The New Face of Capitalism
Private buyers are gobbling up some of the premier names in corporate America
Time was, America's largest corporations would fight tooth and nail (and with poison pills) to remain public companies. No longer. Now many of the world's biggest and best-known brands clamor to be taken private by investors they once shunned. A parade of marquee names have sold out-Clear Channel Communications, Cablevision, Reader's Digest, Dunkin' Donuts, SunGard Data Systems, Freescale Semiconductor, Toys "R" Us, Neiman Marcus, Metro-Goldwyn-Mayer, and hospital giant HCA, to note just a few. And the deal making shows no sign of abating anytime soon, as the private Blackstone Group announced plans last week to buy Equity Office Properties Trust, the nation's largest owner of office buildings, in a record-breaking deal.
It is a significant turn not just in corporate thinking but in the way the private-equity buyers are viewed. They have never been so loved. What a difference a couple of decades can make. Nearly 20 years after Kohlberg Kravis Roberts's $30.6 billion hostile takeover of RJR Nabisco left private-equity firms tagged as the "barbarians at the gate" and their partners vilified by Hollywood's Gordon "Greed is good" Gekko, these firms have mainly shed the perception they are corporate raiders pillaging for profit. These days, private-equity firms like KKR and the Blackstone and Carlyle groups aren't feared so much as revered-as deep-pocketed saviors willing to pay a premium to take over companies feeling neglected and misunderstood by Wall Street or overburdened by securities regulations.
Gone are the days when other publicly traded companies, known as strategic buyers, were the usual buyout suitors. Private-equity firms now surface as the chief bidders in most deals, say investment bankers and others involved in the buyout business. And new funds pop up every week focused on industry niches such as aftermarket auto parts or specializing in geographic areas like Idaho or Montana.
This year, there have been more than 2,282 private-equity buyouts worldwide with a combined value of $601.3 billion, up from only 885 deals valued at $71.4 billion in 2001, according to researchers at Dealogic.
Dark side. But as the number and size of the private-equity deals have soared, uncomfortable questions have again been raised about whether the hot leveraged-buyout market they are fueling may end up leaving some companies and shareholders burned. Federal prosecutors are probing charges of collusion among various private groups. The Securities and Exchange Commission is looking into allegations of insider trading and multimillion-dollar fraud.
Shareholders have filed lawsuits to stop some deals, such as the recently successful buyout of hospital chain HCA, complaining they are being shortchanged. Stunningly large dividend payouts to private-equity buyers from companies such as Hertz have sometimes made the firms seem greedy. And overseas, where many of the best deals are to be had, private-equity partners have been called "locusts" and threatened with arrest.
For much of their history, private-equity firms existed in a quiet corner of the financial world, content with buying, building, and operating promising companies. Many still do just that. But what made them household names in the 1980s was the increased use of leveraged buyouts, where the groups added huge borrowings to their own cash, mainly because of debt-friendly laws that shield profits from the tax man.
The earlier buyout wave revealed the potential downside of piling debt on companies-the turning of beloved brands like Federated Department Stores into bankrupt shells that had to struggle mightily to come back, giving private-equity firms a black eye for the immense sums they took out of such deals.
These days, private-equity firms have largely changed their stripes, taking on less debt and often concentrating more on building up companies rather than cutting them to the bone. But problems do remain. And private-equity firms are painfully aware of the damage bad publicity can do to their positive new image. Fear of being lumped in with hedge funds-whose own practices have drawn sharp attention from regulators-is one reason that Carlyle, Blackstone, KKR, and Texas Pacific Group are moving to form the Private Equity Council, the industry's first concerted attempt to educate the public and lobby the government. Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth's Tuck School of Business, says the firms are setting up the council "largely because of the potential backlash they could get around the world because of their expanded activities."
