Friday, October 20, 2006

Warning (Again) re: Buyout Funds

Less than three months after running an article titled “Buy It, Strip It, Then Flip It” — “investors beware,” it warned — BusinessWeek is back with another dire examination of the private-equity business, this time with a cover article called “Gluttons at the Gate.” (The title is a variation on the theme of buyout firms as “barbarians,” but we are not sure if “gluttons” is better or worse.)
Beneath all the newsstand-friendly alarmism, though, is a decent analysis of the current climate in the buyout business. Industry insiders might dispute the article’s conclusions, but it makes for interesting reading.
“These are crazy times in the private equity business,” writer Emily Thornton concludes. “It used to be that buyout firms would spend 5 to 10 years reorganizing, rationalizing, and polishing companies they owned before filing to take them public.” Nowadays, it is down to months — sometimes weeks.
She cites a few examples of what appear to be quick exits, though, as DealBook noted in August in response to BusinessWeek’s strip-and-flip article, the average buyout firm stays at least partially invested in its portfolio companies for years after an acquistion.
Still, Ms. Thornton is correct that there is a lot of money sloshing around the the private-equity business, as shown by the record-setting funds that have been raised or are in the works at firms such as Carlyle Group and Blackstone Group. That cannot help but speed up the business as firms seek quick returns for their investors in an increasingly crowded market.
Buyout firms “have always been aggressive,” Ms. Thornton writes:
But an ethos of instant gratification has started to spread through the business in ways that are only now coming into view. Firms are extracting record dividends within months of buying companies, often financed by loading them up with huge amounts of debt. Some are quietly going back to the till over and over to collect an array of dubious fees. Some are trying to flip their holdings back onto the public markets faster than they’ve ever dared before. A few are using financial engineering and bankruptcy proceedings to wrest control of companies. At the extremes, the quick-money mindset is manifesting itself in possibly illegal activity: Some private equity executives are being investigated for outright fraud.
All of this, she writes, shows that the business “has entered a historic period of excess.”
Stock values were way down after the “crash” of 2000-2002 while interest rates were also hitting new lows. The combination, Ms. Thornton writes, sent investors away from stocks and bonds, looking for new vehicles. They found one in private equity – where those low rates meant cheap leverage.
But then, as with earlier booms, too many players with too much money got into the game. She writes:
Today firms are brimming with cash, and they’re sinking more of it into bigger companies–in many cases even joining together in “club deals.” With more skin in the game, they’re extracting what they can, as quickly as they can, from companies to satisfy their investors. And since they’re buying bigger companies, the amounts are soaring. Some justify it with euphemisms such as “an early return of capital.” Critics liken it to strip mining and say dividends and other fees are becoming goals in themselves.
Private-equity firms in the past brought some benefit, Mr. Thornton writes. They often added value to the companies they bought by imposing discipline on their target companies. Now — not so much, she argues.
This year, buyout-backed initial public offerings are lagging their non-buyout peers by nearly 10 percentage points, thanks to all that “strip-mining,” as well as the massive debt being laid on many companies (which in part is to pay the fees), she writes. “With firms finding ever-more-novel ways to reclaim big chunks of their initial investments quickly, their incentive to produce lasting improvements may be diminishing. Too many appetizers spoil the meal.”
Ms. Thornton also wrote a short sidebar on the record-breaking paychecks being earned by partners in private-equity firms. The average in 2005 was $2 million. This year’s average is likely to top that amount by an appreciable margin, she reports.

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