What Does the Buyout Boom Mean?

March 2007

By Jeffrey Marshall

When Prince sings about partying “like it’s 1999,” private equity players can relate: They’ve have been busy bringing out the party favors. But this time, it’s not just venture capitalists in Silicon Valley erecting the dot-com industry, like it was back then. It’s about private equity shops buying big companies — sometimes huge companies — and taking them private.

The preceding story effectively shows how and why that has happened, what private equity players are doing and how big the phenomenon has become. But the implications of the private equity surge are harder to sort out. What does it mean for the capital markets, and for the stock exchanges? And how long could it last?

Those aren’t easy questions to answer, and predicting the future is a fool’s game. But market participants, consultants and others interviewed agree that if current trends hold up, there is no reason to expect a slowdown any time in the near future. New records are waiting to be set, even as nine of the world’s 10 largest leveraged takeovers have been done in the past 18 months; the only exception was the RJR Nabisco leveraged buyout in 1989.

Carol Levenson, research director at Gimme Credit, a New York firm, argues that the way things are going, being a huge public company will offer little or no protection from bulked-up private equity firms that would be able to bid on almost anything.

The surge in private equity makes the vehicles that investors put their money into appear a lot like unregulated mutual funds, says Mark Sunshine, CFO and chief operating officer of First Capital in West Palm Beach, Fla., a firm engaged in factoring, asset-based lending and accounts receivable for middle-market companies. While the popular press focus during the dot-com initial public offering (IPO) boom was on the extraordinary gains and losses by individual investors, the vast majority of the real investment action was in institutional money that bought speculative equity investments in small public companies, he says.

“The current private equity wave is the reincarnation of that without regulation — more than anything, it’s a way to avoid compliance with [the] Sarbanes-Oxley [Act],” he says.

“A lot of this is cyclical, but there is also a reactive piece — there are people who were afraid to go public or stay public,” says Cynthia Jamison, managing partner for the Chicago office of Tatum LLC, the country’s largest executive services firm. “The idea of private money in the short term seemed easier, but that is moderating. When Sarbanes-Oxley first hit, there was a thought that they would go to other exchanges abroad” where regulation wasn’t as strict.

Indeed, concerns have been building about the competitive posture of U.S. capital markets; once the envy of the world, they have been losing ground as international exchanges pick up listings and U.S. companies that go private de-list. Studies and reports in recent months have raised a series of issues, with much of the focus on the ostensibly high cost of regulation in the U.S. And, that has prompted deeper concerns.

“The U.S. has enjoyed financial supremacy in last few decades, with the dollar effectively becoming the reserve and exchange currency for the world,” Sunshine says. “I fear that if the United States loses its preeminence as the financial market of choice for publicly traded companies, there are very bad and very dramatic implications for our national and economic security.”

Overseas competition for IPOs and the surge of capital into the London Stock Exchange — especially its Alternative Investment Market (AIM) — were covered in an October 2006 article (“Are Foreign Issuers Shunning the U.S.?”). Bruce Evans, managing partner at private equity firm Summit Partners, says his firm’s London office has been growing “exponentially” in recent years, and that much of the talk during a recent visit there was about the regulatory burden in the U.S.

“The real issue for the exchanges is that the American exchanges are no longer viewed as the most desirable places to go public. It’s directly related to the regulatory environment,” says Kevin O’Mara, corporate M&A partner with law firm Cadwalader, Wickersham & Taft in New York. “To say that we will relegate the U.S. exchanges to a second tier because of a few bad apples doesn’t make much sense to me.”

Value of a Listing

With so much private capital out there now, why should companies stay public? A stock market listing offers important value, Sunshine argues: it’s a currency for employee compensation; it provides “a readily ascertainable yardstick for relative performance” of companies and their executives; and it offers “a definite advantage in fund-raising” over private capital. “There is a level of transparency and regulatory scrutiny [accorded there] that tends to give you better access to funding, and funding for acquisitions,” he says.

