General partners are masterful at telling investors what they want to hear, but lately they've outdone themselves by both telling investors what they want to hear and giving investors what they want.
What investors want to hear, apparently, is that the days of big returns through financial engineering are over. What they want, of course, are big cash distributions, and they've been getting these in spades thanks largely to financial engineering.
During the dark days of the early 2000s, when the credit markets ground to a halt and lenders stopped lending, general partners turned overequitisation into a virtue, albeit one born of necessity. Returns would now come chiefly from operating enhancements to the portfolio companies. The application of leverage to juice returns seemed, in retrospect, too easy and even a little unfair, and “financial engineering” was for a time a slightly embarrassing relic of a bygone era, like suspenders, slicked-back hair and Kenny Loggins.
Then the lending markets came roaring back and financial engineering was suddenly back in fashion, as always happens when a strategy makes money for investors. Over the past two years, limited partners around the world have received back an unheard-of amount of cash from general partners. A big chunk of these distributions have been the result of exits facilitated in the M&A market. But an equally significant but hard-to-pinpoint amount of the recent returns have come from techniques that, for lack of a better term, are called financial engineering.
PLUMBERS AT WORK
In general, financial engineering skills are applied to the capital markets, to balance sheets and to deal structures. Current and former investment bankers are studied in the science of financial engineering. It is a broad term that implies the portfolio company itself is a set of cash inflows and outflows that can be made more valuable if the plumbing is rearranged.
Financial engineering is not changing management, introducing new products and strategies, improving infrastructure and governance, cutting costs, or growing profits. Within private equity firms, nowadays this work is typically the province of operating partners – former CEOs, CFOs and entrepreneurs.
A gross but fairly accurate caricature of the evolution of the private equity industry begins at the homo erectus stage with ex-investment bankers wielding Rolodexes and pure financial structuring skills. It emerges fully formed in the present day with the mass hiring of operating partners – note the recent addition of former Viacom CFO Richard Bressler to the ranks of Thomas H. Lee Partners, a firm which until recently preferred to keep its operating expertise outside the partnership.
Certainly both financial and operating skills are needed within a modern-day private equity firm. But over the past two years in particular, the financial engineering activities of some firms have been so profitable that whatever operating improvements have been effected at the portfolio companies have barely moved the needle of the overall returns.
Times are indeed good for financial engineers, but the good times won't last indefinitely. What's more, many LPs who are currently enjoying the froth of financial engineering worry that when the tide of leverage recedes, many buyout firms will be caught not wearing their operating swimsuits.
“Financial engineering has been commoditised,” argues Joseph Landy, co-president of global private equity firm Warburg Pincus. “In order to generate returns that are competitive on a relative basis compared to peers, one has to go beyond financial engineering, because everybody is good at it.”
The term financial engineering has been applied to many different techniques, including securitisations, capital markets arbitrage and the creation of innovative capital structures to acquire companies at belowmarket multiples. But the technique that comes first to mind today when the expression is used is the dividend recapitalisation, by which the proceeds of a loan taken out by a portfolio company are used to pay a dividend to the company's owners.
A huge amount of capital returned to LPs in 2004 and 2005 came from dividend recaps. According to Standard & Poor's Leveraged Commentary and Data, the value of private equity-sponsored dividend recapitalisations in the US never exceeded $3.8 billion (€3.1 billion) between 1997 and 2002. As recently as 2001, the total number of dividend recaps was $1.1 billion. But in 2004, recap volume leapt to $21.3 billion, thanks to the surge in liquidity in the debt markets. Last year, Standard & Poor's counted $18.3 billion in sponsored recaps through December 15.
The “tidal wave of availability” has reached Europe too, according to John Markland, a partner in the London office of law firm Kirkland & Ellis. “I see ever more borrowerfavourable terms being secured in the European market, which has been an enabling factor for a lot of the recapitalisation activity going on,” says Markland.
Private equity firms have found it “temping when being offered money, and you realise that you can refinance existing borrowings of your portfolio companies on more favourable negotiated terms than you were able to as recently as 18 months ago, and in greater quantities”, says Markland.
If investors have mixed feelings about the distributions from these transactions, they are not voicing them publicly. Steven Millner, a managing director at New Yorkheadquartered BISYS Private Equity, which provides fund administration services, says his firm has noted a “significant increase in recaps”, and his conversations with LPs on the subject of these distributions have been entirely positive. “LPs are happy with the taste of cash on cash returns,” says Millner. “I'm not sure they bifurcate whether this is value created through financial engineering or through operational enhancements. Value is value, and as long as the sponsor is creating value, it doesn't matter what bucket it's coming from.”
Many of the dividend recaps have been structured in the form of second-lien loans, which are subordinate to senior loans in the capital structure and require the cooperation of the senior lenders. An alternative form of financing has recently reemerged in the capital structures of portfolio companies – holding company notes. This type of seller paper rests above and separate from the operating company but draws cash or payment-in-kind from the operating company. So-called holdco pieces were more commonly seen in the 1980s, and now that they have crept back into deal structures, some market observers interpret them as further evidence that portfolio companies are being overleveraged.
