Leveraged Burnout?

The stars have been perfectly aligned for leveraged buyouts these past few years. Are the good times coming to an end?

In July 2004 four of the world’s biggest leveraged-buyout firms teamed up to acquire electric utility Texas Genco Holdings from CenterPoint Energy for $3.65 billion. The consortium -- Blackstone Group, Hellman & Friedman, Kohlberg Kravis Roberts & Co. and Texas Pacific Group -- put up just $900 million and borrowed the rest by loading Texas Genco up with debt. In October, barely a year later, the firms more than quintupled their money by agreeing to sell the utility to Princeton, New Jerseybased competitor NRG Energy for $5.8 billion.

During the past few years, big, quick and easy paydays like the Texas Genco bonanza became ever more common in the world of private equity. When KKR, Carlyle Group and Providence Equity Partners sold satellite broadcasting company PanAmSat to Intelsat for $3.2 billion in August 2004, they quadrupled their initial investment in just one year. The consortium that plans to take Burger King Corp. public this spring likely will earn more than four times what it forked over to buy the fast-food chain scarcely three years ago.

Returns have been spectacular. These firms are making profits not only by selling portfolio companies, but also by extracting big dividends and fees from them. Funds with $1 billion or more in assets gained 33.4 percent on average last year, says data provider Venture Economics.

Consequently, money is pouring into buyouts -- $106 billion for U.S. firms last year alone, up from $24 billion in 2003. Private equity firms in the U.S. now have a record $150 billion to invest, according to J.P. Morgan Chase & Co. With modest leverage of about 3.5 times equity, that’s more than half a trillion dollars of buying power. It’s an era of power and profit not seen for LBOs since the heady 1980s.

“The past four years have truly been a golden age in private equity,” says Daniel D’Aniello, a founding partner of Washington-based Carlyle.

Increasingly, though, even the savviest LBO practitioners and investors are beginning to wonder how long these flush times can last. There’s no shortage of cautionary signs. Start with tightening credit markets. Federal Reserve Board chairman Ben Bernanke has signaled that the Fed may stop hiking short-term interest rates -- after two years of steady increases -- but long-term rates have been climbing. Last month the yield on the benchmark ten-year U.S. Treasury bill rose above 5 percent for the first time since 2002. The steepening yield curve signals that investors perceive more risk in holding long-term debt, which is the foundation of LBO financing. Eventually, of course, higher interest costs eat into the cash flow of the companies that private equity firms acquire, reducing their earnings and exit valuations and depressing the financial buyers’ returns.

Investors are also beginning to worry about deteriorating credit quality and companies overleveraging their balance sheets. The average LBO in 2005 used leverage of 6.4 times the target company’s operating earnings, up from 4.6 times in 2001, according to Standard & Poor’s and J. P. Morgan Chase. Many deals are being financed with as much as 70 to 80 percent borrowed money. That’s fine when rates are low and credit is strong. But when interest costs rise, it’s a recipe for trouble, especially when private equity firms are issuing new debt from their portfolio companies to pay themselves fat dividends -- not for operating purposes. S&P says that firms took $18 billion out of U.S. portfolio companies this way last year. That compares with gross proceeds of $20 billion from LBOs exited via IPOs, according to Dealogic.

More and more, this debt is of the riskiest variety. In 2005 the percentage of junk bonds issued that were graded triple-C or lower by rating agencies reached a record 21 percent, according to Merrill Lynch & Co. The previous record, 20 percent, was established in 2004. Bonds related to LBOs account for the biggest single share of these highly speculative issues.

Another troubling sign is that LBOs are increasingly being financed in the fast-growing second-lien loan market, in which hedge funds and other sharp investors charge higher rates for secondary claims on bank-loan collateral. That’s a great source of capital now but could come back to bite companies that run into trouble, as second-lien investors may see their investments as simply a route to gaining control of companies that fall into default and bankruptcy.

“We have never seen firms paying as much for industrial companies as they are paying today,” says Michael Psaros, a managing principal at KPS Special Situations Funds, a private equity firm that specializes in turnarounds. “And the second-lien loan market is providing up to seven turns of leverage, manufacturing tomorrow’s bankruptcies today.”

Higher levels of risky debt inevitably lead to more blowups. Defaults on U.S. junk bonds are projected to rise from 1.9 percent at the end of the first quarter to 2.8 percent by the end of the year and 4.5 percent in 2007, according to S&P. That’s still below historic norms but a cause for concern to some observers, who see rising default levels leading lenders to rein in credit or to demand better terms, cutting further into returns as buyout firms are forced to put up a greater percentage of equity to finance takeovers. So far banks remain sanguine, confident that surging demand for structured products like collateralized loan obligations -- bunches of loans that are packaged to spread risk -- will keep debt markets liquid.

“I don’t see anything in the intermediate term that is going to derail continued tight credit spreads,” says David Flannery, Deutsche Bank’s head of leveraged capital markets in the Americas. “We’re optimistic that the financing market for LBOs will continue to be very strong.”

