Interview: Private Equity Mega Buyout Fund
Today in the next set of interviews with Private Equity, I will be providing the text from a conversation with an investment lead at what is considered to be one of the mega Private Equity funds. I will not be able to provide specific information on the interviewee or the firm name due to the fact that approvals from their PR department would be quite lengthy, so I decided on anonymity, speed and content over names. I assume you will find it useful none the less and I am very appreciative of my interviewee for the taking time to answer some questions.
Private Equity has been undergoing pressures, just like other sectors in the economy, what are some of your biggest concerns?
(A): The macro environment is the biggest concern for us and everyone else out there. Demand is weak, which weakens pricing and causes profits to erode. Declining profitability is a particular concern for a Private Equity firm since we built our leverage models on growing and not declining earnings. If we thought earnings would decline, we would have never completed the purchase in the first place. The effect on the leverage model on declining earnings is more severe since it inhibits your ability to service debt. Because that is not in the investment thesis, it makes the debt more ominous. Of course, on the upside, the use of debt is what enhances returns for our investment. You just need to be careful in your investment model.
What steps are you taking to address these issues?
(A): Obviously, there are only so many things you can do in a down economy. However, you can take the opportunity to enact long term beneficial changes within your holding company or make decisions aggressively capture market share from the competition which may be distracted in this challenging climate. A down market is a good time to examine these and other tough decision since it is often hard to enact change in good times due to a higher level of resistance (if it’s not broke don’t fix it). The key is not remaining paralyzed in any market.
Being Private, we also have the benefit of not having to answer to the street in the short term. This allows our people who have expertise operating in leveraged environments to implement long term plans to create long term value for our investment. We manage the short term earnings to service debt requirements and reduce distress. Another lever we use is to align management incentives to a larger degree with this approach. While our portfolio management teams may benefit on the upside, they share the risk on the downside so we tend to have very close alignment of goals when we set our corporate expectations and strategy. This is different from many managers of public companies who may benefit with positive or negative corporate performance. [ed note- see current news stories and furor regarding Wall Street bonuses]
Lately there has been more talk of Equity Buy Outs (EBOs), what are your thoughts on a model without leverage?
(A): That option is always on the table and I can see where it could become more popular due to current lending issues. I see it as more of an option for small add-on purchases to complete a market need for roll up strategy than for other types of acquisitions unless it is just a drastically under performing asset that you feel you can turn around quickly.
[For more reading on EBOs http://www.bloggingstocks.com/tag/EBO/ ]
Have you changed your investment strategy? What are you looking for in a target company?
(A): In my opinion, the $30-40B buyouts have passed us for a while. They may eventually come back, but it will take a significant amount of time and those types of transactions will be as a result of corporate mergers. Right now, deal flow is very limited across the board, I think we will get it going, but buyer and seller expectations have not yet merged. We will see more creative corporate partnerships due to financing restrictions, but there are not many great examples out there just yet. We will need to sharpen our pencils on any new transaction.
I am spending over closer to 90% of time on the portfolio holdings conducting strategic and analytical support in addition to planting seeds to meet companies and build relationships when the turnaround happens. With very little new deal execution, this is your only options right now.
My guess is that one area of opportunity open up in the near term would be corporate carve outs where companies are running into financial distress and wish to shed non-core assets in pre- or post-bankruptcy. These assets may not have made as much sense to sell in an up market, but, for example, can go from dilutive to accretive once multiples have dropped from 8-9x to a 5x range in a down market because that 6x offer now really looks much better.
Speaking of financial distress, have you seen any “vulture” activity with your holdings?
(A): There are vulture positions made in every part of the market, so they are not unexpected. What you see now are positions being taken to establish a “loan to own” structure where those large debt positions become convertible to equity if the company fails. On the upside, those notes simply get paid out. You are starting to see some coercive debt exchanges where this is a concern and restructuring is required. The PE firm can swap junior for a senior notes or a better rate to get a lien on the assets. The bottom line is that you just need to ensure your investment company performs for reasons beyond these types of debt positions.
[For a definition of vulture investing http://www.gsb.stanford.edu/news/bmag/sbsm0211/trends.shtml ]
