Jeff Matthews isn't the only one predicting a shake-up in private equity. But then, that's easy since "private equity" is a pretty expansive term. Depending on the proclivities of the person you ask it may or may not include hedge funds, may or may not include venture capital, may or may not include real-estate partnerships, may or may not include mezzanine funds, etc. etc. etc. I'm not particularly qualified to comment on anything other than buyouts and hedge funds (as those are the firms I have direct experience with), and I might not even be particularly qualified to comment on those, depending, again, on the proclivities of the person you ask.
Peter "The Informed Observer" Cohan joins the fray in a pair of scribes, the first back on the 2nd of August, wonders if private equity is "long in the tooth," echoing the arguments of (rising interest rates, too much cash, tough to find deals) and even sounding remarkably like Jeff Matthews' same-day missive I referenced here yesterday- right down to the dangerously inductive logic used to draw from one lawyer's quote on the Phillips deal the conclusion that firms are "stretching for deals," and a particularly interesting, if historically miopic, view; as if "private equity" (which here I take to mean buyouts, as only buyouts are used for examples) is a new invention without an active history over the last 30 years, two boom-bust cycles under its belt already and tendrils going back to the 1960s. (Much further if you start looking at original "boot-strap" deals).
HCA is mentioned also, presumably to support this "stretching for deals" theory, but the only evidence given in that context is that debt to EBITDA ratios of the company will soar by the rather vague figure of somewhere between 200% and 600%. (Quoting the Debt Bitch: "Of course they will, it is an LBO, duh.") There is, the argument goes, therefore less "margin for error." Given the similarities to the Jeff Matthews piece, I sort of wonder which one was actually written (as opposed to "published") first.
I notice also that none of these missives mention the likes of J. Crew (which is certainly at the high end of LIPOs, actually managing credit rating upgrades after submitting itself gracefully to the gentle ministrations of the public and sitting today, as it does, nearly 30% above its initial offering price).
Cohan follows in a penning dated August 5th citing an Alan Abelson article in Barron's that happily cites him in order to jump on the shake-out bandwagon. Curiously, in this post Cohan refers to the "August 7th" Abelson article, even though the post he does it with is listed as published on August 5th. I'm not a huge Barron's reader so I don't know how well their publication dates actually match reality, but this is certainly somewhat curious and either Barron's is careless or Cohan is a time traveler. I suspect the former because the later would beg the question "why is Cohan wasting his time blogging?"
Completing the circle and reminding me once again how inbred financial "reporting" is, Cohan cites the Bloomberg HCA article by Rubinroit, which an insightful Going Private reader adroitly deconstructed last week, to pulls his facts for the HCA deal. That posting on Going Private prompted another Going Private reader, who wished to remain comfortably anonymous, to wonder in a highly detailed and example filled email if Rubinroit's job description was merely to transcribe for Bloomberg S&P's Leveraged Commentary and Data service articles (usually written by Chris Donnelly) and then a third Going Private reader in email again to question (this time with no small amount of vitriol) the facts in the Rubinroit piece. Then a fourth reader chimed in via email to comment in the same vein on the HCA deal, and Rubinroit by proxy, but he/she asked not to be quoted. I haven't read enough Rubinroit yet to have an actual opinion on the topic of his reporting prowess but Going Private readers seem to have formed a consensus of sorts. Shame on me anyhow, as I had cited the Bloomberg piece somewhat blindly and neglected the much superior and well researched July 25th work (subscription required) by The Deal's debt master, Vipal Monga that, interestingly- because she never has anything good to say about anything- meets with the Debt Bitch's seal of approval. "He gets it," she says. It must be love.
Far from "a stretch," Vipal said instead of the HCA deal:
HCA's financing depends on a successful closing of the deal, which is expected in the fourth quarter. The agreement between the buyout consortium and HCA allows the company to solicit superior bids from third parties for 50 days, and the hospital group plans to search actively for higher bids.
Although there have been no confirmed reports of other bidders contemplating jumping in, one source close to the deal said initial interest in HCA from other mega-buyout firms has been high. That's not surprising, considering that the proposed deal is modestly valued, at 7.8 times HCA's Ebitda in the 12 months ended June 30, well below the double-digit multiples that have become common in today's sizzling buyout market.
Setting aside for a moment the accuracy or non-accuracy of Matthews, Cohan and Abelson, (Vipal must be right if the Debt Bitch likes him) or if we consider 7.8 times EBITDA "modestly valued" let's consider what a "shake up" in private equity looks like. And by "private equity" I mean the rather limiting definition of: "LBOs."
