How fashions have changed

From the golden age to the age of pragmatism: private equity is an industry with evolving strategic priorities. PEI looks at how tastes have altered in five key respects.

If the green shoots now becoming evident are carefully nurtured, it may be that the private equity market can pull away from the trough it reached at some point in 2009. One thing is for sure: the preoccupations of a subdued asset class have been very different to those of a rampant one. In the following pages, you will find the results of the collaborative efforts of the PEI editorial team as we sought to identify the five most fashionable and unfashionable themes.

So last cycle: Dividend recapitalisations
Why it was hot, but now is not: With leverage available by the truckload, GPs were able to add an extra turn or two of debt on their portfolio companies and use the proceeds to pay investors, and themselves, nice fat dividends. This tactic was trumpeted as returning value to LPs, and it should be noted that very few LPs asked hard questions about the source of these welcome distributions. Now not only has this kind of loose leverage evaporated completely, but the “dividend recap” may emerge as the number one public relations disaster for private equity, as a recent front-page New York Times exposé on the demise of Simmons Bedding made clear.

Prime examples:
• Simmons Bedding, a mattress maker bought in 2003 by Boston’s Thomas H. Lee Partners. The financial sponsors paid themselves a $375 million dividend after a recap. Simmons now is reportedly on the verge of bankruptcy.
• Bare Escentuals, a beauty products company purchased in 2004 and recapitalised four times in three years by US sponsors JH Partners and Berkshire Partners. Now publicly traded.

Today’s hot fashion: Portfolio company equity infusions
Why it’s hot: There are two reasons for raising an annex fund in today’s market – one happy and one sad. The happy reason, as told to investors, is that the main fund has come to the end of its investment period,  and yet the market has changed so dramatically that the portfolio companies have unprecedented  opportunities to expand, acquire and take market share. Then there’s the sad reason (often dressed up in happy-reason language) which is that the portfolio is in dire shape and some of the equity is in danger of being wiped out unless it is bolstered by the infusion of new leverage. Many companies were bought at rich valuations and then levered up to irresponsible levels. The message to LPs in these instances is “Same great portfolio, much lower entry price” or even, “Invest more equity or watch the existing equity go up in smoke.”

Prime examples:
• Kohlberg Kravis Roberts recently raised a €400 million fund to support the portfolio companies in its €4.7 billion third European fund.
• Investindustrial recently closed on a €100 million annex fund to fuel the expansion of existing assets within its portfolio. It will support an existing €500 million fund raised in 2005. LPs have the ability to “vote against” annex-fund deals if they choose.

Expert View:
John Pouschine, Managing director Pouschine Cook Capital Management New York
John Pouschine, who oversees a collection of lower mid-market investments, says: “Like everybody, we are spending more time on the portfolio. And everybody has cases where they are acting defensively and other cases where they are acting more offensively.”

“In one instance, we needed to support a company with additional equity because the business had turned down and we needed to support our bank covenants. We had also put in a new management team and needed to make sure they had the appropriate capital to run the business. But in another case, we had a company with $15 million in an unused credit line, where we were looking to act offensively. There was a wounded company we took advantage of. In that case and another, our add-on acquisitions had paybacks in under two years.”

Pouschine reports that his lenders have not been as understanding as his LPs. “I’ve been doing this for 25 years, and the banks are engaged in the most self-focused behaviour I’ve ever seen, which says something about the state of these organisations. In the past they’ve been more willing to work with us if a portfolio company gets into trouble.”

So last cycle: Highly leveraged public-to-private LBOs
As the buyout juggernaut gathered momentum, GPs were able to raise vehicles many times larger than their predecessors. These vast pools of capital had to be put to work and needed equally vast companies to target. For the first time since the RJR Nabisco saga hit the headlines in 1989, the largest listed companies were firmly within the sights of private equity groups. And with banks falling over each other to finance buyouts, the planets were aligned for some major take-privates. By the very nature of public processes, these acquisitions would prove to be among the boom era’s most controversial.

