Return Of The Lbo
A quick glance inside Kohlberg Kravis Roberts & Co.'s New York City headquarters, with its sweeping, panoramic views of Central Park, shows how good the world of leveraged buyouts has been to KKR. And this year, the good times are rolling again. With contributions such as $1 billion from the State of Oregon's pension fund, KKR is well on its way to gathering the capital needed for its newest $6 billion fund, the largest LBO fund ever.
It's the same story at other LBO outfits. The industry is emerging from the shadows into which it was cast in recent years by the sexier and more profitable venture-capital business. LBO funds are set to raise a record $80 billion this year, vs. $50 billion in 1999, as pension funds, insurers, university foundations, and superwealthy individuals fall over themselves to pour cash into them in an attempt to beat lackluster stock market returns.
Behind the scenes, however, the LBO industry is in turmoil. The glory days of 1989, chronicled in the movie Barbarians at the Gate, when KKR bought food conglomerate RJR Nabisco Inc. for $31 billion, are long gone. Alongside that deal, still the largest LBO ever, today's affairs are modest, not to say puny, in scale: So far in 2000, only five LBOs over $1 billion have been completed, which means large funds looking for big LBO deals are stuck. "For the most part, the day of the large buyout shop is over," says Richard A. Friedman, co-head of merchant banking at Goldman, Sachs & Co.
As pressure to perform builds, many funds are starting to move into uncharted waters. With the plain-vanilla business of leveraging and reselling Old Economy companies losing much of its appeal, LBO outfits are moving into venture-capital investments, doing buyouts of tech companies--and even taking small, noncontrolling stakes in listed companies. "They have morphed into large, private equity groups that are making investments people wouldn't have considered in the past," says Friedman.
To be sure, the traditional buyout isn't yet dead. Last September, for instance, David A. Stockman, the former White House budget director, announced that he was creating an LBO firm to invest in old industrial companies in the Midwest. To some, the revival of an old idea sounded downright hip: "It's a great shtick," said one of Stockman's competitors. And in one of the biggest deals in years, Donaldson, Lufkin & Jenrette Inc. on Oct. 2 announced that it purchased the largest U.S. meat producer, IBP Inc. (IBP), for $3.7 billion. Just as in an old-fashioned LBO, two-thirds of the deal was financed with debt. IBP's stock had drifted downward from $25 earlier this year to the low teens and had not come close to reaching its all-time high of $33 in five years. "A lot of excellent Old Economy companies have seen their stock prices sink. Only recently have boards of directors begun to consider that it might be time to sell," says Thompson Dean, managing partner of DLJ merchant banking.
But such deals are still few and far between. And many people, including the funds' investors, are miffed at some of the trends, such as a push into venture-capital deals. "One thing I'm concerned about is having LBO funds doing what brought them to the dance, not having them chase the hot new topic," complains Howard J. Bicker, executive director of the Minnesota State Investment Board.
DEBT DEARTH. The hunt for new styles of LBO investing is no big surprise. Today, the major challenge facing the erstwhile Masters of the Universe is simply to find any deal at all. The plethora of industrial conglomerates ripe to buy, break up, and then resell that fed the LBO pipeline in the 1980s has long disappeared, except in Europe, which is why many U.S. firms are now setting up shop there. To make matters worse, midsize Old Economy companies in the U.S.--with rare exceptions such as DLJ's deal with IBP--are reluctant to sell to LBO players, mostly preferring to tough it out until stock prices rebound.
Although deals are becoming harder to find, ever more firms are chasing them. Where the likes of Henry R. Kravis of KKR and Theodore J. Forstmann of Forstmann Little & Co.--founders in the 1970s of two of the earliest LBO outfits--once had free rein, they now face 850 competitors. And even leverage, the hallmark of traditional LBOs, isn't what it used to be. For starters, debt, the magic ingredient that boosts returns, is hard to come by since the junk-bond market hit the wall in 1998. In the 1980s, debt accounted for as much as 95% of buyout prices. But because of the extra risk of bankruptcies, and low credit ratings, high debt loads over 75% are frowned upon by lenders. Having to use two to three times more equity in deals dilutes returns: LBO performances have drifted downward from an annualized return of 35% in 1989 to 20% in the first quarter of 2000. In the same period, venture-capital returns soared to over 50% from 5%.
