Private Equity: Is mega back?
With the high-yield market on fire and household names being plucked from public markets, Joseph Mariathasan asks if we are heading back to the heady days of the 2006 ‘mega’ buyout
When banks were shovelling money at the leverage-loan market in 2006-07, enabling private equity buyout firms to tilt speculatively at public-market large-cap firms they could only have dreamt of acquiring before (and on the odd occasion actually running away with the spoils) only one word would do to describe the phenomenon – mega.
Now, barely four years after the financial crisis devastated anything with a hint of leverage around it, credit markets, particularly in the US, are booming again. Moreover, GPs are sitting on three years’ worth of investment capacity that they have to put to work before they can raise new funds. Does Warren Buffett’s bid for Heinz and the $24bn proposed buyout of the computer maker Dell by its founder and Silver Lake Partners signal the re-emergence of ‘mega’?
It is clear that there is still appetite for large-cap buyouts.
“Over the last 10 years they have performed as well as, if not better than, the mid-market,” says Paul Newsome, head of private equity investment selection and monitoring at Unigestion. “That is because they are investing in large, stable businesses that can withstand economic downturns and have the scale and means to attract higher-quality management.”
He argues that while they were both over-leveraged and over-priced in 2006-07, few actually went under water because the banks were so anxious not to see them fail that they were willing to finance their loans when covenants were breached. As a result, investors still see large-cap buyouts as stable investments that deserve a place in the portfolio.
Add to that the fact that there is more debt available now than in the immediate aftermath of the crisis. Across the US and Europe, the high-yield market has hit record highs. Last year in the US, almost $500bn of high-yield debt and $400bn of leveraged loans were raised for private equity deals. And then there is the exit market, which also looks increasingly supportive. Russell Steenberg, head of private equity at BlackRock points out that the corporate sector has several trillion dollars of cash on its balance sheet.
“This cash will ultimately come into the marketplace, so the private equity community, at the large end in particular, will benefit,” he predicts.
The strength in the leveraged loan and the high-yield markets has also meant that distributions that have been coming out of private equity portfolios have also been very strong. “In 2012 the total distributions were even better than the 2007 totals which were the best in history and, as a result of that, the amount of equity that has to go into transactions is coming down a bit and you are seeing the volume of transactions pick up,” says Steenberg.
Nonetheless, the consensus appears to be that the Heinz and Dell deals are very much outliers, driven by very specific circumstances not reflective of the wider market.
“Despite the growth in volume of deals, the size of individual deals has not picked up – except for the Heinz and Dell deals,” explains Steenberg.
Of course, it’s all relative. It is perhaps not surprising that the definition of what constitutes a ‘large’ or ‘mega’ deal has changed dramatically from the pre-crash years of excess. Steenberg sees a mega deal today as anything above $5bn in deal size – and even those have been very rare. Steenberg’s preference is for what he refers to as the upper mid-market, with transaction sizes of between $800m and $2bn.
“Historically, this has been a very good place to be because they have the exit opportunities of public markets as well as strategic buyers, but they can also sell to the mega funds that are looking to deploy their capital to build up their portfolios,” he reasons.
And there are good reasons why the mega deals of the pre-crash world are unlikely to recur. “Raising debt to finance private acquisitions of publicly listed companies at premiums to their quoted prices was simply feasible because of the high level of debt mispricing,” says Neil Harper CIO of the private equity group at Morgan Stanley Alternative Investment Partners. “That is not the case today.”
The good news, he adds, is that today’s ‘mega’ deals have to be transformational and, therefore, the sources of added value have to be more sustainable.
“On the other hand, I don’t see a large number of them happening and the subject is getting attention only because it is so rare and there have been a couple of high-profile transactions attempted,” he suggests.
Newsome concurs: “Is the debt capital being raised today generally going to go to mega deals? I would say no”.
Even the general overhang of investment capacity still in the marketplace gives a misleading picture. Today’s overcapacity is 40% down from in 2008-09, when buyout firms were sitting on five years’ worth of capacity, Newsome reckons.
While there is strong demand for large-cap deals, another factor that has changed sentiment towards the $10bn-plus mega sector is that a number of the pre-crash mega deals, while not disasters, were not great successes either.
The $11.3bn acquisition of Sungard in 2006 in a deal led by Silver Lake with a club of six others has not performed as well as expected. Nowadays, LPs show little patience with these kinds of boom-time syndicates. “They say: ‘We invest in Bain Capital because they have all this operational value-add, so we don’t want them teaming up with someone else and diluting that just to do a larger deal’,” says Newsome.
Finally, Newsome points out that recently-raised private equity funds are much more modest than the pre-crisis behemoths, and therefore much less able to put capital to work in mega deals.
“Recent funds by Cinven, Apax and so on in Europe, and from US firms like Carlyle, Bain and Providence, are all targeting significantly smaller fund sizes,” Newsome observes. “If you talk to them they are much less inclined to club together and do large mega deals than pre-2007, as a result of LP dissatisfaction.”
The demand for mega funds has also fallen somewhat, primarily because fund-of-fund investors find that they cannot justify their existence to their own client base by having large weightings to well-known mega funds launched by large household names that their own investors can access directly. “In our managed accounts around 20-30% would be large-cap while eight years ago, it would have been perhaps 30-40%,” Newsome admits.
LPs are insisting that the skill of the fund-of-funds investor is to find the off-the-beaten-track middle-market and lower-middle-market sector funds, and special opportunity funds. Mega-funds, whatever their size, might still provide a useful component of any private equity portfolio, but their time of domination will remain a memory of days gone by.