Private Markets at a Breaking Point?

The FT reports that the crisis deals bitter hand to buy-out bosses:

After Jon Moulton’s bitter resignation letter at Alchemy Partners and an acrimonious boardroom bust-up at France’s PAI Partners, the strains of the credit crisis are starting to show in many leading private equity groups.

As the credit crunch deprives private equity of the debt needed to finance deals and many of the investments made at the top of the market look unlikely to be sold for a profit, tension is growing inside the buy-out industry.

“In every large European fund, some deals are not doing well and have been written down to zero,” says a big European investor in private equity. “When things are tough it increases tensions between partners.”

This tension and the downturn in financial markets has triggered a string of shake-ups at several private equity groups. Already the top teams have been reshuffled in the past year at Permira, Cinven, Candover, 3i and BC Partners.

“There is some sacrificing of people going on to show investors that you are taking action,” says one UK private equity boss.

While in some cases, the handover of power at the top of these groups was done in a smooth and orderly way, such as at Permira and Cinven, in others it has happened in a more sudden and contentious fashion, such as at Alchemy and PAI.

At Permira, Damon Buffini has handed over as managing partner to Kurt Björklund and Tom Lister, and in June he announced plans to step down as chairman next year, going back to dealmaking and managing portfolio companies.

In July, Cinven appointed Hugh Langmuir as its managing partner, replacing Robin Hall, who is to become executive chairman after 22 years at the helm. Both Cinven’s and Permira’s succession plans seemed well-orchestrated.

In contrast, Mr Moulton announced his surprise retirement from Alchemy in spectacular style, calling for the group he founded to be wound up and telling investors he thought Dominic Slade was not up to the job of succeeding him.

Mr Moulton proposed splitting the group up, allowing Mr Slade to take the financial services part of the portfolio as the base to raise a new fund and leaving him to manage out the rump of manufacturing and technology companies.

When this was rejected, Mr Moulton quit, triggering a “key man” clause in the agreement with investors, which allows them to freeze new investments by the group and could result in them forcing it into run-off.

The bust-up at PAI is, if anything, even more acrimonious. Dominique Mégret and Bertrand Meunier have been forced out by what one insider called “a coup d’état” led by Lionel Zinsou, a former Rothschild banker, who joined last year.

The reasons for the management shake-ups differ with each group. But in most cases, there was growing friction between the groups and their investors as well as internal tensions among the partners within each group. The problems were underlined by figures published on Wednesday from the Centre for Management Buyout Research, which showed the total value of buy-outs in Europe tumbled to €10.3bn (£9bn) in the first half of the year.

This was the lowest since 1995 and was even smaller than just one buy-out deal at the peak of the market in 2007, the £11bn buy-out of Alliance Boots, the pharmacy chain.

Investors are losing their patience with private equity groups that raised big funds during the debt bubble, on which they continue to charge hefty fees, while not doing any deals and facing growing problems on existing portfolio companies.

“Whenever investors have a window to reduce their commitment to a large buy-out fund they will take it,” says the investor. “It is hard to justify the large fees on such a big fund when there are no deals of that size in the current market.”

As the pace of deals has fallen sharply, buy-out bosses have more time to spend on plotting uprisings against increasingly unpopular bosses. They are also frustrated as their carried interest – a share of profits – looks worthless.

“It boils down to money versus power. In some cases these guys can’t bear the idea of giving up the power, but in others they feel they have made enough money and are happy to go,” says a City of London headhunter who works with many buy-out groups.

“I think this is the starting point of a major reshuffling of the cards in the private equity industry,” says Antoine Dréan, head of Triago, which advises private equity groups on fundraising. “It will result in a number of spin-offs as the carried interest in many of these funds is worthless, so the golden handcuffs don’t work any more.”

In this environment, the golden handcuffs certainly don't work. The private equity industry is going through a major upheaval and tensions are high in Europe and North America.

But the top private equity firms are trying to adapt as best they can. Last week, Bloomberg reported that the world’s biggest private-equity firms, shut out of the market for leveraged buyouts as banks curtail lending, are turning to bankruptcy courts to make acquisitions:

KKR & Co., the New York takeover firm co-founded by Henry Kravis, is part of a group converting loans made to Lear Corp. into a controlling stake in the bankrupt car-seat maker. Late yesterday, Hayes Lemmerz International Inc. said it reached an agreement with the lenders who financed its bankruptcy, giving them an equity stake in the maker of wheels for cars.

