Wall Street’s Wallflowers

Leveraged-buyout investors are loaded with cash and blessed with the cheapest stock prices in a decade. So why do so few deals see the light of day?

Holcombe Green Jr. spent much of last year watching his company’s stock drift lower and lower. The CEO of Georgia textile maker WestPoint Stevens announced a stock buyback and a tender for 6 percent of the company’s shares. Nothing worked. By the end of 1999, the stock was trading at 53 percent below its price of the previous April. Green, who controls 46 percent of WestPoint, had had enough. He decided to take the company private in an $800 million leveraged buyout.

It wouldn’t be the first time WestPoint was bought out: In one of the last big LBOs of the 1980s, raider William Farley acquired the company just before the collapse of the junk bond market. Farley’s inability to refinance his highyield debt landed WestPoint in bankruptcy.

Unfortunately for Green, his takeover ambitions were also thwarted when the U.S. Federal Reserve Board hiked interest rates in May. Days later, Green abandoned his bid. An outside investor had backed out, he reported, concerned that increased borrowing costs had made the deal less attractive. (Green won’t identify the investor, but sources close to the deal confirm that it was Greenwich Street Capital Partners II, a private equity fund slated to contribute $250 million in common and preferred shares.)

“The economics just didn’t work,” says a source involved in the buyout. Even though Green was planning to buy WestPoint at a 37 percent discount to the stock’s 52-week high, the price apparently wasn’t low enough. With no other deal makers willing to step up to the plate, WestPoint’s shares soon collapsed to just $8.75 a share—though by late August they’d rebounded slightly, to $13.50, after Greenwich, attracted by the depressed price, accumulated a 5.5 percent stake.

WestPoint has plenty of company. The rash of scuttled LBO deals comes as a rude awakening to all those bankers and pundits who had been predicting an LBO resurgence this year. After all, many stocks are as cheap as they’ve been in years; nearly half of all public companies trade at less than six times cash flow, according to Salomon Smith Barney. Added to that: deal makers’ pockets are bulging. The largest among them are launching funds that are twice as large as those raised just two years ago.


Most prominently, überfinancier James Lee, vice chairman of Chase Manhattan Bank, boasted in a Forbes magazine article in April that he’d just promised a client he could raise $100 billion for a deal. “There’s a revolution coming,” Lee assured Forbes. “You could see some LBOs that are bigger than anyone has seen before.”

Not yet. Buyouts of more than $1 billion remain rare, and certainly, there have been no recent deals even one tenth the size of Lee’s $100 billion. Not long after the Forbes story appeared, Lee was bounced as head of investment banking at Chase, to be replaced by buyout investor Geoffrey Boisi, who joined the bank after it acquired his firm, Beacon Group. “We still feel conditions are conducive to these deals,” Lee insists, unable to resist adding that Chase nearly financed one that “would have been the largest since RJR Nabisco [acquired in a $25 billion buyout in 1989].”

Lee talks a good game, but most buyout investors feel quite frustrated these days. Deals have been tough to finance, thanks to a sluggish junk bond marker, where the appetite for new financings is meager amid a steady drain of money from high-yield bond funds. Even where financing is available, CEOs and their boards are not quite ready to sell, as they remain hopeful of a rebound in stock prices.

Moreover, many of their recent deals have soured, especially investments in publicly traded companies that fell victim to the Nasdaq correction last spring. Among the hardest hit were more than $10 billion in privately structured convertible bond deals, mostly issued by telecommunications companies or active consolidators, some of whose common shares have traded down by two thirds. As more and more junk bond issues default, a number of high-profile buyouts have ended up in distress or bankruptcy. These include AMF Bowling, acquired by Goldman, Sachs & Co.'s merchant banking fund; and Regal Cinemas, a theater chain controlled by Kohlberg Kravis Roberts & Co. and Hicks Muse Tare & Furst.

“I’ve been doing this for 18 years, and I haven’t seen a period as tough as this,” says a partner at one major buyout fund. “Every LBO investor has a bomb in their portfolio, whether it’s convertibles or a bankruptcy. We’re all on pins and needles.’'

