Friday, August 1, 2014

Private Private-Equity Deals?

Ryan Dezember of the Wall Street Journal reports, Buyout shops look to rivals for deals:
Private-equity firms have all but stopped buying public companies, retreating from a cornerstone of their business as rising stock prices push acquisition targets out of reach.

Public companies taken private accounted for 3.5% of the $89 billion of U.S. leveraged buyouts in the first half of this year, the lowest share on record, according to data tracker S&P Capital IQ LCD. In the first half of 2008, at the apex of a buyout boom, these types of deals represented about 68% of all buyouts by dollar volume.

Instead, private-equity firms are buying companies from one another, a shift driven in part by the relative simplicity of completing an acquisition of a private company compared with a publicly traded one. Transactions between private-equity firms have made up 60% of U.S. leveraged buyout volume through June, according to S&P. That is a higher percentage than the ratio for any full year tracked by the firm, whose data date to 2002.

Overall dollar volume of U.S. leveraged buyouts through June was up 30% over the same period a year ago.

Carlyle Group LP this week said it would buy Acosta Inc., a marketing firm that helps consumer-goods companies launch products and track sales, from Thomas H. Lee Partners LP. Carlyle is paying roughly $4.8 billion, according to people familiar with the matter, making the deal one of the year's largest buyouts.

The Jacksonville, Fla., company has had four private-equity owners since 2004, including Carlyle, an increasingly common occurrence for businesses that generate enough cash to keep up with payments on the debt that private-equity firms use to buy and extract dividends from companies.

The trend marks a big change from earlier eras of private equity, when buyout firms plucked multibillion-dollar companies off the stock market with regularity. The bidding war leading up to KKR & Co.'s $25 billion buyout of RJR Nabisco Holdings Inc., in 1988, was detailed in a best-selling book, "Barbarians at the Gate," and a movie.

That deal opened the door to a burst of public-company takeovers in subsequent years and in the run-up to 2007's financial crisis.

The handful of public companies to go private this year are tiny in comparison. The largest deal has been Apollo Global Management LLC's $1.3 billion takeover of Chuck E. Cheese parent CEC Entertainment Inc. The other four, a maker of robotic cutting tools and a real-estate developer among them, cost private-equity buyers less than $400 million apiece.

"There have been some lessons learned," said David Mussafer, managing partner at Advent International, which is investing a $10.8 billion fund. "The badge of honor comes from the returns you generate for your fund, not the size of the deal."

Private-equity firms combine investors' cash and borrowed money to buy companies with the aim of selling them profitably a few years later. Public companies have historically been a top target, along with family-owned businesses and divisions carved out of corporations. Purchases of companies owned by buyout industry rivals aren't new, but they have become more frequent.

Higher stock prices are one reason, as they drive up public-company valuations. After a number of large deals backfired on private-equity firms amid the financial crisis, the companies since then have generally shied away from big buyouts.

The S&P 500 index soared 30% in 2013 and is up 6.6% this year.

Plus, with the rise of acquisition activity this year, corporate buyers who for long sat on the sidelines are now competing for deals.

Some say the private deals are proving good for business. On a call Wednesday discussing Carlyle's second-quarter results, co-Chief Executive David Rubenstein said returns on these deals "have been pretty robust for investors in recent years, and I think, therefore, you're likely to see more."

Private-equity executives also say deals with peers are simply easier. The stock market's run has prompted private-equity firms to seek ways to cash out of older investments in droves, making these firms motivated sellers, unlike many public companies that resist takeovers.

And public-company buyouts are more complex. They can require postagreement auctions, called "go-shop" periods, in which boards seek higher offers. Shareholders must approve deals. Lawsuits from shareholders challenge nearly every deal. Activist investors can enter the fray and agitate for higher prices.

"If you have a choice between a public company and a private company in the same industry, certainty of closing is much greater in a private deal," said Mel Cherney, co-chairman of the corporate department at law firm Kaye Scholer LLP.

