The leveraged-buyout boom and bust that Michael Milken led in the 1980's could end up looking like a dress rehearsal for the mess this time around.
The Great Global Buyout Bubble
By ANDREW ROSS SORKIN
Published: November 13, 2005
A year ago this week, Henry R. Kravis, the legendary buyout mogul who invented the modern-day private equity industry, gave a rare speech to a group of investors in a ballroom of the Waldorf-Astoria. In describing how far the business had come, Mr. Kravis, a slight man with a dry wit, recounted how difficult it had been for him to raise $355 million to buy one of his first companies, Houdaille Industries, in 1979.
Performing Almost Too Well? "The availability of financing was our biggest challenge," he said. "Literally, we had to add up the potential capital sources at that time, which consisted of several banks and insurance companies, and one by one go out and raise the money."
Today, he has the opposite problem. Investors have been throwing money at the red-hot leveraged-buyout industry - so much so that Mr. Kravis now has to turn away some of them, rejecting their cash as a mere "commodity."
Private equity firms, it seems, now own everything: Hertz, Neiman Marcus, Metro-Goldwyn-Mayer, Toys "R" Us and Warner Music, to name a few. So far this year, buyout firms have spent more than $130 billion gobbling up parts of corporate America. And with more than another $100 billion in unspent money this year still swirling around the industry, there is a lot more buying to be done. The boom isn't limited to America: in Britain buyout firms own so many companies that they now employ 18 percent of the private sector, according to the British Venture Capital Association.
The trillion-dollar question is whether these shopaholics are setting themselves up for a giant fall. If the market begins to show even the faintest signs of strain, this bubble may pop, say many financial analysts as well as private equity players themselves. If that happens, the leveraged-buyout boom and bust that Michael Milken led in the 1980's could end up looking like a dress rehearsal for the mess to come. As Mr. Kravis said during his speech: "Unfortunately, there is a flip side to having access to plentiful capital. It means that too many people without experience in building businesses have too much money."
The numbers tell the story. Over the last three years, private equity firms have had record returns through a series of quick flips, spurred in part by superlow interest rates that allowed them to borrow huge sums of money. As a result, big institutional investors like pension funds have poured $491 billion into the business, according to Thomson Venture Economics, a firm that tracks data for the industry. If you figure that the firms can borrow three to five times that amount - a conservative assumption - the industry has more than $2 trillion in purchasing power.
But here's the rub: In the next three years, to reap returns on all those big-name investments they have been making, private equity firms are going to have to sell $500 billion worth of assets. The question is, to whom? Even in the last three years, in as big a bull market as they come, private equity has never sold more than $153.2 billion in a year, according to Freeman & Company. At the same time, the investment firms will have to keep spending. And the low-hanging fruit has already been taken.
"There's no question this is going to end badly for some," said Colin C. Blaydon, a professor at the Tuck School of Management at Dartmouth and the dean emeritus of its Center for Private Equity and Entrepreneurship. "It's almost a classic boom-bust cycle. When you see a big boom, people see the returns, go rushing in, stuff more money in than can be dealt with. Suddenly, something will happen that makes people say: 'Oh, my God! Look at the leverage we've got on these things. Isn't this way too risky? Shouldn't we pull back?' And then the question becomes: Does it crash like a rock or is there an adjustment down over time?"
Already, there are reminders that the business can turn ugly overnight. Thomas H. Lee Partners, the Boston private equity firm famed for buying Snapple for $135 million in 1992 and selling it two years later to Quaker Oats for $1.7 billion, recently was badly burned on its investment in Refco, the commodities trader that filed for bankruptcy protection last month. While the setback has hardly sunk the Lee firm, it is an illustration of how risky these investments can be.
Firms may have a particularly tough time exiting some of their investments because investors are taking a more skeptical view of initial public offerings backed by private equity. In recent months, several high-profile quick flips have left critics wondering whether buyout firms were using such offerings simply to line their pockets, rather than using the proceeds to support companies.
Earlier this year, the Blackstone Group sold a German chemicals company, the Celanese Corporation, to the public after owning it for less than 12 months. The firm quadrupled its money and all of the proceeds from the offering were used to pay out a special dividend to Blackstone. Mr. Kravis's firm, Kohlberg Kravis Roberts & Company, also quadrupled its money by flipping PanAmSat, the satellite company it owned for less than a year.
Performing Almost Too Well? Investor scrutiny of private equity-backed I.P.O.'s forced Warner Music, which is owned by a consortium of buyout firms led by Thomas H. Lee Partners, to scale back its offering significantly: the firms made several last-minute adjustments that kept them from cashing out as much as they had hoped, in part as a way to inspire confidence in the offering.
According to Dealogic, which tracks the industry, initial public offerings backed by private equity firms have performed worse than other offerings; the average first-day return for a private-equity-backed I.P.O. this year is 8.3 percent, compared with 13.9 percent for other offerings. Analysts ascribe some of that discrepancy to concern by investors that private equity firms will later cash out of their position, depressing the stock price. Over time, though, that gap often narrows and some private equity offerings have outperformed other offerings.
Then there is the issue of sky-high prices that some private equity firms have been willing to pay for acquisitions. According to Standard & Poor's, buyout firms now pay, on average, about eight times a company's earnings before interest, taxes, depreciation and amortization - or Ebitda, a common measure of cash flow - for companies worth more than $1 billion. That is a significant increase from a multiple of about 6.5 only several years ago. Private equity firms have felt comfortable paying more because debt remains so cheap and banks have been willing to allow the firms to add ever-larger amounts of leverage to transactions.
But if the debt market turns against them - and it is bound to do so at some point - potential buyers or public investors may not be willing to pay the same prices. In the consumer retail sector, where private equity firms have paid prices of more than 12 times Ebitda during frenzied auctions, selling may be especially tough. Tommy Hilfiger and Dunkin' Brands are both for sale, and some bidders have already left the auction, a sign that the price may be moving too high.
"I'm pessimistic about the economy, interest rates, credit markets, and all that," said Hamilton E. James, president of the Blackstone Group. "I feel people are paying prices that are too full. I think some mistakes will be made. We've pulled in our horns a little. We've become more conservative about the types of companies we buy, the prices we pay, the exit multiple assumptions and so on and so forth."
Of course, many people in the industry disagree with the premise that there is a bubble ready to pop. They note that private equity is still only a small part of the mergers-and-acquisitions and I.P.O. market, and they say that if they've done their homework, they will have made the right bet.
Even Mr. James, the economic bear, is still bullish on the overall leveraged-buyout market. "I have no concern about the markets being big enough to accommodate L.B.O. sponsors getting liquidity for their successful, good-quality portfolio companies," he said. "The very growth of private equity, don't forget, adds a whole other option: the secondary buyout," referring to a trend in which private equity firms buy and sell businesses to one another.
You can't argue with that. But not everyone can make a brilliant bet, and headwinds can make things more difficult.
The advent of supersized deals also lurks below the surface. For years, buyout firms focused on businesses worth several billions of dollars at most. Today, flush with cash and under pressure to spend it, private equity firms are splurging on huge businesses like Hertz ($15 billion) or SunGard ($11.3 billion). The Computer Sciences Corporation is being eyed for a $12 billion takeover. But selling those businesses or putting them back in the public markets could be even more difficult because of their size.
How will this shake out? Will the bubble pop? For some, absolutely. There will be bankruptcies, restructurings and fire sales. Others, who made the right bets, may be luckier and be able to ride out the bad years.
"In hot markets, you can sell crummy companies," Mr. James said. "In less ebullient markets, the really marginal companies take more than their disproportionate share of the pain. That's where you'll see it."