Not everyone shares such a rosy view. “The markets are incredibly liquid right now, and investor tone remains strong, but this is all based on default rates staying low,” says Steven Miller, a managing director who analyzes the credit markets for S&P. “If they go up, then liquidity could begin to dry up.”

Junk bond investors are already becoming less receptive to LBOs. In recent months many buyout firms have had to turn instead to bank loans, which are less attractive because they require a pledge of collateral and give lenders a senior position in any bankruptcy-related reorganization. The banks leading the financing for Bain Capital’s $2.1 billion purchase last month of Burlington Coat Factory Warehouse Corp., for example, scrapped a $200 million bond offering amid spotty demand and instead turned to the loan market for the entire debt component of the deal.

Meantime, LBO firms are looking more and more like victims of their own success. All the money pouring into the asset class means that competition is intensifying for acquisition targets, driving prices to ever-headier levels.

“The seeds of excess are there,” warned Blackstone CEO Stephen Schwarzman, whose firm is raising a $13 billion fund, during a February address to investors in Germany. “If we keep on bidding prices up, I worry what the outcome will be.”

The average LBO today has a purchase price of more than 8.4 times the target’s annual operating earnings, up from 6.9 times earnings in 2003 and 7.5 times in 2004, according to S&P. Bain Capital, Carlyle and Thomas H. Lee Partners in March bought Dunkin’ Brands for $2.4 billion, or 12.8 times operating earnings. Bain is buying Burlington at nearly double the company’s market valuation when its board first explored a sale one year ago. At least 15 other potential buyers, both financial and strategic, reviewed Burlington’s books and passed on making bids, say bankers close to the deal. (A Bain spokesman says the firm is paying a fair price.)

There’s more unpleasant news for private equity firms: Corporations are returning in force to the M&A market after years of sitting on the sidelines. Their deep pockets and long-term plans have led to megamergers like AT&T’s $67 billion agreement in March to buy BellSouth Corp. and telecommunications equipment maker Alcatel’s $13.4 billion takeover of Lucent Technologies, announced last month. These so-called strategic buyers are bringing additional pricing pressure to the market because they often are willing to pay top dollar for assets that they covet for long-term business purposes, not to resell for a good profit. In December, for example, Koch Industries bought Georgia Pacific Corp. for $21 billion, or $48 per share, outbidding a private equity firm’s offer of $40 per share that GP’s bankers at Goldman, Sachs & Co. had advised the company to spurn because of doubts about financing an LBO of that size.

Rising asset prices are a double-edged sword. They can allow private equity firms to more profitably exit investments that were bought on the cheap and leveraged to the hilt with low-interest debt. On the other hand, LBO shops may increasingly find themselves priced out of the market for choice targets, or having to acquire them at unattractive prices that will, by definition, limit returns. They may also break with long-standing investment approaches -- as Blackstone did last month when it acquired 4.5 percent of Deutsche Telekom for $3.3 billion (the firm typically takes controlling stakes in companies). KKR, too, is reportedly devoting 25 percent of a planned $5 billion publicly listed fund to noncontrolling investments. KKR warns in the fund’s offering prospectus that the firm’s stellar buyout returns are unlikely to continue.

How difficult the market may get is hard to tell. There are bound to be blowups -- a triple-C-rated, highly leveraged company, after all, is just one currency fluctuation, energy-price spike or disappointing product launch away from a cash flow pinch. But markets have evolved since the LBO-fueled default spike of the early 1990s. Then credit risk was concentrated in the hands of a few major lenders and junk-bond investors. Now it is spread more widely, as more investors participate in the loan market, especially through the use of CLOs and other structured vehicles.

“We’ve emerged from an extraordinary period,” says Erik Hirsch, chief investment officer of Hamilton Lane Advisors, which oversees $48 billion in private equity investments for institutions. “There was a perfect storm of liquidity in the lending markets, and strategic buyers were on the sidelines. I don’t expect it to be a bubble bursting, but we are not going to continue to generate record returns.”

Buyout professionals and experts who study the business expect that firms will need to alter their approach to thrive in the new era. Some LBO shops, anticipating a lower-return environment, are moving into new products and new markets, teaming up more frequently to make acquisitions and focusing more intently on operational improvements and cost-cutting at the companies they acquire. These approaches all carry new risks of their own, though.

Many firms are busy diversifying into markets that promise higher returns than those of the U.S. and Europe. Asia, with its fast-growing economies and less-efficient M&A markets, is particularly attractive. The Chinese government last month announced plans to privatize half of its state-owned companies, creating plenty of opportunity for financial and strategic buyers alike.

Among the benefits of setting up shop in Asia, says Ta-Lin Hsu, founder and chairman of H&Q Asia Pacific, which recently launched a Chinese joint venture with Boston-based Thomas H. Lee Partners, is that firms can outsource the operations of their U.S. portfolio companies to local concerns they buy in India and China. “We can help them with manufacturing and to penetrate into the emerging Chinese market,” he explains.

