A decade af­ter the buy­out boom, those megadeals look mega meh

The big buy­outs of the mid-2000s turned out to be mostly mid­dling “The en­tire in­dus­try has be­come more dis­ci­plined”

Bloomberg Businessweek (Asia) - - CONTENTS - −David Carey and Devin Ban­er­jee

Henry Kravis, a K in KKR, dubbed it pri­vate equity’s golden age. From 2005 to 2007, buy­out firms paid fat prices to ac­quire about 20 su­per­size com­pa­nies, from ho­tel chain Hil­ton World­wide Hold­ings to rental car gi­ant Hertz Global Hold­ings.

A decade later, the re­sults of that debt-fu­eled spree can be tab­u­lated — and they hardly shine. The megadeals yielded mostly medi­ocre re­turns,

ac­cord­ing to sep­a­rate data com­pi­la­tions by Bloomberg and as­set man­ager Hamil­ton Lane Ad­vi­sors.

“The big deals were done more out of ego than eco­nomic sense,” says David Fann, chief ex­ec­u­tive of­fi­cer of Tor­reyCove Cap­i­tal Part­ners, which ad­vises pen­sion plans that in­vest in buy­outs. “Peo­ple paid steep prices and put on too much debt.”

Pri­vate equity firms pool money from in­vestors, in­clud­ing pen­sions and en­dow­ments, and use debt to help fi­nance buy­outs and mag­nify po­ten­tial re­turns. They typ­i­cally charge in­vestors an an­nual man­age­ment fee of 1 per­cent to 2 per­cent of in­vestors’ funds and keep 20 per­cent of profit.

Buy­out shops gen­er­ally aim to at least dou­ble in­vestors’ money within three to five years. Ac­cord­ing to data culled from U.S. Se­cu­ri­ties and Ex­change Com­mis­sion fil­ings and the firms, 19 large deals each val­ued at $10 bil­lion or more pro­duced a me­dian profit of about 45 per­cent above in­vest­ment cost—well short of the tar­get.

The re­sults also pale when com­pared with the 70 per­cent me­dian gain yielded by all pri­vate equity trans­ac­tions dur­ing that pe­riod, ac­cord­ing to Hamil­ton Lane. That group in­cluded thou­sands of smaller deals.

On an an­nu­al­ized ba­sis, the largest deals gen­er­ated a me­dian re­turn of about 4 per­cent, says the study by Hamil­ton Lane, which looked at 25 big trans­ac­tions. The Stan­dard & Poor’s 500-stock in­dex re­turned 7.3 per­cent per year from the start of 2006 through the end of 2015.

The big­gest trans­ac­tion of the lot, the pur­chase of util­ity TXU for a record $48 bil­lion, was a flop. The com­pany, re­named En­ergy Fu­ture Hold­ings, filed for bank­ruptcy in 2014. As a re­sult, the ac­qui­si­tion, led by KKR, TPG Cap­i­tal, and Gold­man

Sachs Group, va­por­ized $8.3 bil­lion

of equity. Other no­table losers: the $30.7 bil­lion takeover of casino op­er­a­tor Har­rah’s—now Cae­sars

En­ter­tain­ment— by Apollo

Global Man­age­ment and TPG, and the $16.6 bil­lion buy­out of satel­lite ser­vices com­pany In­tel­sat by BC Part­ners and Sil­ver Lake Man­age­ment.

Have the Masters of the Uni­verse learned a les­son? “This crop of deals dragged down pri­vate equity re­turns,” says Joe Baratta, the global head of pri­vate equity at Black­stone Group, one of the lead­ing dealmakers. As a re­sult, he adds, “the en­tire in­dus­try has be­come more dis­ci­plined.” TPG has sworn off buy­outs as large as $30 bil­lion, peo­ple with knowl­edge of the firm’s think­ing say. No firm has led a trans­ac­tion of $10 bil­lion or more since the fi­nan­cial cri­sis.

Sev­eral fac­tors con­trib­uted to medi­ocre re­turns. Dur­ing the boom, low bor­row­ing costs led pri­vate equity firms to buy com­pa­nies for as much as twice the usual val­u­a­tions, based on mul­ti­ples of a tar­get’s sales and cash flow. They rea­soned that buy­ing big, es­tab­lished com­pa­nies would bring pro­tec­tion. The fi­nan­cial cri­sis that be­gan in 2007 dashed that idea, im­per­il­ing com­pa­nies big and small.

Al­most all the tar­gets were pub­lic com­pa­nies, which are harder to buy at bar­gain prices. “The fun­da­men­tal flaw with large pub­lic-to-pri­vate deals is you pay the full mar­ket rate,” says Scott Sper­ling, the co-pres­i­dent of

Thomas H. Lee Part­ners, which paid an above-av­er­age 16 times cash flow for

Univi­sion Hold­ings. “That de­creases the odds you can sell the com­pany later for a higher mul­ti­ple.” (Sper­ling de­clined to dis­cuss the per­for­mance of his firm’s spe­cific deals.)

An­other prob­lem, Black­stone’s Baratta says, was that many tar­gets were al­ready well-run, leav­ing less room for op­er­a­tional im­prove­ment—a key el­e­ment of the pri­vate equity play­book. The com­pa­nies also were too big to sell to an­other com­pany or pri­vate equity group for cash. To cash in, buy­out firms of­ten had to ar­range pub­lic stock of­fer­ings, which takes time, erod­ing an­nu­al­ized re­turns.

It’s harder now to fi­nance such gi­ant trans­ac­tions, in part be­cause in 2013 the Fed­eral Re­serve put curbs on loans tied to buy­outs.

How long buy­out ti­tans will heed the lessons of the era is an open ques­tion, says Josh Lerner, a Har­vard Busi­ness School pro­fes­sor who re­searches the pri­vate equity in­dus­try. “Mem­o­ries of­ten last a decade,” he says. “Get­ting them to last two decades may be overop­ti­mistic.”

The bot­tom line Most of the big buy­out deals from a decade ago made money, but not the kinds of re­turns in­vestors were look­ing for.

“The big deals were done more out of ego than eco­nomic sense.” ——David Fann, chief ex­ec­u­tive of­fi­cer, Tor­reyCove Cap­i­tal Part­ners

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