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Last updated: March 7, 2014 7:26 pm
For many investors, 2013 was a very good year. For the founders of four of the top US private equity funds, it was a year of outrageous fortune.
Leon Black, founder of Apollo Group, made $546.3m. His rival, Stephen Schwarzman of Blackstone, received $374.5m. Henry Kravis and George Roberts of KKR made more than $150m each, while Bill Conway, David Rubenstein and Daniel d’Aniello, the co-founders of Carlyle, shared $750m.
The enormous payouts, while exceptional, reflect a broader revival in the fortunes of private equity firms. As stock markets boomed, private equity firms were finally able to sell the companies in their portfolios – many of them bought before the crisis at high prices. And pension plans, sovereign wealth funds, insurers and wealthy families have started to entrust big buyout fund managers with their money again.
“People are in a good mood because they can finally sell companies and make money,” Kevin Albert, a 30-year private equity veteran, said at the Super Return conference, the industry’s annual gathering last week in Berlin. “The Federal Reserve is printing money and investors are risk-on. But a lot of it feels bubbly. We’ve seen this before – in 2007 and 2008, just before the crisis.”
After four meagre years, private equity groups raised $485bn from investors last year, up 26 per cent from 2012. The “mega funds” – criticised not so long ago as relics of the boom years – have had a dramatic revival. Apollo raised $18.4bn, 20 per cent more than what it amassed in 2008, on the eve of the crisis. Carlyle secured $13bn, while Warburg Pincus raised $11.2bn. In Europe, which has been attracting investors amid signs that it is emerging from the sovereign debt crisis, CVC Capital Partners attracted almost €11bn.
The industry has been helped by the Fed’s quantitative easing programme, which has kept long-term interest rates ultra-low, pushing yield-starved investors into buying riskier corporate bonds. Private equity groups took advantage of that demand by delaying loan maturities for their most fragile companies. They went even further by pursuing contentious “dividend recapitalisations”, which involved adding more debt to a company to pay for a dividend for investors. These made a strong comeback last year, with volumes of about $54bn in the US, up 25 per cent from 2012 and more than double the amount in 2007, according to S&P Capital IQ.
Surveying this new landscape, Mr Albert, a partner at Pantheon, remarks that the private equity industry has been “bailed out” by the Fed. “They were able to refinance their companies’ debt and are able to float their companies now because the Fed’s money has heated up equity markets. Ironically, Barack Obama has done more than any other president for real estate and private equity.”
Such sentiments could be music to the ears of those who contend that QE has primarily benefited the rich. Others in the industry, including David Bonderman, co-founder of TPG Capital, were quick to say that private equity was not the only beneficiary of the programme.
“Easy money is good for our business if it’s not speculative,” Mr Bonderman said in Berlin. “Yes, it helped. It helped the whole economy.”
The recovery, he adds, is part of the “cyclicality of life”. The cycle has certainly turned from its low of six years ago, when the Lehman Brothers bankruptcy roiled public markets and private equity dealmaking was brought to a screeching halt.
As stock markets crashed and profits contracted, buyout houses from Blackstone to Permira faced huge paper losses on multibillion-dollar acquisitions. These included hotel operator Hilton and clothing designer Valentino Fashion Group – companies they bought at the peak of the credit bubble with big piles of debt. They struggled to invest the money that remained, as banks curbed lending and credit markets shut down.
At the same time, cash-strapped state pension plans stopped committing to new funds. Fundraising volumes shrank 60 per cent within two years from the 2008 peak of $688bn. The machine was stuck and few saw how it could be fixed with so many large leveraged buyouts fallen victim to reckless “financial engineering”.
Now, with the recovery in sight in the US, the eurozone debt crisis contained and the huge financial support of central banks around the world keeping interest rates at record lows, money is flowing back into the system – at a dizzying speed.
Buoyant credit and stock markets on both sides of the Atlantic helped private equity groups return $471bn to their investors last year from sales, initial public offerings or refinancings. This was 57 per cent more than the 2007 peak, according to Hamilton Lane, the pension fund adviser.
“It’s an industry of cycles and private equity groups are good at playing the cycles, at being arbitrageurs of markets, equity or debt markets,” says Mr Albert.
Public markets nearing record highs helped restore funds’ asset values. Half of the pools raised in 2007 posted losses of more than 21 per cent in 2009, according to research firm Preqin. Half of those funds are now returning more than 12.4 per cent a year.
Some deals that were left for dead ended up turning a handsome profit. Hilton went public in December, enabling Blackstone to post a gain of more than 100 per cent on an investment that had been written down by about 50 per cent. Permira has also marked up the value of its investment in Valentino and Hugo Boss to about twice the money.
Yet despite the buoyant mood, some have voiced concern about another bubble that could spoil the party. And not all of the pre-crisis deals have had a happy ending. Terra Firma lost heavily on its acquisition of EMI. Texas Energy Future, purchased with $40bn of debt by KKR, TPG and Goldman Sachs in 2007, may file for bankruptcy this year. Other difficult deals have included Clear Channel and Cengage.
Then there is politics. With inequality emerging as a talking point ahead of US midterm elections, the big private equity paydays may raise the volume of the long-running debate about their taxes.
While the buyout kings were gathered in Berlin, Dave Camp, the Republican chairman of the House ways and means committee, proposed ending the special tax treatment enjoyed by the industry. Under the proposal, carried interest – the 20 per cent cut they receive from asset sales – would be taxed as ordinary income, higher than the capital gains tax rate. The industry has fended off previous efforts to raise the rates.
This is not what preoccupies private equity dealmakers, however. Investors’ renewed enthusiasm for their funds means the cash available for deals is swelling. “Dry powder” – the money private equity firms have raised from their clients for investments – has risen to a record $1.07tn, when including leveraged buyouts, venture capital, credit and infrastructure funds, according to Preqin.
This should be good news. But the rising stock markets that lifted the value of their investments also means potential buyout targets are more expensive. Using that dry powder is more of a challenge.
“Significant leverage is available again and this is also pushing up pricing”, says Jim Strang, a managing director at Hamilton Lane.
The volume of private equity deals is still half of what they were at the pre-crisis peak. Prices for those assets have already crept up to levels close to the 2007 high, Mr Rubenstein says.
The amount of debt used to finance deals has also increased to levels reminiscent of the boom years. Loans represent almost two-thirds of the cash used to finance private equity acquisitions. Those metrics are “things to watch”, Mr Rubenstein says.
“It is inevitable that people will chase the market up,” Mr Bonderman says. “There is always pressure to invest.”
Mr Kravis echoes Mr Rubenstein’s concern over debt in deals, blaming the banks. “When there’s money in the banks, it’s starting to move leverage ratios back up again, maybe beyond some level of safety,” he says. “The Federal Reserve has actually reached out to the banks and said, ‘please watch what you’re doing’.”
The frenzy is casting doubt on future returns, which industry chiefs say will inevitably decline amid increasing competition for deals. This is why the largest of them – including Blackstone, KKR and Carlyle – became public companies and are diversifying beyond the traditional buyouts into property, credit and infrastructure, which are less risky areas than corporate acquisitions. They have become big asset managers, emphasising their ability to invest “flexible capital“ across companies’ capital structure.
Investors should beware. The surge in asset sales is not sustainable, Mr Bonderman says. “It is a truism in our business that when you can’t raise capital, returns go up and when you raise a lot of capital, returns go down.” Asked if there is a solution, he says: “Whisky and soda, perhaps.”
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