2005 Private Equity Roundtable Recap
The 2005 Private Equity & Venture Capital Roundtable
On April 12 and 13, Ropes & Gray (“the Firm”) hosted its third annual Private Equity and Venture Capital Roundtables in Boston and New York, respectively, to discuss current trends in the acquisition marketplace. The panels, comprised of placement agents, sponsors, investors and partners from the Firm, were led by Josh Lerner, Jacob H. Schiff Professor of Investment Banking at the Harvard Business School. The combined audience of over 500 represented a broad cross-section of the private equity and venture capital communities.
Boston: Milton Berlinski, Managing Director, Goldman Sachs; Paul Edgerley, Managing Director, Bain Capital; Peter Dolan, Director of Private Equity, Harvard Management Company; Robert L. Friedman, Senior Managing Director, Blackstone Group; Dana L. Schmaltz, Partner, J. W. Childs; Scott Sperling, Co-President, Thomas H Lee Partners; and R. Newcomb Stillwell, Partner, Ropes & Gray.
New York: Ben Adler, Managing Director and General Counsel, Goldman Sachs Merchant Banking Division; Nicole Arnaboldi, Deputy Head, Alternative Capital Division, Credit Suisse First Boston; Bob Friedman, Senior Managing Director, Chief Administrative Officer, and Chief Legal Officer, The Blackstone Group; Erik Hirsch, Chief Investment Officer, Hamilton Lane; Ros Stephenson, Managing Director and Head of Global Financial Sponsors Group, Lehman Brothers; and Al Rose, corporate partner, Private Equity Group, Ropes & Gray.
The theme of this year’s discussion was “Current Trends in the Acquisition Marketplace.” Some of the topics discussed included deal generation, club deals, convergence in alternatives, returns and fundraising. The following summary provides an overview of those discussions.
Proprietary Deal Flow: Despite consistent GP claims to the contrary in their PPMs, one LP pointed out that “totally proprietary deal flow doesn’t exist on every transaction.” The same LP admitted, however, that the very good groups do have access to proprietary deal flows through their networks and differentiated investment models. And even if other firms are examining the company, certain firms will have access to different information and base of knowledge that, while not totally proprietary, make a big difference at the margin. A GP pointed out that the larger the company being sourced the less likely that it will be via a proprietary deal flow, and the more likely that it will be publicly auctioned. But another GP, representing a successful large buyout firm, countered that 80 percent of its transactions came through proprietary sources.
Strategic Investors: Although some strategic transactions have occurred in 2005, strategic investors have largely been uninterested in making significant acquisitions for the last several years. “Most bigger corporations today are trying to not diversify as they did in the 1990s, but really shrink back to the core and then grow from the core” said one panelist. So rather than competing with private equity firms, strategic investors have provided buyout shops with a steady transaction flow as they dispose of non-core assets. The absence of strategic players from the acquisition market has also kept prices relatively low, making many companies more attractive targets.
Sarbanes-Oxley: As one panelist succinctly put it, “It’s not quite as much fun being a public company as it was a few years ago.” The cost for public companies to comply with new regulatory laws is making private ownership an attractive option. In addition, private equity firms are viewed differently than they were a few years ago. The private equity dealmakers of the 1980s and 1990s were clearly financial engineers, but today they are viewed more as problem solvers. “Many CEOs are now more than willing to engage in a discussion or even talk strategy,” said one panelist. Together with the compliance issues, that creates an abundance of opportunities for private equity firms to take public companies private.
LP Overexposure: The media have recently suggested that “if all the big buyout firms go into the same deals, you will have regression to mean in return.” Shouldn’t the limited partner go to the buyout firm with the lower carry? In reality, however, “no overlap between any fund is more than 20 percent,” a GP was quick to note. The general consensus was that the media were attracted to the club deal concept because of the novelty, prevalence and increasing size of the deals, but that press criticisms of club deals overexposing LPs were misplaced. As one LP put it, “Most LPs have a diversified portfolio, and the amount of money that’s going into one deal inside a total private equity portfolio inside of a total pension fund, is negligible. The fact that you triple-dipped on SunGard doesn’t move the needle in terms of diversification for most clients.” In addition, LPs are getting savvier at figuring out who the leaders and followers in club deals are, and making sure that they don’t make too many commitments to follower firms.
