Private Markets at a Breaking Point?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

The FT reports that the crisis deals bitter hand to buy-out bosses:

After
Jon Moulton’s bitter resignation letter at Alchemy Partners and an
acrimonious boardroom bust-up at France’s PAI Partners, the strains of
the credit crisis are starting to show in many leading private equity
groups.

As the credit crunch
deprives private equity of the debt needed to finance deals and many of
the investments made at the top of the market look unlikely to be sold
for a profit, tension is growing inside the buy-out industry.

“In
every large European fund, some deals are not doing well and have been
written down to zero,” says a big European investor in private equity.
“When things are tough it increases tensions between partners.”

This
tension and the downturn in financial markets has triggered a string of
shake-ups at several private equity groups. Already the top teams have
been reshuffled in the past year at Permira, Cinven, Candover, 3i and BC Partners.

“There is some sacrificing of people going on to show investors that you are taking action,” says one UK private equity boss.

While
in some cases, the handover of power at the top of these groups was
done in a smooth and orderly way, such as at Permira and Cinven, in
others it has happened in a more sudden and contentious fashion, such
as at Alchemy and PAI.

At Permira, Damon Buffini has handed over
as managing partner to Kurt Björklund and Tom Lister, and in June he
announced plans to step down as chairman next year, going back to
dealmaking and managing portfolio companies.

In July, Cinven
appointed Hugh Langmuir as its managing partner, replacing Robin Hall,
who is to become executive chairman after 22 years at the helm. Both
Cinven’s and Permira’s succession plans seemed well-orchestrated.

In contrast, Mr Moulton announced his surprise retirement from Alchemy in
spectacular style, calling for the group he founded to be wound up and
telling investors he thought Dominic Slade was not up to the job of
succeeding him.

Mr Moulton proposed splitting the group up,
allowing Mr Slade to take the financial services part of the portfolio
as the base to raise a new fund and leaving him to manage out the rump
of manufacturing and technology companies.

When this was
rejected, Mr Moulton quit, triggering a “key man” clause in the
agreement with investors, which allows them to freeze new investments
by the group and could result in them forcing it into run-off.

The bust-up at PAI is,
if anything, even more acrimonious. Dominique Mégret and Bertrand
Meunier have been forced out by what one insider called “a coup d’état”
led by Lionel Zinsou, a former Rothschild banker, who joined last year.

The
reasons for the management shake-ups differ with each group. But in
most cases, there was growing friction between the groups and their
investors as well as internal tensions among the partners within each
group. The problems were underlined by figures published on Wednesday
from the Centre for Management Buyout Research, which showed the total
value of buy-outs in Europe tumbled to €10.3bn (£9bn) in the first half
of the year.

This was the lowest since 1995 and was even smaller
than just one buy-out deal at the peak of the market in 2007, the £11bn
buy-out of Alliance Boots, the pharmacy chain.

Investors
are losing their patience with private equity groups that raised big
funds during the debt bubble, on which they continue to charge hefty
fees, while not doing any deals and facing growing problems on existing
portfolio companies.

“Whenever investors have a window to reduce
their commitment to a large buy-out fund they will take it,” says the
investor. “It is hard to justify the large fees on such a big fund when
there are no deals of that size in the current market.”

As
the pace of deals has fallen sharply, buy-out bosses have more time to
spend on plotting uprisings against increasingly unpopular bosses. They
are also frustrated as their carried interest – a share of profits –
looks worthless.

“It boils down to money versus power. In some
cases these guys can’t bear the idea of giving up the power, but in
others they feel they have made enough money and are happy to go,” says
a City of London headhunter who works with many buy-out groups.

“I
think this is the starting point of a major reshuffling of the cards in
the private equity industry,” says Antoine Dréan, head of Triago, which
advises private equity groups on fundraising. “It will result in a
number of spin-offs as the carried interest in many of these funds is
worthless, so the golden handcuffs don’t work any more.”

In
this environment, the golden handcuffs certainly don't work. The
private equity industry is going through a major upheaval and tensions
are high in Europe and North America.

