January 10, 2008
By Doug Warner (email@example.com)
This past year witnessed both the golden era of private equity and a good old fashioned credit bust. It was remarkable both for how good the good times were in the first half of the year and how suddenly fortunes changed in the second half of the year. We witnessed both $40 and $50 billion mega-buyouts in the first half of the year and backlogs of unsold loans and nasty court fights between buyers and sellers over shattered deals in the second half of the year. For deal professionals, both halves of 2007 were riveting and we saw the emergence or continuance of a number of trends in the U.S. private equity market. This article summarizes some of those trends, with particular focus on the current state of the market, and contains predictions for 2008.
Trends in 2007
Some of the trends from the U.S. private equity market in 2007 included:
Robust Fund Raising Environment – This past year saw a continuation of the strong fund raising environment, particularly for sponsors with track records of top quartile returns who had little difficulty achieving their fund raising targets. We saw a continuation of the trend towards mega-funds with a small group of sponsors raising funds in the range of $10 billion to $20 billion and a larger group of sponsors raising significantly more capital than their previous funds. Despite talk in the LP community over the lowering of return expectations due to the large amount of capital chasing deals, lower available leverage, higher cost of debt and only a modest decline in seller price expectations, LPs continued to increase allocations to private equity (for example CalPERS recently increased its allocation to alternative investments from 6% to 10%) due to the perception that private equity provides superior risk-adjusted returns and meaningful portfolio diversification for institutional investors.
Increasingly Competitive Deal Environment – The deal environment became increasingly competitive in 2007 for private equity sponsors with meaningful competition for deals from strategic investors and increasing competition from SPACs, sovereign wealth funds, hedge funds and certain pension funds. Sponsors lost much of their competitive advantage against strategic investors in the second half of 2007 as their cost of capital increased, available leverage decreased and they suffered negative publicity from busted deals. Strategic investors began to top sponsor-backed going private transactions, including Community Health Systems coming in as a result of a go shop to top the sponsor-led buyout of Triad Hospitals. Sponsors also witnessed increasing competition from SPACs. In 2007, SPACs went mainstream with bulge bracket Wall Street firms underwriting offerings by experienced management teams led by such reputable dealmakers as Tom Hicks, Ronald Perelman, Nelson Peltz and Michael Gross. Sovereign wealth funds also began to make their mark in direct investments such as Barneys and active pension funds such as Teachers Private Capital and PSP Investments led direct investments in BCE and Loral Skynet. Hedge funds are also increasingly raising stand alone private equity funds which will compete with private equity sponsors, particularly in special situation and distressed investments. On the positive side, the increasing activity by other financial investors may enhance sponsors’ liquidity opportunities for their existing portfolio companies.
Breaking Up Is Hard To Do – One of the lessons of the credit crunch was that buyers and sellers didn’t always have a meeting of minds on the circumstances in which a buyer could terminate a merger agreement and a seller’s available remedies in the event of termination. Another lesson was that even if there had been a meeting of minds merger agreements were sometimes drafted so ambiguously that the rights and obligations of buyers and sellers were unclear. Two examples of this were the lawsuits over whether there had been a material adverse change allowing the buyer to terminate its agreement to buy SLM Corp. and whether a reverse termination fee was United Rentals’ exclusive remedy upon termination (as opposed to specific performance of the agreement). On the other hand, we also saw some creative dispute resolution mechanisms used in connection with the termination of existing deals. Examples of this included HD Supply, where Home Depot agreed to reduce the price of HD Supply as well as to guarantee a portion of senior debt and make a minority equity investment, and Harman, where the sponsors agreed to make an investment in the convertible debt of Harman as part of the settlement of a dispute as to whether a MAC had occurred which would have entitled them to terminate the merger agreement.
Increased Creativity in Arranging Debt Financing – After traditional LBO credit sources dried up over the dog days of summer, debt financing ceased to be a commodity and became a differentiating ability for sponsors. Some of the more creative approaches that emerged included seller financing in the Chrysler transaction, financing from non-traditional LBO lenders such as Asian banks in the 3Com transaction and arranging financing directly with hedge funds rather than through an arranger in the Goodman Global transaction. In addition to the demise of PIK toggle tranches, covenant-lite loans and equity bridges, we also saw a renewed focus by both borrowers and lenders on the nitty gritty details of debt commitment papers. Certain lenders pushed for the return of “market MAC” and “no new adverse information” conditions but lenders were generally more successful at broadening “market flex” provisions and tightening up on “sponsor precedent” language in commitment papers. Other provisions in credit papers, such as maintenance covenants and the ability to do “equity cures” of those covenants, were also generally tightened.
