Diminishing returns threaten take-privates

The number of successful take-private deals is unlikely to increase significantly in 2007, as buyout firms struggle to meet their return expectations from the targets currently available, according to a new research note.

The note, from the credit strategy team at Merrill Lynch, suggests that deals like the mooted buyout of Sainsbury’s may struggle to meet return expectations. So despite increasing interest in large listed companies from buyout firms looking to put their record-sized funds to work, the number of take-private deals in 2007 will continue to be “a handful rather than a wave,” the report said.

Sainsbury’s: Prospective buyout could struggle to meet return expectations

Recent weeks have seen some high-profile examples of private equity interest in listed companies, with both supermarket chain Sainsburys and building products supplier Wolseley finding themselves the subject of bid speculation. At the same time, 3i has been embroiled in two eventful bids for Countrywide, an estate agency chain, and Enterprise, a maintenance group.

This has created the impression that take-private deals are higher up than agenda for buyout firms than they were in 2006, when according to Merrill’s research, large European public-to-private deals were “virtually non-existent”. Indeed, deals worth over €1 billion accounted for just 6 percent of all transactions.

The increase in corporate disposals was one of the major drivers behind this. With large corporates looking to divest non-core divisions, private equity had a ready source of dealflow without having to pursue public-to-private deals: Linde’s sale of its fork-lift division, Royal Philips’s spin-off of its semiconductor unit, and Unilever’s disposal of its frozen food division being just three examples. The report said that these deals generally provided “better economics for financial sponsors”, since they were not forced to pay a “control premium” – as is often the case with public-to-private deals.

Merrill has also put together an IRR model, which looks at the likely rate of return under private equity ownership for publicly listed European corporate bond issuers. The model employs a number of assumptions to calculate the potential return over a 4 year period for a buyout firm which takes a public company private.

On average, it found that the likely returns have decreased since November, the last time the model was calculated, thanks largely to a 5 percent increase in the price of European equities. This is despite some companies actually improving their potential returns thanks to upgraded earnings forecasts.

In general, only six companies produced potential returns of more than 20 percent over a four-year period. Sainsbury’s, for example, had an estimated IRR of just 15 percent – well below the kind of level expected by private equity investors.

Although the Merrill analysts accepted that returns could be boosted by selling off property assets, decreasing equity contributions (from the assumed 20 percent) or paying out special dividends, they concluded that average returns were now fairly slim across the board, which would probably limit the number of public-to-private deals attempted.