But the top private
equity firms are trying to adapt as best they can. Last week, Bloomberg
reported that the world’s biggest private-equity firms, shut out of the
market for leveraged buyouts as banks curtail lending, are turning to bankruptcy courts to make acquisitions:

KKR
& Co., the New York takeover firm co-founded by Henry Kravis, is
part of a group converting loans made to Lear Corp. into a controlling
stake in the bankrupt car-seat maker. Late yesterday, Hayes Lemmerz
International Inc. said it reached an agreement with the lenders who
financed its bankruptcy, giving them an equity stake in the maker of
wheels for cars.

This year, 162
companies merged or were bought out of bankruptcy, a 60 percent jump
from the same period in 2008 and almost triple the amount in 2007,
according to data compiled by Bloomberg.

Private-equity
firms in the U.S. are finding new ways to invest the $600 billion of
capital raised mainly before credit markets froze in 2007. With
corporate defaults forecast to reach a record as soon as March, they
are making loans to the neediest borrowers and muscling in on turf
traditionally dominated by so- called vulture investors.

“It’s
not a tactic that private-equity firms have historically employed, but
it seems to be an idea whose time has come,” said Steven Smith, global
head of leveraged finance and restructuring at UBS AG in New York.
“This is clearly one of the new and most distinctive features of the
current wave of restructurings.”

More Opportunities

In
an LBO, private-equity firms usually put up about one- third of the
purchase price and borrow the rest. Lending for those takeovers is down
91 percent from 2007 levels, Bloomberg data show, so buyers are instead
making prepetition loans, which is financing before a bankruptcy, and
debtor-in-possession loans, or those made in conjunction with a filing.

Besides Lear and Hayes Lemmerz, firms are exchanging
loans for stakes in Reader’s Digest Association Inc. through the
bankruptcy courts, and a unit of Apollo Management LP is in a syndicate
doing the same with Lyondell Chemical Co.

Moody’s
Investors Service said while it’s too early to say if the amount of
prepetition debt being converted into equity through reorganizations
will exceed the record high of about $52 billion in 2003, it’s
“expecting a continuation of the trend.”

While the
so-called loan-to-own strategy isn’t new, opportunities are rising.
Worldwide, 211 companies with bonds and loans missed interest payments
in 2009, up from 55 in the same period of 2008. Standard & Poor’s
forecasts the U.S. speculative-grade default rate will rise to 13.9
percent in July 2010, from 10.2 percent last month, even as the economy
emerges from the worst recession since the 1930s.

Fewer Loans

The
amount of leveraged loans needed by buyout firms has shrunk to $67.7
billion this year from $311.2 billion in 2008 and $962.9 billion in
2007, Bloomberg data show. Leveraged loans are rated below investment
grade, or less than Baa3 at Moody’s and BBB- by S&P. The amount of
private-equity deals this year totals $43 billion, compared with $569
billion in the same period of 2007.

KKR and the other
lenders to Lear will get as much as a 26 percent stake, $500 million in
preferred shares convertible into an additional 26 percent stake and a
new $600 million term loan in return for their $1.6 billion of debt,
according to a reorganization plan filed with the court last month.

Lear,
based in Southfield, Michigan, is no stranger to private equity. A
predecessor was acquired by New York investment firm Forstmann Little
& Co. in 1986. Forstmann, which sold off some units before taking
the company public in 1994, was one of the biggest rivals of KKR
forerunner Kohlberg Kravis Roberts & Co.

‘Enormous’ Returns

“There
are certain circumstances where we think it makes sense to provide DIP
financing that converts to a substantial portion up to 100 percent of
the equity post the restructuring process,” said William Sonneborn,
head of New York-based KKR’s asset management division. “Lenders end up
owning control of the company, and providing a means for a substantial
portion of the existing loan-holders to get paid off at par.”

Investors
in loan-to-own deals may earn an 18 percent annual return on the
financing, plus get equity, compared with the potential for 12 percent
returns and no equity on DIPs, according to Smith at Zurich-based UBS.

“I’m
seeing more of these deals now than at anytime in the past,” said
Jonathan Landers, head of the bankruptcy practice at New York-based
Milberg LLP and co-author of three books on bankruptcy and creditors’
rights. “People are much less risk- averse and the potential returns
are enormous. The vulture investors have gotten their courage back.”

Vulture investors historically bought distressed bonds and exchanged them for controlling stakes in troubled companies.

‘Hugely Advantageous’

Lyondell
filed for Chapter 11 in New York on Jan. 6 and received a record $8
billion DIP loan. Members of the senior lending group included Apollo’s
LeverageSource SARL unit, which is the largest owner of the
Houston-based company’s secured debt, KKR, and Los Angeles-based Ares
Management LLC, according to court documents.