Meanwhile, private-equity firms need to find companies to buy, if not public, then private. They have about $326 billion to put to work in buyouts, according to data provider Preqin.

Criticism of deals between firms has focused on what value one manager can bring after another has owned the company.

Mr. Rubenstein of Carlyle on Wednesday said that the deals "have had their ups and downs in terms of the way that people look at them" and the key is to "have a good management approach and a plan when you're buying."

A 2012 study by three European researchers compared the results of more than 5,300 leveraged buyouts from 1986 to 2007 and found that there often wasn't a big difference in performance between the 435 deals made between investment firms and buyouts of companies with other types of owners.

The researchers said the downside of these deals is limited, and so, too, is the upside.
So why are private equity funds selling to their rivals? They obviously don't think stocks are attractively priced. Also, as the article explains, deals with peers are easier because they are motivated sellers unlike companies that resist takeovers.

But limited partners should be asking themselves a lot of questions with the latest trend in private equity. In particular, what value does one PE fund add that another couldn't capitalize on? Then there is that little problem of private equity's trillion dollar hole weighing on the industry.

One thing I did find interesting is what Carlyle's co-founder, Bill Conway, said during the conference call earlier this week, namely, ‘Europe Is The Best Place To Be’:
William Conway Jr., co-founder and co-chief executive of the $199 billion alternative investment giant Carlyle Group , is in little doubt about where he wants to do deals.

“Europe is not just the safest place to be but the best place to be.”

Mr. Conway said the firm was in a bullish mood about making new investments and exiting existing holdings in the region.

“I expect interest rates to stay low for quite a while,” he said. “That allows us to pay one or two times [earnings before interest, taxes, depreciation and amortization] more and get the same return on deals.”

In the last 12 months, the Washington D.C.-based firm has been able to find “eight to 10 good deals and paid an average of 7.5 times [Ebitda] for those assets – much lower than multiples in the U.S.”, Mr. Conway added.

Carlyle yesterday reported strong figures for its 5.6 billion euro 2006-vintage Carlyle Europe Partners III fund, which has risen by 47% over the past year and generated performance fees of $44 million as a result of three exits in the second quarter of 2014.

The firm has a EUR3 billion target for its fourth European buyout fund and has secured EUR1.1 billion so far, according to a report in the Financial Times this week.

Private equity firms have made the most of buoyant market conditions in Europe this year to exit a host of investments, especially via the initial public offering route. Investment banks earned $2.9 billion from advising private equity clients on exits during the first half, according to the data provider Dealogic, up 54% year-on-year. The figure meant that exits accounted for the highest percentage of overall financial sponsor revenue over a half-year period on record.

Mr. Conway said Carlyle was making twice as many exits as acquisitions in the current market. “Companies we bought, we’re very happy we own,” he said. “[But] is it easier to buy or sell? It’s easier to sell.”

Last week, Carlyle announced the sale of Ada Cosmetics from its 2008-vintage Carlyle Europe Technology Partners II fund, with the German business netting the firm a three-times return. Caryle is also looking to raise EUR500 million for a new technology fund in Europe.

Other investments in the region include U.K. roadside assistance provider RAC, which Carlyle bought for 1 billion U.K. pounds in 2011, and U.K. taxi operator Addison Lee, which it acquired in a deal valued at about GBP300 million last April.

“Trying to find companies like RAC and Addison Lee is tough to do. And you’ve got to do something with them. It’s not a game of checkers,” said Mr. Conway.

He said that in Europe, the firm saw more value in deals in the “EUR150 million to EUR200 million equity check area” and that the healthcare sector was of particular interest. This is despite negative press in recent years around private equity’s involvement with healthcare companies, which has centred on deals including Blackstone 's ownership of Southern Cross and August Equity’s portfolio company Old Deanery Care Home.

