90 seconds at 9 am with BNZ; another big private equity failure

Fair point Keyser. The disasters like Feltex, Vertex, Yellow Pages and RedGroup have been overseas PE operators. My understanding is that the local PE folk, on the whole, didn't leverage to crazy levels during the bubble period.

Here's an article I wrote in my previous life on the subject.

 

The Independent Financial Review — NEWS — 4 MAR 2010 — Page 14 Lessons from private equity's collapse

 

Editorial

The private equity model is broken, crushed by the global crisis. But only for now. It will be back.

It was a classic pat ourselves on the back piece of commentary, titled Growing the Private Club and written by Bain & Company consultants who presumably had never had it so good. It ran in The Wall Street Journal in May 2007.

The article highlighted private equity's "one-two-three punch at public ownership" through three recent takeovers worth a combined US$21 billion (NZ$30.18b). Private equity was apparently becoming a benchmark of performance for public company boards constrained by red tape in the post-Enron and WorldCom world.

The three deals were Cerberus Capital Management's takeover of Chrysler, Blackstone Group's purchase of Alliance Data Systems and Terra Firma buying EMI. All three deals have since unravelled, spectacularly, with law suits flying after the highly leveraged private equity business model was broken by the sub-prime crisis.

The US taxpayer bailed out Chrysler and the British government has stepped in to protect EMI's Abbey Road studios, famously used by the Beatles, as concern mounted over a sale or revamp of the complex. Here in New Zealand, we had our own private equity boom through 2005-07. Overseas firms, flush with cheap credit, surged into New Zealand buying everything from Yellow Pages Group from Telecom, TV3's parent MediaWorks, the late Michael Erceg's alcopops empire Independent Liquor, rubbish group EnviroWaste Services and window provider Metro GlassTech, the latter after outbidding Fletcher Building by $100 million on a $366.2m deal.

The private equity firms funded 75 per cent, or more, of the purchase price through debt. They then dumped this on the acquired firm's balance sheet planning to make interest payments through its cashflows. This has proven tricky given the over inflated prices paid in the first place and the recession, which has stalled or shrunk the earnings of the purchased companies.

In several cases, banking covenants have been breached and now many private equity-owned businesses are in sailing's equivalent of the doldrums, going nowhere fast.

Sure, none of the local deals has yet blown up as Chrysler did.

But the owners, at best, face holding on to the assets for significantly longer than their typical three to five-year ownership timeframe or, at worst, them and their investors losing their shirts to their banks.

And even though the banks are now in the driver's seat, they have a tricky course to navigate. That's because an old saying, slightly adapted, comes to mind: If you owe the bank $1000 you have a problem, but if you owe the bank hundreds of millions of dollars, the bank has a problem.

So where does the high leverage private equity business model go from here?

The big deals have certainly dried up. Globally, private equity backed merger and acquisition activity had its slowest year since 2002 last year, plunging in value 43.5 per cent to US$133.8b, according to Thomson Reuters. And it's surely going to be a long, long time before banks loan as much money, as cheaply, as they did three or four years ago. So it's safe to say the high leverage private equity model is dead, but probably only for a generation. Because make no mistake, a new generation will bring it back in some form.

For as collateralised debt obligations and credit default swaps were all the rage in mid-noughties, junk bonds provided the debt capital in the mid-1980s. Those burnt by the recent global crisis will retire, but younger financial engineers will turn up - with what they think are bright, new ideas - and do it all again in 15 to 20 years.

And they'll be inspired by hearing stories of the massive returns generated by the deals that came off, such as Kathmandu for Goldman Sachs JBWere and Quadrant Private Equity. They sold the retailer via a sharemarket float late last year, booking returns of about 250 per cent on their equity investment over three-and-a-half years.

And the banks, at some point, will raise the stakes again. Offering debt on takeover deals of six or seven times a company's earnings before interest, tax, depreciation and amortisation (ebitda) three years ago, apparently today you can't get more than three times.

Note here that as of June 30 last year, Yellow Pages had debt of $1.7b, in excess of 10 times its annual ebitda - $166.3m - on its balance sheet. Interestingly, local private equity firms, either unwilling or unable to take part in the 2005-07 debt feeding frenzy, are now thriving.

Direct Capital, which manages money on behalf of the New Zealand Superannuation Fund, this month announced the successful completion of fund raising for its Direct Capital IV fund, securing $325m. And Maui Capital, having bided its time since launching in 2008, has made two investments in the past six months.

Deals these firms do may include debt of as little as one or two times ebitda. And this surely is the sustainable future of the private equity business model. Instead of paying over-inflated prices for companies and then loading them up to the rafters with debt, hoping to sell at a fat profit in three or four years time, the idea should be to grow and develop businesses over a longer timeframe.

And this is much easier to do when equity, not debt, is pumped into the company. GARETH VAUGHAN