The Odds in Favor of SMALL BUYOUTS

Anyone with a stake in the twisting fortunes of the large-market buyout business over the past few years may be haunted by the old adage: “By the time you see the bandwagon, it’s too late.” If one were to describe the state of the buyout business in recent times, the operative word would be “down.” In the case of some industry benchmarks, “way down” is a more apt description. Consider that rolling three-year capital-weighted returns for large funds, defined as those that feature capital commitments of $1 billion or more, have declined from 18% in 1998 to negative territory today. Large-market buyout funds pace the averages for the LBO industry since 75% of all committed capital is invested in funds of $1 billion or more. Big funds mean big deals. But the risk-reward landscape for big deals has degraded to such an extent that a complete reassessment of this investment discipline is now compulsory for any serious private equity investor. To properly understand how valuation and credit multiples have changed the face of this industry, consider contrasting market conditions for LBO deals over the last decade. According to S&P Portfolio Management Data, LBO transactions in 1993 garnered a purchase price multiple of around seven times EBIT-DA with average debt to EBIT-DA of 5.2 times. So a $500 million acquisition in 1993 would require an equity stake of 25% and 2.7% annual growth in EBIT-DA to generate a 25% internal rate of return (IRR), assuming the exit multiple remained at seven. Fast forward to 2003 when the same $500 million acquisition, now priced at 6.3 times EBIT-DA and requiring a much higher equity stake of 41%, necessitates EBIT-DA growth of 9.1% per year to achieve a 25% IRR. From a theoretical perspective, future IRR’s can be gleaned from prevailing market conditions. EBIT-DA growth aside, LBO returns are a direct function of transaction leverage, or average debt as a percentage of purchase price. In any investment year, this number offers a good indication of future IRR, assuming no multiple expansion. Over the past decade, average transaction leverage has fallen from 75% in 1993 to around 59% today. Look for large and middle-market returns to average only 15% over the next several years. Leverage dynamics and performance results formerly associated with large-market investing are in short supply now and are more reliably the province of lower-middle-market dealmaking. A $100 million investment in a lower-middle-market company today would likely be priced at five times EBIT-DA with total debt support of 3.5 times EBIT-DA, which requires a 30% equity stake and a 4.8% annual rate of EBIT-DA growth to generate a 25% return. Investors have 25% less equity at stake in smaller deals requiring nearly 50% less EBIT-DA growth to achieve the same returns. The lower middle market requires greater selectivity because of lower cash flows, poorer scale economies, and less secure franchise durability. But it is a conspicuously underserved LBO niche that looks stronger by the day. From 1995 to 2000, an estimated $230 billion was raised by buyout sponsors whose average deal size rose from $144 million in 1995 to $223 million in 2000, when the bandwagon changed to a roller coaster. Deal volume peaked at 364 transactions in 1999 with a total value of $63 billion but declined to $23 billion by 2001 before recovering to $41 billion in 2002. Capital commitments to the industry topped $63 billion in 2000 and fell to just $29 billion last year. Performance data pertaining to large- and mid-cap funds, which jointly account for 98% of all committed capital, vary slightly, with large-cap funds returning 15.3% over 20 years and mid-caps returning 17.4%. Most recent 12-month performance data place large-cap funds at negative 8.5% versus a mid-cap return of negative 11.9%. Bad performance figures of the magnitude we are seeing lately are seldom presented on time and in full view. They are more likely to dribble out until the generals can retreat to higher ground. Accounting and disclosure regulations still permit fund managers to value assets in a buyout portfolio as a matter of opinion (theirs). Consider too that in the year 2000, nearly 75% of all private equity investing took the form of telecom or Internet investments made at high stock market valuation multiples. In addition, buyout managers began to rationalize investment models in the mid-90s as correlating stock market returns “chased” them into uncharted markets featuring towering valuations and higher risk, the so-called “New Economy.” For large buyout funds and their limited partners, many “turkeys” haven’t yet come home to roost. In truth, between 1999 and 2001, the buyout business probably delivered 10 to 12 quarters of dealmaking, which, on average, will yield negative returns to their investors. Very few large or middle-market funds raised since 1998 have positive book value. Money invested by fund managers in the 1996-1997 time frame with five-to-seven-year exit strategies are also suspect because of tough intervening market conditions, plummeting valuations, and a virtually nonexistent IPO market of late. Today, there are more than 