Yet the fall in returns isn't driving investors away. That's because the top 25% of LBO funds still regularly beat the returns on the Standard & Poor's 500-stock index (chart, page 133). Instead, the avalanche of new money is causing an identity crisis in the business. "The changing landscape has left many firms wondering what they want to be when they grow up" says David Rubenstein, founding partner of Carlyle Group, an LBO outfit that manages over $11 billion of funds.
"SCANDALOUS." Some of the answers they're coming up with are raising eyebrows. By far the most controversial trend is a move to PIPEs, or private investments in public equities. The technique involves taking minority positions in public companies by buying common or convertible preferred stocks. If that sounds just like what mutual funds do, it is--except that investors pay LBO funds a 1% management fee and 20% of the profits on every deal. "I think it is scandalous," said the head of one LBO firm that hasn't invested in any PIPEs. Brett Fisher, senior vice-president of GIC Special Investments, which manages money on behalf of the government of Singapore, says GIC can make similar investments without the high fees. "We invest in LBO funds to purchase private companies," he adds.
The leading exponent of PIPE investing is Hicks, Muse, Tate & Furst Inc. of Dallas. It invested over $1 billion in local telephone companies only to see the stocks plummet 75% or more in value. One of these companies, ICG Communications Inc. (ICGX), a voice and data service provider based in Englewood, Colo., in which Hicks Muse invested $230 million, has seen its stock tank to 50 cents, from $29 at the time of the deal. Hicks Muse declined to comment.
The Dallas firm wasn't the only one to find its PIPE investments disconnected. Billions of dollars from LBO firms went into PIPEs (table, page 138), mostly in telecom. What was the attraction? Simply, telecom equities offered a handy place to park cash and--at the time--the tactic seemed to promise quick returns. The result is a big turn-off. "Most investors in LBO funds hate them because the concept has yet to be proven," says Lawrence M. Schloss, chairman of DLJ's merchant banking. "We shy away from them."
PIPE DREAMS? All the same, some LBO pros shrug off the embarrassment, blaming the losses on poor timing rather than the structure of the deals or the concept itself. "Those deals were done at the top of the market," says Thomas H. Lee, president of Boston's Thomas H. Lee Co. "The criticism of PIPEs is a canard, a red herring." Lee is a stout defender of PIPEs because his LBO fund invested over $1 billion in them. Lee invested some $700 million in two such deals: Metris Cos. (MXT), a credit-card issuer, and Conseco Inc. (CNC), a financial-services company. Lee rates Metris, which has risen sixfold since the investment, as "one of the best deals we've ever done." Conseco, however, has fallen 57% since Lee's investment. In Metris, says Lee, the LBO fund obtained four board seats and in Conseco, one seat, and thus gained influence over strategy.
An unrepentant Lee forecasts that LBO firms will continue to make large investments in public companies in the future. That, of course, remains to be seen. For one thing, PIPE investments have lifted the veil a little on the secretive world of LBO funds. Since their portfolio companies are private, even those performing poorly are normally shielded from the glare of scrutiny by the press. But PIPEs allow investors to track how some of the funds' investments are performing, simply by following the stock prices. "It's like they're airing their dirty laundry day to day," says Marc E. Sacks, executive director of Brinson Partners Inc., which invests in LBOs.
The losses in telecom PIPEs raise an awkward question: As LBO managers start to embrace the New Economy, are they out of their depth? Known for their financial prowess in analyzing cash flows, can they really evolve into tech specialists? The issue is becoming pressing as the trend amplifies. KKR, for instance, has formed a company called Accel-KKR to build Internet businesses in partnership with large companies like McDonald's Corp. (MCD) The two companies have recently set up a joint venture called eMac Digital to offer a wide array of business services, such as back-office support systems, through the Internet to McDonald's 25,000 franchisees. Meanwhile, T.H. Lee has just raised $1.1 billion for an Internet fund, and Texas Pacific Group (TPL), based in Fort Worth, has a staff of nine specialists for technology turnarounds.
If TPG's experience is any guide, leveraged tech buyouts are here to stay because they have the potential for stratospheric returns. TPG pioneered such deals in 1996 when it bought a loss-making modem maker called AT&T Paradyne Corp. from Lucent Technologies (LU), investing $51 million in equity and $123 million in debt. It was the perfect candidate for a buyout, a small division of a large parent. There were no other buyers, because of the danger of denting their own earnings growth, says David Bonderman, founding partner of TPG. "Large technology companies, which were likely candidates to acquire a company like Paradyne, could hardly afford to take the risk."
