Private Equity Financing (2007)

Introduction

The following blog gives an overview of the leveraged buy-out boom in the 80s and problems which followed in the 90s.  Up to 2007 there had been a sharp increase in Private Equity investments again, especially in the last two year, but it decreased with the 2007 subprime mortgage crisis, which is outlined as well. For discovering certain patterns in the development of Private Equity, both developments and crisis will be compared and analysed to give the answer to the question, whether alternatives to public corporations are financially desirable or possible. Therefore a Private Equity lifecycle will be developed, which will be used for the argumentation of preventing those crisis and a better evaluation of the problems and risks that Private Equity carries.

I will start with a few definitions, but readers are suggested to have certain financial knowledge and understanding. The further structure is chronological starting in 1980 and ending with the future of Private Equity. 

Private Equity

Private Equity is equity capital given by private and institutional investors for non-public companies. Private Equity can be divided in to risk-capital (e.g. Venture Capital), Mezzanine and Buy-out Financing.

 Buy-out

Established Companies or parts of it will be taken over through Private-Equity companies (LBO) or through the existent Management (MBO). The takeover is mainly financed by debt capital, which is ensured by assets of the company taken over. The reasons to sell leveraged equity –with respect to LBO or MBO are -e.g.- focusing on core competencies or (under hard conditions) to get debt capital (subject index Basel II).

The ideal target for a buy-out transaction has high and stable Cash-Flows, a well established Brand-name, and a high market entry barrier and needs low money for new investments, e.g. R&D.

While medium businesses use private equity to build up assets in long-terms, will the companies taken over by LBOs after debt relief sold to another company (trade sale) –mostly from the same branch.

 The world wide amount of Private Equity Companies of take-overs was 3% in 2000 and increased in 2004 to 14% to a volume of 294 Billion US Dollar. For take-overs of larger companies the Private Equity Companies raised more and more bidding consortiums. “Buyout firms raised $210 billion in 2006, 57 percent more than a year earlier, according to London-based research company Private Equity Intelligence Ltd. They announced a record $701.5 billion in takeovers, according to data compiled by Bloomberg.” (Lim & Tan 2007). The major role however has the bank, because the bank can finance around 2/3 of the takeover –mostly, consequently debt levels rise as Private Equity rises. 

Criticism on Private Equity Companies

Private Equity Companies are accused, that their only target is optimization of profits at all costs –from the Business Ethnical perspective (e.g. run down personal costs), but critiques oversee that many companies would otherwise not sustain on the market. However, there are always people/companies, which are miss-using systems, but oftentimes Private Equity Companies are the only available capital giver. 

Leveraged Buy-out Boom of the 80s

“Leveraged buyouts are probably one of the most remarkable success stories of the 1980’s.” (Jing & Wan 2002)

The major event happened, when a management group bought Gibson from RCA for $80 million, which used just one million of equity, increased the value of the company within 18 month to $290 million –without making major modifications in the company.

The LBOs became one of the most profitable investment ideas of the 1980s, “…attracting many participants, including banks, insurance companies, Wall Street firms, pension funds, and wealthy individuals.”

After the Wometco transaction of $1 billion in 1984, there had been a sharp development and massive growth in LBOs, with an increase of $72,1 billion between 1983 and 1989.

 Financial difficulties of the early 90s, followed from 80s

As it was realized that the leveraged buy-out had immense risks inherent the boom stopped and creditors did not want to additional risks. The firms’ profits struggled under the high repayments and legal changes they had to operate with. The huge investments had been to speculative within of the boom and many companies made products which had not the expected demand, so they had to cut down their prices to levels of loss and they still had to pay back their debts. At this point a company is lost, because they can’t reinvest because of their debt capital structure and their huge repayments.

“In 1990, the number of corporate bankruptcies that involved more than $100 million in liabilities each reached 24 and amounted to an aggregate of $27 billion in liabilities. The number of such large filings rose in 1991 to 31, while total liabilities stood at $21 billion. In 1992, the number of large bankruptcies declined sharply but the debts involved dropped down only slightly.” (Jing & Wan 2002)

Furthermore 18 large deals, between 1985 and 1989, went into bankruptcy near to 1992. 

Subprime crisis USA

In the USA residential properties were bought rather then rented in a lot of cases. The banks gave credits to debtors even with a bad creditworthiness, because of the increasing prices for properties. The Mortgages (security = property) were mostly allowed to have a high of 100% of the financing costs. The higher risk of those debtors was carried out by higher interest rates. A major part of those high risk credits was sold from the credit institutes to other finance companies (e.g. Hedge Funds), to spread and reduce the risks. Furthermore those credits are variable in the USA, so it hasn’t got a fixed payback period.

 The increasing interest rates from 2005 led since the middle of 2006 to less Subprime Mortages, because the debtors were not able to pay the increased interest rates. An additional indicator was the decrease of property prices. The so called subprime crisis started in June 2007 after the investment bank Bear Stearns published a decrease of few Hedge Funds, which dealt manly with subprime credits. This message led to a sharp decrease of the readiness to assume a risk of private and institutional investors, which took a valuable amount back out of the capital markets. This especially affected funds which had problems of liquidity, which were invested in the subprime market.