100 firms with $1 billion or more each under management. Uninvested equity in the buyout business may run as high as $125 billion. There is four times the number of buyout firms today than there were 10 years ago. Battered by portfolio problems, fund-raising impediments, management fee criticism, and a decline in investor confidence, many funds are sounding a “back-to-basics” strategy, sometimes referred to as “buy and build.” Others take refuge in middle-market investing, superior operating experience, and industry-focused investing. A middle-market refuge may be “where the heart is” for large funds but they cannot efficiently diffuse huge amounts of committed capital in smaller deals in the middle market. In any event, return prospects and leverage geometry in large-cap companies with $1 billion or more in sales don’t vary greatly from the upper reaches of middle-market investing, frequently defined as including companies with $500 million to $1 billion in sales. During the 1980s and early 1990s fund managers frequently targeted under-leveraged balance sheets, leading them to focus on low-end manufacturing firms and companies specializing in consumer goods. Growth in non-financial corporate productivity, a critically important driver in the outcome of a private equity investment, averaged just 1.4% from 1973 to 1995 but accelerated dramatically from then. In the seven years following, productivity growth more than doubled to 2.9%. Productivity increases largely driven by technology facilitated operating efficiencies and spurred unprecedented LBO equity growth to create a golden age of returns. Another important driver in this golden age was blistering GDP growth. Strong GDP growth is especially vital for LBO players striving to arbitrage a debt load and capture the high rates of capital appreciation needed to justify lofty purchase price multiples and premium rates of return. Most are familiar with the expression “a rising tide floats all boats.” Consider that GDP increases in the 1980s averaged 2.9% but climbed steadily to an average level of 4.4% annual growth from 1995 to 2000. Stronger sustained growth in GDP happened only once before, from 1962 to 1966, when expansion averaged 5.8% yearly. This six-year time frame of 1995-2000 is important to understand because it opened a huge exit window for the most favorable LBO realizations in history. Low inflation also contributed. LBO investments ran under the cover of an average inflation rate of just 2.6% between 1992 and 2000, bettered only by the 1.9% average rate from 1962 to 1966. Critical to the impressive LBO results in the 80s and early 90s was a gross lack of corporate discipline among large public companies that were hit by a withering assault from a business culture called “Japan.” Large funds in those days enjoyed lower pricing and could capitalize on conspicuous inefficiencies across a wide swath of the value chain, including unfulfilled strategic and operational initiatives, unrealized consolidation opportunities, and unsatisfactory expense economies. An abundance of cheap credit from multiple sources was available. Anyone interested in understanding the leading sources of change in the buyout business need look only at revised lending multiples. Not that long ago, a conversation between a buyout executive and lenders would begin with the question: “What is your minimum equity requirement?” For large deals in the 1980-1990 time frame, you could capitalize a transaction with as little as 10% to 15% equity. By the mid- to late 90s equity requirements were climbing to 25% to 30% along with reduced valuation multiples and a gradual tightening of credit policies. Today large deals at premium valuations – seven to nine times EBIT-DA – require a pledge of equity equivalent to 40% of the purchase price. Not surprisingly, assorted forms of credit support for the leveraged buyout community soared throughout the industry’s golden age. Lenders raced to compete for cash flow and asset-based credits with competition so fierce that as many as a dozen banks would actively bid to support an LBO with senior debt. Mezzanine support adopted a similarly liberal stance, rounding out a “buyer’s market” of unprecedented proportions until a broad-based contraction of credit commenced in early 2000. Another deal driver worth reviewing is interest rates. Given that virtually all LBO capitalizations are characterized by variable rate debt structures (mostly based on LIBOR or the prime rate), sustained periods of low, stable interest rates are highly beneficial to results. From 1992 to 2000, the prime rate averaged 8%, never breaking through 9% until 2000. The last nine-year period featuring an interest rate environment that favorable to private equity was 1969 to 1977 when the prime averaged 7.5%, despite considerable deviations in 1973 and 1974 when the key rate hit 10.5%. After discounting for volatility, it is fair to assert that the interest rate environment in the 90s was the kindest in the history of the buyout business. The only period featuring a superior rate environment was 1958 to 1966, which also had a low inflation rate. No useful comparison of past and future prospects