Are the world's private equity firms going through a midlife crisis?
They've spent decades getting fat taking measured financial risks on companies the rest of the market was underestimating. Now that buccaneering spirit looks to be tipping over into recklessness.
KKR has offered to buy the founding family's 60 percent stake in Japanese airbag-maker Takata, the Nikkei newspaper reported Thursday. TPG, alongside Takeda Pharmaceutical, approached Valeant with a bid earlier this year that was rejected, the Wall Street Journal reported the same day.
What both these mooted deals have in common is a fat tail of potential legal liabilities that plays a large part in the targets' cheap valuations.
From a certain angle, Takata looks like a steal. It's one of just a handful of large industrial companies globally trading at less than a third of book value. In a worst-case scenario, a buyer could spend 39 billion yen ($355 million) to acquire the company at a 10 percent premium to market value, liquidate all its assets to pay off liabilities, and walk away with a cool 221 percent return from swallowing the 125 billion yen of net assets on its balance sheet .
A similar argument can be made for Valeant. The Journal's story says the approach was made a month or two ago, and that Takeda wanted to buy Valeant's Salix digestive-disorders business, with TPG taking most of the rest. Valeant's market value has been hovering in the region of $10 billion since late March, a year after the company paid $13 billion to acquire Salix.
If TPG bought Valeant at the market price, it could let Takeda have the diarrhea pills at a 25 percent discount to what they were valued at a year ago. That would leave it with a business that was worth as much as $88 billion in July, more or less for free.
The trouble is that the balance sheet doesn't tell the whole story for these companies.
The 43 billion yen Takata has set aside to cover the cost of recalling 69 million potentially fatal faulty airbags is unlikely to be enough. Jefferies estimates it may cost $11.5 billion, and Takata has a worst-case internal estimate of $24 billion, according to a person familiar with the matter. That's before we get into the battery of class action suits filed against the company in Florida, Hawaii, and Canada.
Valeant has similar issues. Whether or not the arguments of short sellers are accepted, the company is clearly on the receiving end of an awful lot of scrutiny by U.S. and Canadian legal authorities:
Those probes may come to nothing -- SEC investigations are so routine these days that they amount to little more than a cost of doing business. But it they come to something, it's very hard to know how much they're going to cost or what damage they would do to Valeant's business.
A bid for either company isn't a complete leap in the dark. Private equity investors pride themselves on being able to spot the opportunity no one else has noticed, so it's always possible for a buyer to decide that the market is overestimating the legal risk attached to a company.
Private equity funds have raised record amounts for investments in Asia and continue to sit on plenty of dry powder, heightening the incentive to make big bets. KKR is considering raising a record $9 billion for its third Asia-focused buyout fund.
The firm co-founded by Henry Kravis and George Roberts previously got handsome returns buying stakes in Chinese agricultural companies while tainted-food scandals were causing other investors to shy away. Both KKR and TPG made bids for Australia's Treasury Wine Estates in 2014, at a time when four of the company's most senior managers had quit and equity analysts were accusing the winemaker of channel-stuffing, a fraudulent retail practice.
But if you're taking on significant leverage for an investment, it helps to know what you're getting into. Credit, currency and market risks can be calculated and priced with some confidence, but the risks that may arise from legal or regulatory action are notoriously opaque. Private equity shops are much safer dealing with known knowns, to paraphrase Donald Rumsfeld, rather than the known unknowns that loom over Takata and Valeant.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
This relies on the (uncertain) assumption that the company's assets could be sold for the value at which they are recorded in the balance sheet.
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Matthew Brooker at email@example.com