Fifty years ago, leveraged buyout (LBO) sponsors had a straightforward goal in mind: to assist division heads of huge firms gain independence and extract more value from previously cash-starved operating units.
But the low-hanging fruit of management buyouts and company spinoffs has largely disappeared. Management teams are rarely the originators of transactions. Even investment bankers often lose when LBO fund managers acquire deals directly.
Excess capital fuels deal activity
Since the worldwide financial crisis (GFC), financial markets have been flooded with fresh capital. The central banks’ securities purchasing and low rate of interest policies have led to excess liquidity and a hunger for returns.
Pension fund managers and other institutional investors continued to see latest highs in market-priced stock and bond holdings for this reason influx of capital. Mechanically, these institutions have had to extend their exposure to non-public equity (PE), if only to keep up a balanced portfolio.
Two years after the beginning of the pandemic, dry powder in private markets exceeds $3 trillion, two thirds of which come from PE alone. This was particularly problematic last 12 months The lion’s share went to public listings the exit value to capitalize on extravagant valuations, making LBOs less attractive to sellers.
The increased allocation of funds on this asset class attracted latest market participants. There are actually greater than 5,000 PE firms worldwide, twice as many as a decade ago. Generous fee structures and straightforward money were not possible to withstand. The result: There are too many prospective buyers for too few acquisition targets.
The crowded competitive landscape led to a pointy increase in valuations – entry EBITDA multiples have ranged between 12x and 14x over the past three years, a rise of eight times in 2009 — in addition to a noticeable decline within the variety of portfolio firms held in each investment vehicle.
Twenty years ago, a typical vintage buyout fund invested in 10 to 12 firms. Today, six to eight investment firms are more the norm. This has forced fund managers to adopt buy-and-build strategies to spend their dry capital. Last 12 months, just about all of them were add-ons three quarters of US buyout activity in comparison with 57% a decade earlier.
The unprecedented PE fundraising is just not only putting a stop to global M&A activities. A worrying impact of intense competition is the proliferation of uncontrollable deals.
First, let’s take a look at the 2 sorts of LBOs which have gained popularity, if not justification, within the wake of the worldwide financial crisis.
Sponsor-to-sponsor or secondary buyouts
Secondary buyouts (SBOs), also often known as pass-the-parcel transactions, emerged within the early hours of the morning in probably the most mature – read: saturated – markets of North America and Europe. The rationale for such deals – during which one PE firm buys one other’s portfolio company – depends upon whether one is buying or selling.
On the buy side, where there are fewer latest acquisition targets, financial sponsors goal firms which have already been acquired. An SBO typically requires recapitalization. As a structuring process, this is far simpler than fully underwriting and syndicating a loan package for an organization with which the debt markets are unfamiliar.
On the sell side, fund managers struggling to exit an aging portfolio may turn to competitors with excess dry powder if corporate buyers prove unwilling to pay very demanding valuations or in the event that they face volatile stock markets, which don’t guarantee a correct IPO process.
In 2001, lower than 5% of acquisitions were SBOs. But the thought quickly gained traction. In January 2003, following the sale of bingo operator Gala to British rivals Candover and Cinven, a director of PPM Ventures stated: “This is the era of tertiary buyouts.“At some point, quaternary and quintenary takeovers would develop into the norm. Today, SBOs are liable for at the very least 40% of PE exits worldwide. Your share has reached or exceeded half of the full buyout volume lately.
For some financial sponsors, SBOs account for virtually all of their deal flow. For example, of the 18 transactions that Paris-based Astorg Partners has accomplished within the last five years 15 were SBOs. The three exceptions were acquisitions of VC-financed firms.
Because sponsor-to-sponsor transactions profit from pre-existing relationships with lenders, they have an inclination to support higher debt ratios. This explains why they account for greater than half of the world’s total annual leveraged loan volume – in 2017, their share was nearly two-thirds of the U.S. LBO lending market.
But the larger problem with SBOs is that, based on academic research, they have an inclination to underperform and destroy value for investors in the event that they are made by buyers under pressure to purchase.