Expanded Universe: There was also a general consensus that, particularly with strategic buyers sitting on the sidelines for the most part, there was an increasingly “expanded universe” of deals within reach of private equity firms willing to club together. With club deals becoming commonplace, the ceiling for deal size has gone up significantly and continues to rise. One GP also noted that “as you go up the size spectrum in your acquisition targets, you go up the spectrum of better-managed companies and better-quality businesses.” With less of an opportunity to cut costs and bring in new management to improve operating performance, this would seemingly affect returns in a negative way. But the panelists argued that a company with great market positions and excellent management doesn’t need major surgery to continue growing. This also strengthens the case for club deals, one panelist suggests. Because different firms can contribute in different ways to every transaction, the more operational experience you can bring in, the more value you can add to the investment.
Club Politics: The panelists agreed that the real test for club deals will be when a transaction gets into trouble. In a deal with several partners, “it could be a little chaotic and be tough on the CEO trying to listen to everyone,” one panelist noted. Most consortiums, however, are attempting to mitigate the potential for problems by agreeing to effective governance rules in advance and picking members who think a lot alike, are familiar with each other, and have amiable relationships. “It’s kind of like a marriage,” said one panelist. “It seems there are a lot more fights during the engagement period than once you are married and have to figure out a way to get along together.” The panelists agreed that a deal like SunGard was unprecedented, and they all would be watching closely to see how it played out.
Convergence in Alternatives
Hedge Funds Invade the Private Equity Space: At least one panelist believed that the threat posed by hedge funds was very real. This panelist pointed out that hedge funds currently have $1.2 trillion in assets under management, “so if they really put their minds to it, even a small allocation from that sector could have a dramatic impact on the private equity business.” Another panelist noted that hedge funds are evolving into formidable competitors as they are beginning to be able to “speak for the whole capital structure.” One GP in the large buyout space pointed out that to date they hadn’t seen much of hedge funds in their space, although he expected that to change over the next four or five years. “Because they have much lower return expectations, theoretically they could outbid you for something,” said the GP. “On the other hand, they don’t have the long-term money that we have.”
A Benefit to Private Equity? Hedge funds, for the most part, have been good for the buyout business. “From a leveraged finance standpoint we’re seeing the acceleration of the hedge funds, which I think are not only participating in the traditional strips of the capital structure, but also being incredibly creative in their willingness to play outside the traditional AB and high yield branches,” said a panelist. Their participation, another panelist remarked, will be critical going forward as deals continue to grow. Still another panelist noted that hedge funds are going into the high yield market as buyers to get their returns up, which was the reason that high yield could be sold at such low rates. Finally, several panelists made the case that hedge funds participating in private equity will generate acquisition opportunities for operational experts, simply because hedge funds don’t have the infrastructure in place for these investments.
Hedge Funds are not adept at control-style investments: Although no one questions the financial capabilities of hedge funds, the panel cited the operational aspects of private equity investing as an area in which they are severely lacking. “I think they do the spreadsheet stuff,” a panelist remarked. “It’s the analysis to get to the spreadsheet, studying the company and making sure that, notwithstanding what you know about the industry, this company has a relative position in the industry where it can achieve the economic model you lay out for it.” One GP added, “Private equity firms spend weeks and weeks looking at every angle before we conclude whether we’re interested in a deal and at what level. We worry that they just don’t have the analytical involvement that we do.” However, other panelists noted that “there are firms like Cerberus who come from a distressed angle and have substantial experience as operators,” and that “the funds that don’t have that experience can acquire talent.” When the cycle turns down, the panel agreed, that’s when it will become clear whether or not hedge funds really have the operating expertise.
Brain Drain: The panelist agreed that hedge funds do not currently have the infrastructure or personnel to do control-style investments, and until they learned how to do proper due diligence, there will be some “major blowups.” However, because of their more attractive compensation structure, hedge funds have been successful in attracting top talent away from private equity. If hedge funds continue to lure top private equity talent over to their side of the alternatives world, they will make the adjustment to control-style investing fairly smoothly.
