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“You’re going to find out your biggest problem is not bringing in the stuff but what to do with all the . . . cash!” – Frank Lopez (Robert Loggia), Scarface (1983).
Private equity firm principals have a problem similar to the one that burdened Scarface’s drug kingpin. They can also bring in the “stuff”, by successfully floating limited partnerships. But what are they going to do with all the cash?
There are a couple of hundred billion dollars burning a hole in the pockets of the private equity firms. I have heard from many people that there have been several recent attempts at floating $10bn plus IPOs. They have foundered on the reluctance of rating agencies or junk underwriters to sign up.
Now, however, the rumblings about mega-deals are getting louder and it is likely at least one will be announced within the next month. Apparently, the leveraged buyout artists want to go for the biggest deals of all time – $30bn, $40bn, or more.
The great thing about mega deals, from the point of view of the LBO professionals, is that each one is not that much more work than smaller deals, and you get to put more of your partnership’s money to work, quicker. Also, more of the time spent on them will be taken up with big picture stuff, such as which divisions to sell, or which banks to include in the syndicate. Less time is consumed by the tiresome and dirty work of actually improving existing operations.
There are, however, a number of persistent real world problems in the way of the mega-LBOs. So far, though, the private equity people are determined to rise above them. As Mark Howard, the chief US credit strategist with Barclays Capital, puts it: “There are some people who want to bag the big one out there but that doesn’t prove the economics.”
Along with the private equity money for the buyout there is a lot of money ready to buy the subsidiaries or divisions that the LBO people would divest after the main acquisition. As Mr Howard says: “What a lot of these big [target] companies, as well as the equity market, may not realise is that there is a set of new bidders out there. There is a tremendous demand to buy a $500m to $3bn business that may be buried in a company with an enterprise value of $40bn. Those buyers exist not only in the US and Europe but also in Japan, South Africa, or even Brazil and China.” Mr Howard believes: “What an LBO guy couldn’t do two years ago is borrow $30bn and then sell off $10-$15bn of the assets. Now he could.”
The private equity people would have to find a target company with a management so unresponsive to market pressure that it would be unwilling to sell non-core activities on its own. In the 1980s there were many such companies but slow-moving managements are harder to find.
Still, there is no question that the equity tranche of a mega-LBO could be put together. Also, the leveraged loan market is just as accommodating. Banks are capable of quickly assembling syndicates to take the senior tranche of the capital structure of a giant deal.
The problem will come with the unsecured debt part of the transaction; with selling the junk bonds, in other words. Gregory Peters, senior analyst with Morgan Stanley’s corporate bond strategy group, says: “A big deal has to have dollar and euro high yield attached to it, which means it has to have interest on the European side, so it has to be a multinational. The biggest high yield deal done so far was for $3.5bn. That gives you a sense of what a record size could be [for the US dollar part]. Add in the largest levered loans that have been done, then [add] a 35 per cent equity piece, and you have an aggregate value of $22.5bn. Maybe you could go a touch larger but it would have to be a pristine deal.”
That shows why a mega deal would have to cross the Atlantic. “I am less clear on the European high yield limit,” says Mr Peters. “Could it be €3bn?”
The easiest target companies with which to compose a PowerPoint showing logical divestitures are “multicompanies” such as Tyco or United Technologies. Then you go to out of favour companies with lots of real estate, for which there is a universe of specialised buyers.
Even with those supposed easy targets, the private equity cowboys will still have a problem with credit market capacity. All the credit market people agree: you could do one mega-LBO but it would be hard to do two. There is a lot of pressure on the deal people to be the first to move.
Martin Fridson, of FridsonVision, the independent credit analysis company, points out that most institutions may have a formal limit for a given deal of 5 per cent of the balance sheet but in practice prefer to stick to a limit of half that. “The actual risk appetite of the institutions would mean that about $20bn could be absorbed. But it wouldn’t be easy, and probably would have to be priced at 350 basis points off the curve.”
That’s perhaps less than 100 basis points below the long-term equity risk premium. In other words, the LBO people would not be gaining much return by adding that leverage.
The mega LBOs would impose agency costs on the investors who trust their money to private equity firms. These deals would be compelling value only for “professionals” who will be reaping the fees. As Frank Lopez said: “Never underestimate the other guy’s greed!”