Back to basics as credit crunch hits buyouts
London, November 27, 2007
Buyout firms face a return to basics as debt becomes harder to raise, say bankers who see the focus for returns swinging back from financial engineering to the skillful management of companies.
The debt stacked on to buyouts soared to record highs in the first half of 2007, but the global credit crunch is taking its toll.
'We had got to a point where there was a definite leverage bubble,' said Anthony Burgess, co-head of global M&A at Deutsche Bank.
'Private equity firms now need to go back to basics and add value by restructuring businesses,' he said.
'The easy times of the last few years where excess returns have been generated by the application of ever increasing leverage in a rising asset price environment are over.'
Buyout firms tend to hold on to assets for three to five years before selling them to a buyer or via an initial public offering for high returns, traditionally 25 to 30 per cent a year.
These returns can be generated by reorganising the company, with measures including cutting costs or by combining it with other businesses.
In recent years, bumper returns have also been achieved by leveraging up companies in the booming loan market.
Adding debt boosts a firms's return on the equity it has invested. And as banks offered cheaper and cheaper debt, this seemed a sound way of making money.
Debt multiples which hit historic highs in the first half of 2007 as buyout firms piled on the cheap debt have been falling since the credit crisis intensified, however.
Average total debt to EBITDA on deals hit six times in the second quarter, with some of the most highly leveraged carrying total debt ratios of seven, eight or even nine times total debt.
Yet the recent 900 million euro buyout financing for Oak Hill Capital's acquisition of metal parts manufacturer Firth Rixon had 5.6 times total debt and senior debt of 3.9 times EBITDA.
Bankers say such a fall in debt-raising ability will likely lower buyout firms' returns, as it was the debt market that allowed them to pay such huge prices for companies being sold by rivals, outbidding the corporate buyers who are now dominant and giving the seller a boost in returns.
Buyout firms often sold businesses to one another in so-called secondary buyouts and bankers say this is likely to slow down, as well.
Secondary buyouts are 'likely to decline in proportion as one of the exit options until leveraged financing markets recover,' said Kathryn Swintek, Global Co-Head on BNP Paribas's Financial Sponsors Coverage Group.
Businesses that have already been owned and revamped by private equity mean secondary deals rely heavily on better debt terms.
Such deals accounted for more than 20 per cent of buyouts by value in four of the last five years, according to Dealogic figures.
They included the sale of Intelsat to BC Partners by buyout firms including Apollo and the sale of France's Vivarte to Charterhouse by PAI Partners.
In 2007, such deals have accounted for almost a quarter of all buyout deals, according to Dealogic. There have even been tertiary buyouts.
'Secondaries picked up in importance in the last cycle in tandem with debt multiples,' said Swintek. 'In many cases valuations of targets were dilutive to corporate acquirors, and the listed corporates would not and could not gear to the same point as private equity buyers.'
In the end, making money in private equity may just come back to old-fashioned management know-how -- something that debt investors certainly are focused on.
'We seek companies with strong and sustainable business models, great management teams and predictable cash flows,' said John Manser, chairman of specialist lender Intermediate Capital Group, as the company reported results last week.
'The credit bubble ... has burst.' Reuters