Night of the living debt

When professor Tim Jenkinson gave a lecture to private equity professionals in Stockholm in 2007, he asked the audience what was wrong with the Modigliani-Miller capital structure irrelevance theorem - which assumes that in an efficient market how you raise your capital doesn't affect the value of the company. Obviously, in addition to disregarding taxes, the model also didn't take into account the cost of financial distress or asymmetry of information, seemingly similar to the private equity audience. The response was unison: "Yes, we can take on as much debt as we like."

When Jenkinson returned to Stockholm two years later, the mood was very different. The GPs who had remained in the shadows during the boom years were now boasting their "prudent strategies" of leveraging at around 3-3.5x of EBITDA. With the benefit of hindsight this can be legitimately described as responsible: debt levels at the height of the market were as high as 7x and averaged at 5x.

Indeed, the LBO model became very much a credit driven model, where easily available debt drove valuations through the roof. 2006 and 2007 were record years for private equity - volumes were pushed and values were on an upward spiral.

As a result of the spiralling of valuations, Jenkinson explains, the main beneficiaries of increased debt levels were not the winners of the auctions but the vendors, who achieved what can only be described as inflated prices. This proved particularly true for the secondary buyouts completed at the peak of the market in 2005-2007. Jenkinson counts about 300 such transaction across Europe, and describes these deals as "investments from hell". "Some horror stories will come out this period," he says, "leverage amplifies returns, but this works both ways - an important point that people tend to forget.".

Jenkinson does not reject the fact that there are good reasons for leverage. For utility companies with constant steady cash flows, for example, high levels of debt can be both beneficial and sustainable. For most companies, however, leverage is only healthy to a certain point. "You don't want to be in leveraged equity when markets fall: leverage is not a free lunch."

Zombie invasion
His argument backs up the findings of the much talked about study published by Boston Consulting Group earlier this year, which predicted that two out five of private equity buyout houses would collapse. "A 40% rate sounds completely plausible," Jenkinson comments, adding that, in his view, the smartest funds weren't doing much in 06/07 - apart from selling.

Part of the problem was the definition of risk and LPs and GPs alike fell into the same trap. Risk was viewed and assessed in terms of operational risk and market risk, while the textbook risk analysis linked to debt levels was seemingly ignored. With the collapse of financial markets, academia has been proved right: operational risk appears trivial compared to financial risk. Today, portfolio companies with perfectly functioning and profitable businesses models are being squeezed by private equity owners feeling the pressure from bank syndicates as targets breach covenants. The terms and conditions were often based on overly aggressive growth ambitions, which have proved unsustainable in the long-term.

Investments that were made "cov-lite" - which became a common feature in the latter part of 2006/7 - will face a different fate. Jenkinson labels them "zombies": the living dead. These companies survive on the debt taken out the top of the market, often with few on-going requirements and a bullet payment at the end of the period. As a result, they are unlikely to default, even if the value of equity is near zero. To the benefit of the creditors, these businesses are being held alive by private equity firm. It is a no-win situation, where effort (and money) is spent on projects that could have benefited new productive projects.

The scapegoat?
These concerns have brought back the age-old debate surrounding private equity: does the asset class add value? The industry itself is mainly concerned with the extent of returns, as opposed to the public's concern with the source of returns, which comes into focus when things go sour. Are returns generated through "asset-stripping", "quick flips" or "financial engineering"; or does private equity add real operational value, through increased efficiency and productivity?

Trade bodies argue that private equity contributes to increased employment. However, the problem with these surveys is that more often that not the data is based on with self-reporting and thus is often skewed. Other studies on private equity's contribution are often biased as the research has been undertaken under unprecedented favourable economic times. Additionally, the industry has been gone to great lengths in the past to maintain secrecy and a lack of transparency.

Nonetheless, increased transparency seems unavoidable. Disclosure could go a long way to avoid a repetition of recent (and unfolding events) as this would reveal debt levels. It will also allow for much greater analysis of the industry's real impact on the economy, which can only help to inspire best practice in the long-term. The drawback is that such transparency is coming at a time when there is likely to be a stream of bad news emanating from portfolio companies, some of which will be a result of over-leverage and some will simply be due to general economic climate.

As the final numbers and write-downs from the latter half of 2008 are finalised, Pension schemes and institutional investors will get full overview of their losses. Jenkinson notes that the impressive returns made in recent years were not risk adjusted, and as such commitments were perhaps made without properly evaluation. "Some funds will lose so much that LPs will wake up," he predicts. "To understand the true risk and return profiles of private equity, we need full disclosure of the required data at portfolio company level. Only then can we make benchmark comparisons to other asset classes."

The PR challenge
In a financial crisis, a lack of clear information becomes a source of suspicion. the seeming reclusiveness of the industry it seems hasn't, even in the boom years, served the private equity community well. As Jenkinson points out: "Often there is a very good story to tell, but the message hasn't come across to the media and the public." The stories in the few months, however, are likely to be grimmer. Under the careful watch of the public scrutiny, the public relations teams will have their hands full convincing the public of the private equity value-add.

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