As if all this weren’t enough, for the first time in years, LBO firms are struggling to cash out of existing deals, as the market for initial public offerings has slowed. “Exiting is more difficult,” concedes Thomas Lee, who heads the eponymous Thomas H. Lee Co.

Even with these woes, most of the largest LBO firms are raising new funds, in some cases doubling the size of previous partnerships. After raising a record $55 billion in 1998, buyout firms, which mostly live off a 20 percent cut of the profits from their investments, plowed more than two thirds of that total into deals, according to Venture Economics. Still, their recent returns are mixed: Last year, Venture Economics reports, the average fund returned 25.9 percent. That’s almost 5 points ahead of the Standard & Poor’s 500 index. Longer term, the LBO funds lag the market: Since 1995 these partnerships have returned an annual average of 19 percent, versus 29 percent for the S&P.

Buyout firms sell themselves as a breed apart: Their investments are not supposed to be correlated to the public stock market, although, arguably, given the extent of their recent investments in public companies, their future returns might more closely track the stock market. “We are not market timers, and we believe the asset class will outperform the public markets over the long term,” asserts Barry Gonder, who oversees $11 billion in private equity investments and commitments for the California Public Employees’ Retirement System.

To be sure, not every deal is doomed. Plenty of small buyouts are getting done. Of the $22 billion in LBOs announced in the first half of 2000, nearly half were less than $250 million in size, according to Thomson Financial Securities Data. Another bright spot is Europe, where corporations are busy restructuring.

Still, the recent struggles have been a humbling experience for LBO investors—or, as they came to be called in the 1990s, private equity firms. Over the past decade these money managers shifted away from taking undervalued companies private, as high stock prices made attractive targets hard to find. Increasingly, LBO firms, taking a cue from the recent success of their venture capital cousins, have been making growth investments, even if it means taking minority stakes in publicly traded companies.

It has been a gradual evolution. At first, LBO firms avoided unproven business. They typically took stakes in companies that needed cash to expand, like copy shop chain Kinko’s—as Clayton, Dubilier & Rice did in 1997. If private equity firms did move into technology investments, they favored stable, mature companies like Amphenol Corp., a maker of electrical connectors that was acquired for $1.5 billion by KKR in 1997.

In the fall of 1998, even as buyout firms were raising their previous round of megafunds, the junk bond market struggled to recover from the disarray that followed Russia’s August default. With buyouts nearly impossible to finance, the firms sought alternatives. Nor surprisingly, they were seduced by the lure of heady returns in the New Economy.

Chase’s Lee, who built a franchise financing LBOs, devised an investment that joined the buyout investors with the startup companies. With their seemingly unquenchable thirst for cash, telecom companies seemed to offer an attractive investment opportunity.

To entice the buyout firms, Chase offered them paper a notch above ordinary equity—convertible preferred stock in privately negotiated transactions. Christened Pipes, an acronym for private investments in public companies, this paper typically has a dividend yield of around 8.5 percent annually and is convertible into an equity stake of 10 to 30 percent. Pipe investors often claim one or two board seats.

In the past year and a half, practically every major LBO firm has smoked a Pipe. Between January 1999 and the end of March 2000, firms issued $15 billion of such securities. Last year Pipes accounted for 44 percent of the money invested by private equity firms, according to promotional material that Chase produced in April; early this year their share of the LBO firms’ deal flow was closer to 80 percent.

Unfortunately for LBO investors, when Nasdaq swooned this spring, the prices of the common stocks underlying the Pipes also fell. Now, four months later, many of these stocks have yet to recover. Hicks Muse sank $1.3 billion in six telecom startups in 1999 and earlier this year; since then, all but one of these companies’ stocks have fallen anywhere from 27 to 79 percent. (Globix Corp., in which Hicks Muse invested just $80 million, is up 192 percent.) “The important thing is, most of the companies are on target with their business plans. So we’re not unhappy just because the stock market is throwing the baby out with the bathwater,” says Daniel Blanks, a partner at Hicks Muse. “Ultimately, we’re going to make money on these.”

Maybe so, but for the moment most Pipes are an embarrassment for LBO firms. Traditionally, limited partners are kept in the dark about the private investments that these firms make, until the funds sell out. But even the least sophisticated pension fund manager can monitor the progress of a Pipe by glancing at the price of the underlying stock. “There are others within our organization who can invest in these companies without paying additional fees,” says a dour Brett Fisher, who manages private equity investments on behalf of the Government of Singapore Investment Corp.

