A tightening of private equity groups’ credit lines has eased the takeover fear that haunted many boardrooms during last year’s leveraged buyout spree. But the big funds are still in action, and looking for enhanced power through new relationships with fast-growing sovereign wealth funds. And while prepared to pounce on any undervalued assets, they insist they’re supporters – not saboteurs - of strategically minded management. 

A year ago, private equity seemed so strong that any underperforming PLC was at risk from its unwanted advances. Now, the debts that the large funds ran up for the latest and biggest acquisitions are hanging over their further expansion, with some nursing balance-sheet wounds as deep as those of the investment banks that backed them.

KKR, which less than a year ago achieved the first ever private equity takeover of a FTSE-100 company by paying £11.1bn for Alliance Boots, is currently having to reschedule the debts of its KKR Holdings bond fund, after struggling to meet repayments on the asset-backed commercial paper it issues to finance past buyouts. The estimated $150bn of debt from leveraged buyouts that still sits unallocated on banks’ books prevents any recovery in the severely subdued prices of the bonds already floated.

Even private equity groups that avoided extreme leverage are worried that they paid too much for companies whose stocks were about to be pushed down by gloomier markets. The inevitably strikes a fear into some managements that have already seen private equity supplement or supplant their public shareholding – that eagerness to return some cash will lead to serious cuts, in investment, training and research budgets as well as current running costs.

Taking leverage of its senses?
Hans Schenk, who’s led a study of private equity at Utrech University, points out that since 2000 80% of the investment has been in leveraged buyouts (LBOs), and less than 20% into the venture capital start-ups and expansions with which such financing was traditionally associated. In the US, leveraged buyouts backed by private equity have shown a much higher bankruptcy rate than others, and the survivors record a much slower rise in research development (R&D) investment.

But private equity funds are keen to point out that they are the deals whose results are under fire – and whose financial sustainability is now in question – are only the ones that relied on heavy borrowing, which the sector may be better off without. Permira partner Charles Sherwood, addressing the same Judge Business School conference at which Schenk presented his findings, argues that the higher bankruptcy rate is misleading because private equity tends to take on the more ambitious turnaround tasks. So its chances of failure are higher but so are those of outstanding success.

That may explain why average return on private equity investment has been above 20% in recent years, and reached around 15% even in the more troubled 2007, a substantially better performance than average stock market investments. Company pension funds, while sometimes at risk when private equity takes control, have become increasingly reliant on private equity’s superior return for the market-beating performance that keeps them out of deficit.

Clean-up act
As a result, private equity, though still worth less than $3,000bn worldwide - equivalent to less than 6% of total stock market capitalisation – has become disproportionally important for attacking inefficient management structures (including those left behind by past M&A) and delivering the gains to institutional shareholders.

Sherwood, speaking to a business audience convened by the Business School’s Centre for International Business and Management, also defended the five-year time horizon with which private equity managers tend to work – as adequate for newly-appointed management teams to achieve a turnaround based on genuine value creation, and substantially longer than many listed-company managers are allowed under the pressure of annual or quarterly profit reporting and dividend decisions.

Schenk agrees that most of the mergers and acquisitions in the wave of 1995-2000 – concluded with little private equity involvement - created little or no shareholder value, and that private equity (when no using excessive leverage) has played a major role in reversing that damage. But a sharp division arises between low-leveraged deals, which allow strategic reshaping of assets, and deals with higher leverage that tend to require a faster return and lead, at the extreme, to the asset-stripping that has recently tarnished the sector’s image.

Longer-term solutions
Research published last month by the World Economic Forum confirms the rapid acceleration in private equity activity. Of the buyouts tracked since 1970, 40% have taken place since 2004, and 75% of the $3,600 trillion present-value of deals have been concluded since 2001. With more companies entering LBOs than leaving them every year since 1970, numbers operating under “the LBO organisational form” have risen from under 2000 in 1995 to 5000 in 2000 and 14000 in 2007, with 40% still in it after ten years.

It also highlights the average gap between private equity acquisition and resale – more than five years – as evidence for the long-term approach often denied to top teams under public shareholder pressure. ‘Quick flip’ deals, cashed-out in two years or less, accounted for only 12% of the Forum’s sample. As further evidence for private equity encouraging or enabling a longer-term strategic perspective, the WEF team found that companies taken over by it raise their patenting activity (compared with the pre-buyout period), and ultimately create more jobs than comparable public companies (though after an initial shake-out that causes employment to grow more slowly).

However, fewer than 7% of the deals, representing 28% of the capitalisation in the WEF survey, involved publicly listed companies ‘going private’ through a buyout. “The vast majority of buyouts are acquisitions of private firms or corporate divisions,” say authors Josh Lerner and Anuradha Gurung. Three times as many private equity investments are exited by selling the unit to a trade buyer (39% of cases) than by an initial public offering (IPO).

This confirms the sector’s role in restructuring and reallocating units between large listed companies. But also lends weight to the fear that a growing proportion of large enterprises is becoming inaccessible to investors through the highly accountable PLC route, and has to be accessed by the less transparent private equity fund route.

Return of the higher return
The Walker Working Group, reporting last July, acknowledged “a major transparency and accountability gap”, exacerbated by the fact that private equity’s “recent rapid growth… has outstripped its recognition of implicit contractual obligations” to employees, suppliers, customers and other corporate constituents.

While the dealmaking scope may now be restricted by loss of leverage, and market slowdown that closes some exit routes, private equity partners remain confident they can new capital willing to support their raised on wasting assets. There is particular excitement surrounding the estimated $5,500bn – and rising – now held by the sovereign wealth funds of various export-surplus economies. The government agencies that handle these want professional management, and a way to nuy assets in other nations without political objections. Big private equity groups believe they’re ideally placed , on both counts, to become a principal channel for sovereign wealth seeking high returns.

If the Walker recommendations for better disclosure are followed, then, with the excess of leverage stripped away and new private and public wealth flowing in, sector players may soon be beating again at underperforming corporates’ doors.