When will increased competition drive down the returns to private equity/buyout investors? Given the nature of markets you would think that it is a matter of time. In a prior post* we noted the likelihood that despite the hype this wave of buyouts could continue longer than expected. In the meantime private equity investors are enjoying both high returns and substantial power to effect corporate mergers and acquisitions activity.
Greg Ip and Henny Sender in the Wall Street Journal document the strong returns private equity funds have experienced of late. They show how the nature of the industry has changed. Firms now are front-loading their returns by borrowing large sums to pay themselves dividends and other assorted “management fees.” This process has changed the game in two important respects.
First this has created a self-reinforcing cycle where high returns have lead to high fund inflows which allow for ever larger deals. This has attracted the increased attention of investment banks who want into the game.
The resurgence of the buyout investors, and their new skill at quickly extracting money long before any turnaround bears fruit, are signs of the ascendance of private money and its broad impact on the world of finance. The new power players are private financiers — hedge funds, buyout firms and venture capital firms — that often operate with limited scrutiny from the public and regulators.
There is no doubt that the private equity/leveraged buyout business has always been risky. The question now is whether this “front loading” has increased this risk even more.
Dividends, he says, allow private-equity firms to reap a quicker return than through an IPO or sale. That in turn attracts more investors, enabling more and bigger deals. “Are they logical?” Mr. Madden asks. “Yes. Do they increase the systemic risk in the buyout business? Absolutely.”
DealBook summarizes a number of articles on the subject of these megadeals and does not find a workable consensus on the sustainability of the trend. The sticking point, if and when it comes, will be the credit market’s willingness to provide the debt capacity needed for these megadeals. This may become increasingly difficult if the market is continually facing markdowns on the pre-existing debt of buyout targets.
Randall W. Forsyth at Barrons.com is apparently of two minds on the buyout trend. First he believes there are few “hidden treasures” of sufficient size out there to push the megadeal wave forward. On the other hand the HCA is just another reminder that there is too much cash on the balance sheets of corporate America and in the coffers of the private equity industry. Those who believe in the continued buyout boom believe that this “excess” cash will continue to fuel large transactions.
All good things come to end. The end of the mega-buyout deal wave is justifiably in doubt. What is not in doubt is that when the music stops there will be finger pointing, whether justified or not. Randall Smith in the Wall Street Journal documents the many roles Merrill Lynch (MER) played in the most recent megadeal, HCA Inc. These investment banking firms, most of which did not exactly cover themselves in dignity during the last boom (Internet) will be in the difficult situation going forward. While these firms may be taking all the appropriate precautions in their roles as bidder and adviser, this potential conflict will make them obvious scapegoats when the music stops.
*As a matter of follow-up we would also point you to this breakingviews piece by John Christy on the WLvia DealBook). Their point is that Amvescap (AVZ) is making a relatively low-risk move to try and “institutionalize” the deal-making skills of firm founder Wilbur Ross.