Fifty years ago, leveraged buyout (LBO) sponsors had a simple goal in mind: to help divisional managers of large corporations gain their independence and extract more value from previously cash-starved operating units.
But the low-hanging fruit of management buyouts and corporate carve-outs has mostly disappeared. Management teams are seldom the originators of transactions. Even investment bankers frequently lose out as LBO fund managers source deals directly.
Excess Capital Drives Deal Activity
Since the global financial crisis (GFC), financial markets have been inundated with fresh capital. The central banks’ asset-purchasing and low-interest rate policies have produced excess liquidity and a rush for yield.
Pension fund managers and other institutional investors saw marked-to-market stock and bond holdings repeatedly hit new highs due to this inflow of capital. Mechanically, these institutions had to increase their commitment to private equity (PE), if only to maintain a balanced portfolio.
Two years into the pandemic, dry powder in private markets exceeds $3 trillion, two-thirds of which is assigned to PE alone. This was particularly troublesome last year as public listings grabbed the lion’s share of exit value to take advantage of extravagant valuations, making LBOs less attractive to sellers.
Increased fund allocation to the asset class lured new entrants. Worldwide, there are now more than 5,000 PE firms, double the number a decade ago. Generous fee structures and easy money were impossible to resist. As a consequence, there are too many prospective buyers for too few acquisition targets.
The crowded competitive landscape led to a sharp increase in valuations — entry EBITDA multiples hovered between 12 and 14 times in the past three years, up from eight times in 2009 — as well as a noticeable drop in the number of portfolio companies held in each individual investment vehicle.
Twenty years ago, a typical vintage buyout fund invested in 10 to 12 companies. Nowadays, six to eight investees are more the norm. This has forced fund managers to pursue buy-and-build strategies in order to spend their dry powder. Last year, add-ons accounted for almost three-quarters of US buyout activity compared to 57% a decade earlier.
Unprecedented PE fundraising is not just putting a floor on global M&A activity. A troubling repercussion of the intense competition is the proliferation of runaway dealmaking.
First, let’s review the two types of LBOs that gained in popularity, if not justification, in the wake of the GFC.
Sponsor-to-Sponsor or Secondary Buyouts
Also known as “pass-the-parcel” transactions, secondary buyouts (SBOs) emerged in the early aughts in the most mature — read: saturated — markets of North America and Europe. The motivations behind such deals — wherein one PE firm buys the portfolio company of another — depend on whether one is buying or selling.
On the buy-side, with fewer fresh acquisition targets, financial sponsors go after companies that have already undergone a buyout. An SBO usually requires a recapitalization. As a structuring process, this is much more straightforward than the full-blown underwriting and syndication of a loan package for a business that the debt markets are not familiar with.
On the sell-side, as fund managers struggle to exit an aging portfolio, if corporate buyers prove unwilling to pay very demanding valuations, or face volatile stock markets that do not guarantee an orderly IPO process, they can turn to peers with excess dry powder.
Back in 2001, less than 5% of buyouts were SBOs. But the idea quickly gained traction. By January 2003, upon the disposal of bingo operator Gala to UK peers Candover and Cinven, a director at PPM Ventures explained, “This is the era of the tertiary buyout.” Eventually, quaternary and quintenary buyouts would become the norm. Nowadays, SBOs account for at least 40% of PE exits worldwide. Their share has reached or exceeded half of total buyout volumes in recent years.
For some financial sponsors, SBOs practically account for the entire deal flow. Of the 18 transactions completed by Paris-based Astorg Partners over the last five years, for instance, 15 were SBOs. The three exceptions were acquisitions of VC-backed businesses.
Because sponsor-to-sponsor transactions benefit from preexisting relationships with lenders, they tend to support higher debt ratios. That explains why they make up more than half of total annual leveraged loan volumes globally — in 2017, their share was close to two-thirds of the US LBO loan market.
Yet the larger issue with SBOs is that, according to academic research, they tend to underperform and destroy value for investors when they are made by buyers under pressure to spend.
