PRIVATE EQUITY:In this era of the megadeal, the private equity industry appears to be unstoppable but just how long will this winning streak last?
'IT WAS THE BEST OF TIMES, IT WAS the worst of times." In many ways, the private equity industry has never had it better. A combination of prolific fundraising, cheap debt and high levels of leveraging has created the era of the megadeal, where no company is too large to be considered as a buyout target. To put it in perspective, nine of the 10 biggest private equity deals ever have taken place in the last three years.
But in the midst of all this frenetic dealmaking, the private equity industry has being dealt some body blows on both sides of the Atlantic.
In the UK, trade unions have led a witchhunt against what they perceive to be an industry of rapacious asset-strippers who slash jobs and operate under a cloak of secrecy.
Such criticisms are hardly new, but what has really whipped the unions into a frenzy in recent months is the realisation that private equity partners in the UK are availing of an extremely favourable capital gains tax (CGT) break known as taper relief.
A former industry player in the UK, Nicholas Ferguson, inflamed the situation when he broke rank and claimed that private equity partners were paying less tax than cleaning ladies. Four buyout chiefs were called to account before the UK treasury select committess as part of its investigation into the industry, and former British prime minister Tony Blair said that a review of private equity taxation will be carried out later this year.
Favourable tax treatment is also proving to be the bête noire of the US private equity industry, where carried interest (the profits that private equity executives earn on investments) is subject to CGT at 15 per cent rather than much higher income tax rates. Senators, trade unions and, most recently, two former US treasury secretaries have all joined the swelling ranks of critics.
Concerns are also growing that the industry is displaying classic symptoms of a bubble reaching bursting point. In its Global Financial Stability Report in April, the International Monetary Fund (IMF) highlighted private equity as one of the biggest threats to the global economy, and warned that a large-scale collapse of the sector is increasingly possible. Rising debt levels make it more likely that there will be an increase in defaults, it said.
Private equity houses have raised unprecedented levels of investment capital, but rating agencies have reported that the number of viable targets is diminishing, which in turn is pushing up prices.
Figures from the European Private Equity and Venture Capital Association (EVCA) indicate that the high level of M&A activity in Europe, combined with a positive economic climate, has pushed up valuations for companies by over 50 per cent since 2002.
In addition, the level of leveraging employed has risen considerably. In the past, the amount of debt piled into an acquired company was typically in the region of five times EBITDA (earnings before interest, tax, depreciation and amortisation), but industry sources now report that that this has crept up to nine times earnings, and in some cases even higher, which could prove problematic if interest rates continue creeping higher.
One of the UK's star investment managers, Anthony Bolton of Fidelity, did little to allay concerns when he warned recently that the quality of lending by deal-hungry banks to private equity firms was deteriorating, and pointed to the practice of "covenant lite" (the loosening of debt covenants) lending as a factor. "In many cases it appears to mean no covenant at all," he is quoted as saying, and as this reduces the bank's ability to reclaim loans if a firm goes under.
In the US, Federal Reserve chairman Ben Bernanke has jumped on the bandwagon, cautioning banks on the risks they take on when financing private equity deals. In spite of the recent harsh criticism, private equity has some strong proponents. EU Internal Market Commissioner Charlie McCreevy came out in support of the industry in a speech to British legislators in March. "The private equity industry is the most critical source of capital for start-up and developing businesses that stimulate innovation, competitiveness and growth," McCreevy said. "There is a big selling job to be done. The industry must go out and tell the many stories of success."
In relation to the astronomical bonuses paid to some private equity managers, these could be justified if they outperform substantially, he said. "If those rewards are properly performance driven I ask myself why they should be less acceptable than performance fees paid to professional golfers or transfer fees paid to professional footballers," he added.
The EVCA has also mounted a staunch defence against critics who have branded private equity investors as "casino capitalists".
"Private equity is here to stay and that is to the benefit of the competitiveness of Europe at all levels," EVCA secretary general Javier Echarri said recently in a letter to the Financial Times.
Also in a letter to the FT, UK private equity practitioner Guy Hands defended the controversial taper relief. "Unlike the bonus and option system used to reward listed company directors, carry [interest] is risk capital and should be taxed as such," he wrote.
