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Private
equity
The charms
of the discreet deal
Jul
3rd 2003
From The Economist print edition
Secretive private-equity
firms are behind many of today's biggest corporate deals. What exactly are
they up to?
DISENCHANTED with
public stockmarkets, wealthy investors have for some time been seeking
alternatives. Low returns on quoted shares, and countless scandals over
rigged results and the excessive pay of top managers, have encouraged
them to look elsewhere. One popular alternative has been private-equity
funds, multi-billion-dollar pools of money that are involved in many of
today's biggest and shrewdest corporate-finance deals.
The firms that
manage these funds are increasingly well known. The doyen is probably
the Carlyle Group, which employs a former American president (George Bush)
and a former British prime minister (John Major). Its reputation for behind-the-scenes
power-broking was enshrined in a recent book (“The Iron Triangle:
Inside the Secret World of the Carlyle Group” by Dan Briody). Other
leading firms include the Blackstone Group, which has raised over $14
billion of private equity, and Kohlberg Kravis Roberts (KKR),
forever famous for its $25 billion leveraged buy-out of RJR
Nabisco in 1988, immortalised in the book “Barbarians at the Gate”.
Such firms are
not short of business these days. When the owner of America's NASDAQ
wanted to rid itself of the American Stock Exchange earlier this year,
it turned to a Chicago private-equity firm for help. The Blackstone Group
and Thomas H. Lee, another top-ranking firm, are currently trying to help
Edgar Bronfman to regain control of Universal Studios, Vivendi's dabble
with Hollywood, now that the French conglomerate wants to shed the farther-flung
assets that it acquired during the stockmarket boom.
Europe too is
seeing plenty of action. On June 11th, investors led by a pan-European
private-equity firm, BC Partners, bought Seat Pagine
Gialle, a telephone-directories business, from Telecom Italia for euro3.04
billion ($3.55 billion). This was the biggest private-equity deal ever
seen in Europe, and it was won by BC Partners against
stiff competition from American firms such as Carlyle and KKR.
The enthusiasm
for private over public markets, however, is giving investors no guarantee
of superior returns. For one thing, it is extremely difficult to calculate
the returns on private-equity funds (more of that later); and for another,
those returns depend crucially (and with not a little irony) on the public
markets. Most private-equity deals look ultimately to a stockmarket for
their returns. Take the example of Yell Group, a telephone-directories
business bought from British Telecom in 2001 for some $3.5 billion by
a group of private-equity investors. Those investors are currently trying
to realise some of their gain (if there is any) through an initial public
offering (IPO), a sale of shares on a public stockmarket.
The roadshow to advertise the offering began this week.
Private equity
has a broad definition—any equity not traded through a public exchange
can be included, whether it be a family firm, a young biotechnology start-up,
or even Bill Gates's holding in Microsoft. All types of private-equity
investment, however, share some basic features:
•The investors
are typically wealthy and supposedly sophisticated—they include
family trusts, university endowments and big pension funds, especially
state-run ones.
•Private-equity
firms take substantial stakes in a portfolio of companies, giving them
the power to sack managers and appoint new ones, with the intention of
building better, more valuable businesses.
•Their route
to profit is via an “exit”—a way of selling the firm,
or bits of it, at a higher price than was paid for it, on some long but
fixed time-scale of between three and ten years. Such a sale often takes
place through a public stockmarket.
At one end of
the business are the venture capitalists (VCs)
who try to get in on the ground floor, building companies from nought.
Thomson Venture Economics, a research company, reckons that the returns
on venture capital have been better than on other forms of private equity
(see chart). But the venture capitalists' heavy involvement in the short-lived
telecoms, media and technology boom has turned sour and they are slowly
facing up to the painful realities of their tattered portfolios.
Being private
partnerships, however, they are under little pressure to be open about
the true worth of those portfolios. A common ruse is to carry the value
of companies at cost, even when it is clear (as it often is) that a buyer
would have to be paid to take the companies off the VC's
hands. Lay-offs at prestigious VCs such as Boston's
Battery Ventures suggest that all is not well in the industry.
Scott Delman of
Capital Z, a private-equity investor, thinks the
venture-capital industry still has a long way to fall. Apart from the
absence of a big new thing in technology—even investment in biotechnology
fell in 2002—he sees long-term structural problems for the industry.
As with other forms of private equity, VCs usually
find their exit (and hence their reward) by floating off investments through
an IPO. But technology-focused investment banks—such
as Montgomery, Hambrecht & Quist and Robertson Stephens—which
used to serve as the pipelines to an IPO, have
either gone bust or been swallowed up by bigger rivals.
An article by
William Meehan, a McKinsey consultant, in this month's issue of the Harvard
Business Review, predicts a shakeout in the VC
industry, “one that in the worst case could force up to half of
all current VC firms to close shop over the next
several years.” Mr Delman is more precise about the timing: “I
see around 50% fewer venture-capital funds in the next two to three years,”
he says.