for large-market buyout funds would be complete without an understanding of how the 1990s stock market boom throttled LBO valuations and supported easy exit strategies for the industry. The stock market prices public companies that serve LBO investment targets, and acts as an a important “peer-group” barometer for the valuation of larger private companies. The vitality of the public marketplace is important for publicly traded assets in an LBO portfolio and especially for premium exit strategies taking the form of an IPO. Just as LBO momentum was returning in 1993, the Dow Jones Industrial Average was about 3,000. By year-end 2000, the Dow had risen 267% to a level of 11,000. For the Nasdaq, an especially popular IPO venue, the move upward was even more dramatic, increasing from 700 to 4,700 over the same time frame. Odds of picking a winner were 80% and sometimes 90%, as long as you held the stock for five years. At no time in history have the equity markets experienced a period of prosperity remotely comparable to this era. From 1995 to 2000 the equity markets moved skyward on nearly a straight line. Pouring through this special window in time were many LBO exits driven by an S&P price-earnings ratio that migrated slightly above a historical average of 15 in 1995 to an all-time high of 62 in 2001. Stop to consider that the S&P 500 P-E ratio valuations steadily doubled from 1991 to 2000. It would be difficult to argue that the stock market phenomenon catapulted growth and exit valuations in connection with fundamentally sound LBO investments and provided downside cover for a raft of less worthy investments throughout the period. A burgeoning IPO market, which more recently is down 90% from its former peak, routed any concept of valuation fundamentals as it converted many private companies into “fool’s gold.” Consumer confidence, a broadly significant factor underlying 75% of GDP in the United States, averaged 99.9% between 1994 and 2000. This is the highest level of consumer confidence ever recorded by the University of Michigan. Industrial production generated an average growth rate of 7% between 1992 and 2000 – a record surpassed only in 1961 to 1969, when the Vietnam War was at its peak. Finally the U.S. added more jobs – 23.1 million from 1992 to 2000 – than in any eight-year period in history. In summary, the 1990s were marked by an extraordinarily favorable confluence of economic factors that cannot be replicated in the near future. The economy was coupled with a record-breaking availability of credit, a bounty of lumbering under-leveraged balance sheets to prey on, and a stock market gone mad. To the conditions and performance results that gained such momentum and notoriety at the close of the 20th Century, more particularly from 1995-2000, there is the Latin expression “De mortuis nil nisi bonum” or “Say nothing but good of the dead.” The value drivers that helped LBO dealmakers during the lush years, including financial engineering, operational initiatives, or quick and easy strategic plays, are scarce since the turn of the century. Large companies have consolidated market share and are running “smart” operating models to optimize shareholder value. Explosive growth in the size and number of large funds threatens to keep valuations artificially high as managers look to commit unused money. The large- and middle-market buyout industry is fishing in dangerous waters for a diminished supply of trophies that offer IRRs of 20%, not 40%. The buyout business began to degrade rapidly in mid-2000. Deal volume, fund-raising, and performance results are all down now from the highs of 1999. Many “new economy” investments made in the 1998-2001 time frame are hobbled by market dislocation, inflated purchase price multiples, and a deep trough in the economy. Large buyout volume declined to a trickle for much of 2001-2002 as fund mangers made history with the magnitude of their losses and a willingness to return billions to their limited partners. For most LBO players, the last five years have amounted to busted hopes for equity participation and the emergence of unprecedented risk. Many funds face shorter time frames to enter and exit new investments. As if things weren’t bad enough, limited partners are “organizing” to protest poor results, high fees, and a lack of investment momentum. One of the best-known university endowment investment directors vows to battle the buyout community, although the same person had nothing but praise for large buyout and venture funds before the bandwagon crashed. The Future Only a strong fourth quarter pushed buyout volume for 2002 to $41 billion, nearly double the rate in 2001 but about 35% off the high water mark set in 1999. LBO fund-raising declined from approximately $63 billion in 2000 to a level of $37 billion in 2001 to just $29 billion in 2002. The strong fourth quarter sparked hopes of an LBO comeback. This time around, beware of the bandwagon. The ice is thin out there and average rates of return will be measurably lower over the next 10 years. While many economists are predicting economic growth of 3% to 3.5% over the next 12 months, there are strong reasons to suspect that