Private equity in more robust position than before crisis

March 29 2018

The market is just as competitive as before the crisis but with added awareness of risk

Is the private equity market better placed than it was before the financial crisis? Some say it is, with reduced debt levels and an overall greater awareness of risk.

In December 2008 what would have been the world’s largest ever leveraged buyout collapsed. Auditor KPMG was unable to declare that Canadian communications company BCE would meet solvency tests after its planned privatisation. A consortium led by the Ontario Teachers’ Pension Plan pulled out, one year after they announced their intent to purchase all of BCE's shares for about $50 billion. The consortium would have borrowed $15.9 billion to finance the deal.

In spite of BCE’s share price skyrocketing since – it has paid $3.9 billion in dividends and a further $1.4 billion repurchasing shares – other private equity firms would have been wise to exercise more caution in this period famously named private equity’s ‘golden age’. KKR, Bain Capital and Vornado Realty Trust bought Toys ‘R’ Us for $6 billion back in 2005 despite concerns about toy stores ability to compete with online marketplaces, and the company entered administration last month. Providence Equity Partners and TPG together with media companies Song and Comcast bought MGM for $2.85 billion and assumed $2 billion in debt in 2005. MGM filed for Chapter 11 bankruptcy in 2010.

"The magnitude of buyer competition is similar to 2008 but there is more of an awareness of risk"

But while it has been well documented that private equity is performing at a similar level to 2008 with record levels of dry powder and company valuations, a greater awareness of risk provides hope that the events during and immediately after the crisis will be avoided this time.

“The magnitude of buyer competition is similar to 2008 but there is more of an awareness of risk,” said Mike Preston, partner at Cleary Gottlieb. “I don’t think people have forgotten about the mistakes of that time.”

There is a far greater focus on due diligence and a greater emphasis on this being done well before any transaction is completed, in spite of the seller-friendly conditions, which should reassure those in private equity and beyond. Because of the mass competition for deals, companies and private equity sellers are in a position to ask for cash up-front, with no shortage of alternative buyers if the deal falls through.

“Things change according to economic cycles,” Preston said. “In the early 2000s, it was a much more equal market between buyer and seller and the risk allocation was balanced - however in 2007/08 it was a very seller friendly market with less buyer protection built in.”

Last year, private equity reached a post-crisis high of $453 billion and 2,183 deals completed. Most significant is the extraordinary amount of funding that suggests this growth will continue for the immediate future, but funds are being more careful. In a PwC report for 2017, no fund reported using on average more than 60% debt for deals completed last year. Eighteen percent of respondents said they used less than 40% debt on average. If a crisis is to arise soon, then private equity is in a much more robust position to overcome any crisis.

KEY TAKEAWAYS

Private equity is performing at a similar level to 2008 but the market has learnt its lessons from the financial crisis. Leverage is down from before;
This is a very seller-orientated market with high valuations and lots of competing buyers. Sellers are focusing on terms like requiring all the money upfront rather than earnouts;
Given the record amount of dry powder in the market, it appears that this will continue for the immediate future.

In this seller-orientated market, buyers do not have the strongest negotiating position. In transactions there is often a difficult line to draw between seller and buyer and this can lead to disputes if the terms are not very clear.

“Certainly most disputes are about benchmarks; what happens when there is a change and also how you measure success,” Preston said.

Certain incentives placed in contracts could motivate owners to neglect certain parts of the business with the aim of solely fulfilling the contractual terms for remuneration. Earnouts, for example, could encourage board members to make decisions only on the basis of boosting the earnout figure rather than looking at the company’s long-term objectives.

Herbert Smith Freehills partner John Taylor said earnouts were more prevalent a while ago.

“Buyers are less willing to give protections to sellers,” he said. “The terms are more typically about ensuring the fundamental approach of the business is not changed.”

According to Taylor, buyers are more hesitant than one year ago and this could result in more favourable terms offered by sellers, bringing it in line with the market conditions of the early 2000s. But with the magnitude of funding available, there is unlikely to be a significant power shift in the buyers’ direction.

An investment manager at a global asset manager said that earnouts are rarely included and the focus is more on getting cash upfront rather than a deferred payment.

“In my experience it isn’t something that is particularly prolific as opposed to a potential solution to find agreeable terms with the buyer or seller,” they said. “I wouldn’t say that has changed recently.”

This is indicative of the sellers’ strong position in the market, but this is something that can continue for only so long.

Fatema Orjela, partner at Sidley Austin partner said the situation has not got out of hand or ventured into bubble territory yet. When it inevitably does change, the negotiating power will shift again and contractual terms like earnouts may become more frequent.

But if the market does venture into bubble territory, private equity firms are in a much more solid position than before to get through the crisis.