New York: Private equity moguls build their fortunes out of other people’s money. Now, the other people have snapped their wallets shut—and all of Wall Street is feeling the pinch.
Investors who financed the biggest buyout bonanza in history are running for the exits. Since the subprime mortgage mess spread to the broader credit markets in late July, many money managers have baulked at buying the risky debt that private equity firms rely on to fund acquisitions.
So, after two years of deal making that drove prices—and leverage—to new heights, the buyout crowd is being forced to sober up.
On an average, the 10 biggest private equity deal makers worldwide borrowed 9.54 times their targets’ total annual earnings before interest, taxes, depreciation and amortization (Ebitda) when making US acquisitions from 1 January 2005 to 12 September 2007 according to data compiled by Bloomberg. Ebitda is a common measurement of a company’s cash flow.
Chicago-based Madison Dearborn Partners Llc tops the list of borrowers. The firm, run by John Canning, employed leverage equal to an average 11.82 times its targets’ Ebitdas. Providence, Rhode Island-based Providence Equity Partners Inc. was second, with a ratio of 10.97.
New York-based Blackstone Group LP was third, at 10.60, followed by Boston-based Thomas H. Lee Partners, LP, at 10.29, and Washington-based Carlyle Group LP, at 9.61.
Like big home mortgages, buyout leverage can fatten buyers’ profits when they go to sell—or end up crippling their investment if prices decline. In buyouts, leverage varies by deal and industry.
Seven Blackstone acquisitions involved real estate companies, among them the firm’s purchase of Equity Office Properties Trust for $39 billion (Rs1.55 trillion) including assumed debt.
Private equity firms usually employ more leverage to buy property companies because they assume they’ll unload some of the target’s real estate quickly.
That’s what Blackstone did with Equity Office Properties. Also, buyout firms typically calculate leverage using adjusted Ebitda, which varies by company and industry.
Many private equity firms are now unable or unwilling to leverage up as they did before, says Steven Kaplan, a professor at the University of Chicago Graduate School of Business who studies private equity.
That means the companies they target will no longer command such lofty prices, Kaplan says.
Money floods in
“Those multiples are dead,” Kaplan says. “The amount of leverage they can get has gone down and will stay down.”
Pension funds, endowments and other institutions invest in private equity funds hoping to reap bigger returns than they can in the stock market.
During the first half of 2007, investors ploughed a record $260 billion into buyout funds, according to London-based research firm Private Equity Intelligence Ltd.
For all of that cash, leverage is the lifeblood of private equity. Firms such as Madison Dearborn, Providence Equity and Thomas H. Lee supplement investors’ money with debt.
Many use the companies they acquire to tap the junk bond market.
Back in June, companies paid just 2.41 percentage points more than US treasury yields—a record low—to borrow in this market for the riskiest corporate bonds, according to Merrill Lynch & Co.
Investment banks were willing to lend at low rates for a chance at reaping billions of dollars in fees for advising on takeovers. Now, banks are balking at guaranteeing debt they may not be able to resell to skittish investors.
By 12 September, junk bonds’ premium over treasurys had climbed to 4.79 percentage points, almost doubling the cost of each borrowed dollar.
Two types of LBO financing that thrived in recent years—so-called covenant-lite loans, named for their easy repayment terms, and payment-in-kind bonds, which enable borrowers to pay off debt with securities—have all but dried up.
The Wall Street landscape will change dramatically without all of that easy money. Private equity firms, banks and corporate targets are all adjusting their expectations. Some deals have stalled.
Last week, a group of buyers led by private equity firm JC Flowers & Co. told SLM Corp., known as Sallie Mae, that it was no longer willing to pay $23.5 billion for the company, in part because of a slowing US economy. That’s a far cry from earlier in 2007, when sellers were able to extract higher prices from eager private equity buyers.
Market turmoil aside, private equity pros never like to sit on money.
Their investors pay annual management fees equal to 2% of a buyout fund’s assets and expect private equity firms to make their money work.
“The money in their pockets will continue burning,” says Frederick Joseph, managing director at New York-based Morgan Joseph & Co. and former chief executive officer of Drexel Burnham Lambert Inc. “There may be fewer large deals, simply because there are limits to the availability of capital.”
Mega deals stall
The mega deals that dominated headlines during the past two years may be a casualty. The ability to win large commitments from a spate of banks allowed buyout firms to hunt big game once considered off limits.
The past 12 months saw some of the biggest LBOs ever announced, including BCE Inc., TXU Corp. and Equity Office Properties. Those kinds of deals are next to impossible unless banks commit to guarantee financing.
Now, private equity firms will think smaller, says Steven Rattner, who heads DLJ Merchant Banking Partners, the buyout arm of Credit Suisse Group, in New York.
“The investment banks want to do good deals, but they’re going to be cautious about size,” Rattner says.
That may be a boon to the so-called middle market funds, which typically buy companies at prices from $500 million to $2 billion.
Convincing companies that they can no longer command the prices they did during the boom may take time, further stalling deals.
“The private equity firms will start to think more about pricing, but it’s a question of when does the reality for sellers set in,” says Paul Schaye, managing director of New York-based Chestnut Hill Partners, a firm that hunts for companies for buyout firms and makes its own investments. “That’s a psychology nobody knows.”