Steven Anreder, an Apollo spokesman, declined to comment.

“Having
available capital for these types of deals is hugely advantageous,”
said Jason New, the head of distressed investing at GSO Capital
Partners LP, a unit of New York-based private-equity firm Blackstone
Group LP. “I don’t think the banks will be active in the DIP market
anytime soon. New financing is difficult to find.”

Banks,
the traditional providers of bankruptcy loans, are unwilling or unable
to provide the credit because their capital is constrained, creating
opportunities for the funds, New said. The world’s largest financial
institutions have taken $1.6 trillion in writedowns and losses since
the start of 2007, Bloomberg data show.

Tighter Standards

The
Office of the Comptroller of the Currency said in July that its survey
of 59 banks holding $3.6 trillion of loans on Dec. 31 found that 86
percent of lenders toughened lending standards, up from 52 percent in
2008. DIP financings fell to about 23 percent of companies defaulting
this year as of July, the lowest since at least 2003, according to
Jeffrey Rosenberg, a strategist at Bank of America-Merrill Lynch in New
York.

Private-equity
firms in the U.S. have $609 billion of available capital, compared to
$281 billion in December 2004, the lowest amount in the past six years,
according to London- based researcher Preqin Ltd.

With
banks pulling back, the loans are becoming costlier even as credit
markets open up. Companies raised at least $904 billion in the U.S.
corporate bond market this year, a record pace, according to Bloomberg
data.

Costlier Loans

The interest
payable on DIP loans this year has averaged 7.25 percentage points more
than the three-month London interbank offered rate for dollars, up from
5.3 percentage points in 2008. In previous years, the margin has never
exceeded 4 percentage points more than Libor, according to Rosenberg.
Three-month Libor was set at 0.33 percent yesterday, down from 1.425
percent at the end of last year.

Eaton Vance Corp., a
mutual fund company in Boston, said in May that it was raising $1
billion to invest in bankruptcy loans. Sankaty Advisors, also in
Boston, announced last month it was raising a $400 million DIP fund.

The
downside to the loan-to-own strategy is that it may put private equity
firms in competition with lenders seeking the interest payments on DIP
loans, not longer-term equity investments.

“We would be
suspect if there was extensive involvement from hedge funds or private
equity firms looking to acquire control of a company through the DIP,”
said Neal Neilinger, vice chairman of Stamford, Connecticut-based
Aladdin Capital Holdings LLC, which has started a fund for DIP
financing. “We expect our DIPs to have a tenure of between 6 to 18
months. We are not looking to hold the equity of the company.”

Lawsuit Threat

Lawsuits
are another obstacle. Litigation has plagued Lyondell’s reorganization.
In one suit, a committee of unsecured creditors is suing lenders over
alleged fraud in the 2007 buyout that saddled the company with $22
billion in debt.

That isn’t the case in Lear’s
reorganization. U.S. Bankruptcy Judge Allan Gropper in New York, in
approving a bonus payment last week to Lear’s executives, noted how
quickly the case was proceeding. According to the company, holders of
68 percent of Lear’s secured debt support the restructuring plan.

“We
wanted the opportunity to participate in the recovery in the automobile
supplier market,” KKR’s Sonneborn said. “The DIP lenders will also own
some of the company post restructuring, which in theory, after our DIP
and exit financing loans are paid off at maturity, we can hold for a
long period of time.”

Ownership Transfer

A
majority of Reader’s Digest’s lenders agreed to a Chapter 11
reorganization that would swap what it called a “substantial portion”
of $1.6 billion in senior secured debt for equity and transfer
ownership of the Pleasantville, New York-based media company to the
group. The lenders are led by JPMorgan Chase & Co. in New York and
include Eaton Vance and Ares Management, said Kathy Fieweger, a
spokeswoman for Reader’s Digest.

Hayes Lemmerz, the
world’s largest maker of automotive wheels, filed for bankruptcy
protection in May. Its workout plan called for the lenders who financed
the reorganization to get 84.5 percent of the equity. The Bankruptcy
Court for the District of Delaware approved the reorganization
yesterday, the company said in a statement.

In a May 12
filing with the bankruptcy court in Delaware, lawyers for the
Northville, Michigan-based company wrote that a debt-for-equity
conversion was a last resort for distressed companies trying to
navigate Chapter 11.