This year, 162 companies merged or were bought out of bankruptcy, a 60 percent jump from the same period in 2008 and almost triple the amount in 2007, according to data compiled by Bloomberg.

Private-equity firms in the U.S. are finding new ways to invest the $600 billion of capital raised mainly before credit markets froze in 2007. With corporate defaults forecast to reach a record as soon as March, they are making loans to the neediest borrowers and muscling in on turf traditionally dominated by so- called vulture investors.

“It’s not a tactic that private-equity firms have historically employed, but it seems to be an idea whose time has come,” said Steven Smith, global head of leveraged finance and restructuring at UBS AG in New York. “This is clearly one of the new and most distinctive features of the current wave of restructurings.”

More Opportunities

In an LBO, private-equity firms usually put up about one- third of the purchase price and borrow the rest. Lending for those takeovers is down 91 percent from 2007 levels, Bloomberg data show, so buyers are instead making prepetition loans, which is financing before a bankruptcy, and debtor-in-possession loans, or those made in conjunction with a filing.

Besides Lear and Hayes Lemmerz, firms are exchanging loans for stakes in Reader’s Digest Association Inc. through the bankruptcy courts, and a unit of Apollo Management LP is in a syndicate doing the same with Lyondell Chemical Co.

Moody’s Investors Service said while it’s too early to say if the amount of prepetition debt being converted into equity through reorganizations will exceed the record high of about $52 billion in 2003, it’s “expecting a continuation of the trend.”

While the so-called loan-to-own strategy isn’t new, opportunities are rising. Worldwide, 211 companies with bonds and loans missed interest payments in 2009, up from 55 in the same period of 2008. Standard & Poor’s forecasts the U.S. speculative-grade default rate will rise to 13.9 percent in July 2010, from 10.2 percent last month, even as the economy emerges from the worst recession since the 1930s.

Fewer Loans

The amount of leveraged loans needed by buyout firms has shrunk to $67.7 billion this year from $311.2 billion in 2008 and $962.9 billion in 2007, Bloomberg data show. Leveraged loans are rated below investment grade, or less than Baa3 at Moody’s and BBB- by S&P. The amount of private-equity deals this year totals $43 billion, compared with $569 billion in the same period of 2007.

KKR and the other lenders to Lear will get as much as a 26 percent stake, $500 million in preferred shares convertible into an additional 26 percent stake and a new $600 million term loan in return for their $1.6 billion of debt, according to a reorganization plan filed with the court last month.

Lear, based in Southfield, Michigan, is no stranger to private equity. A predecessor was acquired by New York investment firm Forstmann Little & Co. in 1986. Forstmann, which sold off some units before taking the company public in 1994, was one of the biggest rivals of KKR forerunner Kohlberg Kravis Roberts & Co.

‘Enormous’ Returns

“There are certain circumstances where we think it makes sense to provide DIP financing that converts to a substantial portion up to 100 percent of the equity post the restructuring process,” said William Sonneborn, head of New York-based KKR’s asset management division. “Lenders end up owning control of the company, and providing a means for a substantial portion of the existing loan-holders to get paid off at par.”

Investors in loan-to-own deals may earn an 18 percent annual return on the financing, plus get equity, compared with the potential for 12 percent returns and no equity on DIPs, according to Smith at Zurich-based UBS.

“I’m seeing more of these deals now than at anytime in the past,” said Jonathan Landers, head of the bankruptcy practice at New York-based Milberg LLP and co-author of three books on bankruptcy and creditors’ rights. “People are much less risk- averse and the potential returns are enormous. The vulture investors have gotten their courage back.”

Vulture investors historically bought distressed bonds and exchanged them for controlling stakes in troubled companies.

‘Hugely Advantageous’

Lyondell filed for Chapter 11 in New York on Jan. 6 and received a record $8 billion DIP loan. Members of the senior lending group included Apollo’s LeverageSource SARL unit, which is the largest owner of the Houston-based company’s secured debt, KKR, and Los Angeles-based Ares Management LLC, according to court documents.

Steven Anreder, an Apollo spokesman, declined to comment.

“Having available capital for these types of deals is hugely advantageous,” said Jason New, the head of distressed investing at GSO Capital Partners LP, a unit of New York-based private-equity firm Blackstone Group LP. “I don’t think the banks will be active in the DIP market anytime soon. New financing is difficult to find.”

