Deal Mania
Shades of the '80s: The leveraged buyout is back in vogue
In the world of leveraged buyouts, both the predators and the prey are growing a whole lot bigger. Armed with bloated investment pools of private funds that can exceed $6 billion, buyout firms were involved in last week's bidding war over Adelphia Communications, the bankrupt cable company that looks to be going to rivals Time Warner and Comcast, and they continue to pursue Wind, the heavily indebted and weakly positioned Italian mobile telecom firm. Both deals are in the $15 billion-plus range--a mammoth sum for any buyout firm, the majority of which normally traffic in far smaller companies.
To snare such behemoths, the buyout firms are teaming up. Two weeks ago a seven-member consortium agreed to purchase SunGard Data Systems, a Wayne, Pa., maker of financial software, for $11.3 billion. The previous week, Toys "R" Us announced it was selling itself to a group of two buyout firms and a real estate concern for $6.6 billion. "The deals are bigger, they're more complex, and there's more money coming into this business," says Daniel Akerson, a managing director at the Carlyle Group and cohead of its U.S. buyout fund.
The buyout phenomenon is fueled by three forces: lots of cash in the hands of institutional investors and wealthy individuals who want higher returns; a growing number of investment firms with track records in finding underperforming or undervalued public companies or units within those companies; and a strong economy that still has debt available at low interest rates. The buyout firms leverage their cash--thus, leveraged buyout, or LBO--by mixing it with debt and purchasing the companies, usually taking them private. Out of the glare and short-term demands of the stock market, they restructure the companies to increase their value. Then, a few years down the road, the buyout firms either sell them or take them public. After a hefty commission--usually 20 percent--they pay returns to investors.
The latest deals are big, though not yet on the scale of the first buyout boom, which was capped by the legendary $31 billion takeover of RJR Nabisco by Kohlberg Kravis Roberts in the late 1980s. That one went into the buyout hall of fame when it was chronicled in the book and movie Barbarians at the Gate.
Big bucks. Yet the record may not stand for long. Last month Carlyle announced it had raised $7.85 billion in a span of four months for U.S. buyouts. Because such deals are financed mostly with debt, that level of cash goes a long way. At a conservative debt-to-cash ratio of 2.5 to 1, Carlyle has access to at least $35 billion. Funds raised by Blackstone Group, Goldman Sachs, and Thomas H. Lee Partners, among others, are reportedly hot on Carlyle's heels in the megamoney marathon.
According to Private Equity Intelligence, a London-based financial information firm, about $145 billion of private equity was raised worldwide last year, and 2005 should see that rise to a record $250 billion. The cash is coming predominantly from pension funds like the New York State Common Retirement Fund and the California Public Employees' Retirement System. Many such institutional investors consider their stakes in private equity too low and are itching to get in deeper. "We're currently trying to put more money into private equity," says Jay Fewel, senior investment equity officer at Oregon Public Employees' Retirement Fund, which now has 8.1 percent of its $50 billion at buyout firms KKR and Texas Pacific Group.
One reason buyout firms are so flush is that the alternatives have become meager for large investors. The S&P 500 index of large stocks is down 2 percent this year; bonds and real estate funds were underwater in the first quarter. The outlook isn't much rosier. The consensus is that equities will return 5 percent to 7 percent this year and some bond funds could post negative returns because of rising interest rates.
And even though the Federal Reserve is raising interest rates, the cost of debt is still near historic lows. "There's a lot of capital out there but not a lot of returns," says Robert Teitelman, editor-in-chief of The Deal, a publication that tracks the global deal business.
In such a drab investing landscape, private equity stands out. Buyout funds are a long-term investment--10 years is the norm, with the bulk of the return coming in the second five years. Money invested in U.S. buyout funds in 1994 has returned 19.6 percent a year, on average, according to Private Equity Intelligence. "Barring the bad years, net returns of 15 percent to 25 percent are achievable," says Mark O'Hare, PEI's managing director. Carlyle's Akerson says that's doable: "We're shooting for returns of 20 percent to 25 percent," he says.
Best of all for buyout firms, there's an abundance of companies in need of restructuring. Two on the radar are retailers J. C. Penney and Saks Department Store Group. And the technology sector, once considered too asset and cash poor for successful buyouts, is now all the rage.
One player, Silver Lake Partners, a six-year-old firm that organized the SunGard consortium, actually specializes in technology. "We only shop for investments in our neighborhood," says Glenn Hutchins, cofounder of the Menlo Park, Calif.- and New York-based firm. It has raised two funds totaling $5.9 billion, half of which is already invested. The firm led the $1.97 billion buyout of disk drive maker Seagate in 2000, which it took public again a little over two years later, turning a $382 million investment into a stake worth $1.8 billion.
The original idea behind leveraged buyouts was to purchase a company with undervalued assets and sell them off. Now, the goal for at least some deals seems to be to "look for good companies and make them great," says Hutchins. That's apparently the case with SunGard, a fast-growing firm with good cash flow. Hutchins says the company's value can be greatly enhanced with additional investment and commitment to its long-term strategy, "something the public markets generally do not tolerate."
Yet such enormous deals with multiple new owners will present operating obstacles. Will egos get in the way of unified and decisive management strategies when things go wrong? Will the abundance of private equity capital and competition among buyout firms bid up deals beyond profitability? Already, a number of the biggest players are finding some deals too rich. Says Akerson of Carlyle, which balked at the SunGard deal because of its price, "now comes the hard part."
THE TOP LBO FUNDS
FUND SIZE (BILLIONS OF DOLLARS)
J. P. Morgan Partners Global 2001 7.90
Carlyle Partners IV 7.85
Permira Europe III 6.70
BC European Cap VIII 6.57
Blackstone Capital Partners IV 6.45
Source: Private Equity Intelligence Ltd.
This story appears in the April 18, 2005 print edition of U.S. News & World Report.