General partners are not inclined to apologise for taking advantage of all the opportunities for profit afforded them by the capital markets. “You would be foolish not to,” says Charles Baird, founder of Greenwich, Connecticut-based mid-market focused private equity firm North Castle Partners.
At different points in economic, capital markets and interest rate cycles, it is possible that financial engineering will outweigh the effect of operational improvements
According to Scott Sperling, copresident of Thomas H. Lee Partners, the trick in dividend recaps is to find companies with strong free cash flow and then be conservative in how much leverage is applied. Sperling says THL Partners has been careful when it has taken out dividends not to leverage its portfolio companies beyond 5 or 6 times EBITDA, even where the ability to apply up to 8 times leverage has been offered by the banks. Sperling says that in the case of Warner Music, a portfolio company purchased from Time Warner, within the first year THL Partners took out dividends that returned roughly 110 percent of the deal's capital cost. But he notes that about half of the dividends came from Warner Music's free cash flow and the other half was in the form of a holding company refinancing that was done at less than 5 times leverage.
Limited partners and their advisors see GPs who undergo dividend recaps as doing exactly what they are paid to do – realising value from portfolio companies by any means necessary. “This is a cyclical business, just like many other businesses,” says Mark Weisdorf, a private equity investment consultant and the former head of private market investments for the Canada Pension Plan Investment Board, a major LP. “At different points in economic, capital markets and interest rate cycles, it is possible that financial engineering will outweigh the effect of operational improvements.”
Just as the high price of oil lifts profits across the oil industry, each new opportunity for financial engineering is seized upon rapidly across the private equity market. This is due in part to the strong deal-structuring skills resident at most private equity firms, but also to the unrelenting salesmanship of investment bankers, who shop innovative financial techniques to all their clients.
“Intermediaries take whatever idea they have and bleed it out in a cycle to their clients, starting from the biggest and most important,” says a GP. “The book that KKR saw today was at Blackstone yesterday.”
Says Landy of most financial engineering techniques: “You don't keep these things proprietary very long. An investment banker will be pitching it to someone else the very next week.”
In other words, there isn't a private equity pro breathing who hasn't recently been presented the opportunity and tools to lavish leverage on the portfolio. And the less exotic the form of financial engineering, the quicker it percolates throughout the market. As David Eich, another London partner with Kirkland & Ellis, notes, sellers still make distinctions between private equity sponsors in their perceived ability to rapidly execute complicated deals, but Eich adds: “With each successive turn of the cycle, the low-hanging fruit is increasingly gone.”
Once the ability to lever up a company recedes, many private equity firms will no doubt find it difficult to provide attractive returns to investors. A founding partner at a large New York private equity firm argues that many operationally unskilled buyout GPs were saved by the sudden resurgence of the debt markets two years ago, which allowed them essentially to perform highly leveraged buyouts retroactively on otherwise underperforming companies.
North Castle's Baird, who spent 11 years at consultant Bain & Co. prior to entering the private equity industry, believes not only that the opportunities for financial engineering will ultimately dry up, but that many portfolio companies that have undergone refinancings will not be able to weather a recession with their current debt levels. “There may be companies that can live with 7 or 8 times leverage, but the great majority cannot,” he says.
Baird, whose firm specialises in “healthy living and aging” investments, argues that only private equity firms with strong operating orientations will thrive through the cycles. “The thing that comes and goes is the opportunity for financial engineering,” he says. “But the ability for operating improvements is always there. People who understand how to build businesses will be able to make equity returns in good times and bad.”
Baird dismisses the claims of operating expertise made by most private equity firms as “pablum”. He asks: “What private equity professional wouldn't suggest he's a value-added investor? Everybody says they are hands-on. But the number of people who can truly get involved in a business and change the operating characteristics is small.”
Landy says Warburg Pincus applies operating know-how as well as financial engineering to its global portfolio of investments, but the firm's definition of financial engineering extends to markets not teeming with Western financial techniques. He cites the example of Bharti Televentures India, which Warburg Pincus bought into in 1999 and took public on the Mumbai Stock Exchange in 2002. The firm gradually exited the investment through three block trades, the largest such trades ever executed in India (the firm's remaining equity stake was sold to Vodafone last year).
Similarly, Warburg Pincus harvested profits in a Czech pharmaceuticals business, Zentiva, through an IPO on the Prague Stock Exchange in 2004 – the first-ever IPO on that market. As for financial engineering opportunities closer to Warburg Pincus' New York base, Landy says his firm has been unimpressed by the many offers it receives. Of the more than $6.1 billion the firm returned to limited partners in 2005, less than $250 million was from dividend recaps, or approximately 3.5 percent of total distributions for the year.
Weisdorf sees the recent rash of dividend recaps as a profitable sidetrack in an otherwise steady progression towards a more operatingoriented strategy across private equity firms. He notes the many firms that have added operating partners. “The longer term trend is that financial engineering will be less of a factor,” says Weisdorf. “Valueadd is growing. But that doesn't mean that from time to time financial engineering might not play a material role in what the ultimate returns are.”