Banks, the traditional providers of bankruptcy loans, are unwilling or unable to provide the credit because their capital is constrained, creating opportunities for the funds, New said. The world’s largest financial institutions have taken $1.6 trillion in writedowns and losses since the start of 2007, Bloomberg data show.

Tighter Standards

The Office of the Comptroller of the Currency said in July that its survey of 59 banks holding $3.6 trillion of loans on Dec. 31 found that 86 percent of lenders toughened lending standards, up from 52 percent in 2008. DIP financings fell to about 23 percent of companies defaulting this year as of July, the lowest since at least 2003, according to Jeffrey Rosenberg, a strategist at Bank of America-Merrill Lynch in New York.

Private-equity firms in the U.S. have $609 billion of available capital, compared to $281 billion in December 2004, the lowest amount in the past six years, according to London- based researcher Preqin Ltd.

With banks pulling back, the loans are becoming costlier even as credit markets open up. Companies raised at least $904 billion in the U.S. corporate bond market this year, a record pace, according to Bloomberg data.

Costlier Loans

The interest payable on DIP loans this year has averaged 7.25 percentage points more than the three-month London interbank offered rate for dollars, up from 5.3 percentage points in 2008. In previous years, the margin has never exceeded 4 percentage points more than Libor, according to Rosenberg. Three-month Libor was set at 0.33 percent yesterday, down from 1.425 percent at the end of last year.

Eaton Vance Corp., a mutual fund company in Boston, said in May that it was raising $1 billion to invest in bankruptcy loans. Sankaty Advisors, also in Boston, announced last month it was raising a $400 million DIP fund.

The downside to the loan-to-own strategy is that it may put private equity firms in competition with lenders seeking the interest payments on DIP loans, not longer-term equity investments.

“We would be suspect if there was extensive involvement from hedge funds or private equity firms looking to acquire control of a company through the DIP,” said Neal Neilinger, vice chairman of Stamford, Connecticut-based Aladdin Capital Holdings LLC, which has started a fund for DIP financing. “We expect our DIPs to have a tenure of between 6 to 18 months. We are not looking to hold the equity of the company.”

Lawsuit Threat

Lawsuits are another obstacle. Litigation has plagued Lyondell’s reorganization. In one suit, a committee of unsecured creditors is suing lenders over alleged fraud in the 2007 buyout that saddled the company with $22 billion in debt.

That isn’t the case in Lear’s reorganization. U.S. Bankruptcy Judge Allan Gropper in New York, in approving a bonus payment last week to Lear’s executives, noted how quickly the case was proceeding. According to the company, holders of 68 percent of Lear’s secured debt support the restructuring plan.

“We wanted the opportunity to participate in the recovery in the automobile supplier market,” KKR’s Sonneborn said. “The DIP lenders will also own some of the company post restructuring, which in theory, after our DIP and exit financing loans are paid off at maturity, we can hold for a long period of time.”

Ownership Transfer

A majority of Reader’s Digest’s lenders agreed to a Chapter 11 reorganization that would swap what it called a “substantial portion” of $1.6 billion in senior secured debt for equity and transfer ownership of the Pleasantville, New York-based media company to the group. The lenders are led by JPMorgan Chase & Co. in New York and include Eaton Vance and Ares Management, said Kathy Fieweger, a spokeswoman for Reader’s Digest.

Hayes Lemmerz, the world’s largest maker of automotive wheels, filed for bankruptcy protection in May. Its workout plan called for the lenders who financed the reorganization to get 84.5 percent of the equity. The Bankruptcy Court for the District of Delaware approved the reorganization yesterday, the company said in a statement.

In a May 12 filing with the bankruptcy court in Delaware, lawyers for the Northville, Michigan-based company wrote that a debt-for-equity conversion was a last resort for distressed companies trying to navigate Chapter 11.

The loan-to-own structure “has emerged as one of the few viable mechanisms for lenders to allow major U.S. businesses, particularly those in the depressed automotive sector, to survive the current world-wide crisis,” the lawyers said in the filing.

Indeed, I think loan-to-own will be the only game in private equity for a long time. Others are more optimistic. In Australia, a rebound in global markets is prompting private equity houses to consider further share market listings of businesses acquired over the past four years, which could lead to a string of initial public offerings:

Pacific Equity Partners managing director Tim Sims, who heads one of the nation's most influential private equity funds, said market conditions seemed to support the exit of some funds from quality assets.

