In the 'blame game' that invariably followed Mitt Romney's unsuccessful bid for the US Presidency, Republican strategists have identified his links with the secretive world of private equity investment as a negative factor at the polls, rather than any reluctance on the part of the electorate to vote for a devotee of a religious minority.
After all, they opted for Barack Obama four years ago when - according to a survey conducted by the Washington-based Pew Research Centre - one-in-five registered voters believed he was a Muslim. Only in America. Of course, Mitt may have secured a popular mandate despite the Swiss bank account and the funds squirrelled away in tax havens such as Bermuda and the Cayman Islands, but his tenure as chief executive of Bain Capital was never likely to endear him to a US populace already wary of deal-makers who go out of their way to avoid public scrutiny.
As Mitt Romney found to his cost, distrust of private equity companies has never been more acute. Many believe they actively encouraged the reckless behaviour of the Wall Street investment banks that precipitated the 2008 financial crisis - and then profited from the ensuing collapse in asset prices.
A class action lawsuit was recently filed by a group of US investors against Bain, Carlyle Group, Blackstone and other private equity companies, alleging that they colluded to artificially lower the prices they paid for companies in 19 deals leading up to the crisis. We've been here before, of course; the rash of leveraged buyouts during the Reagan era generated a similar degree of opprobrium.
Despite the criticism, there are those who maintain that the industry creates value by helping to transform underperforming assets into stronger and more profitable businesses. That might be true of many individual deals within the sector, but how have the private equity companies fared once they've gone public? Is there really a case for 'following the smart money?' If we look at four prominent multi-billion dollar private equity companies that were listed in New York over the past five years, we can see that it's been a decidedly mixed bag for investors.
Where's the equity?
Shares in both Blackstone Group (NYSE: BX) or Fortress Investment Group (NYSE: FIG) have been trading below their opening price since their initial public offerings (IPO) on the NYSE five years ago. Investors who took that initial plunge would have seen their capital shrink by 57 and 86 per cent respectively, although shares in Blackstone have demonstrated a degree of resilience since they bottomed out in February 2009.
That's a truly abysmal performance, but it might explain why management at Carlyle Group (Nasdaq: CG) decided to price its $671m (£419m) IPO at a significant discount to sector peers when it joined Nasdaq in May. Since closing at $22 on its first day of trading, the shares have gained $4.03 in the intervening period. Suffice to say, neither Carlyle's chief executive David Rubenstein, nor any of the co-founding partners, were forced to hive off any of their personal holdings on the same terms, but at least investors who got in on the ground floor have already made a tidy return on their capital.
The decision to pitch a lower than expected IPO price raised a few eyebrows, but it was obviously a tough sell at the time, and it may serve to improve institutional sentiment over the long haul, particularly after the abject performance of some sector peers. And prospects could be improving; a note just published by analysts at JPMorgan asserts that "fundamentals are good at Carlyle as market conditions are presenting opportunities to both invest and harvest, in a way we are not seeing for other private equity firms".
JPMorgan is also positive on prospects for KKR (formerly known as Kohlberg Kravis Roberts & Co). An analyst note from October points out that while KKR is building out a capital markets business, and has less private equity under management than Carlyle, the "aggregate multiple to 2013 consensus earnings of 5.8 is well below the peer group average of 7.5". It's worth noting that KKR currently offers a yield of 3.5 per cent.
Since floating on the NYSE at the tail end of 2010, shares in KKR have increased by 38 per cent in value, although they are now $3.74 adrift of their high point of $18.96 achieved at the end of April last year. KKR created corporate history during the late 1980s through the $31bn leveraged buyout of US food giant RJR Nabisco – this remained the largest deal of its type for nearly 20 years – and was chronicled in the best-selling exposé Barbarians at the Gate.
The suspicion must remain, however, that the chief beneficiaries of the public listing of shares in private equity companies are the partners themselves. By going public these companies can raise cheap capital by selling non-controlling stakes that can be used to provide a one-off windfall for partners and pay down any accumulated debt. Let's not forget that the basis of the private equity model is to acquire a controlling stake in an underperforming, or undervalued asset, utilising a high equity/debt ratio - knock said asset back into shape - and then float it publicly at a substantial premium.
As private concerns, the likes of Blackstone and Fortress Investment have been very successful at doing just that, which begs the question: why would they be inclined to sell low when they're hiving off their own shares? Perhaps the penny dropped by the time the Carlyle IPO was set in motion.
UK perspective
The UK private equity industry, though relatively modest by US standards, does account for around 60 per cent of the allocated funds in European markets. There’s no shortage of investment options for gaining exposure to this segment of the investment market, but the contrasting experiences provided by two well-known UK entities - 3i Group (III) and HgCapital (HGT) - are worth examining. They point to a clearly defined investment strategy as being the most important attribute of a successful private equity investment company.
