Private Equity: The Challenges Ahead

Pioneer Tom Hicks says competition and higher interest rates may drive down returnsand smaller deals may end up being the most lucrative

The last year has been notable for a string of massive leveraged buyouts that have extended the limits of what private equity firms can do. Kohlberg Kravis Roberts bought hospital company HCA for $33 billion, beating the record that KKR established in 1988 with the RJR Nabisco deal (see, 11/10/06, "The Dark Side of the M&A Boom"). The record was broken again in November with The Blackstone Group's $36 billion acquisition of Sam Zell's Equity Office Properties Trust (see, 12/08/06, "Private Equity: What's the Limit?").

But in a year of record deal volume (see, 11/07/06, "The Money Behind the Private Equity Boom"), the vast majority of transactions are much smaller. Buyout pioneer Thomas Hicks specializes in those smaller deals, which he says can be at least as profitable as bigger LBOs that dominate the headlines. On Dec. 8, his Hicks Holdings teamed up with The Watermill Group, a private equity firm in Lexington, Mass., to acquire Latrobe Specialty Steel of Latrobe, Pa., for $215 million in cash and $35 million in assumed debt. The company sells steel to civilian and military aircraft makers.

Picturing His Profits

On Dec. 6, Hicks and Investcorp bought trucking services company Greatwide Logistics Services for $730 millon. Greatwide, of Dallas, manages transportation and warehouse operations for big clients such as Wal-Mart (WMT), Target (TGT), and IBM (IBM). In September, he launched a company called DirecPath, which will resell DirecTV (DTV) and other communications services to apartment buildings, condos, and gated communities.

Hicks says he expects to generate returns of 30% or more on his recent investments. In some cases, he expects to make four to eight times the amount of his invested capital. That can be more profitable than some larger deals.

Earlier this year, Hicks and a group of investors that included Blackstone, KKR and others walked away from a bidding war for radio and advertising company Clear Channel Communications. Thomas H. Lee and Bain Capital Partners ended up buying Clear Channel for $18.7 billion and the assumption of $8 billion in debt. "The Clear Channel deal came down to who was willing to accept the lowest equity return. I think they are looking at a return in the high teens," Hicks says.

Small Deals

In private equity, the best returns have historically gone to a relatively small group of firms. "All studies show that the top quartile of private equity funds outperform the market. But other than that, they don't necessarily outperform the public market. It's a question of how good your private equity manager is," says Jim Leach, head of the $6 billion in-house private equity fund at the $96 billion Ontario Teachers Pension Plan.

During the last year, "mega" funds such as KKR, Carlyle, Blackstone, and Texas Pacific have enjoyed gains of 40% or more, according to one private equity executive who declined to be identified. The same executive said it was inevitable that returns for "mega" funds would head somewhat lower over the next year or so.

As outsize returns become more challenging to achieve, Hicks says he will continue to focus on smaller, "under the radar" deals in an increasingly competitive private equity market. He adds that rising interest rates will reduce the opportunities for financial engineering that boosted returns. "Interest rates have been at an historic low. That led to great financial engineering, which has slowed down if not ended," Hicks says.

A "Rare Bargain"

Asset prices are rising, too. The private equity market has been flooded with cash from pension funds and other institutional investors. As a result, financial sponsors are looking to put a record amount of cash to work. That has led to bidding wars for assets such as Clear Channel and Freescale Semiconductor (see, 9/12/06, "Bidding on Freescale Sets Off Alarms").

If Hicks is correct, the Latrobe deal could turn out to be a rare private equity bargain. The price of the deal works out to a multiple of three times earnings before interest, taxes, depreciation and amortization, or EBITDA, Hicks said. The Timken Co. (TKR) put Latrobe on the block a year ago, because it didn't fit its core businesses, which include bearings. Latrobe's high-alloy steel business picked up during the last year, thanks to rising demand for military and civilian planes in the U.S. and abroad. But Timken didn't raise its price, and no other bidders showed up. "We think the current cycle has legs for another five years, and maybe longer," Hicks said.

Hicks first made his name in the '80s with the highly profitable buyouts of Dr Pepper and 7 Up. His firms—Hicks & Haas, and Hicks, Muse, Tate & Furst—did a range of deals in media, energy and other sectors. Hicks left Hicks, Muse—now known as HM Capital—in 2004. He also runs Southwest Sports Group, which acquired the Texas Rangers baseball franchise from a group of investors including President George W. Bush. Southwest also owns the Dallas Stars hockey franchise.

Staying Confident

Hicks says he expects the deal market to remain strong, even if the stellar returns of the last year are difficult to match. "The economy has been strong for the last four years and I expect it to remain that way, barring an external shock such as terror attack, a spike in energy prices, or a sudden downturn in China," Hicks said. He isn't particularly alarmed that "the air has come out" of real estate bubbles in markets such as the East and West coasts, Florida, Las Vegas and Phoenix. "The rest of the country—such as the Midwest and Texas—didn't have such a runup in housing prices, and those regions have a strong foundation for growth," he said.

Hicks doesn't expect the change in power in Congress or the potential change of power in the White House in 2008 to have a big impact on the economy either. He says the tax cuts have been a big driver of economic growth and deal making, and that Democrats are unlikely to roll back those cuts.

A strong deal market creates challenges, though. Asset prices rise as buyers bid on takeover targets, and stronger economies can lead to higher interest rates, too. In that environment, the best deals may be the smaller deals that don't attract a lot of attention.