we are facing a protracted period of slow growth in the U.S. Japan has suffered three recessions since its own bubble burst at the beginning of the 90s. Consider that the American economy has been in recession less than eight quarters in the last 20 years. For those anticipating a revival of the stock market, Martin Barnes, an economist at Bank Credit Analyst Group, points out that from 1935 to 1995, the S&P 500 traded at an average of 15 times historic operating profits; now the ratio lingers at around 20. At the bottom of the bear market in 1982, a slide comparable to the recent market weakness, the S&P 500 traded at only eight times operating profits. Another of Barnes’ plausible observations is that “we will be lucky” to see average real returns of equities surpassing 5% per year into the future, causing households to save more and further slow GDP growth. It is certainly worth noting that household net worth will decline for the third straight year in 2003. At the same time, Dresdner Kleinwort Wasserstein estimates that American corporate balance sheets are more highly leveraged than at any time in the past half century. Does any of this sound like certain impetus to growth? Interest rates to the rescue? Judge for yourself. The long bond is at its lowest point in 40 years and the Fed has exhausted its ammo. But don’t blame the Fed. If it hadn’t brought rates down at such a precipitous rate, things might be a lot worse. Over the next five years, fund managers may see a greater percentage rise in variable debt structures than at any time since the mid-1970s, a time when many were attending high school proms and the buyout discipline was barely established. Those rooting against an upturn in rates must realize that their dream comes true only in the continuing absence of economic growth – a very precarious wish for anyone in the buyout business. Since the beginning of 2001, commercial and industrial loans at commercial banks have fallen $142 billion, or 13%. In the credit crunch of 1991-1993, loan value only fell $61 billion, or 9.5%. This indicates a more restrictive lending posture in the face of higher risk for LBO investors. Charge-off rates for commercial and industrial loans were 2.04% in the third quarter of 2003, the second-highest level since the Fed began tracking these statistics in 1985. Only the fourth quarter of 2001 was higher. In its quarterly survey of bank lending standards, the Federal Reserve found a significant increase in the number of bank tightening credit standards. Over the past two years, the net percentage of banks reporting tighter standards has averaged 39%. At the same time, the net percentage reporting stronger loan demand has averaged 50%. More positive signs of credit support for the buyout community are anecdotal but encouraging. Banks appear to be easing both the supply and applicable terms for leveraged investing even to the point where some are warming up to cash flow credits. Time will tell, but higher deal volume in the fourth quarter of last year speaks for itself. More than any other factor, lower valuations and the appearance of higher-quality credits will increasingly lure lenders back into the field. Against this backdrop of economic variables, LBO funds face heightened operating challenges, declining leverage geometry, and embedded valuation premiums resulting from too much capital chasing too few deals. That is the nature of a supply/demand imbalance that isn’t going disappear soon despite pledges of fund managers that they will move “down market.” We close on an optimistic but cautionary note. The buyout industry is far from discredited as a reliable and attractive alternative asset class. The industry’s fundamental underlying investment characteristics will endure. There will be higher risk and lower returns than in the past but returns should beat stocks and bonds where the consensus favors single-digit returns for the rest of the decade. The fundamental investment characteristics guaranteeing the survival of the LBO industry include management expertise, value-added strategic and operating prowess, market imperfections, capital resources, and economics of scale. The only remaining LBO landscape where leverage and valuations are reasonably promising for returns in excess of 25% is the lower middle market, in my opinion. It involves less than 2% of all LBO capital raised last year but features six times the number of target investment opportunities than those in the upper reaches of the market. This underserved market will continue to feature inefficiencies reminiscent of large buyouts’ finest hour. Investments in the lower middle market, frequently defined as companies with $20 to $100 million in revenues, have, on average, generated 25% returns over the last 20 years versus 18% and 15% returns for large- and middle-market funds, respectively. Look for that performance gap to increase in favor of smaller dealmaking in a more diverse and less mature market setting. Michael Dailey is President and CEO of Dailey Capital Management LP, a private equity firm based in Southport, Conn. Copyright 2003 Thomson Media Inc. 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