“There’s a universal feeling among the buyout community that Pipes are misunderstood,” sighs Thomas Lee, who says he’s not concerned by the lagging stock prices underlying some of his Pipe investments. “To us it’s a way around the pain and strain of taking a company private. It’s a way of buying a controlling interest at a discount to the common, with the protection of a preferred, including indentures and a coupon.”

WITH THEIR TELECOM DEALS UNDER SIEGE, buyout investors are trying to put a fresh spin on their investment strategies. It may not be a coincidence that soon after Nasdaq took its rumble, Hicks Muse abandoned plans to market a separate, $1.5 billion New Economy fund. The firm insists that money was no object. “Internet and other New Economy opportunities have become such an important and integral part of what we do, it is both inappropriate and impractical to treat them as a special or separate focus,” the firm wrote in a letter to its limited partners.

Right. These days Hicks Muse and its competitors prefer to talk about “bricks and clicks,” referring to the dressing up of dowdy, Old Economy companies with a snazzy new Internet strategy. “We expect to find lots of opportunities to make Old Economy companies more efficient through the use of technology,” says Hicks Muse’s Blanks. He points to the firm’s $3 billion joint acquisition (with Bear, Stearns & Co.'s merchant banking fund) of building materials manufacturer Johns Manville, announced in June.

Hicks Muse had been eyeing Manville since 1997, but only after its stock rumbled—falling to $7.50 a share in March, down 60 percent from January 1999—was the company’s board willing to entertain an offer. “We had discussions over the years, but Johns Manville’s board wanted too much money,” explains Blanks. The company is controlled by a trust for asbestos claimants, who have received 76 percent of the equity since the company emerged from bankruptcy in 1988.

The Manville deal ranks as the largest of seven buyouts of $1 billion or more that have been announced this year. Not all Old Economy stocks can be deftly transformed into New Economy darlings. Bain Capital, Blackstone Group and Apollo Advisors, for example, took a preliminary look at a proposed $2 billion acquisition of Borders, the bookstore chain that has a much smaller presence on the Internet than Amazon.com and Barnes&Noble.com. The buyout firms weren’t willing to pay more than $18 a share—a 40 percent premium to where the stock traded before speculation that the company would be sold, but the Borders’ board insisted on $20 a share. Ultimately, the buyout firms were wary of paying a high price, given that the more established online players are still struggling.

“We came to the conclusion that the threat of the New Economy was too great, especially at the price the company wanted,” says a source involved in the deal. Since the buyout firms walked away, Borders stock has slumped, to a recent 13¼ a share.

With fresh memories of their stocks’ recent highs, many CEOs refuse to sell out at a steep discount to those lofty levels. “It’s what I call the ’52-week high’ problem,” explains Alan Jones, co-head of global leveraged finance at Morgan Stanley Dean Witter. “Even if you’re offering a 30 percent premium to the current price, if they can still remember when the stock traded higher, CEOs and their boards may be reluctant to do a deal at a discount to the high.”

The ailing junk bond market presents another stumbling block. Through mid-August, nearly $32 billion in junk bonds has been raised in the U.S., according to Donaldson, Lufkin & Jenrette Securities Corp., less than half the total during the same period last year. Amidst the market’s sorry returns of -0.46 percent, junk bond mutual funds have had outflows of $6.7 billion this year, according to DLJ. As they scramble to meet redemptions, fund managers have little appetite for new issues. What money they are spending has largely gone to finance telecom companies.

Bankers insist that mutual funds and other junk bond investors would applaud a large, liquid financing of an industrial LBO. “Investors would welcome the chance to diversify out of telecom and get more industrial exposure in their portfolio,” says Bennett Goodman, global head of leveraged finance at DLJ, who anticipates a few such deals after Labor Day.

It will soon become clear whether the bankers are right, as Bear Stearns tries to raise $2.1 billion in financing—including as much as $600 million in high-yield debt—for its Manville acquisition. The firm will underwrite the debt—meaning it’s on the hook if junk bond investors spurn the offering. “We feel extremely confident,” says John Howard, who runs Bear’s merchant banking group. “This is a high-quality business.”