The loan-to-own structure “has
emerged as one of the few viable mechanisms for lenders to allow major
U.S. businesses, particularly those in the depressed automotive sector,
to survive the current world-wide crisis,” the lawyers said in the
filing.

Indeed, I think loan-to-own will be the
only game in private equity for a long time. Others are more
optimistic. In Australia, a rebound in global markets is prompting
private equity houses to consider further share market listings of
businesses acquired over the past four years, which could lead to a string of initial public offerings:

Pacific
Equity Partners managing director Tim Sims, who heads one of the
nation's most influential private equity funds, said market conditions
seemed to support the exit of some funds from quality assets.

At
the same time, support from bankers for private equity transactions was
returning, with lenders likely to back acquisitions of up to $1 billion
in enterprise value, although there was unlikely to be a repeat of the
mega-deals of recent years, he said. ''The market has been short of
strong new companies to invest in for some time and is looking for
upside. Logic suggests that businesses that have demonstrated
resilience and growth in the eye of the storm will be attractive to the
current market.''

His comments came as the Australian
market yesterday notched up a fresh 11-month high, which gained on the
back of strength in materials and financial stocks as business

confidence rebounded.

Department store operator Myer is
expected this week to detail plans regarding its return to the
sharemarket, with an initial public offering expected to be worth at
least $2 billion.

Investment banks Goldman Sachs JBWere, Macquarie and Credit Suisse are acting as lead managers to the deal.

Myer's
owners - a consortium led by private equity house Texas Pacific Group -
have been reviewing options for the ownership of the department store
following a four-year turnaround under chief executive Bernie Brookes.

Details
of Myer's sharemarket float, timed as sales are gathering momentum as
Christmas approaches, is expected to coincide with the release of the
department store's annual results on Friday.

Among
companies that Pacific Equity Partners operates are cinema group Hoyts,
credit research house Veda Advantage, and book retailers Angus &
Robinson and Borders. It also owns alcoholic beverage producer and
distributor Independent Liquor, and share registry operator Link Market
Services, which are among those in the Pacific Equity Partners
portfolio speculated to return to the sharemarket sooner rather than
later. Mr Sims declined to comment on plans for companies that Pacific
Equity Partners is involved with.

Once dubbed ''Mr Private Equity'' by Asian Venture Capital Journal, Mr Sims' Pacific Partners remains cashed-up after last year raising $4 billion for its fourth private equity fund.

The raising was more than three times larger than any previous Australian fund.

In
weighing up whether to exit an investment through a sharemarket
listing, private equity investors had to weigh up whether to continue
to hold on to assets and enjoy further dividend and future upside, Mr
Sims said.

It's too early to tell whether
market conditions will keep offering PE funds exit opportunities. So
far, M&A activity is picking up and the IPO market is showing signs
of life, but remains in a moribund state.

Finally, Reuters
reports that commercial mortgage defaults of loans made by banks are
projected to peak in 2011, and could set a new record next year, according to a report released on Tuesday by Real Estate Econometrics:

The
real estate research firm revised its early projections for the rest of
the year, viewing the default rate of mortgage loans on office
buildings, hotels, shopping centers hotels and other non-residential
income earnings property to be 4.2 percent, up the most recent forecast
of 4.1 percent.

Falling
rental rates, higher vacancies and the absence of a functioning credit
market have combined to undermine borrowers' abilities to keep current
with their monthly payments.

Real Estate Econometrics also raised its default projections for next
year and 2011 to reflect a larger number of loans moving from
delinquency to nonaccrual -- loans lending institutions do not expect
to be repaid in full.

In
the second quarter, delinquent commercial mortgage balances across all
banks fell by about $2 billion, while those in nonaccrual balances
jumped $6.5 billion.

The shift corresponds with banks working to identify and mitigate
losses associated with problem loans earlier in the delinquency period
and a rise in the share of delinquent loans that will require
modification or foreclosure, Real Estate Econometrics said.

At 2.88 percent, commercial mortgage defaults in the second quarter
were at their highest level since 1993/1994, the report said.

The most aggressively underwritten commercial mortgages begin to mature
in 2011 -- just as property fundamentals and prices are stabilizing,
Real Estate Econometrics said.