Prime examples:
• The £3.2 billion (€3.4 billion; $5.1 billion) take-private of UK music group EMI in the summer 2007 was not the largest public-to-private in Europe, but is proving one of the most talked about. Financial sponsor Terra Firma has injected more equity into the deal, undertaken dramatic restructuring and is currently renegotiating the company’s debt.
• The largest private equity deal of all time saw a consortium comprising TPG, Goldman Sachs Capital Partners and Kohlberg Kravis Roberts delist TXU (Energy Future Holdings) for $47.96 billion in 2007.

Today’s hot fashion: PIPEs
Why it’s hot: The two sides of the supply/demand equation are aligning to make PIPE deals – private investments in public equity – an intriguing proposition, say industry participants. When public equities are relatively depressed, those listed companies needing to raise capital – either for rescue or expansion – may be reluctant to go down the rights issue road as it can involve pricing at a significant discount to ensure success. Private equity firms, on the other hand, are flush with cash to invest, short on leverage and keen to get into the ownership base of any decent company, listed or not.

Prime examples:
• London-headquartered BC Partners sealed its maiden US deal in June this year by pumping $350 million into Office Depot, an office supplies company listed on the New York Stock Exchange.
• Premier Foods, a London-listed conglomerate, received £64 million (€68 million; $101 million) from New
York-based private equity firm Warburg Pincus in March, for which Warburg received a 10.3 percent stake in the business.

Expert View:
Brian McKay, Managing director Houlihan Lokey London
While previously many private equity firms would have shied away from what is often an uncertain process, says Brian McKay, managing director of investment bank Houlihan Lokey, many are now keen to take a more creative approach. “They may like the company and like the value, but a full public-to-private transaction may be unachievable. Many would prefer control investments, however a minority interest with significant negative control features would make a compelling investment, particularly at a discount to a control premium price,” he says. “In an environment with a lot of cash for equity investment, limited leverage lending, relatively lower public equity values and the never-ending need for cash to grow, PIPE deals may well be the shape of things to come,” he adds.

Simon Tilley, managing director at Close Brothers Corporate Finance, adds that while there is a greater sense of optimism among private equity firms – especially in the mid-market space – a number of issues mean that when deal activity returns, PIPEs will remain on the margins. “There are some substantial obstacles, such as the investment mandate firms have been given by their LPs, the lack of control over their investment and complications around exit.”

So last cycle: Developed markets
Why it was hot, but now is not: During the height of the financial meltdown, markets like the US and UK were seen as safe harbours compared to riskier, less developed countries. For instance, Europe’s mature markets such as the UK, France and the Benelux region saw the gap widen in comparison with Central and Eastern Europe in terms of funds raised in 2008. However, some of the biggest economies – especially the US, with  its unemployment rate of nearly 10 percent – have been the slowest to emerge from recession, while the economies of many developing countries continue to grow. Asia’s private equity market is narrowing the gap  on the US and Europe in terms of size, thanks to rapid growth by China and increasing attention by investors  on India, while Brazil also goes from strength to strength.

Prime example:
In 2006, Apollo Global Management bought a $201 million stake in Linens ‘n Things, once the second-largest houseware retailer in the US. Less than two years later a number of factors in the US – including a decline in consumer spending, a growing housing crisis and lack of available credit – forced the company into  bankruptcy. Linens ‘n Things was one of several major private portfolio companies to fall in 2008, including Sun Capital-backed department chain Mervyns.

Today’s hot fashion: Emerging markets
Why it’s hot: The lack of excessive leverage and banking crises in many emerging markets has left them in a better position to weather the storm. In fact, a study conducted earlier this year showed that the appeal of emerging markets to institutional investors has remained largely untouched by the economic upheaval. More than two-thirds of current investors in emerging markets said they plan to commit to additional managers and geographies over the next five years, while – of those investors which currently have no allocation to emerging markets – 35 percent expect to commit in the next year or two. Jerome Booth, head of research at Ashmore Investment Management, may have well summed up the feelings of many emerging market  investors when he told sister website PrivateEquityOnline earlier this year: “All countries are risky, emerging  ones are where this risk is priced. As the whole world becomes emerging, the ones already there have an advantage.”