As the venture
capitalists rest, the buy-out side of the private-equity business—the
funds that purchase whole companies, or big chunks of them, often borrowing
heavily for the purpose—is growing strongly. Huge amounts of money
have flowed into private-equity funds in recent years (see chart), though
the flow dropped off sharply last year. Much of it has been waiting to
find an investment home. For many, buy-outs are proving to be that home.
The opportunities
are widespread. The Carlyle Group, for example, is seeking to take advantage
of changing political attitudes to aerospace and defence. Along with Finmeccanica,
a state-owned Italian defence company, it agreed this week to buy a bunch
of aerospace businesses from Fiat Avio, a division of the Agnelli family's
troubled conglomerate.
Many funds see
Germany—where such big companies as Siemens are struggling to restructure,
and medium-sized Mittelstand companies are looking for ways to
grow beyond their founding families—as especially fertile ground.
Likewise the telecoms industry, where debts taken on in the boom years
are now crippling many companies. Typically, the publicly quoted Telecom
Italia nudged Seat Pagine Gialle to become private in order to reduce
the high debts that it had taken on in the years when nobody said “No”.
Overall, deals
such as these are more typical than headline-hitting blockbuster takeovers
like the legendary RJR Nabisco deal, although KKR
did take a trip down memory lane earlier this year when it (unsuccessfully)
tried to take over Britain's Safeway supermarket chain, a company that
it had taken private in the mid-1980s before returning it to the public
markets (and making a large profit).
Some VCs
have switched their business to benefit from this shift to buy-outs. 3i,
for instance, is a London-based private-equity fund that once styled itself
as a venture capitalist and poured millions into technology start-ups.
Yet one of its most successful recent deals has been a traditional buy-out.
In 2001, it took a stake in British Airways' low-cost subsidiary, Go,
in return for £110m ($175m) of financial backing for a management buy-out.
Barely a year later, it sold the stake to easyJet, an independent low-cost
airline, for £374m. Not a bad return for a year's work, though it barely
compensates for all 3i's technology investments that have gone sour.
Another firm that
has adjusted to changing market conditions is Hicks, Muse, Tate &
Furst, one of the firms behind the Yell deal. After a disastrous foray
into telecoms, it is now most proud of a much less sophisticated deal:
a buy-out of the maker of “Hungry Man” frozen dinners. Hicks,
Muse is so involved with the company that it even supervised one of its
advertising campaigns.
Many of today's
buy-out opportunities have arisen out of the hangover from the investment
boom of the late 1990s and the world economic downturn. Firms in a host
of distressed industries are looking to dispose of non-core businesses,
and the buy-out funds are eager to help them. A private-equity firm called
Texas Pacific, for example, snapped up the assets of Swissair's catering
operations after the carrier went bust. And, on top of its aerospace deal
with Carlyle, Fiat also recently unloaded some of its other assets to
a French private-equity-style fund called Eurazeo.
A number of private-equity
groups have taken advantage of the agony of the telecoms industry to buy
companies' cash-rich yellow-pages subsidiaries. In Britain there was the
Yell deal, and last year saw the biggest leveraged buy-out since that
of RJR Nabisco: the $7 billion purchase in August
by two firms of QwestDex, the yellow-pages subsidiary of Qwest, an American
telecoms firm in difficulties.
America's
bankruptcies and distressed companies have provided plenty of opportunities
|
America's bankruptcies,
from WorldCom to Enron, and a host of distressed companies, such as Tyco
and Adelphia, have provided further opportunities. Adelphia, a cable-television
company, went so far as to approach a small private-equity firm to offload
its stake in a New York hockey team.
Vivendi Universal,
whose ill-fated expansion under Jean-Marie Messier was largely unwound
last year, gave birth to one of the biggest private-equity deals of 2002:
Houghton Mifflin, an old Boston publishing house, was sold to a group
of private-equity funds for 25% less than Vivendi paid for it a year ago.
Both American and European private-equity firms are salivating at the
prospect of disposals to come from the likes of ABB,
Deutsche Telekom, France Telecom and Siemens.
Deals would be
even bigger were it not for constraints on the ability of private-equity
funds to borrow in order to leverage their buy-outs. Back in the 1980s,
a buy-out firm would put up only 5% of the value of a deal in equity;
the other 95% would be financed by debt, in the form of bank loans and/or
junk bonds. By the late 1990s, however, the required equity stake had
widened to 20% of a deal's value. Now, with big banks' balance sheets
stretched, the buy-out specialists are finding that they have to put up
around 30-40% in cash.
Raising that much
is not necessarily an obstacle, especially when firms work together (as
they increasingly do). But lower leverage threatens to yield sharply lower
returns in future. As it is, returns on private equity are notoriously
hard to measure because investors' cash is put into many different companies
at many different points in time. Since most companies in a portfolio
have no stockmarket listing, there is no reliable guide to their value.
Comparing a private
firm with the share price of a similar listed company is one way to get
a figure, but it fails to account for the extra value of holding a controlling
stake. The only true measure of returns is the cash that is received when
the portfolio firms are sold, either to other companies or through an
IPO. In the meantime, investors have to rely on
the “internal rate of return” (IRR),
a mathematical calculation of returns that gives many a rocket scientist
a headache.