Criticism of private equity has spread to Germany, South Africa and Australia, but Ireland seems to have escaped the mudslinging. One very simple reason for this, according to Ulrich Kenny, partner at private equity investors Ion Equity, is that a large private equity industry hasn't developed here yet. "In terms of the number of businesses in Ireland that have been in private equity ownership, up until recently most deals would have been done by UK funds, so it's a new phenomenon to have players like us being able to buy businesses.
"Ireland doesn't have private equity funds in the traditional form," he continues. "Within Ireland it tends to be institutions or ultra-high net worth individuals investing directly in deals. In other countries it tends to be people investing in funds, which are then invested in deals," he says.
Kenny also refutes the assertion that private equity is in for a rocky time if the economic climate worsens. "Private equity is actually very well placed to make good money in the downturns, because they can react quicker and can take a longer view."
The Republic may not yet have a large private equity industry, but that is unlikely to be the case forever. "The characteristics of the Irish market are conducive to private equity investment," says David Byers, corporate finance partner at McCann FitzGerald solicitors. "The atmosphere is relatively benign. In the UK we've seen various political rumblings about private equity, but to date there hasn't been much of that in Ireland."
In fact, an Irish consortium led by Atlantic Bridge recently completed the largest buyout in Europe this year, when it acquired LogicaCMG's telecoms product division (now renamed Acision) for €392 million.
He explains the intrinsic advantages of the private equity model: "Private equity is just that - it operates out of the public glare. As the management of a listed company, effectively you spend a good deal of your time on the road talking to your shareholders, discussing your results and justifying what it is that you're doing.
"Private equity managers don't have that," he says. They have to justify to their investors after five or six years what they have done across a portfolio of investments, which is a very different thing.
There may be a lot of doom merchants talking down the private equity market, but Stuart Draper, head of research at Dolmen Stockbrokers, says that there's still a lot more to come. He suspects that the prospect of rising interest rates will actually accelerate the rate at which deals are done, as private equity managers make hay while the sun shines and before further hikes kick in.
Top five recent global private equity deals
1 KKR/Texas Pacific Group and TXU
In February of this year, Kohlberg Kravis Roberts (KKR), and partner Texas Pacific Group, set a record with its $45 billion (€33.2 billion) agreement to buy TXU Corporation, the Texas utility company that is the largest producer of power in that State.
This is the first leveraged buyout ever to break the $40 billion (€30 billion) mark.
In an attempt to appease potential critics of the deal, the buyers agreed to scrap plans for eight of 11 controversial coal-fired power plants that TXU had sought.
2 Blackstone and Equity Office Properties Trust
Recently-listed rapacious private equity house Blackstone came out on top of a highly competitive battle for US office building owner Equity Office Properties late last year.
A fierce bidding war drove the price up by $3 billion (€2.2 billion), with Blackstone agreeing to buy the company for $39 billion (€28 billion) buyout, when debt is included.
As predicted, within months of the takeover, Blackstone has already sold off some of the Equity Office Properties' portfolio.
3 KKR/Bain Capital/Merrill Lynch - Hospital Corporation of America
Last summer a consortium of Bain, KKR and Merrill Lynch sealed an agreement to acquire Hospital Corporation of America (HCA) for $33 billion (€24.4 billion), which held the record for the world's largest leveraged buyout until it was eclipsed by the KKR/TXU deal this year. The buyers, which included HCA co-founder Bill Frist, reportedly paid only $5.5 billion (€4 billion) in equity, with the balance made up with debt. Co Clare businessman Domhnal Slattery was also believed to have taken a $50 million (€36.7 million) stake in HCA through his personal investment vehicle Claret Capital. HCA manages some 5 per cent of all hospital admissions in the US.
4 Apollo, Texas Pacific Group - Harrah's Entertainment
A club of investors comprising private equity firms Apollo and Texas Pacific group agreed last year to acquire casino giant Harrah's Entertainment for $27.8 billion (€20.4 billion). The club's $90-per-share (€66) offer was a huge 35 per cent premium over the casino's closing stock price. This was the largest ever transaction for a gaming company.