The private-equity buyouts are fueled by several factors. The shares of many public companies, after wringing out the excesses of the late 1990s, are now trading at cheap prices compared with their underlying assets and revenue streams. The Sarbanes-Oxley Act, passed in 2002 as the antidote to a wave of corporate accounting scandals, makes it more difficult and expensive for smaller firms to go public and for already public firms to stay listed. And private-equity firms have found plentiful and cheap debt to leverage their own considerable treasuries, money hoards that continue to attract almost unprecedented amounts of capital from pension funds, university endowments, and wealthy investors seeking greater returns than found in the global stock markets. "When you are looking for historically high rates of return, where else do you go?" asks Dennis Block, a partner with the law firm Cadwalader, Wickersham & Taft who helped shepherd KKR's bid for RJR Nabisco. In recent years, even union pension funds-whose members can be on the other end of the stick when private interests take over and downsize some of these companies-have invested.
Although returns vary greatly, the best and the brightest private-equity firms often provide returns to their investors of 25 percent a year, experts say. Data from Thomson Financial and the National Venture Capital Association, an industry group, show that U.S. leveraged-buyout funds have averaged at least 13 percent annual returns over the past 20 years, and the California Public Employees' Retirement System recently reported cumulative returns of up to 133 percent over the past six years from one of its private-equity-fund investments.
"There has been an explosion in not just the number of funds but also the dollar value of the capital that they are raising," says Jeanne Montague of Montague Partners, a small San Francisco-based investment bank. "I can remember when the first announcement of a $1 billion fund set the market stirring. Now Blackstone has raised $15 billion in one fund. The numbers are becoming almost difficult to comprehend."
Clubby. The funds are likely to keep getting bigger. In fact, Blackstone recently announced that it would bring its $15 billion fund up to $20 billion. Other large private-equity firms are building similar war chests. At the same time, they are often combining forces in "club deals." These accounted for $414 billion in buyouts over the past 12 months, according to Thomson Financial. This is roughly a 10-fold increase from the same period five years ago. Home-improvement behemoth Home Depot, whose shares are worth some $79 billion, and computer maker Dell, at around $56 billion, have both been bandied about as possible targets, if some of the biggest private-equity firms combined forces.
"If I represent a seller and I go to 40 buyers, half will be private-equity firms now," says Montague. "Ten years ago, there'd be maybe two."
But the amount of money chasing deals has bidden up prices and thereby crimped returns for some private-equity funds. There's an "illogical" element to parts of the market, complains Mark Jrolf of Heritage Partners, a Boston-based private-equity firm. He notes that some investor groups are paying well beyond what strategic, public-company buyers would in some takeovers, and "that doesn't make sense."
Attempting to avoid this competition, private-equity firms have increasingly looked both farther afield and farther up the food chain for their next deal. But in doing so, their activities have drawn the scrutiny of shareholders and regulators, and not just in the United States.
The Bank of England signaled its concern recently by calling the voracious appetite for leveraged takeovers one of the six greatest threats to the financial system, while the country's Financial Services Authority, Britain's version of the SEC, said this month that it is monitoring private-equity firms for insider trading and conflicts of interest. The FSA warned that the collapse of a large private-equity firm was likely, given the number of deals such firms were making and their high levels of debt.
Politicians have also weighed in. In Germany, a prominent lawmaker recently compared private-equity firms snapping up companies there to "locusts." And in South Korea, where the buyout firms are called the moktui, or "eat and run," trouble abounds. One lawmaker there has said that private-equity firms' interest in "short-term profits could lead to the drain of national wealth."
Private-equity players aren't always helping defuse the situation. The subject of the lawmaker's ire, Dallas-based Lone Star Funds, recently admitted that it broke South Korean tax laws when the firm's former head in the country embezzled $12 million. Now prosecutors are delving through Lone Star's Korea Exchange Bank deal looking for, among other things, evidence that the private-equity firm might have intentionally driven down the bank's share prices in 2003 before making its bid. Prosecutors are seeking the arrest and extradition of several members of the firm, including Lone Star Funds cofounder Ellis Short.
