For a long time through the last economic cycle and the bull market that it produced, there has been a quiet, shadowy force operating underneath the radar of the average man in the street, fanning the flames of the burning stock market rally. Private equity is a term oft used but, mostly misunderstood (at best). It was used almost everyday, as a rumour in the equity market, to pump a stock up and sustain generous premiums for many more equities above their realistic book value. This secretive group of financial magicians seemed happy to pay above the odds for companies to take them private and then sell them a few years later for handsome profits. The original concept behind private equity was for a sophisticated group of investors to take an underperforming asset private, make the necessary difficult changes to improve its profitability, and then sell it back to the stock market investors for a tidy profit. However, in the last few years, this practice was dumbed down and profits made were almost exclusively down to the magic that is leverage. Cheap cash.
Private equity firms have, for some time now, exclusively practised the art of leveraged buy-outs (LBO's) as a means of buying publicly listed companies with borrowed money. They take a moderately leveraged company, listed on the stock exchange, and buy it with money borrowed from banks, using the company itself as the security - much the same as how you might buy a house. Most publicly quoted companies are leveraged about 3-5 times. This means that it has borrowings (or debt) 3-5 times the amount of equity invested by the shareholders. After an LBO, a company may have this leverage increased by a factor of up to 4 times that. This means that the private equity firm has to invest far less money in the company but, owns and controls it entirely. Over the subsequent 2-3 years they use cashflow from the company's operations to pay down this increased debt at a much faster rate than usual and so, deleverage the company back to its original level of debt. When they then sell the company, usually by re-listing it on the stock exchange, they will have tripled or quadrupled their original investment. This simple process meant that the old practices of streamlining and updating a companies processes and operations of a company in order to increase its value were made an unnecessary hassle. Cheap cash made the process very easy and so, as long as a company has decent cash flow, it was up for grabs. Not anymore.
Recent economic deterioration has turned off the tap on cheap cash and now, these private equity magicians have to roll up their sleeves, dust off the old management text books, and go back to basics. Nearly all of the debt used to finance these LBO's have maturities between 2 and 5 years and so, need to be refinanced or repaid once it matures. Banks are currently struggling to recapitalise their own balance sheets and leverage has become a dirty word. These LBO'd companies now have to find a way to deleverage fast, or the private equity companies that own them will walk away, lose their investment, and let the company default on the debt. A lot of this debt was restructured into large structures and then sold to various institutional investors like hedge funds, insurance companies and, other banks. They may find themselves being the ultimate owner of these companies but, if so, the private equity gurus will have lost their investment entirely. This pressure may not be a bad thing - it tends to sharpen the mind.
While the existing investments of private equity firms may be under threat, future investments can no longer follow the LBO model. In order to ensure a future for themselves, PE firms will have to find another way to make money. Many are now aware that any investment will have a longer turnaround time and will require them to make real improvements in the operations and profitability of their target companies in order to flip them for a profit. The obvious new hunting ground for any management guru looking for an underperforming asset would therefore seem to be the banking world. Recent approaches by PE giants of the likes of KKR and the Carlyle Group, towards Bank of Ireland have been met with some nervous reaction. Their reputation as aggressive asset-strippers have many people worried however, we must remember that the incumbent management have hardly overwhelmed the investment community. Strong, aggressive management may be exactly what some ailing banks need. Also if, in the event of LBO companies defaulting on their debt, they end up owning some of these leveraged enterprises, they will need management who know how to run them too. The US auto industry may also be a prime target for the type of business process reorganisation that private equity used to specialise in.
Many of the people running these private equity companies are some of the finest management minds of their generation and so, forcing them to go back to their basic management skills to improve the operations and so, the profitability of the companies they have invested in, can't be a bad thing. The death of cheap cash may have wiped a large chunk off the value of stock markets all over the world but, it may also have heralded the rebirth of old-fashioned good management principles. A well run company will make a profit and so, be worth something. Anyone remember that one?
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