Investment Focus Shifting – One of the principal stories of the first half of the year were mega-LBOs where industry professionals speculated that not even $100 billion buyouts were out of reach. However, due to the uncertain credit environment, mega-LBOs are now mega-gone and sponsors are increasingly shifting their investment focus from traditional LBOs to investments that require little or no additional leverage to achieve targeted investment returns, including PIPEs, growth capital minority investments, investments in companies that already have leverage that can be rolled over and emerging market investments. Sponsors are also increasingly focusing their investment activities on
making accretive add-on acquisitions at portfolio companies that are platforms for further growth.
Evolving Nature of Clubs – Club deals were still popular in 2007 but clubs among sponsors involved a smaller number of sponsors and the nature of clubs evolved to include lending banks providing equity bridges, clubs between sponsors and strategics (e.g., 3Com) and clubs arranged by sponsors comprised primarily of a large number of “passive” institutional investors (e.g., Laureate Education). In 2007, one lawsuit against several sponsors alleging violations of the antitrust laws was dropped while another lawsuit was filed in Federal District Court in Massachusetts just before year end. It is also unknown whether the reported Department of Justice inquiry into club deals is continuing or not.
Death and Taxes – Due to the publicity and returns achieved by the private equity and hedge fund industries, Congress began to focus its attention in 2007 on changing certain tax characteristics applicable to the private equity industry, including proposals to eliminate the capital gains treatment of carried interest, the exception to the publicly-traded partnership rules relied on by sponsors that go public and limiting the benefit of offshore deferral of management fees. Across the pond, the UK went one step further in actually announcing legislation that increases taxes on carried interest from a 10% to an 18% tax rate effective April 2008.
Increasing Interest by Regulators and Others – The regulatory spotlight also began to shine on sponsors in 2007 with Congress holding hearings on private equity ownership of nursing homes. Unions also became more active critics of the private equity industry, with the SEIU attacking Carlyle’s purchase of Manor Care and making personal attacks on David Rubenstein and Henry Kravis. Across the pond, the British Venture Capital Association adopted proposals by Sir David Walker to make the private equity industry more transparent to regulators and union activists in an attempt to stave off additional governmental regulation of the industry. Accessing Public Capital – Sponsors continued to try to access the public capital markets in 2007 with Fortress, Blackstone, Apollo, Oaktree and Och-Ziff all completing IPOs. Apollo and Oaktree elected to effect their IPOs through an unlisted 144A offering that trades through the GS TrUE platform. Although the stocks have not performed as well as hoped, other sponsors such as KKR are lined up to take advantage of any market openings for additional IPOs in 2008. Sponsors also continued to have an interest in public offerings of permanent capital vehicles in 2007, including the offering of a permanent capital vehicle by HarbourVest on the Euronext exchange.
Predictions for 2008
Predictions for the U.S. private equity market in 2008 include:
Strong Private Equity Activity Continues – It is hard to bet against this one. Yes, the credit markets are currently sub-optimal but sponsors have a lot of equity capital at their disposal and debt is available for midmarket and select larger LBOs. We expect sponsors to also deploy capital in an increasing number of PIPE transactions, un-leveraged control investments, minority investments and emerging market investments, as well as add-on acquisitions by existing portfolio companies. However, we also expect to see increasing competition for sponsors from strategic investors as well as from sovereign wealth funds, hedge funds, SPACs and certain pension funds (and we expect that sponsors will focus on these investors to also provide them with liquidity options for their portfolio companies). The competitive landscape for sponsors is worse than it has been for awhile as their cost of capital has increased, available leverage has decreased, seller price expectations remain high and sponsor return expectations remain relatively high compared to many of their competitors. After price, deal certainty is the most important point to sellers and some of the recent negative publicity about sponsors related to busted deals may make some sellers more wary of dealing with sponsors.
