With the LBO bubble bursting, the future world of private equity is likely to be very different from the heady conditions of recent years. Here are six predictions of what that brave new world will look like.
First, when the current credit crunch ends, liquidity won’t ooze back on the same terms. LBO houses have been pretty much able to dictate conditions to borrowers. The recent past was characterized by extremely high debt multiples, “covenant-lite loans” and so-called “PIK toggles” where they could issue IOUs instead of paying interest. The private equity brigade was also able to strong-arm banks to provide them with ”equity bridges”, which allowed them to buy companies by deploying only a small amount of their own money.
Mega-loans for some big deals—such as Chrysler and Alliance Boots—are now stuck on banks’ balance sheets. Until they shift them, they are going to be less inclined to provide yet more highly-leveraged loans. But even when the pipeline is cleared, it’s unlikely the debt multiples will be as high. Nor will LBO houses be able to benefit from trinkets like PIK toggles.
Second, quick flips will be rarer. Oozing liquidity hasn’t just helped LBO houses buy assets, it has also helped them exit rapidly. One particular technique has been “dividend recaps” under which an LBO-backed company borrows more money to repay its backer’s equity. Another trend was “secondary buyouts” under which one LBO house sells an asset to another. These schemes only really work when debt multiples are expanding. If the brave new world consists of lower debt multiples, LBO houses will have to sweat their companies for much longer before they can exit at a profit.
Third, new deal flow will slow. Several deals that were supposed to be in the pipeline—Cadbury’s sale of its US drinks business for instance—have been delayed. Other potential deals such as Virgin Media could be postponed, too. With less abundant credit, LBO houses won’t be able to afford to pay as much for assets. They hope that sellers’ price expectations will fall. That’s probably true. But it will take a while for sellers’ expectations to adjust downward. What’s more, they probably won’t fall as far as the LBO houses want. As a result, private equity houses won’t be able to deploy their funds as breathlessly as they have been.
Fourth, returns will fall. That will be pretty much a direct consequence of less attractive financing and an inability to flip assets rapidly. The LBO industry is already preparing its investors for the end of the golden age—guiding expectations for returns to around 15% rather than the 20% plus that it has enjoyed. But even that might be too optimistic. So long as the global economy stays strong, private equity should still enjoy decent enough returns. The real problem would come if economic growth stalled. Then overleveraged companies would start defaulting, making returns miserable.
Fifth, new megafunds will be harder to raise. The big LBO houses have been hoovering up $20 billion (Rs81,000 crore) funds over the past year or so as investors have rushed to climb on the private equity bandwagon. But they’ll be less likely to want to jump on now. That said, the pension funds and insurance companies that provide the bulk of the money are rather slow to take decisions. So there may be a lag before they change their minds. KKR, Bain and Carlyle—which are still completing fund-raising—will certainly be hoping so.
Sixth, LBO houses will find it much harder to float. The private equity going public phenomenon—epitomized by Blackstone’s IPO—was a derivative on the LBO bubble. With Blackstone shares now trading below their offer price, it’s going to be harder to drum up enthusiasm for other planned floats like KKR’s.