There are many who claim that the buyout business is dead due to the lack of senior lending in the market. A recent program title for a private equity conference struck me. It was along the lines of “Are leveraged buyouts feasible in a financial world with no leverage” This existentialist questions bears further analysis. The very fact that this question is posed reveals much about the practices of the private equity business. Many years ago, private equity was a niche, a real backwater of the alternative asset world. It started its ascent to mainstream in the 1990’s. Those that originally succeeded in the business did so for two primary reasons, less competition for deals and lower valuations.
The industry back then was small and there was not a lot of mezzanine capital or senior debt available. If an investor could find a good company and pay a reasonable price for it, chances are they made money. Due to the lack of senior debt and mezzanine debt in the market back then, deals were done at either lower prices or with more equity. Over the past 10 years, the private equity world has grown enormously as an asset class, well beyond the level of a niche. This has resulted in large amounts of equity capital supported by cheap debt chasing finite deal flow. Valuations were bid up to unsustainable levels. The mega private equity firms pursued a growth at all costs approach. They chased public companies, cyclical companies, and turnarounds with abandon. The types of deals that were done in the last few years before the financial crisis bear little resemblance to the deals done in the early days. Back then, LBO’s were deemed appropriate for stable, non-cyclical, non-capital intensive, strong cash-flowing business. Typically, these were companies whose valuations were unappreciated by the public market due to their lack of sex appeal and growth sizzle. The thought was that you could buy them for less than their intrinsic value, financed with modest debt and equity. Over time, you could pay down debt, grow earnings modestly and then do an IPO as a stronger, more valuable company.
Over the past several years, the deals chased by mega buy-out funds seemed to defy reason as to valuation and appropriateness. Cyclical companies, capital intensive businesses and operational turnarounds were snapped up. Instead of focusing on stable, sleepy companies that could consistently flow cash and service debt, PE funds seemed to purchase indiscriminately. Why was this so – well many of them had access to cheap financing from banks that allowed them to pay higher prices for businesses. Rather than judging what a company was intrinsically worth, they allowed the amount of financing they could raise dictate the valuation. They appeared not to notice that their competitors were doing the same thing at the same time. This has ended badly with bank loans being underwater and a sharp correction to both valuation and loan volumes. The buyouts of this latest era would certainly appear to be dead and well they should be. Excessive valuations, high debt loads, buying cyclical companies at peak earnings is not a formula for long term success. An adjustment process back to historical fundamentals of the LBO business is underway. This will result in more selection, valuation and operating discipline being brought to bear on the entire LBO industry. Large funds can no longer rely on cheap debt to justify valuation or financial engineer their way to long term returns. The new LBO deals emerging now in the market rely on fundamentals – stable base businesses, reasonable prices, and conservative capital structures. This is the long term ticket to success and a return to normalcy from a speculative boom.