Moreover, there
is no single accepted formula for calculating the IRR.
And the figures that go into the calculation are often fudged, relying
as they do on a fund manager's whimsical judgment of what a company could
be sold for. Rarely does this estimate fall below the cost of the investment,
at least until the day of reckoning comes. In the private-equity world,
such sunny optimism in valuation is referred to as “sticky”
pricing.
Dodgy valuations
also arise when private-equity firms sell or swap assets among themselves,
an activity that is growing in popularity. This provides them with a way
to rejuggle their portfolios, but it does have a downside: the prices
that they record for these deals may have nothing to do with the prices
that the assets would fetch on an open market.
The desire of
investors to shuffle their assets has fed a burgeoning, though still highly
secretive, secondary market in private equity. This allows them to cash
out of their holdings long before a fund reaches the end of its life.
Jeremy Coller of Coller Capital recently raised a $2.5 billion fund to
invest in this secondary market—larger than most primary-market
funds. The move is likely to create more trading, and eventually more
price transparency, for shares in private-equity funds.
Transparency has
recently received a boost. Two big pension funds in California and Texas
have thrown more light on the shadowy world of private equity than has
been seen since the industry's inception. Prodded by lawsuits, CalPERS
and UTIMCO, a University of Texas endowment fund,
have published their performance figures—including the IRRs
of their private-equity portfolios. Most worrying is how little help most
of the IRR figures are, since most private-equity
investments have as yet returned precious little cash.
Some
of the world's best-known bosses are finding second careers in private
equity |
There is another
concern for private-equity investors apart from the lack of transparency.
The stealthy and scrappy investors who used to run the business are being
joined by the establishment. Some of the world's best-known bosses are
finding second careers in private equity: GE's
former boss, Jack Welch, is at Clayton, Dubilier and Rice; Jacques Nasser,
who once ran Ford, is with One Equity Partners; recently, Lou Gerstner,
IBM's former chief, joined the Carlyle Group. Mr
Gerstner's arrival has led to speculation that the firm is looking to
be the first private-equity firm to make its own exit and go public.
Others have already
tried to take steps in this direction. KKR tried
last autumn to sell part of itself to the Washington and Oregon state
pension funds. Another big firm, Thomas H. Lee, has formed an alliance
with Putnam Investments, a high-street vendor of mutual funds. The holy
grail of private equity is to allow individual investors to put their
money into private businesses. Surely, critics say, the end is nigh when
private-equity firms themselves are no longer private.
The firms' high-profile
recruits are a belated recognition that they need to improve their management
skills. They all now make noises about being more than just buyers and
sellers of companies, or of chunks of them. Financial engineering, which
used to be the buy-out firms' primary focus, is now out of fashion. Firms
today claim to be helping the managers of their portfolio of companies
with everything from strategic advice to headhunting to, in one case,
sending in their high-cost MBAs to ring up customers
and collect unpaid bills. With the spate of recent deals, however, some
are sceptical that the firms are up to the task of turning round so many
struggling businesses at once.
Nevertheless,
there is a premium today on more traditional skills, such as choosing
a management team and building relationships with customers and suppliers.
For example, when Texas Pacific bought Burger King from Diageo, a food-and-drinks
conglomerate, one of its first moves was to add an expert in restaurant
turnarounds to the management. Obvious stuff, perhaps, but this is the
way in which private-equity firms expect to be able to add value in future.
The importance
of these more pedestrian skills may explain the rise of niche funds that
aim to tackle buy-outs in only one industry, be it health care, fitness
centres or publishing. With cash piles in the hundreds of millions rather
than the billions, these are better placed to devote time, effort and
industry expertise to turnarounds. One such fund, Falconhead Capital,
specialises in consolidating suburban health-and-beauty shops in America's
roadside shopping centres.
Improving
management and operations is something that the American funds talk
about more loudly than the Europeans |
Improving management
and operations is something that the American funds talk about more loudly
than the Europeans. Firms in Europe are seen primarily as catering to
management buy-outs (MBOs), in which a fund acts
as a source of money for existing managers to take over their own operations.
The fund then remains in the background on most of the big operational
decisions.
The Americans
had hoped to make a big splash in Europe with their different approach.
Many big funds, such as KKR and Clayton Dubilier
and Rice, made much of taking on Europe at the turn of the century, counting
on corporate restructuring and a hoped-for boom in M&A
in Germany. But it has not worked out quite as planned. Clayton
had to write off $400m when Fairchild Dornier, a German aeroplane-maker
which it bought in 1999, went bust last year. And KKR's
adventures in Russia left its fingers badly burnt.
Nevertheless,
private equity's best hope is to become what it has long claimed to be:
an improver of companies. As one industry insider puts it: the 1980s were
about financial expertise, and the 1990s were about specialisation and
deal-making. But the next phase must be about improving operations. That
means the industry's smart MBA types will have
to roll up their sleeves and get much more involved in management.
Copyright
© 2003 The Economist Newspaper and The Economist Group. All rights reserved.
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