PERFORMANCE(2)

Despite current market turmoil, there's no need for gloom when it comes to the likely long-term results delivered by buyout funds. Katharina Lichtner of Capital Dynamics examines the various factors impacting performance and reaches some encouraging conclusions.

Private equity has seen stellar returns in the last 24 months with historic levels of distributions largely driven by the buyout segment. However, last year's developments have significantly changed the financial markets and the effect on private equity has been substantial. The following article will identify the parameters which have driven those strong returns in the buyout segment and address how they are affected by current market conditions.

It will also share our view of how this could play out going forward.

Furthermore, it will discuss the three most pressing questions: how safe are current asset values, what are return expectations for investments made in 2005 to 2007, and what are expectations for deals being closed now? Triggered by the subprime crisis, the debt bubble burst with the result that debt liquidity collapsed and has not recovered to date. Up until June 2007, the US market saw between $50 billion and $60 billion of new loan issues per month. As the debt crisis unfolded and the magnitude of the problem became apparent towards the end of 2007, these levels of available new loan issues were crimped to between $10 billion to $20 billion per month from the beginning of 2008. Much of the continuing problem is driven by two factors: hung debt and huge writeoffs by the major lenders. As the subprime crisis unfolded, over $300 billion of underwritten debt could not be placed in the secondary market and remained on the balance sheets of the underwriting banks. The backlog is being worked through but in June 2008 an estimated $160 billion was still on the banks' books awaiting syndication.

Over the same period, the very same banks had to write off $318 billion as a result of subprime-related losses, further adding to balance sheet problems. These issues have caused some high-profile losses, with most recently Merrill Lynch being sold to Banc of America and Lehman Brothers filing for bankruptcy.

Nevertheless, banks are actively working through the healing process.

Currently hung debt is being syndicated at an approximate rate of $22 billion a month so should be cleared by the end of 2008. Furthermore, banks have been able to raise approximately $240 billion of fresh capital to support asset growth.

At the same time, the problems in the financial system have spilled over into the real economy. Fading consumer confidence as well as rising commodity and energy prices have put pressure on the economy globally.

HOW ARE PERFORMANCE DRIVERS IMPACTED BY THE CHANGING ENVIRONMENT?
To put things into perspective, in the years 2004 to 2007 in the US distributions from buyouts were between $40 billion to $50 billion per year or $189 billion in total. This was as much as the 14 years beforehand taken together. In Europe buyout funds distributed €12 billion to €23 billion per year or €75 billion in total – €28 billion more than in the prior 14 years taken together.

These historic returns could be generated because virtually all parameters that drive LBO performance were prevalent. Most of these investments were invested in the aftermath of the venture bubble when markets were in recession and EBITDA multiples upon acquisition were attractive, if not low.

As the venture bubble had little effect on the debt markets, normal levels of leverage were available and companies could be leveraged with debt/equity ratios of 1.6 to 1.8 times.

Then, the start of 2003 brought a market upswing with robust GDP growth as well as strong bull markets in the US and in Europe. In addition debt markets became increasingly liquid, providing unprecedented amounts of leverage to the buyout sector at low cost and on very favourable terms, partly due to the ascendancy of hedge funds as holders and traders of buyout debt. This benign environment created a virtuous circle for buyouts that closed in the years 2001 to 2004. On an operative level, companies saw their top line as well as EBITDA increasing with very strong cash flows that allowed them to pay down debt unusually rapidly. With the increasingly favourable and liquid debt markets, many companies were then re-levered, generating early liquidity for equity investors. The leveraged recapitalisation and quick flip became the norm.

At the same time, larger funds were raised that were able to invest in sizeable enterprises that could be taken to the next level. Over the same period, acquisition multiples rose steadily from an average of 5.8x EBITDA in 2002 to 8.3x EBITDA in 2003, largely driven by the benign economic climate. Thus most companies that were bought at the onset of the growth phase were sold at higher EBITDA multiples, so adding materially to value creation (see accompanying chart). There has been no period in the past 20 years where all three factors – attractive entry prices, robust economic growth and copious amounts of cheap debt – were so positive at the same time. Looking back, we witnessed a near-perfect confluence of events.

This very positive environment allowed buyout funds to raise record amounts of capital driven by new investors entering the market and incumbent investors re-committing the distributions they had received. With the amount of debt available on unusually attractive terms, this capital was invested quickly. To put this into perspective, in the years 2000 to 2004, $118 billion of equity was invested in buyout deals compared to $434 billion from 2005 to 2007. We observed a similar trend in our own portfolio where investment pace as a percent of open commitments picked up, with an average annual growth rate of close to 20 percent between 2003 and the peak in 2006.

HOW SAFE ARE EXISTING VALUES?
The pressing question now is how safe are existing portfolio company asset values? To say it up front, we do not expect the massive losses that were sustained during the venture bubble. In general, companies are in good health.

