Private Equity: Is the bubble about to burst?

Private Equity - 'Is the bubble about to burst?'

Warwick Business SchoolPhilip Ashdown

22nd October 2007

Views expressed are private ones of Philip Ashdown

• Where are we now? • Where do we want to be?• How are we going to get there?

• What ‘worldview’ do we consider?• Systemic issue or a correction?• What strategy do we adopt?• What are the resource and capability gaps?

• (Anyway what is a (the) bubble? (in this context))

Key Questions

M o d e l o f th e E le m e n ts o f S tr a te g ic M a n a g e m e n t

Id e n tifyO p tio n s

E v a lu a teO p tio n s

S e le c tin gS tra te g y M a n a g in g

C h a n g e

O rg a n isa tio ns tru c tu re a n dd e s ig n

P lan n in g a n da llo c a tio n o fre so u rc e s

E x te rn a l - P o rte r e tc .M a rk e t B a se d V ie w

C u ltu re &S ta k e h o ld e rE x p e c ta tio n s In te rn a l - R e so u rc e a n d

C a p a b ility (C o re C o m p .)R e so u rc e s B a se d V ie w

E n v ir o n m e n tA n a ly s is

S tr a te g yC h o ic e

O r g a n is a tio nI m p le m e n ta t io n

Model of the Elements of Strategic Management

External – Market Forces Internal – Resources/Core CompetencesCulture and Stakeholder Expectations

Identify

Evaluate

Select

Planning and Allocation

Culture and Architecture

Managing Change

Must have consistent and high degree of congruency

Road Map

• Helicopter ride– Private Equity - some history and making superior returns– World view– Shocks and changes

• Helicopter landing – Overview of the European LBO Market• Helicopter ride

– World View implications– Private Equity implications– Can Private Equity deliver superior returns?

Private Equity - History

• Culture as ‘master of the universe’ ?• OR any fool could make money in the last 10 year bull run?• Generally minimal understanding, ‘label’ or do not care……….but its ‘centre stage’ since 2006

• Background……

– Governments and entrepreneurialism– Big Bang (1986) >hot boom > 1990-1993 recession– ‘barbarians at the gate’– Financial innovation and disintermediation– Venture capital is way too risky thanks

• TMT and dot.com boom• Economies of scale do not work in my business model

– Investors – ‘hey where do I put all my cash?’ (must have superior returns btw) – Hedge Funds and ‘alternative asset/value managers’– Bull market > 1997-2007 (BUT ‘shocks’)– Reputation– Secrecy, tax and non-doms– Political and social impact

Private Equity – Segment and Asset Class

• Sector maturity, learning/experience curves

– Historical analysis and disclosure– Barriers to entry rapidly rising– Brands and the ‘Goldman Factor’

• Consolidation and/or natural removal of poor performers; swiftly

– Nature of fund raising and business model– Emergence of ‘Alternative Fund Managers’ at meta level– Prescriptive nature of pension fund investors– Regulation etal.

• Performance vz Public equity markets (Mario Levis – Cass Business School)

– RoA, Ebit and cashflow persistently higher – factor of 50% (with PE ownership)– Debt ‘appears’ to set a tight discipline on management– PE investment cases - minimise bureaucracy and committees, lack constant public exposure– Risk/reward profile is clearly set and monitored

• Performance vz Alternative Fund Managers/Assets

– Hedge funds - $2,000bn globally, expected $500bn withdrawal Q42007 – ABCP, CDO’s and other esoteric asset classes

The Credit/Equity Cycle – it’s always in the background!

Phase 1

Phase 3

Phase 4 Phase 2

Credit Equities

Credit Equities

Credit Equities

Credit Equities

Immature Bull

Mature Bull

Source : CitiGroup Investment Research

Intervention period

Emerging Bear

Repair BSheetLeverage builds

Technology Excess

Clock Face

Let’s get in a helicopter

Virtual CirclesNew Paradigms

Financial Models and StatisticsInnovation

Regulation and DeregulationLiquidity

TaxIT

ChinaPetro-DollarsRussiaIndia

USA deficitDollar liabilitiesEmergence of EuroFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobilityGlobalisation

Sovereign wealth fundsRelative sophisticationReal Liquidity

Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs

ASSETS LIABILITIES

World View

………………..but they crash



Regulation and DeregulationLiquidityTax + IT

System Momentum





ASSETS LIABILITIES

Shocks

Asset ValuesInflate

VAR breaks down

complexity

SpeedReaction timeMedia Power

PerceptionDollars/Euro/

Gold???