My own belief is that there is a size beyond which buyout funds stop being "pure" buyout funds. Purity is in the eyes of the beholder, of course. My belief here is not original, but rather formed after a magnificent conversation with David Jaffe of Centre Partners who, referring to the point where buyout funds get unwieldy, quipped, near as I can remember it, that "$750 million is about the right size." I didn't believe it then, but I remembered it. By April, I believed it. Back then I mused:
Didn't we learn in the 1980s that unfocused conglomerates don't work particularly well? Why are we running down that road again, with hedge funds, with Google? Management fees, perhaps? We are long past the point where the management fee just barely pays the bills at a fund and you have to find upside to get wealthy. The incentives to bloat assets under management are simply too significant now, I think.
Buyout funds were designed and have every internal incentive, save one that I will address in a moment, to be smaller, focused and disciplined. They are long-term return vehicles with a variety of golden-handcuffs to allow for (indeed, require) that rarest of qualities in investors today, liquidity-less patience. The patience to endure years of little liquidity in search of value. Larger firms are poorly suited to do the kind of deals I would call "pure buyouts." Buyouts with a turn-around component. Buyouts that look to their management talent to provide value, not just to leverage and financial restructuring. Focused firms. That is not to take away from the accomplishments of larger firms. There are many. But the opportunities for those firms to shine are likely to be the first to dry up.
The misplaced incentive I refer to is, of course, the management fee. The "2" of "2 and 20." 2% of assets under management which go to the fund manager, in theory, to support infrastructure until liquidity events get everyone paid (rich?). And getting rich (the 20%) is contingent on performance. 2% has, with larger funds, become more than just infrastructure support. Moreover, when you start seeing $5 billion, $7 billion and $11 billion funds, 2% looks downright silly. Certainly, funds are not scaling their infrastructure up in a linear fashion after around $1 billion in managed funds. That 2% looks more and more like pure "bonus money." And bonus money not contingent on performance, only on fund raising capacity. Suddenly, you have an incentive problem (the incentive is to raise a lot and develop only limited infrastructure) combined with a last round problem. Who cares if the $11 billion fund folds. After 7 years they've pocketed up to $1.5 billion just in management fees. That takes some of the sting out of being unable to raise $22 billion the next year because of low IRRs.
In my view, club deals and "mega deals" have become mandates on capital structure, not "value added buyouts." LBO capital is cheap. Going private transactions provider better management incentives and less risk, and all the other things I've been rambling about. But turnarounds are few and far between in these larger deals. Also, reading certain of the commentators I cite in this article one gets the impression that "private equity" is entirely going private transactions buying out large publicly held firms. Indeed, that's where the headlines are. But there are those firms that have been quietly doing buyouts for 15 and 20 years and haven't bought a public company yet.
This is oft forgotten today. LBOs were an exceptional tool to undertake turnarounds of troubled and down-and-out business that, perhaps, had just fallen out of favor. Today many of the headline deals are using buyouts as a tool to reform capital structure. As capital grows cheaper, however, the need to find underpriced assets is not as essential as it once was. There is a flight from deal quality. Instead, you just need to find firms that aren't well served by the public capital markets. That's an easy thing to do today.
It used to be that after reaching a certain size as a corporation, you were paying opportunity costs if you didn't go to the public markets for expansion capital and the U.S. capital markets were the place to do that. Cost of capital on equity raised in the public capital markets was such that it was the best way to go in order to really grow the firm. Those days are over. Well, not over, but in decline. Adjusting your balance sheet to enjoy low costs of capital is as American as pantless investment bankers on their third martini in the First Class section of BA's nightly JFK-LHR flight. Now that the expanded reach of cheap debt and equity comes with the added bonuses of higher management compensation and less regulatory burden in the form of mega-buyouts, what's not to like?
The problem is that the focus has shifted. Applying carefully constructed, long-term oriented structures (LBO funds) to buyout candidates in need of management acumen and focus that were poorly served by the short-term (and increasingly costly) public markets for capital has instead become a simple financial tool. Specifically, the shift of any company at all from a public to a private equity structure. Notable about the HCA deal is the constant theme among interviewees commenting on the details that the existing management will basically remain untouched. That's always nice as a buyer, to have a strong management team in place, but it suggests also that not much value is being added on the management side. That leaves only financial structure and regulatory burden. From this perspective, the pattern looks exactly like the conglomerate wave of the 1980s, and it will "end" in similar fashion. The large conglomerates are today not "gone," per se. They are instead "focused on our core business."