Prime example:
David Rubenstein, managing director and co-founder of The Carlyle Group, said in March that there would be more investment opportunities in China than anywhere else in the world. Since then his firm has acquired a  stake of 17.3 percent in Guangdong Yashili Group, an infant formula manufacturer based in China, raised more than $2.1 billion so far for its Carlyle Asia Partners III (CAP III) and held talks to set up an RMB fund  for investments in China.

Expert Views:
Douglas Clayton, chief executive officer, Leopard Capital
Toby Smith, managing director, Lombard Investments

What has been your firm’s philosophy regarding how you invest in emerging markets, and has it changed at  all in the last year?

: Leopard Capital invests in specific pre-emerging markets in Asia that we believe have entered long-term upcycles through internally-driven structural improvements. We like to get in early, well before a country becomes popular within the global investment community. Our strategy has not been changed by the credit crisis, as we don’t depend on leverage to generate attractive returns.

: Over the last year, our philosophy for investing in emerging markets hasn’t changed. We focus on leading enterprises in domestic demand sectors, although we’ve carefully re-evaluated tactics and specific sectors. And given the global turmoil, we’ve enhanced our investor communication, including providing what we call “durability testing” for each of our existing portfolio companies. As we all know, it’s essential for limited partner staff to have adequate tools and data needed to quickly assess portfolio risk, and be prepared to answer questions posed by their various investment committees and oversight boards.

Why do  you think more firms have focused more on emerging markets in the last few years?

: Everyone realises now that emerging markets are where the growth is, especially in Asia. Now more than ever, the sun is rising in the East, and setting in the West. The last phase of Western growth was a Vegas mirage, based on leveraging up leverage, financial engineering and holiday home construction, while Asia actually makes things, studies hard and works overtime.

: More recent focus on emerging markets in part reflects recognition that the 1997 currency crisis provided tough lessons in finance. In our part of Asia, banks are considerably healthier than their Western counterparts and our typical portfolio company is far less leveraged than its US or European cousins. In addition, consumers are typically not over extended – they can still shop. Plus, government policies are, for  the most part, pro-business and the domestic growth path looks attractive. It’s still morning in Asia.

Is there an investment your firm has made that you think best demonstrates the opportunities that exist in emerging markets?

: We have started a company called Cambodia Plantations that will grow rice, which is Cambodia’s core  business. It will acquire 4,000 hectares (10,000 acres) of highly fertile land for just five cents per square metre, which can probably be recovered in just one or two harvests. This is like investing in farmland in Iowa or Kansas 150 years ago. And even in a recession, people still eat rice every day; it’s 20 percent of the  world’s daily calorie intake.

: We’ve recently invested in a retail department store chain that is expanding into under-served, regional  markets. Over the last year, its sales revenue remained healthy: customers are not focusing on a decline in  their personal net worth, or a fall in the value of common stocks in their personal retirement account – they  mostly have savings accounts.

What are your expectations going forward about the best emerging market opportunities?

: From here, emerging markets will rate a premium to developed markets. But absorption capacity must be considered, and too much money flowing in too fast will lead to higher volatility, as happened with Vietnam two years ago. As a contrarian I feel the hunting ground is always best before the crowds discover it; let the masses be your exit. Right now I’m putting all my money into unlisted companies in forgotten Asian frontier markets like Cambodia and Sri Lanka, not into BRICs and certainly not into developed countries.

So last cycle: Covenant-Lite
Why it was hot, but now is not: The advent of covenant-lite basically meant a company no longer had to meet traditional performance benchmarks usually required by lenders to protect their loans. Deals that included  covenant-lite debt proliferated during the peak of the M&A boom between 2005 and 2007, when financial sponsors could pick and choose lenders to secure debt for deals. Banks scrambled to keep up, and covenant-lite grew in popularity. Banks didn’t mind light covenants because they sold on big chunks of loans  to investors like CLO funds, and got the debt off their books. Once the credit bubble popped, investors stopped buying the debt and banks had to hold bigger loan exposures on their books than they had planned  for.

Prime examples:
The prime example of a deal fuelled by covenant-lite debt was Kohlberg Kravis Roberts’s $29.5 billion  acquisition of First Data. The deal involved most of the biggest banks around, including Citi, Credit Suisse, Deutsche Bank, HSBC, Lehman Brothers, Goldman Sachs and Merrill Lynch. According to a First Data filing from 2007, the $16 billion of senior secured debt contained no “financial maintenance” covenants, which are basically financial hurdles companies must meet each quarter to stay out of default on their debt.

