The year of the vulture (page 2)

None of this means that huge private equity deals - formerly management buyouts, formerly leveraged buyouts, formerly bootstraps, soon perhaps to be "transformational equity" (a term that you hear bandied about on the buyout circuit) - are dead. They're just in hibernation.

Buyout firms, which are always in full sales mode, are telling potential investors that this is a great time to commit money to their funds, because investments made in meltdown years and the two following years tend to do exceptionally well. History backs up the idea that investing in a burst-bubble climate is a great way to make money. A Cambridge Associates study shows that investors in funds formed in the years when bubbles popped and the two subsequent years have made returns far superior to those from funds in other years. For example, funds raised in 2001, 2002, and 2003 (after the stock market bubble burst) returned 33%, 29%, and 31%, respectively, after fees, the best three years in the 20-year survey.

Andrea Auerbach, the study's author, says LBO investors do better after meltdowns because in post-bubble years loans are hard to come by and the economy tends to be slowing; therefore, buyout firms tend to make acquisitions at low multiples of low corporate cash flows. Then when the market turns up, firms can resell their properties at higher multiples of higher cash flows.

However, just because post-bubble buyouts have been good in the past doesn't mean they'll be good in the future - history, after all, isn't destiny. The fact that firms are double cropping in the debt markets is a departure from the historical pattern. In the past they kept their powder dry in post-meltdown years and waited for things to improve.

In addition there's a new factor in the buyout biz: going public. Blackstone famously went public last June, just before the window of opportunity slammed shut. KKR and Apollo have IPO registrations pending at the Securities and Exchange Commission, a reason they cited for not talking to Fortune. You can be sure that other firms will file at the first opportunity.

The trend has its detractors. "I wish the Blackstone IPO had never happened," says Harvard Business School professor Josh Lerner, who thinks buyout firms work best when they remain private partnerships. When they're private partnerships, he says, the buyout fund investors (who pay a piece of their gains, typically 20%, to the managers) have to do well in order for the firm to do well. Once a private equity firm is public, he feels, the interests of the managers and the buyout fund investors can diverge. Managers may feel pressure to keep Wall Street happy by generating regular streams of gradually rising earnings by taking profits relatively early in a buyout's life. The interest of the buyout fund investors, however, may lie in delaying gratification and getting a better long-term profit. Private equity's sell was always that, freed from the tyranny of quarterly earnings, its portfolio companies could make the tough decisions and take the long view necessary to repair a damaged business or grow a sound one that was starved for cash.

It's going to take a while - possibly a long while - for the financial tide to turn and for us to know for sure whether private equity's march to the public markets is a good thing. What's certain is that the days of easy money are over. At least for now. You've got to work on the companies you have, do smallish deals, and find really creative ways to keep the Gulfstream in fuel until the market turns.

The folks at Clayton Dubilier & Rice, a low-profile buyout shop that's been around for 30 years, waxed philosophical about this in their year-end letter to investors. "If the wind will not serve," they said, citing an ancient proverb, "take to the oars." In short, get ready for some calluses, buyout boys.  

1 2