Even if the junk bond market stabilizes, it will still cost more to get a deal done than at any time during the past decade. For the handful of deals that have been financed in recent months, the rate on many junk bonds has increased 2 percentage points, to 13 percent. Bank loans are up by 75 basis points, to LIBOR plus 350 basis points. But these rates apply only to sizable transactions. Small buyouts, requiring $200 million or less in subordinated debt, cannot access the high-yield market at all. Such deals are being financed with privately placed “mezzanine” debt that costs 15 to 20 percent—of which 5 points comes from warrants to buy equity.

Today there is precious little margin for error. No longer can buyout firms structure deals with as little as 7 percent of the price coming from their equity, as they did in the 1980s. According to Portfolio Management Data, funds now contribute as much as 36 percent in the form of equity—an all-time high. With more cash paid up front, the potential for profits diminishes. One silver lining: Overall acquisition prices have declined slightly, with the average deal this year costing 7.5 times cash flow, down from 8.5 in 1998.

AS THEY PITCH THEIR LATEST FUNDS, THE established buyout firms are finding that their pension fund managers feel a bit overwhelmed. Some $26 billion was raised in the first six months of this year, according to Venture Economics, with lots more—including a rumored $10 billion fund from KKR—expected to come to market in the second half.

Anticipating an eventual rumble in stock prices, pension funds in the past few years have been looking to alternative invesrmems such as buyout funds. They’ve also had more money to invest, since the rising stock market boosted the performance of their public portfolios, leading them to invest larger amounts to maintain their targeted allocation to this asset class.

Since 1995 pension funds’ stake in buyout funds has nearly tripled, to $70 billion, according to a 1999 study by Goldman Sachs and consulting firm Frank Russell Co. But the overall percentage of their capital allocated to buyouts—which recently accounted for 46 percent of their alternative investments—has barely budged.

This year, with most stocks flat or down and buyout firms struggling to cash out of deals, pension funds have less money to invest—even as buyout funds are seeking larger and larger pools of investors. Fundraisers acknowledge the process is taking longer than expected. “Everything is a little backed up,” says one buyout professional in the market with a multibillion-dollar fund. He hopes to close his latest partnership three months behind schedule.KKR’s expected launch is attracting the most attention. Its new fund would be two thirds greater in size than its last fund, a $6 billion partnership raised in 1996.

KKR has been quietly testing the waters, holding informal conversations with longtime investors. Rumor has it that the firm already asked the Oregon and Washington state pension funds to invest about $1 billion each. “We haven’t arrived at a number yet,” insists Jay Fewel, who runs Oregon’s private equity investments. “KKR is still trying to gauge what size fund the market will bear.” A KKR spokeswoman declines to comment.

Industry insiders suspect that KK R’s principals crave a mammoth fund to regain their status as the biggest on the block—this has never been a business of modest egos. Part of KKR’s cachet is that it has been able to tackle deals that smaller rivals can’t swallow.

Skeptics marvel that KKR would attempt such a high-profile launch, considering that it has suffered its share of recent debacles. Supermarket chain Bruno’s, which KKR acquired for $1.2 billion in 1995, went bankrupt in 1998; another investment, Evenflow & Spalding Holding Corp., had to be restructured; a third, Regal Cinemas, is struggling. Meanwhile, KKR has $300 million tied up in telecom convertible securities, and in both cases the underlying stocks are down sharply.

Perhaps KKR, which has kept a low profile this past decade after dominating headlines in the 1980s, hopes to use its new money to tackle Old Economy buyouts. The firm has been decidedly ambivalent about growth investing. It has avoided investing its most recent fund in Internet deals, preferring to pursue such transactions with its general partners’ own money. “KKR really has much more of a value orienration,” explains one longtime investor. “It really hasn’t been comfortable in this kind of market.”

Many of its competitors undoubtedly share KKR’s squeamishness. After the recent correction in telecom stocks, an environment that allows the buyout firms to tackle old-fashioned deals would probably be greeted with pleasure and, perhaps, relief. For now, LBO invesrors are keeping a wary eye on the health and welfare of their existing deals.