In the United States, the Justice Department's antitrust division sent out letters last month to several of the largest buyout firms requesting information on all their deals in the past five years. "There is no smoking gun that one can point to here," cautions Andrew Metrick, a finance professor at the University of Pennsylvania's Wharton School. "The values being paid are higher than that offered by the public market, and the directors don't have to sell."
More bad publicity for private-equity firms could come courtesy of the SEC,which has begun looking into whether people associated with or informed about some buyouts may have profited from trading on insider information before the deals were announced. SEC Chairman Christopher Cox said last month that his investigators were examining a host of suspicious trades.
A partner at one large firm has already fallen. Justin Huscher, a cofounder of Chicago-based Madison Dearborn, paid more than $116,000 in SEC fines this year to settle charges that he illegally profited by buying stock in Unisource Energy Corp. after learning that a private-equity club deal for the corporation was about to be announced.
There is also growing worry about fraud. The SEC recently charged Chicago-based AA Capital Partners with misappropriating more than $10.7 million in client funds. The firm, spun off from the Dutch financial powerhouse ABN Amro NV in 2001, was headed by John Orecchio, who had once helped run a $5 billion private-equity fund for Bank of America. Investigators allege some investor funds were used to spruce up Orecchio's horse farm, while others were funneled into a strip club.
Richer bids. Shareholders are also squawking about the prices offered in several deals, complaining that they have been shortchanged by an unholy alliance between management and the private-equity firms being favored. In several recent cases, shareholders have found that company management, smitten with deals that would leave them in charge, disregarded higher bids or took measures to dissuade them. Shareholders of the Tennessee-based regional retailer Goody's Family Clothing balked last year when management proposed a leveraged buyout. A later lawsuit revealed that the private-equity firm chosen was not the highest bidder. When the process was finally opened up, a three-way bidding war added 20 percent to the $327 million price tag.
Arthur Abbey, whose law firm, Abbey Spanier Rodd Abrams & Paradis, represented several of the shareholders, says that the higher bid proved that "both the price and the process was unfair." Saying management-led buyouts are "replete with conflicts," Abbey adds: "My view is that the only independent review these deals ever get is in a lawsuit by shareholders themselves."
Private-equity partners argue that they can't be accused of taking advantage of shareholders when they generally pay a high premium over a company's market value. And many of these lawsuits are being filed not by the individual investor but by hedge funds and other market sophisticates, they add. "These stocks are not being held by orphans and widows anymore," says one private-equity partner, who asked to remain anonymous. "These are the same type of 'deal people' looking out the windows in that skyscraper across from me."
Sometimes price shouldn't be the key factor for a company in choosing a suitor, say leveraged-buyout experts, adding that different buyout groups have expertise in certain areas and some will be more willing to take a long-term approach in turning companies around. Stewart Kohl, the co-CEO of the Riverside Co., says his firm tends to take relatively small companies, reinvest in them, and build them over the course of many years, often by combining them with other complementary acquisitions.
In 2000, Riverside took control of a small manufacturer of trailer jack stands and couplers named HammerBlow. The company was a leader in its field, but the owner had died, and his estate wanted to sell. Kohl liked the company's management and inexpensive manufacturing process. While working to expand the company's operation and reduce its costs, he bought other companies in the towing and trailer-hitch market and combined them under the HammerBlow brand. In about two years, he had tripled the company's revenues to $108 million. In 2003, he sold the company for $143 million to a competitor, TriMas, also owned by private-equity interests.
"This isn't drive-by investing or financial engineering," says Kohl. "This is value created through a lot of heavy lifting. We don't just get our hands dirty-we get our whole bodies filthy working to build the companies."
A recent study by economists Jerry Cao of Boston College and Josh Lerner of Harvard Business School counters the perception that private-equity firms are flip artists. Their examination of 496 companies taken public by private-equity firms between 1980 and 2002 found that the share prices of these companies tended to outperform those of both other initial public offerings and the general market. Companies held privately for more than a year did best of all when released into the public markets again.