On average they are cash-rich, have lower levels of debt than in the 80s and early 90s, have healthy EBIT/interest expense ratios and very little overcapacity was built during the last cycle.

Furthermore, debt terms for many of these existing assets are very favourable and by and large financial covenantfree, so putting little pressure on companies. However, we do expect current NAVs to correct downwards as many funds account on a mark-tomarket basis. Thus, with a decline in the public market, private equity values will decline as well – although we would do well to remember to distinguish between write-downs and real losses. While Venture Economics' data still lags in showing this downward trend, in our own portfolio it becomes apparent with the analysis of the second quarter 2008 reports, where write-ups as a percent of NAV are stagnating for the first time since 2003.

However, we believe that these value corrections are transitory and often do not reflect the true status of companies.

Overall, company values are relatively safe although prolonged weakness of the overall economy would probably result in some high-profile losses. In addition, an increasing number of companies will come under pressure when their current credit lines require refinancing. The terms for the refinancing will almost certainly be less favourable and may require additional infusions of equity capital, which will further erode buyout returns.

Furthermore, we expect an increased likelihood of defaults for those companies that will not be able to refinance their credit lines. There may also be good opportunities for distressed players where refinancings prove too difficult to conclude.

With respect to performance it is worthwhile to take a look at the same parameters analysed above. On a fund level or even a company level, the performance will not be visible for another two to four years when companies acquired in 2005 to 2007 are ripe for exit. During that period companies were bought at relatively high entry multiples. As prices are currently falling many of these companies will face lower EBITDA multiples, resulting in a negative multiple arbitrage component. In addition the weakening economic climate will limit the growth potential of these companies.

Plus, many companies have high amounts of leverage and will not be able to pay down debt with the same speed as those acquired in 2002 to 2004. It is also unlikely that large amounts of debt will be available to refinance these companies. Moreover, many managers will wait until EBITDA multiples improve again prior to selling companies. So, taken together, we expect returns for buyouts to decline. With lower growth, reduced ability to pay down debt, declining acquisition multiples and likely longer holding periods we expect buyout returns to correct downwards.

Nevertheless, we still expect returns to be 4 to 6 percent above those of the public markets for investors with well diversified portfolios and access to top quality managers.

WHERE DO WE GO FROM HERE?
The analysis of the value drivers today much resembles the analysis of the 2002 to 2004 investment period. We currently see EBITDA multiples starting to decline and believe this trend will continue as the economy continues to weaken. Thus companies can be bought at attractive prices again. Currently debt liquidity is low and companies have to be financed with larger amounts of equity. For attractive deals managers are prepared to do this. In addition they are looking increasingly to additional sources of equity to ensure they can maintain adequate diversification in their funds.

Thus, the changed environment also creates good opportunities for coinvestments across all size ranges.

We expect a cautious and slow pace of recovery of debt markets and limited refinancing activity in 18 to 24 months, at lower levels compared to the period between 2005 and 2007, and thus the contribution of debt to overall returns will be de-emphasised in lieu of operational improvement and/or top-line growth. As the overall economy is likely to pass the bottom of the economic slowdown during the life of a company acquired today, positioning the company well to profit from the upswing will be a critical element of value generation. In three to four years time we also expect EBITDA multiples to recover, hence many companies bought today will be able to achieve a positive multiple arbitrage at exit.

However, it is unlikely that we will see these parameters play out to the same degree as in the last cycle as it is unlikely that debt markets will be as helpful in the near future as they were during 2005 to 2007. Nevertheless, we believe that companies acquired during the next 12 to 18 months will be able to generate very attractive returns for their investors. With respect to private equity managers we expect a widening divergence in returns among players, thus access and careful manager as well as strategy selection will become increasingly important to generate attractive returns.

CONCLUSION
The correction in the debt markets has drastically changed the environment for buyout investments. After analysing how the main value drivers are affected by the correction, we do not expect massive losses in existing portfolios although we believe investors should expect a downward correction in existing values and returns. Looking further ahead, with the downward correction in prices providing attractive entry multiples coupled with the likely recovery of the debt markets as well as the economy during the life of companies acquired today, buyouts are well positioned to achieve very attractive returns.

Overall, we expect buyout performance to decrease for the vintage years 2005 to 2007 relative to the years before, but do not expect massive value destruction. Also, as experienced managers have demonstrated that they are able to generate attractive returns even in difficult times, we see no reason to believe that private equity should fail to generate an annual out-performance of 4 to 6 percent over public markets for those that have built well diversified portfolios and invested with top quality managers.

Dr. Katharina Lichtner is a co-founder, member of the board and managing director of Capital Dynamics and heads the research department of the Swiss private equity asset management firm. In addition, she is a board member of the IPEV (International Private Equity and Venture Capital Valuation Guidelines) where, among other things, she represents the European private equity association EVCA. She was previously with McKinsey & Co