Large buyouts on hold

Although not a surprise, large buyouts of £1bn+ have been conspicuous by their absence so far this year. With deals at this end of the value spectrum heavily reliant on liquidity in the debt markets, there can be no certainty as to when these houses will once again have the opportunity to invest on the scale they have become accustomed to and the scale that the size of their funds demand.

In the absence of significant levels of liquidity, there have been signs that large buyout houses are looking for alternative methods to place cash and keep up a reasonable investment pace. Distressed debt investing, PIPE deals, minority investments in listed companies and entering new geographies are some of the strategies employed by large buyout firms recently. Yet these methods of investing still rely on access to debt and in any case only a few firms have the experience, mandate and ability to pursue these strategies. A source at a large buyout house concedes, ‘I would love to say that there are a host of creative ways to invest but this isn’t the case.’

Loan notes and minority

Permira recently made a bid to acquire NDS, a NASDAQ-listed majority owned subsidiary of News Corporation which supplies digital technology and services to pay-television platform operators and content providers. Should it go ahead, the deal for the company, which has a market-cap of around $3bn, would be Permira’s first new deal this year. In contrast the firm completed five deals across Europe in the first six months of 2007, a clear sign that the state of the market has curtailed deal-doing at the firm. The NDS deal includes a $200m vendor loan note, which helps to explain the presence of just two banks on such a large deal. The use of vendor loan notes was not necessary when liquidity was abundant, but in the current environment it is useful in helping to facilitate an acquisition. ‘You will see more vendor financing to get deals away; if you’re looking to sell for £100m you might leave £20m as a vendor loan to sweeten the deal,’ says Andrew Harris, partner at DLA Piper.

Investing in a public company for a minority interest is another way to push cash to work. An astute move if it is a prelude to building up a controlling stake over time, it is more questionable from a risk and return perspective if the motivation is not to push for full control. In June PAI Partners increased its stake in French IT services company Atos Origin to 17.9%, and as the largest shareholder is seeking board rights in order to influence the transformation of the company, which recently sacked its chairman. However, PAI says it is not seeking to take the company private even though it attempted to buy the company outright last year. It’s denial of interest in full control is therefore more likely to reflect an inability to effect a deal owing to restricted liquidity rather than a lack of desire to get it done.

Also in June, CVC Capital Partners acquired a 25.1 percent stake in energy company Evonik for EUR 2.4bn, which is majority owned by the German state. This deal is different to the Atos deal, as CVC replaces the sole shareholder and is expected to have a significant say in the future direction of the company. Apax’s recent €1.1bn investment in Italian telecommunications company Weather Investments alongside TA Associates and Madison Dearborn Partners looks somewhat different, as the cash has only bought the investor 5% of the company, which is unlikely to be enough for any meaningful influence.

The question of influence subsequent to a minority investment is a key one according to another large buyout house source. ‘Taking minority stakes can slightly unnerve investors depending on the level of genuine influence they have.’ For some LPs, investing for a minority stake falls outside the mandate of a private equity house. ‘It is not really what we pay them for. I can call our in-house equity trader to purchase the shares at a cheaper price,’ says Britta Lindhorst, head of private equity at German insurance group AMB Generali. Some commentators have pointed to such deals as evidence of the large buyout houses desperation to invest, but this overstates the case - minority investment deals have been around for some time, with CVC itself experienced in the area. And with share prices depressed, investing for a minority stake has more return potential than has been the case in the past few years.

Distressed

Distressed debt is another area that large buyout firms have been eyeing as credits weaken and covenants get strained, yet as with minority stake acquisitions this is not an area firms have opportunistically jumped into as a result of the credit crunch. Earlier this year Carlyle launched Carlyle Strategic Partners II, a distressed debt vehicle targeting $500m, which also has the ability to acquire failing companies. Other US buyout houses such as Blackstone, Thomas H. Lee Partners, TPG, Apollo and Oaktree also run funds which seek out distressed debt opportunities. In Europe, Alchemy launched a £300m distressed debt fund last year. However, these are dedicated investment arms, in many cases launched a number of years ago, and as such do not represent a new strategy. For firms without a dedicated debt fund, buying into debt is legally questionable and difficult at best. ‘Legally it is doubtful whether a traditionally structured private equity fund can buy debt. In many cases the fund documentation will not allow them to do this and even where the documentation is loose enough you would have to get agreement from your LPs and amend the documentation,’ says one UK-based debt advisor.