At the same time, support from bankers for private equity transactions was returning, with lenders likely to back acquisitions of up to $1 billion in enterprise value, although there was unlikely to be a repeat of the mega-deals of recent years, he said. ''The market has been short of strong new companies to invest in for some time and is looking for upside. Logic suggests that businesses that have demonstrated resilience and growth in the eye of the storm will be attractive to the current market.''

His comments came as the Australian market yesterday notched up a fresh 11-month high, which gained on the back of strength in materials and financial stocks as business confidence rebounded.

Department store operator Myer is expected this week to detail plans regarding its return to the sharemarket, with an initial public offering expected to be worth at least $2 billion.

Investment banks Goldman Sachs JBWere, Macquarie and Credit Suisse are acting as lead managers to the deal.

Myer's owners - a consortium led by private equity house Texas Pacific Group - have been reviewing options for the ownership of the department store following a four-year turnaround under chief executive Bernie Brookes.

Details of Myer's sharemarket float, timed as sales are gathering momentum as Christmas approaches, is expected to coincide with the release of the department store's annual results on Friday.

Among companies that Pacific Equity Partners operates are cinema group Hoyts, credit research house Veda Advantage, and book retailers Angus & Robinson and Borders. It also owns alcoholic beverage producer and distributor Independent Liquor, and share registry operator Link Market Services, which are among those in the Pacific Equity Partners portfolio speculated to return to the sharemarket sooner rather than later. Mr Sims declined to comment on plans for companies that Pacific Equity Partners is involved with.

Once dubbed ''Mr Private Equity'' by Asian Venture Capital Journal, Mr Sims' Pacific Partners remains cashed-up after last year raising $4 billion for its fourth private equity fund.

The raising was more than three times larger than any previous Australian fund.

In weighing up whether to exit an investment through a sharemarket listing, private equity investors had to weigh up whether to continue to hold on to assets and enjoy further dividend and future upside, Mr Sims said.

It's too early to tell whether market conditions will keep offering PE funds exit opportunities. So far, M&A activity is picking up and the IPO market is showing signs of life, but remains in a moribund state.

Finally, Reuters reports that commercial mortgage defaults of loans made by banks are projected to peak in 2011, and could set a new record next year, according to a report released on Tuesday by Real Estate Econometrics:

The real estate research firm revised its early projections for the rest of the year, viewing the default rate of mortgage loans on office buildings, hotels, shopping centers hotels and other non-residential income earnings property to be 4.2 percent, up the most recent forecast of 4.1 percent.

Falling rental rates, higher vacancies and the absence of a functioning credit market have combined to undermine borrowers' abilities to keep current with their monthly payments.

Real Estate Econometrics also raised its default projections for next year and 2011 to reflect a larger number of loans moving from delinquency to nonaccrual -- loans lending institutions do not expect to be repaid in full.

In the second quarter, delinquent commercial mortgage balances across all banks fell by about $2 billion, while those in nonaccrual balances jumped $6.5 billion.

The shift corresponds with banks working to identify and mitigate losses associated with problem loans earlier in the delinquency period and a rise in the share of delinquent loans that will require modification or foreclosure, Real Estate Econometrics said.

At 2.88 percent, commercial mortgage defaults in the second quarter were at their highest level since 1993/1994, the report said.

The most aggressively underwritten commercial mortgages begin to mature in 2011 -- just as property fundamentals and prices are stabilizing, Real Estate Econometrics said.

Higher expected defaults are expected to be especially troubling for smaller banks because their exposure to commercial real estate is significantly higher.

For institutions with more than $10 billion in assets, commercial real estate concentrations are 9.5 percent of net loans, while those with less than $10 billion in assets, concentrations surpass 20 percent, the study said.

At 28.4 percent, exposure to commercial real estate is highest for institutions with $100 million to $1 billion in assets, Real Estate Econometrics said.

Clearly we are not at the woods in private markets. Several structural impediments remain, presenting serious challenges to private funds that do not have the pockets and skill set to adapt in the new environment.

These challenges are also weighing on many institutional investors who are growing increasingly impatient with private equity groups charging hefty fees on the big funds they raised during the debt bubble. It's fair to say that unless activity picks up, private markets will reach a breaking point - one that may weaken the industry for a very long time.