The advent of LIPOs (Leveraged Initial Public Offerings, or IPOs of debt-laden, private equity owned firms, for the uninitiated Going Private reader) has also had an artificially extreme impact on IRRs. Flipping something to the public market only a few years after having bought it up (so much so that the company ends up paying "break-up" fees for the prematurely terminated management contract) really boosts IRRs and, again, works against the LBO structure's big selling point: long-term focus and turnaround management.
It was much cheaper from a cost of capital perspective for the firms scooped up in those days to be bought by corporate behemoths and managed as a part of a larger economy of scale. That too was a capital structure shift. Eventually, so much money (stock) poured into the takeover craze that the movement simply ran out of breath. The last many deals were the worst for exactly the same reason. The easy targets were bought up, the model then extended (at greater cost) to pick up firms that never should have been corporate daughters in the first place. The result: a better, cleaner capital structure alternative emerged and had the added benefit of being able to provide more focused management guidance.
As the cycle runs, one of two things will happen, I suspect.
1. Costs of capital and regulation in the public capital markets somewhere will once again become low enough (maybe just because private equity and debt gets dramatically more expensive) and efficiencies high enough that even struggling private equity portfolio firms will just go public again. I tend to think that this will be a jurisdiction other than the United States unless this country gets its act together with respect to being a friendly place to want to incorporate and list oneself, though I find a sudden positive reform by the United States highly unlikely at present- and then there's the whole subject of who wins the 2008 presidential election. Frankly, this really makes me want to be in the foreign financial exchange business. Some careful thought about these dynamics could make an upstart non-U.S. exchange the one stop spot for the former daughters of LBO funds. The 1990's NASDAQ of modern LBO survivors. I am reminded a little bit of the Cayman Islands, and the timely transformation engineered thanklessly by Louis Fenma in perfect sync with changes in the United States in the early 1980s.
2. More likely, I think, struggling private equity portfolio firms will either be bought and broken up by a new generation of raiders (though the drama of the proxy fight will be both less entertaining and more expensive when the major shareholders are all mega-funds with IRR targets) or bought piecemeal by smaller, more focused firms around $750 million in size, exact mirrors of the early LBO funds in the 1980s, except with different sellers and more focused on value as debt gets more expensive.
Mega-funds are the conglomerates of 2007. Big, unwieldy, potentially unable to attend to their many daughters properly. But most of them will live on. Weathering a storm, perhaps, getting a belt tightening, but enduring.
Personally, I quite like the prospects for the high end of mid-market LBO firms. Big, ugly buyouts gone bad are great opportunities for those of us in the buyout business. We like train wrecks here.
Death of the industry? Hardly. Not any more than the demise of Drexel was the death of the industry. There's a ton of equity overhang still sitting around. Even if the LIBOR pops up 2.5% we are still in very healthy debt markets. The business isn't going away any time soon. Maybe the headlines will, but that would be fine with me, and most of the people at Sub Rosa and the hundreds of firms like us that daily go quietly about the business of buying and, more importantly, improving companies. That mostly orderly cycles and seasons in private equity would come to pass should surprise no one.
A flight to quality is certainly in the cards. I can't wait.
If I were a limited partner evaluating LBO funds to invest in, I would look for small, focused funds with under $3 billion, and preferably under $1.5 billion, that weren't going to get rich on their management fee, that had good turnaround talent, actual management talent and not just financial structuring gurus, on the bench. I would focus on funds that had expertise in sectors that I thought could benefit from a lack of short-term capital pressures- sectors that have fallen into disfavor and that needed more than a pair of years to turn around. Let's remember that that's what LBOs were designed for. If I had to look at larger funds because I had too much money to place without violating the concentration restrictions on my investment with any one fund (or theirs for any one limited) I would be very wary of funds with a history of liquidity events peppered with 2-4 year LIPOs with management contract break-up fees. Their IRRs are probably high because they are exiting prematurely with dumb-money, not because they deliver value. I would ask myself daily, "Am I buying into a short-lived corporate governance, cost of capital and regulatory arbitrage opportunity, or a team able to transform businesses?" I'd also spend more time on vacation than I do now.
(Art: "Horae Serenae," 1894, The Baronet Sir Edward John Poynter, one time President of the Royal Academy and editor of Illustrated Catalogue of the National Gallery, 1900. Depicted are the first generation of Horae: Thallo, goddess of spring and bringer of flowers, Auxo goddess of growth, and Carpo, goddess of the harvest, were the goddesses of the seasons and orderly customs who, among other things, dressed Aphrodite as she emerged from the ocean and traveled with Persephone each year to the underworld).