Some firms are venturing into other types of investing altogether. Blackstone, Carlyle and Texas Pacific are among those that recently have formed distressed-investment funds, which seek to buy the debt of companies that fall into bankruptcy or other financial straits. Distressed investing can be a natural hedge for LBO firms whose returns are hurt in a rising-default environment. Additionally, because bankrupt companies often convert their debt into equity upon restructuring, buying distressed debt can be an alternative approach to making value-oriented private equity investments.

In recent years financial buyers have been teaming up to buy big targets, allowing them to spread risk and afford more expensive targets as asset prices rise. Recent club deals include the purchases of Texas Genco and PanAmSat, as well as the $15 billion acquisition of Hertz Corp. in December by three LBO shops and the $11.4 billion buyout of SunGard Data Systems last year by a seven-firm consortium.

Another way to boost performance as the cycle turns is to rely less on financial engineering and more on better business operation of takeover targets. Some firms -- Clayton, Dubilier & Rice, for example -- have been doing this for years. Others have more recently started to pay attention to improving operational efficiencies.

During the past five years, Investcorp, a 23-year-old global buyout group run out of New York, London and Bahrain, has hired a slew of executives with experience running companies. Today more than half of its professionals have operational backgrounds, says Christopher O’Brien, head of direct investment for corporate and real estate. In 2000, KKR started an in-house consulting group, Capstone Consulting, designed to help portfolio companies with strategy and operations. CD&R hired former General Electric Co. chairman Jack Welch as a special partner in 2001 to help screen investments and review portfolio-company operations. In 2003, Carlyle named former IBM Corp. CEO Louis Gerstner as chairman. He sits on Carlyle’s investment committee and grills its executives on how they will execute change in portfolio companies. Texas Pacific intends to increase its operational staff from 17 to 30 in the next 18 months, says partner James Coulter. Last month Texas Pacific, reportedly in the midst of raising a $14 billion LBO fund, hired exWellPoint CEO Leonard Schaeffer and two other former executives of the health insurer as senior advisers to help run companies it owns.

“We’re transitioning private equity into a major asset class and we’re going to have to be doing more than just playing financial markets and financial engineering,” says Carlyle’s D’Aniello. “We’re going to have to create value on the factory floor.”

Other firms are trying to capitalize on the scale of their portfolios. The biggest buyout shops control collections of companies with billions in annual sales, often in related industries and with common suppliers and customers. Some of these quasiconglomerates are exploring the idea of consolidating purchasing and otherwise having portfolio companies band together to cut costs. Blackstone, for instance, hired James Quella from DLJ Merchant Banking Partners in 2004 to monitor and improve performance across its holdings. Blackstone’s portfolio companies, which together have some $60 billion in annual revenues, have so far cooperatively bought goods and services worth more than $3.5 billion from some 30 vendors. The firm estimates that such activities can save the companies it owns as much as 40 percent on these purchases.

Such moves weren’t necessary to make huge profits during the past few years, and were not widely adopted. Now the reckoning may finally be arriving.

“The long-term trend of returns diminishing forced funds to learn to add value to the portfolio companies,” says Daniel Haas, a partner with consulting firm Bain & Co. in Boston. “For the past five years, a lot of the funds did not take it seriously, and the jury is still out. Benign debt markets lengthened the returns of funds that did not adapt and gave them a second chance.”

Investcorp’s O’Brien says that many firms have paid lip service to the notion of working with portfolio companies, but not many back the talk up with action. “Adding value is the mantra of the leveraged-buyout business,” he notes. “But when you dig deeper into each organization and get past some of the clichés, very few firms have the capability to do this.”

Of course, there’s no guarantee that firms will be able to successfully adapt to more difficult conditions. Indeed, each of the approaches they’re exploring carries risks. Take the idea of moving into new markets and products, for example. By definition, these bring buyout professionals outside their core competencies and increase the likelihood of mistakes. Onetime buyout power Hicks, Muse, Tate & Furst ran aground with 1990s investments in Latin America and telecommunications, two areas with which it had very little experience. Today, recast as HM Capital after a restructuring, it is a much smaller firm that focuses primarily on midsize buyouts. New geographic markets bring political risk. China’s Ministry of Commerce, for instance, is delaying approval of Carlyle’s $375 million takeover of construction equipment maker Xugong Group, requiring that it exit the investment only by selling to another Chinese construction concern.

Then there are the big club deals. When everything goes right, teaming up to buy big companies seems like a smart strategy. But what happens if a deal goes south? How will partner firms decide the proper strategy to pursue? Will they be able to work with one another to rescue bad investments? That has yet to be proved. And relying on operational improvements to drive returns on higher-priced, less-leveraged companies may be more difficult than it sounds, particularly for big companies in a healthy economy. As one buyout pro puts it: “It’s harder to make an elephant jump.”

The buyout firms that adopt these tactics while successfully negotiating the risks should be able to generate good, if not spectacular, returns. But for those who get it wrong, there’s trouble ahead. Investors, as a result, may want to think twice about continuing to flood buyout funds with money.

“The better operators will continue to find opportunities that they can exploit on behalf of their investors,” predicts Alan Kosan, head of private equity research at CRA Rogers Casey, which advises institutions on private equity and other investments. “Others are going to overpay for businesses, are not going to be able to add value and are going to get stuck.”