The business cycle: Although they conceded that the last few years have been enormously successful, the LPs on the panel expressed concerns that “there appears to be some extrapolation in the last three years into infinity.” The environment at some point, they cautioned, will get more challenging- interest rates will rise, economic growth might slow or strategic acquirers might reappear. GPs countered that recent successes are the result not only of the business cycle, but also of several positive secular trends in the industry, driven by the fact that private equity is now a well-accepted form of ownership to almost any type of entity or seller. “The demand for private equity dollars has increased dramatically,” one panelist said, “and we see that continuing- not as part of the business cycle, but as a major secular trend.”
Mid-Market vs. Large Buyouts: There was consensus among the panelists, as one LP put it, that “one of the greatest fallacies in the private equity world is this notion that mid-market has outperformed the megafunds.” They agreed that the data are often misinterpreted by mid-market players for their own gain – the staggering performance of the largest funds in the market a decade ago is being credited to mid-market funds because, at that time, they were around $1 billion. One LP pointed out that if one compares the returns generated by today’s largest buyout shops through their history, they far outperform consistent middle market players. The panelists explained that the poorer showing of mid-market firms as compared to the large buyout sector was because there is significantly more competition in the middle market. In the large buyout market, you are less likely to find companies mispriced, as you might on the smaller deals, because companies are often priced by the public market. “You are not going to get a 20-to-1 return on investment with a bigger transaction, buy you also won’t see bottom-quartile performances,” said a panelist. “So risk-adjusted, its still a great place to be.”
Plenty of Money, But are There Enough Deals? Is there an excess of capital chasing a scarcity of good deals? Even though the larger firms have much more capital to spend and are more focused than they have been in the past on giant companies, which naturally are fewer in number, panelists suggested that there is less competition, rather than more for the large firms. “I look at the market cap of the S&P 20 years ago and today, and look at the relative amount of capital in the industry,” a panelist observed. “It hasn’t really changed much. Even though you have $100 billion, if you tried to buy three of the larger companies relative to the money that’s there, you could spend it all.”
Leveraged Finance Market: Most panelists agreed that the current “white-hot” leveraged finance market was helping to fuel returns by making it possible for sponsors to re-leverage a portfolio company after only a relatively short period of time, in some cases no more than a few weeks after acquisition. A deal like SunGard, one panelist said, could never have happened even just two or three years ago. But at least one panelist felt that this is “not a long-term phenomenon.” Another expressed concerns that a lot of returns on highly leveraged investments were being generated by multiple expansions that might evaporate going forward.
The evolution of management: Although the market is decidedly more competitive then it was a few years ago, managers are getting better at what they do, a GP claimed. “You have to keep on getting better in any industry to succeed, but there’s no question that we’re better at what we do today than we were 10 years ago,” said the GP. “We have people who have 20 years’ experience. Think about how rare that was 10 years ago.” On the other hand, a panelist countered, the growth of the industry in the last ten years has caused firms to grow dramatically in terms of personnel and thrust a number of inexperienced people into senior positions.
Undifferentiated GPs: One LP expressed frustration that “most GPs don’t know themselves or their peer group very well… It’s amazing that people who run businesses and set up management teams to be totally focused on their competitive position don’t understand their own competitive position.” This panelist explained that more often than not, GPs come into a first meeting with an investment case based on proprietary deal flow and a top quartile track record. Those GPs that state the most convincing case are very specific about their strategy and niche, know their competitors and their returns, and understand the business in general. One LP claimed that “for a lot of funds, if you cut through the numbers, EBITDA has been flat or down. They’ve done nothing to create value. It was a great financing they put in place, they had a quick recap and put more financing on, and they are showing a high IRR.” But many LPs are looking for managers who understand how to work the markets and can actually add value to the companies. The panelists recognized that the “buzz” factor is also important, whether created by influential LPs getting excited about an elite manager and bringing a critical mass of investors with them, or by the media writing positive articles about a manager.