PerceptionDollars/Euro/

Gold???

VAR breaks down

Rabbits +headlights

…..correction +/or systemic +/or another paradigm?

Virtual Circles INVERSENew Paradigms ‘ITS OLD AGAIN’

Financial Models and Statistics MISTRUSTInnovation EXCESS

Regulation and Deregulation CONFUSIONLiquidity REAL + FALSE

Tax TAKERIT SPEED EXPONENTIAL

System BREAKDOWN


USA deficitDollar liabilitiesEmergence of EuroSTRENGTH BY DEFAULTFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobility Globalisation



ASSETS LIABILITIES

Financial Structures Leverage +Trading ?

What is my risk?

Trade deficitInterest ratesPerceptionDILEMNA

OMG what is my cap’ structure?

Where is my risk?

In/Out fast

SD is 8x!Leverage is

4*4*!

‘banana republic’

…….can this helicopter fly again?








ASSETS LIABILITIES

…..time and process to get control; feedback to real world

Flying the helicopter…not a problem

• System Momentum = mass * velocity (* powerful internal cultural factors)

• Even when we think we understand/see the problem we do not get behaviour change (why?)

‘When liquidity runs out it will be very complex, however, the music is still playing and we are still dancing…..(this is a great time to make superior returns)’ Head of CitiGroup early July 2007 when talking about LBO’s(Private Equity)

$5.9bn losses announced 2nd October ($20bn+ losses Q3 across the market)

PS Volatility/Shock – Citi losses increased by $600m by 15th October

Private Equity Economics

• Buy an asset at the right price

• Optimise the capital structure

• Optimise industry position and operational efficiency (…competitive advantage)

• Sell an asset at the right price

• Where are we in the helicopter today?

• Reflective of where we are

• Am I deep enough in the woods? Its very tough in here

• Where is my helicopter going and do I have enough fuel?

…….let’s land the helicopter in……..

The European Leveraged Buy-Out Market

Source : Standard & Poors LCD Debtwire Statistics as at March & June 2007

€0B

€20B

€40B

€60B

€80B

€100B

€120B

€140B

1999 2000 2001 2002 2003 2004 2005 2006 20070

40

80

120

160

200

240

280

320

1Q 2Q 3Q 4Q Deal Count*

* Deal Count counts First and Second Lien portions of a single transaction as one event; Deal Count also excludes any amendments.

Annual Senior Loan Volume Deal Count:

214

€0B

€5B

€10B

€15B

€20B

€25B

€30B

€35B

€40B

Jul-0

6Aug

-06

Sep-0

6Oct-

06Nov

-06

Dec-0

6Ja

n-07

Feb-

07Mar-

07Apr-

07May

-07Ju

n-07

Monthly Senior Loan Volume (Last Twelve Months)

European LBO Market Volume

Exponential market growth : private equity raised globally in past 5 years $551bn #

# Source : Sunday Times 29th April 2007

Avg. LBO Purchase Price as Multiple of Pro Forma Trailing EBITDA

6.97

7.81

7.276.93

6.72 6.64 6.48

7.17

7.93

8.42 8.57 8.720.350.33

0.39

0.38

0.380.38

0.40

0.35

0.33

0.41

0.380.34

5.00

6.00

7.00

8.00

9.00

10.00

1997(Observations:

14)

1998 (35) 1999 (33) 2000 (40) 2001 (37) 2002 (52) 2003 (66) 2004 (77) 2005 (87) 2006 (120) LTM 31/3/07(126)

1Q07 (30)

Purchase Price Fees/Expenses

Excluding Platform Acquisitions and Other Sponsor Driven Transactions.

