Published: Dec 13, 2007 in Knowledge@Emory
With stubbornly high energy prices and a falling housing market poised to take the wind out of consumer spending, a key driver of the U.S. economy, some observers wonder if a spillover effect will also crimp another economic powerhouse: leveraged buyouts of publicly held companies by private equity firms. Buyout activity has become an increasingly important component of the U.S. economy, growing from $24.6 billion of activity in 2000 to $356.7 billion during the first 11 months of 2007, according to Thomson Corporation, a global provider of financial and other information.
Will An Economic Contraction Affect Private Equity?
But much of that 2007 activity took place in the first half of the year. Now, many lenders are cutting back on activity because of losses associated with the sub-prime lending crisis. As a result behemoth deals —like the $44.3 billion buyout of the Dallas, Texas energy producer TXU Energy that was announced in February—may be the last for some time, say experts at Emory University’s Goizueta Business School.
They add, however, that buyout activity is not likely to dry up completely as investors will continue to seek out companies that they believe are either undervalued by the market or that present unique opportunities. Instead, the pace of such buyouts may drop, and there may be a shift in the kinds of companies that are targeted.
“Cheap debt is gone, at least for now, but that actually makes private equity even more important,” says Larry Benveniste, dean of Goizueta Business School. “The big deals [like TXU] may be over, but we can anticipate seeing less-expensive transactions, for $10 billion or less” such as the $7.4 billion deal that private equity firm Cerberus Capital Management LP struck in August to buy a majority stake in Chrysler Group from the automaker’s former parent, DaimlerChrysler AG.
The big question, says Benveniste, is how private equity firms will be able to add value to their portfolio companies.
“If it becomes more difficult to raise capital, I anticipate seeing fewer ‘financial’ deals [where the buyer hopes to quickly sell an acquired company at a healthy profit] and more ‘strategic’ deals,’ where the buyer adds management and other intellectual as well as financial capital to the acquired company,” explains Benveniste, who is also a chaired professor of finance at Goizueta. “One advantage of going private is that a company is freed from short-term pressures to report increasingly higher profits from one quarter to the next. Management at privately held companies may have the chance to focus on longer-term metrics and goals. There are many candidates for private equity funds since almost every industry has viable target companies that could be improved.”
For example, he says, if the credit market continues to swoon and real estate assets continue to lose value, property developers and other real estate-related companies could represent a buying opportunity for private equity firms.
Benveniste adds that the Goizueta Business School plans to establish a Center for Private Equity and Hedge Funds to study whether investors are getting good risk adjusted returns compared to capital markets, whether businesses improve fundamental performance when they are taken private, and other issues.
Some Risks, But Opportunities Too
“There are risks and opportunities,” says Klaas Baks, a finance professor at Goizueta. “Right now it is more expensive to get money, primarily because the subprime mortgage challenges have caused a pullback in the willingness of banks of make loans. But mezzanine debt [generally, high interest debt capital that also gives a lender the right to convert to equity interest in the company] is still available because mezzanine lenders are satisfied with the rate of return that they may be able to achieve.”
In fact, explains Baks, the current tight-lending environment may actually mean that private equity firms may get a better return on their new investments. It all depends on supply and demand for companies.
“The easy-credit environment, which existed until about August of 2007, tended to increase the demand for companies and drive up the price of companies that were targeted for a leveraged buyout or a merger or acquisition,” he says. “Now that capital is less available, demand for companies has lessened and the acquisition pricing for some companies may start to come down.”
The shift in capital costs may drive a series of other changes, he adds.
“When debt was cheap, stock market valuations tended to be high,” says Baks. “But the combination of a pullback in available debt, and the prospect of a downturn in the economy could make it more difficult for companies to turn a profit and they would be in need of re-structuring. If that happens, then buyout firms are likely to look more closely at takeover candidates, and perhaps renew their focus on the candidates’ performance in their core business activity.”
Private Equity Tries A New Approach
While some private equity investors focus on rebuilding the management of a company, others buy multiple companies in similar sectors and seek to gain operating and other efficiencies through consolidation.
“Depending on what happens in the broader economy, private equity firms may target certain types of takeover candidates,” observes Baks. “Performance, cost, tax advantages and other considerations are all part of the deal-making process. There are likely to be some significant changes in the focus of private equity firms, but it may be too early to definitively say what they will be.”
One visible change is private equity providers’ increased interest in overseas markets, says Jagdish Sheth, a chaired professor of marketing at Emory University’s Goizueta Business School. “Private equity is finding enormous opportunities in emerging economies like India, Russia and, to a lesser degree, in China and Brazil.”
He says in India’s case, this interest is due in part to the high level of global integration the nation has achieved.
“India has engaged the global economy in a different way than most other emerging economies,” says Sheth. “Instead of simply offering itself as a low-cost producer, Indian companies have established themselves as major players by purchasing firms in the U.S. and Europe.”
In February, for example, India’s largest aluminum producer, Hindalco Industries Ltd., agreed to buy U.S.-Canadian rival Novelis for about $6 billion in an all-cash deal. Novelis, the world’s largest producer of rolled aluminum, has a customer list that includes The Coca-Cola Company. Two weeks before that deal, The Tata Group, one of India’s largest conglomerates, paid $8.1 billion for Corus Group Plc, an Anglo-Dutch steelmaker.
“Private equity is racing ahead in India, and in Russia, in contrast to the public markets, because the stock markets are still immature, especially in Russia and China,” explains Sheth. “There is less transparency or corporate governance, and consequently there is some degree of insider trading that can distort the market.”
Sheth notes that in the U.S., private equity’s growth is attributable in part to a shift in its focus.
“The previous generation of private equity firms tended to buy distressed publicly held companies at a steep discount, strip their assets and then dump what was left,” he says. “But the current crop of private equity providers operates more like Warren Buffet’s Berkshire Hathaway organization, investing in a company and working on a long-term growth strategy.”
Sheth sees this, for example, in Cerebus’ deal for Chrysler.
“[Former Home Depot Inc. CEO] Robert Nardelli was hired by Cerberus to be the new CEO of Chrysler,” says Sheth. “Executives like that—who leave a company with a golden parachute—could easily retire. But when they put their own money into a venture and join the management team, you can be assured that they’re not looking for a quick exit.”
He notes that someone like Nardelli, who has hands-on experience running a large company, can bring corporate governance, management, financial and other skills to a venture and possibly prepare it to once again go public. Sheth also says that, independent of up and down cycles in the economy, private equity deals will continue to be driven by two other factors: the short-term results demanded by the public market, and the costly requirements associated with the federal Sarbanes-Oxley Act of 2002.
Stiffer Regulation May Spur Unintended Consequences
Sarbanes-Oxley [passed in the wake of Enron Corp. and other business scandals] was designed to help the public and regulators learn more about the way in which companies run their affairs.
But as Finance professor Baks points out, “instead, it appears to have helped to spur buyouts as more companies go public to escape the onerous costs [$2 million a year or more for large companies, by some estimates] associated with Sarbanes-Oxley.”
Now, he says, multiple segments are calling for increased transparency on the part of private equity firms.
“As more pension funds, universities and other institutions make significant investments in private equity firms, trustees want to get a better understanding of the returns,” says Baks.
Additionally, as private equity investment accounts for an increasing share of overall economic activity, it has attracted more interest from regulators in Washington, D.C., says Baks.
“The concern is that if operational and other details are hidden, it may be tougher for outside investors to have a say in the way that private equity firms run their portfolio companies,” he says. “On the other hand, too much disclosure may tip off important strategies to business competitors. So while too little disclosure may be bad for investors, too.