The value of public ownership is the ability to use stock as currency in acquisitions, echoes Walter Zweifler of Zweifler Financial Research. Organizations have reaped rewards by acquiring a company, boosting its stock, exchanging the hyped-up shares for equity in other growing enterprises and then selling the conglomerate at a healthy profit, he says.

Tatum’s Jamison, who has been a CFO at both public and private companies, thinks that “over time, the only companies that may be publicly listed will be larger organizations that are really well equipped to be listed, and that’s not necessarily bad. Smaller companies aren’t staffed with the sophisticated resources to deal with” the demands of regulatory scrutiny.

But, being owned by private equity doesn’t mean that you get a free pass, either. “There’s something about the idea that the grass is always greener on the other side,” Jamison says, yet private equity firms can be very demanding about value — and potentially as difficult as the analyst and institutional investor community. “It’s the same devil in a different dress,” she says with a chuckle. “When you get outside capital, you are beholden to them.”

At this point, there is little that seems off the table for private equity firms, especially when they pool their resources. But their targets may not be blue-chip companies; a significant number, including hedge funds, may be distressed-asset players looking at troubled industries.

Private equity players looking at the auto industry in Detroit, for instance, may be looking at breakup value, says Thomas Gordy, managing director of CM&D Capital Advisors LLC in Detroit, a firm that provides financial advisory, capital-raising, and restructuring services. “That may be right in some cases, but in other instances companies could make a case for staying intact,” he says.

Exit Strategies

It’s not clear at this point what kind of exit strategy will appeal most to the private equity buyers of big public firms. Some may decide to take them public again, through IPOs, which could themselves be enormous if the investor demand seems to be there. Others will decide to merge with other companies, public or private, or sell to another private equity buyer.

More than a few observers believe that the fact that other corporate buyers have shunned these deals, leaving them to private equity, suggests that the traditional M&A route may be a hard sell should private buyers look to public companies to buy their portfolio companies back in a few years.

“The exit strategy depends on the kind of growth that is generated and the PE firm’s appetite to go public,” Jamison says. “There are lots of costs to being [Sarbanes-Oxley]-compliant. I haven’t seen or heard a lot of private equity interest in going public. As long as valuations stay high and there is a lot of money out there, the companies may bounce around among various private equity firms. They love to do deals with each other.”

“These days, private equity firms are readily trading with each other and selling portfolio investments to another fund or a group of funds, a cycle which can repeat itself ever few years,” says Fentress Seagroves, a partner with PricewaterhouseCoopers’ Private Company Services (PCS) practice. “This phenomenon was not typical a number of years ago, [when] private equity preferred to sell to a strategic corporate buyer in order to get the best value.”

Not many deals appear to be driven by breakup considerations. “A breakup strategy is tough to execute,” says Gordy. “A lot of these [private equity] deals are about how to put in capital to improve or consolidate operations, and work on the cost structure.” With that, he believes, private equity shops may be looking out more than a few years to recapture their expenditures.

O’Mara, however, sees the “velocity” of the private equity market changing. Not long ago, a portfolio company would probably be held for four or five years as part of a billion-dollar fund. “Now you have $15 billion funds blowing through in 18 months,” he says. “You have an increasing number of deals where people are looking to mark their gains. They need to show an impressive IRR [internal rate of return].”

Clearly, exits are proving to be home runs for some private firms. Siemens AG, for instance, recently agreed to buy UGS, a Texas software firm, from three private equity firms. The price, $3.5 billion, represents a 75 percent return from the $2 billion the firms paid for UGS three years ago.

Why Stay Public?

Former CEOs of huge public companies have been public recently about disparaging the public markets. Henry Silverman, who built Cendant into an $18 billion conglomerate, flatly told The New York Times that being public is no longer attractive. Silverman spearheaded the breakup of Cendant into four pieces, and in December sold Realogy, its former real estate unit, to Apollo Management, a private equity firm.

Silverman argues that “the view of the board is that companies with declining earnings and no visible growth should be private.” Realogy, which has major real estate brands like Coldwell Banker, Century 21 and the Corcoran Group, is facing stiff headwinds in the form of slowing real estate sales amid overbuilding and huge price spikes in some desirable markets.