With assets under management in excess of £3.8bn, HgCapital has grown rapidly since it was established at the turn of the millennium. The trust targets medium-sized companies across Europe for its buyout targets, typically within niche sectors that are growing at two to three times GDP. To this end, HgCapital has made a number of prominent private equity investments in the e-commerce industry in recent years, including those for GroupNBT, Visma and Epyx. Despite the economic downturn, these companies have produced consistent growth in revenue and profit in excess of 10 per cent a year since the financial crisis.
HgCapital is also one of the most prominent investors in the renewable energy sector. On the face of it, this might seem an unlikely destination for private equity funds, but the group's strategy essentially revolves around delivering economies of scale through aggregating similar assets. This certainly makes sense in terms of the renewable sector as the attrition rate among start-ups is often linked to fragmentation within the sector and an insufficient concentration of capital.
It is obviously more difficult to realise investments as opposed to identifying them in the current economic environment, but the HgCapital strategy is proving resilient even in tough times. Net asset value (NAV) has grown on an annualised basis by 6.3 and 19.2 per cent over the past five and 10 years respectively.
The performance of 3i Group hasn't been nearly so impressive over the long haul, but with £10.5bn in assets under management, it is perhaps the UK's most prominent listed player in the sector. The group targets investments in private equity through either majority or minority stakes in mid-market companies with an enterprise value up to €500m (£405m) located in Europe, Asia and the Americas.
The group has been attempting to re-kindle institutional support this year after doubts emerged over its existing investment strategy. Performance has been held back by a number of indebted companies on its buyout portfolio that were bought at the height of the debt-driven private equity boom before 2008.
New chief executive officer Simon Borrows has announced a new investment strategy and has pledged to earmark shareholder payouts of between 15 and 20 per cent of any company sale proceeds, assuming gearing is below 20 per cent. Nevertheless, 3i is struggling under the weight of an underperforming portfolio. The group intends to lay off more than a third of its staff and cease new private equity investment outside northern Europe and Brazil. Despite trading at a hefty discount, investors are likely to remain wary until it becomes obvious that management has successfully initiated a more focused investment strategy.
HG holds up in the wake of 2008
Where's the money gone?
So, American private equity companies are having a bumper 2012 and low borrowing costs are making it easier for others, too. Global private equity buyout volume has topped $148bn already this year, according to the latest data from Dealogic. That's down a little on 2011, but the third quarter saw over $63bn of business, more than at any time since the second quarter of 2008. What's more, the amount spent by private equity companies buying and selling to each other - so-called secondary buyouts (SBOs) - hit a five-year high at over $28bn in the three months to September.
True, there have been fewer blockbuster deals normally associated with private equity. Since 2007, hardly any have been worth over $10bn. In fact, only Blackstone's acquisition of Bank United in 2009 hit 11 figures. Nearly all the biggest private equity deals ever done, worth nearly $1.4 trillion in all, were thrashed out in the heady days of 2006-07, before the house of cards came crashing down so spectacularly.
One of them, the purchase of Alliance Boots by KKR for around £12bn, generated a big slice of this year's volume, too, and triggered big profits for its canny buyers. KKR teamed up with Italian pharmacy billionaire Stefano Pessina in 2007. Private equity had never bought a FTSE 100 company before, so the repercussions were tremendous, not least because ownership of yet another much-cherished British brand was heading overseas. The sight of Debenhams going the same way just a few years before was still fresh in the memory.
By then, however, and just months after Blackstone had sold the last of its controversial stake in doomed care homes provider Southern Cross, a Treasury select committee had convened to examine the impact big private equity takeovers of large UK companies was having - Carlyle's Robert Easton, KKR's Dominic Murphy, Permira's Damon Buffini and Philip Yea, who was running 3i at the time, all gave evidence. Pertinently, Jon Moulton of Alchemy said at the time the private equity market was "near its top". He was right.
Incredible, then, that KKR and Mr Pessina easily doubled their money having just sold 45 per cent of their stake to Walgreens for £4.3bn. America's largest pharmacy chain has an option to buy the rest for another £6bn. A turnaround in fortunes means another deal done at the height of the boom - Blackstone's $26bn (£13bn) acquisition of hotel chain Hilton Worldwide - could make its owners a roomful of cash, too. Hilton will float within two years, bosses say. It could be much sooner.
Elsewhere, with Formula One's flotation in Singapore off the agenda, CVC Partners sold down its stake in the motor sport circus during May and June from 63 per cent to 35 per cent. That banked CVC $2.1bn - already more than it paid for the holding in 2006 - and papers seen by Bloomberg show it's made nearly five times its money on the original deal.
But it's a consortium that includes Apollo Global Management and Riverstone Holdings that's responsible for the biggest deal of 2012, so far. They paid over $7bn for the energy and exploration unit of El Paso. UK-based BC Partners has been spending big, too. It teamed up to buy digital TV, internet and telephone provider Cequel Communications for $6.6bn and got together with Carlyle to take Hamilton Sundstrand's industrial pumps business from parent United Technologies for $3.4bn.
