The impending private equity pile up

Nick Louth - Thu 11 Jan, 2007

...Private equity is not just an accident waiting to happen. Its more like financial joyriding. The enthusiastic drivers are new to the game, but have turbocharged their returns with high-octane debt. They dont know whether an economic downturn is around the corner, but it wont take much of one to send them skidding into disaster...

 
 
Private equity is not just an accident waiting to happen. It’s more like financial joyriding. The enthusiastic drivers are new to the game, but have turbocharged their returns with high-octane debt. They don’t know whether an economic downturn is around the corner, but it won’t take much of one to send them skidding into disaster. The trouble is that bystanders are likely to get caught up in the carnage.

We’ve all seen the bids, and many of us have benefited from them. In just the last few months they include AB Ports, John Laing, Viridian, United Biscuits and the estate agency Countrywide. The list of deals done is only swamped by those that are rumoured still to be on the blocks: EMI, Forth Ports, DSG International, Carphone Warehouse and even BT. Though most UK deals have been in the sub-£1bn category, those in the US have been much bigger. News coming in as I write is that Sabre, owner of the Lastminute.com and Travelocity websites, is being acquired for $4.4bn. Actually, this is just a modest deal compared to other recent ones, including pipeline firm Kinder Morgan ($26.5bn), health group HCA ($33bn) and casino firm Harrahs ($15.5bn).  The grandaddy of them all, a $51bn approach to French media and utility conglomerate Vivendi from Kohlberg Kravis Roberts, was dropped over tax issues.

In the first half of 2006 there was more money raised in the UK by private equity, at £11.2bn, than the £10.6bn raised in IPOs. Indeed, the net capitalisation of the entire stock market actually shrank in the first six months of 2006 by £47bn. Now while part of this is share buybacks by companies seeking a tax-efficient alternative to dividends, most of the difference is down to takeovers, and of those the largest proportion involved private equity. According to Private Equity Intelligence, private equity funds in Europe have access to $100bn, and they have much of it still to spend.

So what’s the problem?

Is there a problem? Who cares if a bunch of private financiers with deep pockets and a desire to overpay decide to borrow to the hilt to buy companies? Perhaps it will just allow us to sell out our shares gracefully, at a fat profit.

While there is no doubt that many shareholders and
FSL readers in particular, are doing well from the
heady valuations accorded by private equity bids, the wider ramifications of the trend should not make us complacent. Certainly the FSA was sufficiently worried to issue a report on it in November.

The combination of rising leverage and the unclear ownership of the economic risk associated with the
lending are a time bomb. When the first big deal goes belly up, it will be quite hard to predict exactly who will be caught in the fallout.

The intricacies of private equity

To see where the danger lies we need to delve a little into the intricacies of private equity and its advantages over public equity. At one level it’s quite simple. The interest cost of debt is deducted from taxable profits. The same is not true of dividends. Giving up PlC status has its attractions for senior management too, with the insistent calls from analysts and journalists, the grind of quarterly or half yearly earnings expectations, and increasingly onerous governance requirements. In a private firm, managers can concentrate on operational matters to the exclusion of all else.

However, while that might describe some of the permanent advantages, the real driving force is a temporary one. We are at a juncture where financing is cheap and corporate balance sheets healthy relative to share prices. As brokers Credit Suisse have noted, the gap between the earnings cash flow yield on US shares and the corporate bond yield is three percentage points wider than its historic norm. That leaves an awful lot of room to make money, and if you are a private equity capitalist, why put your own money down when you can borrow it so cheaply?

Loading up the target company with debt is easy when its existing borrowings are low, hence the attractions of healthy balance sheets. However, when private equity firms have finished doing their work, the companies are often obese with debt. Take Debenhams, which was refloated in May at a value of £1.7bn. This is about the same as it was bought out for in 2003, but what buyers were getting this year was less firm and way more debt than they had previously owned. The private equity firms which bought Debenhams sold off its entire property portfolio, covering 23 freehold stores, to British Land in February 2005 for £495m. It now pays market rents on all its property. Despite this cash infusion, borrowings have soared from £100m in 2003 to £1.8bn. This wasn’t just the purchase cost, £1.3bn of the borrowings were to pay the private equity owners an early dividend uncovered by existing cash flows, well before their actual exit in May.

The cocaine of private equity

This process is known as a leveraged recapitalisation, and is about as sensible as remortgaging your home to go on a lavish holiday. Nevertheless, according to credit agency Standard & Poors, it had been used in 63 buyouts worth a total $25bn in the first eight months of 2006, including Burger King, MGM, Eutelsat and CoralEurobet. Though dangerous, it is so tempting to issuers that one US buyout chief described it “the cocaine of private equity”. The high-yield payment-in-kind paper is attractive to buyers because of its potential income, and big fees offered to investment banks means that it has been heavily marketed to hedge funds. These in turn can book much of the profits up front.

There are other little tricks the private equity firms have up their sleeves. One is that having raised cash through sale and leaseback, they offer generous long-lease terms to the freehold buyers which commits the occupier to onerous rent increases for years into the future but maximises the upfront take. The private equity firms don’t care because they plan to exit after a couple of years and sell, as in the case of Debenhams, back to a gullible investing public.

Perhaps the most worrying issue of all, though, is our inability to see who stands to lose money when all this comes tumbling down.

Thirteen banks who responded to a recent FSA survey declared an exposure to Euro 68bn of private equity debt, a 17% rise on the figure a year previously. However, the true extent of their exposure is much greater. The rise of two shadowy and barely understood marketplaces, collateralised debt obligations and collateralised loan obligations have spread the tentacles of risks much more broadly. The banks who responded to the survey revealed that they on average distributed 81% of their exposure to the largest deal within four months.

Who owns it? It is hard to be sure. Certainly, many of these assets with their predictable income streams are attractive to pension funds, as well as hedge funds which are probably their natural home. Besides, those concerned about default can now protect them with credit default swaps of Collateralised Debt Obligations (CDOs). The sellers of those arcane securities are in turn taking on the risk of default.

All this would matter less if there was some flexibility built into the system, but there isn’t. Fixed interest is just that, and if a debt- loaded company is unable to make its payments that can trigger a cascade of defaults. We haven’t seen a big one yet in this country, but don’t worry – it’s coming.

For FSL readers, the advice is pretty simple. If a private equity firm comes knocking at the doors of a firm you hold shares in, feel free to sell into the bids and do as well as you can. However, take cash rather than loan notes, stub equity or other securities, and think twice about buying back into a refloated firm after it has been “improved” by private equity owners. Some banks may well be overexposed to private equity risk, and some pension funds too. The trouble is
no-one really knows which ones.


Regards,

Nick Louth
for The Daily Reckoning