Private equity shops “have a much longer-term view,” Silverman told the Times. “The people who own our stock have a five-second view. There is no reason to be a public company anymore.” Silverman added: “You don’t need access to the public market because of the enormous amount of money sloshing around private equity and hedge funds.”

Arguably, “a good manager would rather work for a private company, where the compensation packages can be fashioned without the need for consistent quarterly earnings growth,” says Cadwalader’s O’Mara. However, “private equity funds are tough taskmasters. They’re not prepared to pay for people who don’t perform.”

Looking Ahead

Is the private equity phenomenon cyclical, or more permanent? Opinion is divided. “The surge in private equity seems to represent a permanent shift of influence in the capital markets,” argues PwC’s Seagroves. “The private markets reflect an increasing level of transactional efficiency as more money creates a higher demand for good deals, driving up prices.”

One possible outcome of the buyout binge, in a worst-case scenario, could be a wave of defaults. That’s largely because most private equity buyers load up companies with debt, borrowing as much as 80 percent of more of the capital put into the deal. That raises the risks that, unless managed well, companies could strain under heavy debt loads and stagger towards bankruptcy, especially if interest rates rose.

In Australia, where Qantas Airways Ltd. accepted a buyout bid recently, Reserve Bank Governor Glenn Stevens said that investment strategies keyed to inexpensive debt and high equity prices present a risk to the financial system. “We need also to be alert to the shift in the wind in the area of corporate leverage that seems to be occurring,” he added in a speech. Adds Zweifler: “Like all surges in the past, the going-private surge which is built on such a [highly leveraged] format will soon reach a bubble-bursting moment.”

Jeffrey Garten, a professor at the Yale Graduate School of Management, warns that this new financial order is held together “by loans and risks that are both highly technical and too opaque for anyone to really understand.” And should problems erupt, and the good times end, he suggests, the hangover could be immense.

For his part, Cadwalader’s O’Mara expects no changes at all in the galloping private equity market for at least six months. Looking 2-3 years out, he said, it will depend on the availability of debt; if that continues as it has, the private equity party can probably continue unabated.

Evans of Summit Partners also sees no short-term slowdown, but warns that “there are some risk points in the market,” among them potentially higher inflation, oil shocks and the housing slowdown. “Any of those things could cause corporate profits to drop and make lenders more cautious.”

One very recent development could also have a decided effect: antitrust scrutiny from the Federal Trade Commission, concerned about how some huge funds are concentrating in certain industries. For instance, the FTC in late January required The Carlyle Group to cede board seats and operational control of a firm in the gas pipeline industry, where it has been amassing assets.

More likely than a back-breaking regulatory fiat is the notion that the private dealmaking bonanza will collapse under its own weight at some point, or from a confluence of market forces. As the old saying goes, trees can’t grow to the sky forever.

Impact on the Exchanges: Some Numbers

With all the surge into private equity, you’d think that listings on the major exchanges would be slumping. Well, they aren’t — at least by absolute numbers of listings. The NYSE Group, parent of the New York Stock Exchange and NYSE Arca, an electronic market, said it added 206 new listings last year, up from 192 in 2005. Nasdaq, meanwhile, said it had 281 new listings last year, up from 269 in 2005.

Yet, the value of companies taken private tripled between 2004 and 2006. An NYSE spokesman concedes that the phenomenon “does have an impact on listings, so it’s something we’re not happy with.” Similarly, IPO volume of $41 billion in the U.S. was well under half of the $97 billion volume in public-to-private transactions (based on completed deals).

The discrepancy was smaller in the U.K., where IPOs for British companies raised $19 billion, compared to $27 billion in deal volume for going-private transactions. Compare that to developing markets like China and Russia, which collectively accounted for $65 billion in IPOs but had literally no public-to-private deals.

“Private equity groups are yet to get their teeth into these countries,” Rupert Hume-Kendall, chairman of equity capital markets at Merrill Lynch, told The Financial Times. “The Russian opportunity for new IPOs is enormous.”