“Some people don’t want to touch [the businesses] involving patients,” Mr. Conway added. “But the patients are a big part of [the sector].”
The Washington Post reports that Carlyle followed rivals KKR and Blackstone with strong second quarter profits:
The Washington-based private equity firm appears to be benefiting from a buoyant stock market and strong prices for the companies and other assets they buy and sell across the globe.

Its economic net income, which is a popular method of measuring profitability at investment firms, more than doubled to $318 million compared to $156 million a year earlier. Revenue was $900 million.

“The big story is the strong performance of our European private equity businesses,” said co-chief executive William E. Conway, Jr. in a statement. He said the company’s Europe Partners III fund “has begun generating substantial realized performance fees, further diversifying the composition of Carlyle’s earnings. Our European technology funds are also performing exceptionally well.”

Carlyle earned $6.5 billion from the sale of companies in the second quarter, while at the same time it poured $3.4 billion of cash into new investments.

The company continues to raise money from investors at a prodigious rate, with $7.4 billion in new money entering its coffers in the quarter. Carlyle has raised $23.1 billion in the last 12 months.

The investment firm also announced a quarterly distribution to shareholders of 16 cents per share, which means the total distribution for the first two quarters is at 32 cents.

Carlyle Group, which bills itself as a global alternative asset manager, is one of the largest of its kind in the world, with $203 billion of assets under management across 126 funds and 139 fund of funds.
Its results follow strong earnings reports from rivals KKR & Co., and Blackstone Group.
Interestingly, the New York Times reports that most on the money coming into Carlyle is coming from sovereign wealth funds:
Investors committed more money to Carlyle in the quarter, and the value of its assets appreciated, helping its assets under management exceed $200 billion for the first time. The firm reported $202.7 billion of assets under management as of June 30, compared with $198.9 billion at the end of March.

David M. Rubenstein, a co-chief executive, said that Carlyle was receiving a proportionately larger share of capital from wealthy individuals and from sovereign wealth funds. In the past, Mr. Rubenstein said, Carlyle got about 14 percent of its capital from sovereign wealth funds, but the proportion rose to about 25 percent in the recent quarter.

“The growth of the sovereign wealth funds is hard to overstate,” Mr. Rubenstein said, citing high oil prices and the growth of economies in Asia. “They just have so much money.”
Indeed, they have more money than they know what to do with which is great news for Carlyle (CG), Blackstone (BX), KKR (KKR), Apollo (APO) and Oaktree (OAK).

Or is it? With all this new money coming in to the top private equity shops, this adds pressure to find deals in an increasingly more competitive landscape where PE funds compete with each other to snap up the best deals. Also, smaller foundations are having a hard time competing for allocations with all this sovereign wealth money piling into private equity.

Maybe private equity funds can focus their attention on Goldman's big problem:
The Volcker Rule may be causing Goldman Sachs to become greedy in the short-term as well.

The investment bank, which has long claimed to be focused on the long-term, beat Wall Street’s estimates in its second quarter. But those better-than-expected results came with a caveat. About $1.2 billion of the firm’s revenue, or nearly 15%, came from investment gains in the shares of private and public companies. That was $800 million more than a year before.

Goldman beat analyst estimates by $500 million. Without those equities gains, Goldman would not have beaten estimates. And Goldman will soon have to make do without those gains, much of which have come from its investments in private equity funds. PE funds, after all, are not Volcker-compliant.

Analysts and investors have known for a while that Goldman will eventually have to dump its private equity portfolio, which was valued at $8 billion at the end of the first quarter. On top of that, Goldman has another $2.4 billion in unfunded commitments, money it has pledged to private equity funds but has yet to contribute. It also has almost $5 billion in hedge funds and funds that invest in debt.

Under the Volcker Rule, big banks are not allowed to have more than 3% of their capital invested in private equity, hedge funds, and other investment funds. At Goldman, at the end of the third quarter, those investments equalled about 21%. So, the bank has a lot to sell.