Relapse or boomerang buyouts
Nothing higher illustrates the industry’s bizarre obsession with business than its penchant for buybacks – whereby a financial sponsor buys back an organization it previously owned, often recently.
There were boomerang or fallback buyouts (RBOs) firstly of the 12 months. Early morning dotcom and telecom crash. As such, they made sense. They represented a possibility for fund managers with intimate knowledge of an asset to purchase it back at what was hopefully a temporarily low valuation.
Unfortunately, this practice became widespread through the credit boom of 2004 to 2008. Like secondary buyouts, RBOs are a byproduct of the industry’s maturity. They cannot hide the perpetrators’ desperation to place money to work due to salesman’s remorse or relapse syndrome.
In a typical scenario, a fund manager acquires an organization, takes it public a short while later, only to take it private again when the corporate’s share price temporarily falls for some reason.
RBOs can often go bankrupt or fall into the hands of their lenders. A main example is the Italian telephone directory publisher Seat Pagine Gialle. European PE firms BC Partners, Investitori and CVC invested in 1997, exited in 2000 and reinvested three years later in a deal value €5.65 billion. They lost their equity in 2012 when creditors took over the distressed company. Previous knowledge of Seat Pagine Gialle was for BC Partners et al. of little use when technological disruption forced the Yellow Pages to go browsing.
A selfish black box
The pointlessness of secondary and fallback takeovers pales into insignificance next to that of newer developments.
Finding it difficult to search out suitable targets in a crowded and overpriced market, fund managers are buying up portfolio firms from themselves. You simply move assets from one vintage fund to the subsequent, charging transaction fees along the way in which. In 2021, such self-serving acquisitions totaled $42 billion worldwide. 55% greater than 2020 and 180% greater than 2019.
Of course, lots of these transactions occur at a premium to the unique price paid by the selling investment vehicle, allowing managers to also charge performance fees. Proprietary trading also entitles PE firms to proceed charging annual management commissions, which then come from the continuation fund moderately than the sales fund.
PE experts claim that purchasing their very own portfolio assets is one approach to proceed supporting their winners. More likely, they’ve discovered that they’ll earn more money from ongoing advice, transactions, monitoring and director fees than from carried interest – their share of capital gains. By raising more capital than they’ll provide through latest acquisitions on the open market, they’re forced to reallocate their portfolio assets internally.
It’s higher to carry on to investees and recycle assets than to not invest and return unused funds to limited partners (LPs), the institutional investors whose money PE firms manage.
Initially, fund managers were afraid of self-dealing. They feared that LP investors would object to such opaque portfolio shuffles and potential conflicts of interest. In fact, without marketing portfolio assets to external bidders, it’s not possible to evaluate whether fair market value transactions are occurring on an arm’s length basis. Given the increasing ubiquity of accounting shenanigans, including EBITDA markups, it is a real problem.
Nevertheless, fund managers have found an answer to fend off accusations of breaching their fiduciary duties. They require auditors and lawyers – whose consulting fees they pay – to make sure a “fair” process by producing “independent” reports justifying the valuations assigned to those internal transactions. Et voila!
Lack of economic purpose
The degeneration of personal equity trading is nothing latest. From asset stripping within the Nineteen Eighties to asset reallocation within the mid-Nineteen Eighties, the downward trend has an extended history. But in any case the cash printing within the wake of the financial crisis and particularly through the pandemic, the trend has accelerated.
To borrow it loosely late anthropologist David GraeberRunaway PE dealmaking is just a transactional activity that’s so completely unnecessary or harmful that even deal makers cannot justify its occurrence.
The fundamental purpose of such transactions appears to be to maneuver assets from one hand to a different simply to be lively and collect fees, leading to little economic value in the method. And increasingly, these two hands belong to the identical party.
The combination of sponsor-to-sponsor deals, fallback purchases, and asset reallocations throughout the same company gives a significant slice of M&A activity in PE an unsavory and even incestuous undertone: capital—debt and equity alike—is continuously recycled behind closed doors throughout the company a distinct segment ecosystem.
What began within the Nineteen Seventies as an modern practice to assist managers find higher homes for distressed or unloved corporate assets has evolved right into a self-serving industry that generates rental income.
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