Today’s hot fashion: Leverage-lite
Why it’s hot: Today, GPs tend to put forward the same line: “We don’t use a lot of leverage in our deals”. And it’s certainly true that private equity firms are, for the most part, using low amounts of leverage in the deals that get done today. For those that transact in the midmarket, this is standard (or so the argument goes). But for mega-firms like KKR, TPG and Carlyle, low leverage is a relatively new challenge. Lenders are not willing  to extend debt with light covenants, and the debt they do extend costs a lot more than it did in the ‘golden age’. Banks have to hold loans on their balance sheet because they can’t sell to the institutional market. This means they are very choosy about the deals they invest in.

Prime examples: The Blackstone Group recently agreed to a deal to buy Busch Entertainment from Anheuser-Busch for $2.7 billion, using $1 billion of equity. London-based buyout house Permira agreed to a deal to buy financial services group Just Retirement using all equity from its €9.6 billion fourth fund. The deal values the company at £225.5 million.

Expert View:
Adam Sell, Director: Loughlin Meghji, New York
“The pendulum is swinging back the other way from the credit bubble. The debt has to go on the bank’s balance sheets because they can’t sell it in the institutional market,” says Adam Sell, a director with investment bank Loughlin Meghji. “Banks are doing deals on terms they want, and where LBOs are getting done, and they’re fairly rare, the transaction multiples have come down dramatically.”

So last cycle: Buying corporates
Why it was hot, but now is not: With the amount of capital raised annually by private equity funds soaring to more than $500 billion at the height of the boom in 2007, the largest investment groups were suddenly very big players able to acquire very big companies. And, when it came to assets out of the reach of just one fund, they could always club together with a few friends in a club deal. There was certainly no need to team up with corporates in order to get their hands on prime assets. In the bidding stakes, strategic bidders were the enemy – and, in auction processes, it was almost invariably the private equity firms that came out on top. Thus, they regularly smashed the theory that synergistic benefits should allow corporates to pay a premium.

Prime examples:
Take your pick from any of the most breathtaking examples of private equity’s buying power during the 2005 to 2008 period. Few would have expected private equity to get its hands on assets like energy giant TXU in the US for $48 billion (October 2007) or UK FTSE 100 retailer Alliance Boots for $21 billion (July 2007).

Today’s hot fashion: Partnering with corporates
Why it’s hot: Today, Corporate/private equity bid partnerships may be fraught with difficulty unless carefully  crafted (see John Gripton’s comments below), but they are now firmly on the agenda due largely to one of  the defining traits of the M&A market today: a lack of liquidity. For corporates, now is a great time to be making acquisitions because there are so many fundamentally sound, strategically attractive businesses that have run into trouble and are consequently available at good prices. The problem is identifying finance for such deals – and that’s where the mountains of cash residing within private equity funds comes into the  equation.

Prime example: Investment giant Kohlberg Kravis Roberts is reported by various sources to be in talks with  Itochu, the Japanese telemarketing firm, with respect to a joint bid for Bellsystem 24, a Citigroup-owned Japanese call centre operator. Bellsystem 24 is thought to be worth around $1.5 billion, meaning that any deal would likely be the largest private equity deal in Japan this year.

Expert View:
John Gripton, Managing director, Capital Dynamics – Birmingham, UK
According to John Gripton, a managing director in the Birmingham, UK office of adviser and funds of funds manager Capital Dynamics, alignment of interest is the key to whether a company/PE fund joint bid will end in success or recrimination. “It’s a case  of making sure the aims and ambitions of the corporate are in line with those of the financial investor,” he says.

Gripton points to the long-term strategic focus of a corporate and the more short-term focus of a private equity investor as one  potential area of conflict. As a result, the respective parties may have very different views on the desirability of making an add-on  investment, for example. “You’d have to have some agreed terms and parameters for what happens under certain  circumstances,” he says. He adds that, where alignment of interest does exist, such partnerships have shown they can work  well. One example is joint investments between corporates and venture capital firms, through which corporates seek insights into  new technology.