Relapse or Boomerang Buyouts
Nothing better illustrates the industry’s whimsical dealmaking obsession than its taste for repurchases — whereby a financial sponsor buys back a company it has owned before, often quite recently.
Boomerang or relapse buyouts (RBOs) appeared at the outset of the dot-com and telecom crash of the early aughts. As such, they made sense. They represented an opportunity for fund managers with intimate knowledge of an asset to repurchase it at what was, hopefully, a temporarily depressed valuation.
Unfortunately, the practice spread during the credit boom of 2004 to 2008. Like secondary buyouts, RBOs are a byproduct of the industry’s stage of maturity. They cannot hide the perpetrators’ desperation to earn fees by putting money to work due to a seller’s remorse or a relapse syndrome.
In a typical scenario, a fund manager acquires a business, then introduces it to public markets a short while later only to take it private again when the company’s share price momentarily drops for whatever reason.
RBOs can often end up in bankruptcies or in the hands of their lenders. Italy’s phone directory publisher Seat Pagine Gialle is a prime example. European PE firms BC Partners, Investitori, and CVC invested in 1997, exited in 2000, and then reinvested three years later in a deal worth €5.65 billion. They lost their equity in 2012 as creditors took over the distressed company. Prior knowledge of Seat Pagine Gialle was of little benefit to BC Partners et al when technology disruption compelled yellow pages to move online.
A Self-Dealing Black Box
The futility of secondary and relapse buyouts pales into insignificance next to that of a more recent development.
As they struggle to find adequate targets in an overcrowded, overpriced market, fund managers are buying portfolio companies from themselves. They simply shift assets from one vintage fund to the next while charging transaction fees. In 2021, such self-dealing buyouts totaled $42 billion globally, up 55% from 2020 and 180% from 2019.
Naturally, many of these transactions take place at a premium to the price paid originally by the selling investment vehicle, enabling managers to also levy performance fees. Self-dealing also entitles PE firms to keep imposing annual management commissions, which are then derived from the continuation fund rather than the selling fund.
PE professionals contend that buying their own portfolio assets is a way to keep backing their winners. More likely, they have discovered that they can make more money through perpetual advisory, transaction, monitoring, and director fees than through carried interest — their share of capital gains. By raising more capital than they can allocate via new acquisitions in the open market, they are impelled to shuffle portfolio assets internally.
It is better to hold onto investees and recycle assets than fail to invest and return unused funds to limited partners (LPs), the institutional investors whose money PE firms manage.
Initially, fund managers were nervous about self-dealing. They worried that LP investors would object to such opaque portfolio reshuffles and to potential conflicts of interest. Indeed, without marketing portfolio assets to outside bidders, it is impossible to assess whether transactions are taking place at fair market values, on an arm’s length basis. Given the growing ubiquity of accounting shenanigans, including EBITDA addbacks, this is a real concern.
Nevertheless, fund managers have found a solution to fend off accusations of breaching their fiduciary duties. They ask accountants and lawyers — whose advisory fees they pay — to ensure a “fair” process by issuing “independent” reports justifying the valuations assigned to these in-house transactions. Et voilà!
Lack of Economic Purpose
The degeneration of the private equity trade is nothing new. From asset-stripping in the 1980s to asset-flipping in the mid-aughts, the downward trajectory has a long history. But after all the money printing in the aftermath of the financial crisis and especially during the pandemic, the trend has accelerated.
To loosely borrow from the late anthropologist David Graeber, runaway PE dealmaking is simply transactional activity that is so completely unnecessary or pernicious that even deal doers cannot justify its occurrence.
The primary purpose of such transactions seems to be to shift assets from one hand to the next, just for the sake of being active and charging fees, spawning little economic value in the process. And, increasingly, these two hands belong to the same party.
The combination of sponsor-to-sponsor deals, relapse buyouts, and asset shuffles within the same firm, gives a substantial proportion of M&A activity in PE an unsavory and even incestuous overtone: constantly recycling capital — debt and equity alike — behind closed doors within a niche ecosystem.
What started in the 1970s as an innovative practice to help managers find better homes for distressed or unloved corporate assets is settling into a rent-extracting, self-dealing trade.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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