And it's Carlyle that's been the industry's major driver of private equity deals in its first year as a public company, nailing a quartet of big-ticket acquisitions that culminated in the $4.9bn purchase of DuPont's global auto paint business. In a strategy that has been likened to that of Warren Buffett's Berkshire Hathaway, Carlyle has essentially been buying non-core businesses with transparent, easily understood profit models.
This year's targets have been involved in traditional industries such as chemicals, print media and energy. Carlyle and the management of Getty Images paid $3.3bn to acquire a business - a huge photo and digital archives library - from San Francisco-based investment company Hellman & Friedman. Earlier this year, the group also teamed up with Genesee & Wyoming in a $1.4bn acquisition of RailAmerica.
It was interested in Chemring at one time, too, until a pair of profits warnings convinced Carlyle to give the struggling UK defence company a miss.
Private equity buy-outs
Quality issue
According to the latest data, it looks as though private equity companies are chomping at the bit to do more. They’ve got a pile of cash and securing credit for new deals is getting easier, according to Ernst & Young. The funding environment is improving, too. But there’s a problem.
Quite how the eurozone crisis is going to pan out remains difficult to predict and a seventh consecutive quarter of slowing annual growth in China is causing frayed nerves in boardrooms everywhere. Indeed, less than a fifth of the 1,500 executives questioned by Ernst & Young expect to sell parts of their businesses in the year ahead. That’s the lowest on record and down from 31 per cent in April.
It seems, then, that the inevitable squabble among private equity buyers for a dwindling pool of assets will drive an increase in valuations. There’s already evidence of a growing gap between the aspirations of buyers and sellers. Over a third of private equity companies are worried about the quality of what’s currently available, and it could get worse.
Reluctance among companies to buy could also mean the industry will have problems selling their own assets, to corporate buyers at least. Only a quarter of company executives plan to buy anything in the next 12 months and most of those have less than $500m to spend. Private equity salesmen will have to be at their best.
Given the treacherous nature of IPOs right now, one suspects the number of secondary buyouts will rise sharply. Certainly, insiders think so. Over three-quarters reckon there will be more deals done between private equity companies in the year ahead, especially for the larger portfolio companies, given shrinking corporate warchests.
So, does this mean fewer headline grabbers? Ed Bridges, private equity adviser at FTI Consulting, doesn't think so. "Yes, more equity is needed to do deals these days - the 80:20 debt/equity split is over for the time being. But that’s not a showstopper in any way. There are still transactions to be done above €2bn."
Where's the hot money flowing?
Whatever the obstacles, deals will get done, but where? Sectors such as medical technology (medtech) are always popular - last year, it accounted for around 40 per cent of all healthcare private equity deals by value. "These businesses can generate the strong cash flows that private equity needs to service the debt and fund expansion," says Mr Bridges.
In the past couple of years there have been more transactions in technology, energy and real estate, too. "Private equity guys are creating separate energy funds with highly skilled teams," explains Jeff Bunder, head of global private equity at Ernst & Young. "There's a large pool of assets such as natural gas exploration and oilfield services."
More than eight out of 10 private equity outfits are chasing assets in so-called emerging Asia. Most of the big hitters are already there - TPG, run by billionaire David Bonderman, has been there longer than most, using Singapore as a base to target the fast-growing economies of Thailand, Vietnam and Indonesia. The rest will follow. "Private equity is always looking to invest, either directly or indirectly, in areas where you can drive growth. South America, Africa, India and Asia are interesting," says FTI's Mr Bridges.
But latecomers may find the pickings not so rich. Research by the Asian Venture Capital Journal (AVCJ) reveals just $2.5bn of deals done so far this year, and only six above $100m. It can be expensive, too. A stake in Siloam, Indonesia's largest private hospital operator, is up for grabs to anyone prepared to pay 25 times cash profits, reports the AVCJ. Private equity buyout multiples in the west are struggling to hit double figures.
Still, old favourites such as China, despite growing competition from new local funds, and India remain popular. And there’s an increased sense of urgency among policymakers in emerging markets to attract investors. Pension reform in Brazil and South Africa means more pension fund money can be invested in private equity. Tax changes in India should help, too.
However, it looks like Russia is beginning to attract the hot money. It’s chicken-feed at the moment - not even $500m of deals have been done there so far this year, six times less than India and just a fraction of the business going on in China. A lack of political and legislative transparency, shortage of large, quality assets and short-termist investment culture is hampering progress, too.
Yet, according to Ernst & Young, almost half the foreign private equity firms it talked to want to pump more capital into Russia. GDP growth of 4 per cent this year is clearly attractive and looks likely to continue for the foreseeable future, underpinned by rising consumer spending among the emerging middle class. Unemployment is falling, too, and there's a well-developed telecoms infrastructure. Setting up the Russian Direct Investment Fund and recent membership of the World Trade Organisation can only help.
