Five C’s of private equity buyouts

21Nov06

For quite some time now we here at Abnormal Returns have been covering the impact of the growing footprint of private equity on the equity markets and business as a whole. While we are not experts like Going Private, we do think investors of all stripes should have some handle on this recent spate of news. In light of the flood of private equity-led transactions of late it seems that pretty soon we will all be working for private equity-owned firms. Fears of the death of public equity aside, let’s take a look at some of the reasons behind this powerful trend.

Capital

Could it simply be the case that private equity firms now feel the need to put to work their vast war-chests? The easiest way to do this in a hurry is to ratchet up one’s target size. In the last few years private equity firms have been flooded with an unprecedented amount of capital.

Tom Petruno and Josh Friedman in the Los Angeles Times note how growing liquidity is fueling the private buyout boom.

More than any other factor, the ascendance of private equity buyers over the last few years reflects the willingness of well-heeled investors to pony up mountains of cash in search of better returns than they can earn in stocks or bonds.

“There is tremendous liquidity in the market,” said Brad Freeman, a 23-year buyout fund veteran whose Los Angeles-based firm, Freeman Spogli & Co., has a $1-billion private equity fund it’s putting to work. “Deals are being done because they can be.”

Unfortunately this makes it all the more difficult for individual investors to find attractively priced asset classes. James Picerno at the Capital Spectator notes the effect of buyouts on REIT valuations and the overall outlook for asset allocation.

There’s lots of money, and it’s being put to work. Never mind that finding bargain-priced deals is getting harder by the day. The money will keep flowing until Mr. Market (or Ben Bernanke) yells stop. For the moment, however, there are only celebrations. Looking for historically healthy risk premiums, as a result, remains a thankless task.

The buyout boom is more than just an abundance of private equity capital. Deals can only be made when there is abundant debt available to finance these leveraged transactions.

Credit

A major reason behind the number and size of buyout deals is that ample high yield financing, with reasonable covenants, remains available. Charles Duhigg in the New York Times writes that the demand for new paper continues to fuel the buyout boom.

Many of those issuances offer surprisingly low yields, suggesting that despite the glut of new debt, demand is still outpacing supply and investors are betting companies won’t default on their new, risky loans.

A further sign that borrowers, rather than investors, are calling the shots is the growth of pay-in-kind notes, which allow a company to pay a bond’s interest with more debt rather than with cash. Both Freescale and HCA used pay-in-kind notes to finance their buyouts.

“There’s a huge amount of money out there looking for a place to go,” Mr. MacDonald said. “So private equity groups are buying companies and debt investors are pouring money into risky bonds to chase returns.”

Justin Lahart in the Wall Street Journal notes how given the buoyant nature of the high yield markets, equities continue to look attractive in comparison.

Compare junk-bond yields to the earnings yields on stocks (the inverse of their P/E ratio), and it seems like stocks are incredibly cheap. “Look at the valuations in the two markets and they’re about as far apart as they’ve ever been,” says M.S. Howells strategist Brian Reynolds.

That creates a great arbitrage situation for deal makers, who get to issue expensive-looking bonds to buy cheap-looking stock. As long as that dynamic persists, the deals will continue and stocks will have at least one reason to rally.

The transformation of the debt markets has been abetted by a growing network of markets and providers.

Complexity

FT Alphaville points to a piece which notes how markets are hooked on “complexity.” Given, of late, the muted returns on plain vanilla stocks and bonds, investors have sought out more complex structures that have the potential to provide incremental returns. Alternatives like hedge funds and private equity clearly fit the bill. They both in turn create demand for more additional financial instruments that can provide additional return leverage.

The private equity-led buyout boom leads to a self-reinforcing cycle of high yield debt issuance, credit derivatives and unnaturally tight credit spreads. These credit spreads therefore allow for even bigger deals. Where this all ends is up for debate, but one must realize that the desire for complexity on the part of investors has created an new industry infrastructure that has yet to be truly tested in light of a significant market (and/or economic) downturn.

Control

We recently discussed how the changing pressures on the CEOs of public companies has provided them with an incentive to align themselves with private equity shops to take control of their current employers. The financial incentives of a buyout are clearly an attractive factor for an incumbent CEO to take part in an MBO type-deal. However the chance to control their own destiny absent the many distractions inherent in running a public company must also play a role.

DealBook pointed us to a piece in Fortune by Geoffrey Colvin and Ram Charan on how the lack of constraints on private equity managers to run their companies as they see fit can be an important catalyst for strong performance.

Freedom to pay is just one example of an advantage that many PE veterans consider critical: general freedom from the pressures of the stock market, media and Wall Street analysts. Remember, these companies have strong incentives to act quickly – but acting quickly often produces volatile quarterly earnings, which Wall Street doesn’t like.

In a perfect world it should be possible to run a large corporation just as well as a private or public company. At the moment it seems that the playing field has tilted towards private ownership. However a changing political landscape may shift it once again.

Congress

Given the increased pace of deals it begs the question: is there some exogenous event accelerating deal making? It has been speculated that the looming change in control of Congress may be forcing the hand of some deal-makers. While Congress has limited power to regulate deals, it could very well be the case that the anti-trust crowd at the Justice Department may feel a new wind blowing.

The past six years has seen a lax attitude toward deals making. More important may be a socio-political shift that may be against big deals. If this really were a binding constraint on private equity then we may very well be seeing the last gasp of this boom. While possible, we would discount this possibility. So long as the economics of large buyout deals remains attractive, deals will continue to be announced and closed.

Conclusion

We have surely missed some reasons underlying the private equity wave, but it should be clear that there are a number of important reasons behind this powerful trend. For individual investors who do not have the ability to access private equity directly, what does it all mean for their investments?

Most would agree that the stock market has been reacting in part to the continuing wave of buyouts. Daniel Gross in Slate.com notes how buyouts and share buybacks, net of share issuance from IPOs, have been draining market capitalization from the U.S. stock market. This “de-equitization” may be leading investors to bid up stocks in anticipation of further deals.

The presence of deep-pocketed corporate and private equity buyers standing at the ready creates what Citigroup strategist Tobias Levkovich calls “an underlying bid,” which tends to dampen volatility and stop prices from falling too far. And it tends to scare away short-sellers.

At some point this buyout trend will dissipate. Any, or all, of the five C’s mentioned above could reverse in whole, or in part. Fears that the public market for equities will become marginalized are undoubtedly premature. The fact of the matter is that to reverse a private equity-lead buyout of any magnitude usually requires a public offering. We have already seen some of those, often in the form of a LIPO, or leveraged IPO. The question is not if we will see some of these very same companies re-list on the various stock markets, the only question is when.

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