When I read about 5 or 6 large buy-out funds bidding on a mature company in a mature market at 10x EBITDA valuations, I wonder where real value creation may come from.
In addition, the financial sponsor will have to add management layers that were probably unnecessary before and will have no access to synergies that an industrial player enjoys.
Truth is that the math of a traditional leveraged buy-out with no revenue growth, no EBITDA growth and no multiple expansion with a 50%/50% equity/debt capital structure is extremely hard, even with 6x EV/EBITDA valuations. Feel free to play around with my stripped down version of an LBO model spreadsheet on Google Docs.
Bloomberg News has an excellent round-up of recent figures of the private equity space: ‘Golden Era’ May Elude Private-Equity Investors as Prices Rise.
Private equity firms (especially the “mega funds” of $5 billion and above) have now significant amounts of money to invest, as in half a trillion dollar. These funds come with a “due date” on them: most funds were raised in 2005-2008 with an investment period of 4-5 years, meaning that this dry powder is going to “expire” in 2010-2012. Only invested funds will earn a 2% management fee when the investment period ends, which creates a perverse incentive to invest at any cost.
Finally there is a major supply and demand imbalance that is building up: when the time will come to realize these investments (made when funds needed to invest a lot of money) in 4-5 years, there won’t be as much “dry powder” floating around, given a 70% plunge in private equity fundraising that is now back at “new normal” levels of 2004.
As unlikely as it may seem, there is still a massive slack in the private equity industry (again, especially in the large LBO market) that will take another 4-5 years to work out.
As banks evolve to become government-regulated utilities, private equity firms and hedge funds will have an even harder time securing financing for their investments.
The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally. Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution.
If this re-regulation process continues, private equity funds and hedge funds will need to adapt their business model to a “new normal” where debt financing might be scarce. Or the new regulations will open up a space for investment funds focusing on providing debt for “speculative” activities.
Applying boring checklists to the investment process works. “Airline captains”, or those investment professionals in venture capital, private equity or stock investing that adopt a checklist method in their investment decisions, have a better track record because they control better our brain biases and common misperceptions.
Sure enough, when Smart tracked the venture capitalists’ success over time, it became clear that the airline captains had by far the most effective style. Those investors taking the checklist-driven approach had a 10 per cent likelihood of later having to fire senior management for incompetence or concluding that their original evaluation was inaccurate. The others had at least a 50 per cent likelihood. The results showed up in their bottom lines, too. The airline captains had a median 80 per cent return on the investments studied, the others 35 per cent or less.
For sure it is a tough sell, but I believe that using a methodical checklist-based approach helps guide our primitive brain to make complex decisions.