Higher expected defaults are expected to be especially troubling for
smaller banks because their exposure to commercial real estate is
significantly higher.

For
institutions with more than $10 billion in assets, commercial real
estate concentrations are 9.5 percent of net loans, while those with
less than $10 billion in assets, concentrations surpass 20 percent, the
study said.

At 28.4 percent,
exposure to commercial real estate is highest for institutions with
$100 million to $1 billion in assets, Real Estate Econometrics said.

Clearly
we are not at the woods in private markets. Several structural
impediments remain, presenting serious challenges to private funds that
do not have the pockets and skill set to adapt in the new environment.

These
challenges are also weighing on many institutional investors who are
growing increasingly impatient with private equity groups charging
hefty fees on the big funds they raised during the debt bubble. It's
fair to say that unless activity picks up, private markets will reach a
breaking point - one that may weaken the industry for a very long time.

Comments

[Anonymous]

Here we go again.....

European Junk Bond Covenants The Same As At Mkt Peak- Moody's

By Ainsley Thomson
Of DOW JONES NEWSWIRES

LONDON -Dow Jones---High-yield bond covenants designed to protect investors remain the same as those used during the height of the bull market of 2006/2007, which is placing long-term bond value at risk, according to Moody's Investors Service.

Alexander Dill, Moody's senior covenant officer, said the most significant and surprising aspect of the recent thawing of the European high-yield market is that issuers have largely replicated the covenants used during the "less discriminating era" at the peak of the market.

"One might think that, in the aftermath of a severe market disruption, covenant structures would tighten, but this is not the case, either for the bonds of fallen angels -companies whose credit rating have been lowered from investment grade to speculative grade- or those of long-time high-yield issuers. High-yield issuers continue to use their relatively loose covenant packages of 2006-07," he said.

The European high-yield market, which had been effectively closed since late 2007 after the effects of the credit crunch caused investors to shun companies with poor credit ratings, began to revive in late May and since then there has been a steady stream of companies, including Italian auto maker Fiat SpA's -F.MI-, Italian telecommunications company Wind SpA, French spirits maker Pernod-Ricard SA -RI.FR-, and U.K. entertainment and communications business Virgin Media Inc. -VMED-, launching high-yield bonds.

High-yield or "junk" bonds are rated below Baa3 by ratings agency Moody's Investors Service and BBB- by S&P and Fitch Ratings.

Dill said the continued use of loose covenants causes risks for longer term bond value.

"Down the road, this [loose covenants] could allow a company to favor shareholder-friendly actions, to incrementally increase leverage, to make payments of cash to private-equity sponsors, and potentially subject the bonds to a degree of downward stress," he said.

In contrast, in the loan market there has been a marked tightening of covenants, as lenders pull back from the buy-boom years, which resulted in a rise in so-called covenant-lite loans that had few restrictions to protect investors.

"People are back to the stage where they will only accept a full set of covenants," one loan banker said. "They won't put any structures in place that are covenant lite."

[SWRichmond]

Excellent, well researched, covers a lot of bases, thanks a ton!

Everywhere I look I see misallocated capital, and PE is no exception.  I've used various analogies to describe a credit bubble to my kids:

• when money is too easy to get, you can start a business selling two pounds of crap in a one-pound bag
• It's easy to be a stock-market genius when stocks just go up, except when they pause briefly, only to resume going up again

An entire generation, including men old enough to know better (judging by the pictures above) made hay while the sun shone and failed to harvest before winter set in.  Misallocated capital, like crops spoiling unwanted in the field, is the legacy of central banking. 

Quite a number of us are sitting on cash and precious metals, waiting for the right time to do our own little personal version of vulture capitalism.

[Anonymous]

The private equity market being severely downsized or destroyed would be a welcome galactic event. We should declare a national holiday if Private equity was to go the way of the Dodo.

Like any useful tool, there was a place for it, but the avaricious fools turned it into another corrupt money pot, like a preying mantis biting off her paramour's head, destroying jobs by the tens of millions to no good advantage for the global economies and the consumer.

I would rather have 15 companies baking and selling cookies that earned 2% net, than one cookie baking company that earned 5%. Competing for my Oreo money, pecan sandies, and chocolate chips is devoutly to be wished for the many reasons that would deprive the Private Equity markets of leverage that was created by banksters, all to pad bonus payments with no regard to the time bombs they set ticking for the future.