation opportunities, wholesale expense reductions and sweetheart convertible deals owing to the absence of competing corporate finance alternatives.

Together with the receding charms of buyouts’ “golden age” is the increasing likelihood that America’s economic downturn is not yet over and that a protracted period of anemic growth or even a contraction of output lurks ahead. Merrill Lynch refers to this prospect as “Post-Bubble Trouble.” Household income, which hadn’t posted a decline since World War II, will drop for the third consecutive year in 2003. Corporate balance sheets are more highly leveraged than anytime in 50 years. Alan Greenspan is quick to remind us that in periods of transition from unsustained to more modest rates of growth, an economy is obviously at increased risk of “untoward events.” Energy prices are worrisome in this regard.

Finally it is our view that the most deadly fly in the ointment for buyouts are New Economy operating challenges of the type that will severely test the mettle of every portfolio manager who hasn’t yet escaped to Aspen, Colo. We are talking about a whole new world of hurt related to increased integration complexities, rising capital costs, shorter product cycles, channel conflicts, and market-pricing and infrastructure displacement wrought by technology and global competition. The fact is that acquisitions have become an increasingly risky business. The majority of recent mergers have yielded fatal results or lived long enough to debase the founding expectations of their creators. The big deal marketplace has become so efficient that the lion’s share of the upside now resides in operational improvements and a “24-7” creative devotion to market positioning and timely exits.

Better prospects for LBO returns are more clearly evident in the lower reaches of the market with acquisitions priced at $100 million or less. Here lies a truly inefficient asset class with immense opportunities for active management and more favorable leverage. But for all sub asset classes, large and small alike, it’s getting tough out there. Selective purchasing and “pin-point” pre-closing due diligence are more important than ever before. Down-range strategic thinking and shorter holding periods as a means of truncating risk are of increased importance to succeeding in this business. Clearly rationalized exit strategies, defensive capitalizations and unambiguous value drivers will all combine to get the job done with more certainty. And finally the premium accent, more than ever before, is on an “all star” management team whose fate is carefully aligned with the people they serve. All of this and more will be necessary to achieve results satisfactory to increasingly wary investors.

Despite the storm clouds, the buyout industry is far from discredited as an attractive alternative asset class. The industry’s fundamental underlying investment characteristics will endure to result in predictably higher returns than stocks and bonds after fund managers dribble out a significant outstanding balance of red ink. But the “field of dreams” for buyouts is smaller than before and more perilous for a combination of operating challenges unmatched by any other since the dawn of the industry.

Michael Dailey is president and CEO of Dailey Capital Management, L.P., a private equity investment firm he founded in 1998, with offices in Southport, CT.