But the deal paid off handsomely for TPG, which promptly divided the new company, Paradyne Networks Inc. (PDYN), into three businesses: a leasing unit with a steady but declining cash flow, a broadband technology division, and a high-speed Internet-access division. The two high-tech units, GlobeSpan (GSPN) and Paradyne, went public last year, producing over $1 billion in profits for TPG, which still holds stock in the companies worth over $2 billion. So far, TPG has made back 58 times its original investment. "The market tells you what makes sense. As technology becomes a greater piece of society, its hard not to do some technologically oriented deals," Bonderman says.
A SPLASH. With returns like that, it was only a matter of time before others began jumping on the tech bandwagon. First, in January, 1999, came Silver Lake Partners, whose founders include David Roux, James Davidson, and Glenn Hutchins. Silver Lake was followed by Francisco Partners, formed by ex-TPG partner David Stanton, and Sanford R. Robertson, the founder of Robertson Stephens Inc.
Silver Lake made a splash last April with the largest leveraged tech purchase to date: a $2 billion deal to buy Seagate Technology Inc.'s (SEG) disk-drive business. The deal, which is not yet completed, was done in conjunction with Texas Pacific Group. Silver Lake has since made investments in smaller companies: $300 million in research outfit Gartner Group (IT), $200 million in telecom-equipment company Cabletron Systems (CS), and an undisclosed amount in SubmitOrder.com, an e-commerce logistics supplier. But other than Seagate, none of these deals was strictly a tech buyout like Paradyne--in fact, two were PIPEs, which Hutchins defends as being right for the fund. "We are primarily a tech fund, rather than an LBO fund," he says. "We will generate returns in the future not just from leverage but from the operating success of our portfolio companies, regardless of the particular security we buy."
In any event, Hutchins is convinced that specialization, such as Silver Lake's in tech, is the key for LBO firms that want to reproduce the high returns of the past. "We're a one-trick pony, but its a great trick," he says.
If Silver Lake is a one-trick pony, then Carlyle, based in Washington, could be called the cavalry. Considered the Fidelity Investments of the private equity world, its founders, David Rubenstein, William Conway Jr., and Daniel D'Aniello, took their vision in the opposite direction. Not only did Carlyle begin offering an assortment of funds specializing in a slew of private equity products like buyout, high-yield, energy, and venture funds, but it was the first to offer private-equity funds investing in specific regions of Europe and Asia. "We'd like to be the model of the future," says Rubenstein.
Unlike most of its competitors who have just begun setting up abroad, Carlyle has 20 offices around the world. "We're not so smart that we think we can sit in offices on Park Avenue and be Masters of the Universe," says Rubenstein. "It doesn't work that way."
Rubenstein thinks that it's only a matter of time before individual investors are allowed to invest in private equity through their 401(k) retirement plans. That's one reason why Carlyle has created a whole array of investment choices. The risk is that sector funds can be held hostage to the changing fortunes of different industries or countries. While it's too early to see returns internationally so far, Carlyle's returns after fees have been 30% over 13 years, putting it squarely in the top quartile of LBO funds.
The race is on to be the biggest, to get the highest returns, to go global. "What you have here is a watershed in which, rather than being a boutique business as it has been for the last 20 years, the LBO industry is now commanding resources at institutional levels," says Charles Frolen, managing director of private equity for General Motors Corp. (GM)
As funds race to differentiate themselves, it appears a change in the pecking order is inevitable. T.H. Lee completed raising a $5.5 billion buyout fund this year, after raising a billion-dollar venture fund this year. That puts Lee in second place for new assets under management, a spot long held by Forstmann Little. Lee is considered to have the best annualized returns in the business at over 40%, KKR among the lowest of the top-tier funds at about 20%. Behind Lee, others are scrambling to become bigger too, also chipping away at KKR's lead: "Five years ago, KKR was 10 times bigger than the rest of us," said one LBO fund general partner. "But there's no longer a gargantuan lead."
Maybe so. But, if the new trends sprouting up in the business take firm root, the old-style deals will account for a dwindling share of the market. And investors will continue to face more complicated tasks. "It used to be you could say, `Here's a group that knows how to structure a buyout transaction.' Now you have to ask, `Do they have the skills to do other things beside a buyout? Do they have technology know-how? Do they have succession plans in place? Are they spread too thin?"' says Mario L. Giannini, president of Philadelphia's Hamilton Lane Advisors Inc., which runs a private equity fund of funds and an advisory business.
But who said life was supposed to be easy? If LBO funds can jack up their rates of return to near those of the good old days, a little brain work might have a big payoff.
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