But the barbarians-at-the-gate perception is grounded in some fact. Standard & Poor's recently found that private-equity firms had loaded their acquisitions with more than $25 billion in debt over the past year just to fund dividends for themselves. Exceedingly rare at the beginning of the decade, these payouts have become commonplace. Sometimes the buyout firms (the general partners) take their profits even before their investors-pension funds, endowments, and other limited partners-have recouped their investment.
In the case of Hertz Global Holdings, a private-equity consortium led by the Carlyle Group paid itself a $1 billion dividend less than six months after putting up $2.3 billion to buy the company from Ford Motor Co. in 2005 for a total of $15 billion, including assumed debt. The firms took Hertz public again last week.
The deal has gained the attention of the Justice Department. But bond watchers are also worried. Citing this case, S&P argued that such equity extractions, known as dividend recapitalizations, greatly increase a company's chance of defaulting on its debt, while also leaving the private-equity partners less concerned about fixing underlying troubles.
This may be a worrisome trend because a sluggish IPO market has made it less likely that many of these deals can be spun out to investors as IPOs after a year or so. "It is not a wonderful time for private equity in some ways because their ultimate exit strategy is to go public, and you don't have a nicely behaved equity market right now," says Satya Pradhuman, Merrill Lynch's chief small-company strategist, who tracks leveraged buyouts.
Instead, some targets of leveraged buyouts find themselves sold repeatedly from one private-equity firm to another, with each deal often leading to a dividend recapitalization that yanks cash from the company's balance sheet. For some private-equity firms, the dividend recap has become the exit strategy.
Many investors did stay away from the Hertz IPO. The company went public November 16 at a lower price than was expected and then barely budged off its $15 offering price. But it was still a sweet deal for Carlyle and the other private-equity firms involved. They are expected to have doubled their money after having owned Hertz less than a year.
Party poopers. So, what will spoil the private-equity party? If returns begin to suffer because of competition, unhappy investors could slow their stampede into the funds. Hints of other frauds could have the same effect.
But the real bogey is the debt markets, because borrowing underpins private-equity firms' ability to make many deals. Any sudden upward move in interest rates could inflict serious pain in the buyout world. Right now, lenders, competing heavily to be part of deals, are giving easy payment and loan terms that could help forestall any default of a company owned by private equity if it got into financial distress. But these lenders are also allowing private-equity firms to take on buyout loans that represent ever-higher multiples of earnings.
Some buyouts are also adding newer and more risky types of debt to the mix, as they offer up more and more of a company's assets and earnings to secure it. Second-lien loans and "payment in kind" notes, which have yet to be tested in a severe economic downturn, have become popular. The notes pay extremely high rates but usually don't begin payments for several years and are likely to become worthless in any bankruptcy.
A few private-equity-owned companies have already had trouble, and some have filed for bankruptcy protection. Concern about the increased risks being taken in new deals is becoming increasingly palpable in bond and derivative markets. For instance, when Anheuser-Busch was rumored to be a private-equity target, the cost of buying credit protection on its bonds rose drastically.
A shakeout is coming, experts say. It is just a question of when. Many banks, law firms, hedge funds, and private-equity groups are already bolstering the ranks of their distressed-debt units and are gathering bankruptcy specialists for just such an occasion. Private-equity player Wilbur Ross, known for his astute nose in picking up distressed companies on the cheap, says it won't be long. Too much money is being paid to take on too much risk with too much debt, Ross warns, adding that bets by some highly leveraged buyout firms that they will be able to cheaply refinance their deals in a few years have "been building in a time bomb." In this scenario, higher default rates aren't just likely, he concludes; "they are quite inevitable."
If Ross is right, many private-equity firms and the companies they take over may find the 1980s have cast a longer shadow than any would have hoped.
This story appears in the December 4, 2006 print edition of U.S. News & World Report.