A GULFSTREAM private jet landed in Frankfurt last Tuesday morning to deliver
billionaire New York financier Stephen Schwarzman, the self-styled king of
the trillion-dollar buyout industry, to the first of nine scheduled meetings
across two countries that day.
The American, who recently marked his 60th birthday with a £2.5m party at
which Rod Stewart sang for 1,500 guests, was in Germany to address the Super
Return conference, the annual jamboree for the private-equity industry. He
would be joined by David Bonderman, the chisel-jawed Texan billion-aire who
founded Texas Pacific Group (he preferred The Rolling Stones for his 60th),
and 1,700 delegates.
They have enjoyed good times. In less than a decade, private equity has been
transformed from a cottage industry into a monster capable of gobbling up
companies worth almost $50 billion (£26 billion) in a single deal. In the
past month alone, Blackstone investment group, of which Schwarzman is
chairman and chief executive, broke the buyout world record with a $39
billion deal for Equity Office Properties, one of America’s largest
commercial landlords. Within days, Bonderman’s Texas Pacific trumped him
with the $44 billion takeover of power giant TXU.
But in the sober surroundings of Frankfurt’s convention centre there was a
sombre atmosphere as delegates pondered whether they were witnessing the
last days of the bonanza. In recent weeks the private-equity industry has
come under unprecedented attack from trade unions, the media and politicians
for its lack of transparency, poor corporate social-responsibility record
and bumper pay packages.
Last week, rather than ignore those attacks, this notoriously secretive
industry admitted for the first time that with its new-found power and
influence must come greater responsibility.
They may have been small in number, but the dozen or so bedraggled trade
unionists standing on the rain-sodden concrete outside the conference hall
had succeeded in starting a minor revolution. They arrived nearly two hours
after the conference began, bearing signs condemning private equity as
“assett (sic) strippers” and “locusts” — and were gone by lunchtime. No
matter. They had achieved their aim by igniting a European-wide debate on
the role and function of the private-equity industry.
Bonderman and Schwarzman were impassioned defenders of the industry; private
equity is a force for good, they said. It creates jobs and delivers superior
returns for its pension-fund investors — many of them policemen, firemen and
nurses.
But as the first day unfolded, a growing number of private-equity leaders
offered mea culpas, pledging to be greener, more communicative, transparent,
socially responsible and accountable. As Tony Blair and Gordon Brown
expressed support for private equity, the British Venture Capital
Association recognised the need for change and announced a working party to
examine how the industry can improve disclosure.
David Rubenstein, founder and managing director of Carlyle Group, said the
industry should be more open and transparent; it had failed to educate
people about what private equity did. Nigel Doughty, chief executive of
Doughty Hanson, said private equity needed to talk about the social and
environmental impact of its activities, adding that his firm was in the
process of going “carbon positive”.
Guy Hands of Terra Firma Capital Partners said bigger deals meant greater
scrutiny. “Once you are that big, your public owns you, not the other way
round.” He added that it was impossible for private equity to ignore its own
“Barbarians at the Gate” — the hostile journalists, trade unionists and
politicians.
Hands said public criticism would only intensify if markets nosedived and more
private equity-backed companies went bust. “Any losses will be seized upon
by opponents. The industry needs to prepare itself for decline and start
acting like a public industry,” he said. Many private-equity executives said
they believed government regulation was a real, serious threat unless the
industry changed.
The other big threat was an implosion in debt markets. The private-equity boom
has been fuelled by the ready availability of cheap debt and pension-fund
cash seeking a home. In the recent, benign economic environment, banks have
been willing to lend ever-larger sums at evermore relaxed terms, but this
could create problems in a tougher economic climate. Jon Moulton, managing
partner of Alchemy Partners, which bid for Rover, the carmaker, seven years
ago, warned there was a “material chance” of a “catastrophic meltdown” in
the debt markets.
Leverage multiples — the ratio between debt and earnings — have hit a
seven-year high and acquisition leverage multiples are at their highest for
a decade. Many private-equity deals are funded by loans of six times
earnings or more, leaving little margin for safety. The biggest, most
powerful houses boast that they typically borrow without any banking
covenants in place.
They claim this makes loans safer because they have only to repay the interest
and do not have to worry about technically breaching any covenants. Many
loans are nonamortising, so only interest on the borrowed sum is repaid. All
very well in good times, but if the investment against which the loan is
secured drops in value, private-equity owners will be saddled with debt they
cannot repay.
The explosion in riskier forms of debt during the past two years will also
exacerbate the dangers, according to Moulton. The use of mezzanine finance —
a halfway house between debt and equity — soared to record levels last year:
€12.2 billion (£8.3 billion), up from a record €8.9 billion in 2005,
according to Initiative Europe and Standard & Poor’s.
But the average credit rating on mezzanine finance is only CCC. If any loans
run into trouble, Fitch, the credit-rating agency, expects the recovery rate
would be only 10% or less.
Meanwhile, collateralised loan obligations (CLOs) which in effect bundle
together a collection of leveraged loans and slice them up into portions
with varying rates of risk and return, tripled last year to €34 billion
across Europe. Tom Attwood from Intermediate Capital Group said that CLO
funds would quickly stop investing if there were any serious defaults.
As deals in private equity get bigger, loans are increasingly syndicated by
banks to a wide range of lenders. With six or seven different layers of debt
not uncommon in the biggest deals, it will be much harder to renegotiate
loans if things go wrong.
“In the larger syndicated deals at no point do you know who your partners are,
which makes it hard to go into a darkened room and work out an agreed
solution,” Attwood said. Rising interest rates and the possibility of a less
benign economic outlook mean that a sea-change in default levels will occur
in the next year or two, he added.
It is difficult to judge whether a catastrophe in the debt markets will occur.
There seems to be a consensus that private-equity returns are likely to
fall; and as the giant buyout groups chase ever-bigger deals they will try
to buy better-run companies like J Sainsbury. This will inevitably bring
greater public scrutiny.
The boom may not turn to bust. But as private equity is forced into the public
eye, some must fear that it has been choked by its own success.