It’s all a matter of timing. The Volcker Rule does not officially go into effect for another year. And Goldman can get an extension so it can hold on to some investments until 2017. So far, Goldman has been slowly selling its investments in hedge funds over the past three years, which are also not allowed under Volcker. But it’s mostly held onto its private equity portfolio. That may now be changing. When Goldman reports its official quarterly numbers to the SEC in the next week or so, a number of analysts expect to see a drop in its PE portfolio.

Goldman declined to comment for this article. In the past, the firm has given no firm timeline on the exit from its private equity positions. And the firm has said it will continue to manage private equity funds for outside investors. And it is reportedly looking for new ways to make private equity investments outside of specific funds. That might be a Volcker loophole. Still, the firm will have to exit much of its current private equity positions.

In theory, selling its PE investments shouldn’t affect its profits much. Goldman marks all of its investments to market, meaning that it takes any gains it has each quarter, not when it eventually sells. But if the bank ends up selling for more than it thinks its investments are worth, that difference would show up as a gain. That’s more likely to happen when Goldman exits the shares of private companies, because the value of those stakes are harder to estimate.

Goldman’s principal investment line on its balance sheet tends to be choppy, so it’s not unusual for it to jump around. And the second quarter’s earnings could have been a blimp. The $1.25 billion gain it registered from equity investments is the biggest it has had from that business in years.

The problem is those gains are coming at a time when earnings from Goldman’s traditional driver of profits—trading—has slumped, dragging down the firm’s overall profitability. Goldman’s return on equity in its most recent quarter was nearly 11%. Goldman’s ROE used to regularly top 20%. When the firm’s highly profitable private equity investment gains dry up, that ROE could drop even further.

But the bigger issue is determining what Goldman will do with the cash it gets after selling its positions. The lower ROE suggests that Goldman is having trouble finding places to put its cash that can generate higher returns. But that may not be a problem. Analyst Matthew Burnell of Wells Fargo says Goldman can give its cash back to shareholders if it can’t find high return investments for it. And the firm appears to be doing that. Burnell estimates that Goldman will pay out 85% of its earnings this year in dividends or buybacks to shareholders. That’s a much proportional pay out than what other large banks are doing, where payout ratios are averaging around 50%.

At the same time, handing money back to shareholders means that Goldman will have less capital to invest when Wall Street profitability does rebound. What’s more, all those payouts to shareholders doesn’t seem to be helping much. Shares of Goldman, which have been up recently, are basically flat for the year. Greed, no matter what Gordon Gecko says, doesn’t always work.
So what will Goldman do with its lucrative PE portfolio and the money it raises from selling it? They'll do what most other companies are doing, increase their dividend or more likely, buy back a ton of shares to boost CEO pay.

What investors should really be asking themselves is why did Goldman become a bank knowing full well they'd be forgoing private equity's free pass? Maybe they think the good days in private equity and hedge funds are over or coming to an end real soon. That's what I think but Bill Conway may be right, Europe could be a boon for private equity funds looking to deploy capital.

Finally, Timothy Spangler wrote a nice article for Forbes touting his new book, One Step Ahead. Spangler argues if returns are meant to justify the fee levels being charged by private equity and hedge funds, then it is incumbent on all parties to clearly understand and report these returns accurately. Take the time to read his article and buy his book, it's excellent.

Below, David Rubenstein, co-founder of the Carlyle Group  recently spoke with Erik Schatzker on Bloomberg Television's "Market Makers," discussing the outlook for the financial markets and investment strategy. He also discusses how financial regulations create opportunities for private equity funds which are not subject to these regulations.

Also, Rubenstein a 1970 magna cum laude graduate of Duke, spoke at the Fuqua School of Business in their distinguished speakers series (May, 2014).  Mr. Rubenstein also addressed the 2014 Wharton MBA Commencement in Philadelphia (June, 2014).

Great clips, listen carefully to David Rubenstein, one of the smartest and most successful private equity managers and someone who understands the importance of giving back to your community.

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