 The crisis causes that the debt multiplier and with that the readiness to assume a risk decreases significantly. This results that the equity ration increases for Private Equity transactions. Through that development the prices for companies will decrease. The actual aloofness of the credit institutes for new company credits lets to the result that a variety of handed out credits can’t be handed over to other institutes. In the last years a major part of the handed out debt finances for Private Equity transactions was handed to institutional investors, like Hedge Funds. This demand increased steadily and those investors invested before the crisis about 80% of debt finance in the USA. It is estimated that the value of credits (from Companies) which will be handed over to other institutes is US $215 Billion, furthermore it is suggested that this “surplus” will be cut down by the next 2-3 month. As a reaction to this the Private Equity Funds try to find alternative sources of finance, like state funds and capital surplus areas from the Middle East and Asia, which invest in both equity and debt finance and will possibly takeover a part of the future debt finance.

As a result the grown fear to take risks the Banks will reduce their credit volume for Private Equity takeovers. When a Private Equity transaction is not possible to the planned conditions the bidding will decrease.

However the debt finance market will still be available for Private Equity transactions. Through the Subprime crisis led to extended credit spreads, which means that credits with lower securities will have a much higher interest rate then before, but the fundamental data of the economies remain quit stable. The banks will keep on financing valuable deals, but Private Equity funds need to a at least 30% of equity.

 Comparing situations of 1990s and 2007

Both situations showed a boom in the Private Equity developments, which carried risks at a high level. These tools of Finance both, Private Equity finance such as Hedge Funds, didn’t have strict regulations, which makes them flexible for investors and investments. Furthermore these markets were carried out by experts –not “usual” private investors. The Private Equity market had in both cases a high rate of return, because of certain trends in certain gaps. The securities were in both cases ensured by a value, which was there but only hard realizable, hard to turn it into liquidity –firms value and properties value. The trends had both a growth of value, the value of companies and the value of properties. Then changing winds ran into both markets, and the value of return decreased or even went negative –the prices dropped. The expectations turned out to be different (bad), which was in both cases realized by a major event. Both times had the problem to turn their securities into cash, because the securities dropped as well within the crisis, but they had to payback their large amount of debt finance, which they largely couldn’t. The reactions of the banks were not to take such high risks anymore and Private Equity funds needed to have more equity. Both developments were mainly based on a speculative bubble –very positive expectations in their development; ensured by the belief of having stable securities. These developments show a certain cycle and similarities in Private Equity financing. 

Within those equity life-cycles the capital structures vary from more debt finance to less dept finance through more equity, then changing in the next cycle to more debt finance again. The end of each cycle has do deal with an overbidding process. “There is too much money, they are paying too high prices and they are leveraging themselves too much,” said Jim Rodgers (MarketWatch 2007). From this point a crisis is pre-assigned and “this has to end badly,” he said. Furthermore he said “I assure you, we are going to see a lot more blow ups.” This leads to the question if alternatives to public corporations are not financially desirable or possible. Public equity is the possibility to finance its investment through equity finances –not debt finance. In a crisis the value of the company will be decreased by its shares. Furthermore public equity has no “interest rates” in a loss situation, which make it more flexible. The capital structures of public corporations are more stable in the sense of equity. There is less fear of deflation and other risks that are pre-avoided through this capital structure. On the other side public corporations are bound to strict regulations, such as large reports. This process makes them slower compared to private companies, harder to handle and to react. Furthermore boosting projects/companies through Private Equity investments is a huge driver for economies. So this idea should be modified to a more stable way. To avoid and prevent a crisis, we have to know were the peak of the Private Equity lifecycle is reached before it is reached and then pre-reacted by slowing down the investments by regulations of the equity structure in private equity, which means that Private Equity transactions need more equity. If we just raise interest rates, this would attract more high risks projects and lead to the affect that the repayment of the existing debt capital takes would struggle to payback. The next issue is to possibility to foresee the peak. On the June 24 2007 there had been the following statement in an online newspaper: “The private equity business is near a cyclical high and the volume and size of buyouts may fall in coming months, said the chairman of Clayton Dubilier & Rice Inc.” (Lim & Tan 2007). This statement proves that the peak can be foreseen. Furthermore it would be helpful to change US GAAP and the IFRS in the particular fields of real value and more frequency in this process, controlled by a new committee, which is focusing on critical areas. This would cut down future bubbles and prevent crisis, so Private Equity can take its quite stable place in economy. 

Conclusion

The financial problems resulting from Private Equity were two main crises –debt crisis. Therefore anti-neo-liberalists claimed failure to the financial world, which had to ask itself whether there are alternatives to public corporations or not. The world economy sank the affects of the crisis through tenders of the worlds note banks. The capital structure of Private Equity had been redefined –an update of % of equity and interest rates. Private Equity is expected to have a 6-7% higher return than public shares, after C. Rubenstein. Every system has its struggles at the beginning and it would not be desirable to withdraw Private Equity sector. The saying from Mahatma Gandhi that the history teaches human, that history doesn’t teach human, is not right –not in the financial world.