Traditional Debt Providers Return Cautiously – At year end, Wall Street banks still had a large pipeline of leveraged loans to syndicate. New commitments will be made but not at the same pace as this backlog is worked through. New commitments will also be on more onerous terms than the first half 2007 commitments. However, despite the prediction by some that financing conditions in acquisition agreements would return and that soon after sponsors would see the return of “market MAC” and “no new adverse information” conditions in their commitment letters, financing conditions have generally not returned given the reality that sponsors must compete with strategic investors and others that do not need financing conditions for deals. We would expect this to continue and that generally sponsors will be able to obtain commitment letters with conditions that are generally tied to the conditions in the acquisition agreement. However, lenders will be taking a harder look at the MAC condition in acquisition agreements and to ensure a successful syndication they will be insisting upon more flexibility in upfront pricing, including more flexibility to issue loans with OID, and broad market flex provisions.
The Written Word – One of the lessons of 2007 was that the contracts that buyers and sellers of corporate businesses signed didn’t always stand up well to stress testing. In particular, many MAC definitions were glaringly ambiguous and didn’t provide either buyers or sellers with certainty as to when a MAC was triggered and, as the United Rentals trial just proved, some acquisition agreements were ambiguous as to whether a seller had the ability to specifically enforce an acquisition agreement against a buyer even when the agreement had an express reverse break-up fee to be paid
in the event of termination of the agreement. We expect that both buyers and sellers will be paying more careful attention to acquisition agreements going forward to avoid these kinds of problems. Based on the limited number of going private transactions announced since the credit crunch began last summer, it is too early to report on any trends in material changes to deal terms as a result of the credit crunch and its aftermath. However, we do note that (i) none of those transactions had a financing out despite the credit crunch as sellers remain unwilling to assume the risk of the buyer obtaining financing, (ii) the sponsors in two of those transactions agreed to fund the purchase price entirely with equity in order to further provide the seller with comfort on the availability of financing, (iii) three of those transactions had an express closing condition tied to trailing EBITDA or some other financial measure rather than relying exclusively upon the MAC, (iv) one of those transactions had a reverse termination fee that was approximately four times the size of the break-up fee, (v) one of those transactions required the sponsor to place the reverse termination fee in escrow at the time the merger agreement was signed and (vi) two of those transactions had no reverse termination fee and no express cap on damages and permitted the target to seek specific performance in the event of a breach by the buyer.
Continued Institutionalization of the Alternative Capital Industry – One of the key trends in recent years has been the institutionalization of the alternative capital industry. Examples of this trend including the expansion of product offerings by private equity sponsors into other alternative asset classes, including real estate funds, infrastructure funds, credit opportunity funds, mezzanine funds, hedge funds, fund of funds, distressed funds, regional funds and sector funds, taking management companies public, raising permanent capital vehicles and offering minority investments in management companies to institutional investors. Much like the situation with investment banks 20 to 25 years ago, the industry is evolving into a handful of global alternative capital brands on the one hand and more boutique private equity sponsors on the other hand. One of the major arguments for going public was that it would permit sponsors to use their equity as a form of currency to acquire other alternative capital platforms. We would not be surprised to see further institutionalization of the industry through stock-for-stock transactions between alternative asset managers. We also expect to see sponsors increasingly attempt to improve their debt and equity execution capabilities by hiring in-house finance specialists (such as what Blackstone and Summit Partners have already done) or by setting up in-house capital markets capability (such as what KKR has done). For example, in the recent Goodman Global transaction Hellman & Friedman arranged a significant portion of the debt itself directly with Farallon and GSO and in the recent Rockwood secondary offering KKR Capital was a co-managing underwriter of the offering.
Return of Distressed Activity – Although the current default rate for leveraged credits remains at a historical low, leveraged credit indices (such as the LCDX index) imply a significant near-term rise in default rates. We expect that sponsors will be spending an increasing amount of time working with their own portfolio companies which experience operating or liquidity issues. We also expect that mainstream private equity sponsors (as opposed to distressed specialists) may be more active buyers of distressed businesses than they were in the last cycle. Healthier operating businesses with balance sheet problems may be more likely to file for bankruptcy than in the past and recent changes to bankruptcy law may give management less latitude to restructure the business rather than sell it.
Meaningful Regulatory or Legal Impediments Unlikely – Despite the noise in Congress and among certain union activists, we don’t see much likelihood of major regulatory changes to the private equity industry in 2008. This recognizes both the hope that the Private Equity Council and the industry will do an effective lobbying job to get the message out regarding the benefits of the industry as well as the lack of strong regulatory initiatives.