5 Bain/Thomas H Lee - Clear Channel Communications
Last November Clear Channel Communications, which owns the largest radio network in the US, announced that it was being bought and taken private by two private capital firms, Thomas H Lee and Partners and Bain. The transaction was valued at approximately $27.5 billion (€20 billion), which included assumption of approximately $8 billion (€5.9 billion) of net debt.
Top five recent Irish private equity deal
1 Lydian Capital and Chrysalis
A group of high profile Irish financiers - JP McManus, Dermot Desmond and John Magnier (pictured above) and Denis Brosnan - agreed in June to buy the radio business of UK media group Chrysalis for £170 million (€252.3 million).
The investors became involved in the Chrysalis deal through Lydian Capital, a Geneva-based investment group founded by Brosnan, a former chairman of Kerry Group. The investment is headed by former ITV chief Charles Allen.
2 Atlantic Bridge and Acision
An Irish consortium led by private equity house Atlantic Bridge pulled off the biggest buyout in Europe so far this year, with the completion of its acquisition of LogicaCMG's telecoms products division (now known as Acision) for €392 million in June.
Atlantic Bridge raised funds from a number of private investors including Denis O'Brien and Dermot Desmond, and also brought US holding company Access Industries on board for the deal.
3 Alchemy Partners and A-Wear
Ladies' fashion retail chain A-Wear was sold by Brown Thomas in May to a management buyout group backed by UK private equity firm Alchemy Partners. The sale price was not disclosed but was believed to have been just over €70 million. Alchemy is thought to have provided most of the funds for the transaction.
4 Doughty Hanson and TV3
Private equity group Doughty Hanson bought TV3, the Republic's second-largest television channel, in 2006 from its shareholders, CanWest, ITV and a consortium of private investors in a deal that valued the station at €265 million. Doughty Hanson said the acquisition was in line with its strategy to acquire market-leading, mid-to large-sized European businesses.
5 Babcock & Brown and Eircom
Australian investment firm Babcock & Brown bought Eircom last year for €2.36 billion, together with the company's Employee Share Ownership Trust (Esot). The takeover represented the fourth change of ownership since the Government sold out of the telecoms group in 1999.
The deal was financed by equity contributions from Babcock & Brown and the Esot.
"If you're running a pan-European fund . . . Dublin is a perfect base"
The Irish private equity scene may well benefit from the ill wind currently buffeting the industry in the UK, according to Jon Moulton, managing partner at Alchemy, the British firm that backed the recent management buyout of A-Wear.
Moulton predicts that the inevitable upshot of the furore over a controversial tax relief available to private equity players in the UK, is that partners such as himself will end up facing a higher tax bill.
"Dublin will look warm and friendly to a few more people," Moulton predicts. "Pretty well whatever [governments] do will have some influence on people wanting to do private equity from somewhere else."
Since it was formed in 1997, Alchemy Partners has established itself as a global player, advising on over 100 transactions, and investing more than £1.8 billion (€2.67 billion) of equity to date. Alchemy has been quite active in the Irish market and made quite a splash in 2003 when it contributed $88 million to the $393 million take-private of Riverdeep from the Irish Stock Exchange. It exited 12 months later during a refinancing, and reportedly doubled its money in the process.
Although Alchemy invests in quite a diverse range of companies, the A-Wear deal in May nevertheless represented a break from the norm. "A-Wear is quite unusual for us," says Moulton. "It's quite a well-run little business. We normally buy poorly-run businesses with something seriously wrong with them."
Moulton dismisses speculation that the firm is eyeing up clothing chain Sasha, but says that there are definitely a number of companies in the Irish market that have piqued Alchemy's interest. However he says that there are generally only three or four deals each year in the Irish market that would be of a size that they would consider.
"The difficulty over your way is that the competition is as much private individual as it is private equity player," he says. "Even in the US, private individuals are much less likely to be a competitor than they are in Ireland."
Where others in the private equity market tend to play down predictions of tough times ahead, Moulton is upfront. "I'll go beyond prediction and tell you that there is a bubble forming. It's not a prediction. It's here."