An easier method to put money to work in the current climate is to transact smaller deals, as Charterhouse did earlier this year when acquiring Giles Insurance for around £185m.

From an LP perspective, ‘it is not a problem if the GP is writing smaller cheques, provided the deal is right’ says John Gripton, head of investment management Europe at private equity asset manager Capital Dynamics, although he points out that, ‘considering their fund size, this couldn’t be done on a regular basis as you would end up with too many companies in your portfolio.’

Guy Eastman, European investment director at SVG Advisers, also sees the potential problem of holding too many companies in one portfolio, but says: ‘The issue is more whether a GP will find it economic to fill a big fund with a larger number of deals than they are used to.’

LP concerns

With large amounts of money left to invest, it would be reasonable for LPs to be concerned about whether their money will ever get invested. Gripton however says that ‘large buyout houses should not invest if they cannot find the good deals. In the past, firms have gone 18 months between deals and this acceptable as long as they seriously work on their deal flow.’ Eastman agrees saying, ‘They should leave it until they feel comfortable that prices for transactions reflect the current risk/reward ratio for acquiring a particular enterprise in the market conditions that prevail now.’

Across all segments of the market price expectations are an issue, but the same percentage differences that can be overcome on smaller deals equal significantly larger cash amounts the further up the size bracket you move. ‘Many vendors are seeking prices that reflect pre-August 2007 conditions and they need to wake up to the new world,’ says Eastman.

The easy access to credit over the past three years changed the landscape for large buyout houses. They could acquire companies for sizes that were not possible to envisage previously. This level of debt is now no longer available yet mega funds raised during this era were raised predicated on the belief that liquidity levels would remain unchanged. Debt levels have adjusted but fund sizes have not. This raises the prospect of significant cash overhang. Eastman says he is not concerned about inactivity in the short to medium term as, ‘a sensible LP would rather see 100% inactivity than money put to work that realises less than cost. In past periods of difficulty, smart GPs have waited 18-24 months between investments.’

However, Eastman raises a prospect which will not find favour with many large buyout managers. ‘If inactivity lasts too long, they should consider returning some of the fund back to LPs with a corresponding reduction in the management fee.’ One buyout house says that it is ‘unfair to measure the management fee on the regularity of investments.’

Caution from banks, unfavourable debt terms and conditions, a relatively static syndication market and vendor price expectations have combined to reduce deal flow at the top-end to a trickle. Portfolio management issues are now at the top of the agenda for many firms, with anecdotal evidence suggesting more equity cures on the way to support assets struggling with headroom issues. ‘Large buyout houses built their portfolios over the past three years and most of these investments require considerable work. The better GPs pride themselves on change management and there may be considerable change needed to create the optimum return from their existing investments,’ affirms Eastman.

One large UK-based buyout house said that conditions were such that ‘partners have been told to be more cautious about entering diligence on a deal. With the economy as it is you cannot afford to spend lots of time and money on a new deal which is unlikely to get done.’

Changing the model

There are no instant solutions for large buyout houses restricted in their ability to put money to work in the current market. Strategies touted as ‘opportunistic’ have not been dreamt up overnight but have been around for many years and only now are being looked at differently because the context has changed.

The day of the large buyout is not over – it took 18 years following the RJR Nabisco deal for that to be beaten in size – but the model used for the last three years will have to change to accommodate lower debt multiples. ‘The model does depend on the leverage available but it should be noted that we are in an exceptional period in economic history,’ says Harris.

Is the model sustainable in its current form? Harris says that ‘if it isn’t, we will know soon enough.’

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• Buyouts
• UK / Ireland