Excess supply of funds and liquidity is chasing higher enterprise valuationsrationalised against increasingly aggressive strategic business plans

+34%

Average Total Debt Leverage Ratio for LBO’s: Europe vs. US with EBITDA of €/$50M or More

4.74.4 4.3 4.4 4.5

4.8

5.55.8

6.1

4.9

4.34.1 4.1

4.74.9

5.4 5.55.8

0.0x

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

7.0x

1999 2000 2001 2002 2003 2004 2005 2006 1Q07

Europe US

Debt multiples have risen c.a. 40% since 2001

0.0x

2.0x

4.0x

6.0x

Debt/EBITDA SeniorDebt/EBITDA

EBITDA/Sr Interest EBITDA/CashInterest

EBITDA - Mainten.Capex/Cash

Interest

EBITDA -Capex/Cash

Interest

1999 (53) 2000 (80) 2001 (75) 2002 (101) 2003 (115) 2004 (149) 2005 (210) 2006 (236) 1Q 2007 (62)

Key Ratios (Europe) – 1999-2007(Q1)

c.a. 40% negative shift ofInterest cover andCore investment coverage

c.a. 40% increase in leverage

Who finances this growth?

Primary European LBO Market by Broad Investor Type

0%

25%

50%

75%

100%

1999 2000 2001 2002 2003 2004 2005 2006 LTM31/3/07

European Banks Non-European Banks Institutional Investors Securities Firms

Clear growth evident in institutional market away from banks,will drive complex outcomes as market deteriorates

10%

55%

314

53

112

3 821

3343

126

303

22

99

718

33

241

70

0

50

100

150

200

250

300

350

1999 2000 2001 2002 2003 2004 2005 2006 1H07

Manager Groups Active Loan Investment Vehicles

Note: Investor group and vehicles include CDOs that are in late stages of warehousing and exclude Finance companiesExcludes U.S. Dollar Tranches Syndicated in the US

Exponential growth inCDO/CLO funds

Institutional Investor Group and Vehicle CountEuropean LBO Market

Institutional Investors’ Share of the Primary Market

0%

20%

40%

60%

80%

100%

1999 2000 2001 2002 2003 2004 2005 2006 LTM30/6/07

LTM30/9/07

Europe US

European market structure has evolved to USA model; what’s over there is coming here

…..back for a helicopter ride

Subprime EconomyCDOs FIsLBOs Xover ABCP

Extreme SensitivityHouse Prices

Ratings Uncertainty

Limited Supply

Haircuts

Liquid hedge UnwindingLeverage

Liquidity BackStopsPB lines

Inability to refiACBPREPOsCapital scarcity

Tighter credit

Slower GDP

Genuine Liquidity Crunch – not isolated to subprime

Financial Product Segments affected – August 2007 - Globally

Source : CitiGroup Global Markets

$6,900bn into$1,500bn $2,670bn $3,000bn $5,700bn $2,400bn

Memo – June 2007Equities $23,500bnTBill $4,300bnMuni $2,500bnAgency $2,700bnMoneyMarket $4,300bnUS Capital Markets data only

Implications for the system








ASSETS LIABILITIES

Huge Complexity

Momentum = (Mass*Velocity)*Culture

World View



ASSETS

Can China keep growing at 12%p.a.+?What happens to oil prices, liquidity flows and investment?Political influences, war mongering, terrorismSocial unrestPowerful exogenous factors impacting interest, FX ratesand asset prices

Investment is being increasingly driven directly•In house wealth funds ($8trillion+ >reserves of central banks globally by 2011)

Industry sectorsGlobally – ‘strategic assets’Hot money (+/or)…..Sustainable ‘locked’ flows




LIABILITIES

• Ongoing change (hetro>homogenous) but cultures• Core driver to investment activity and superior returns• Lessons will be learnt; add the 2007 credit crunch• Financial sector equity, leverage, returns re-assessed• Risk free rates, core risk skills, asset values tested• Time period will lengthen (hold periods)• Safety margin broadens

• USA not able to manage interest rates, ultimately• Equals yield curve volatility; FX volatility; asset volatility• Europe has same problem but for different reason• Economic stability will likely revert to variable • Cycles, inflation and/or Japan• Reduced credibility, intervention, monetarism returns• Consideration to controls (indirect/direct)• Core liquidity is ‘global’ and will move swiftly• Huge liquidity imbalances; funding structures are key






What was old is new (paradigm)Recession (risk of) and cyclesVolatility everywhere InflationJapan experience

Innovation - excess controlled (self and external)Tight(er) regulationLiquidity – deep understanding/controls neededTax abuse (tend to eradicate)IT control and development of betterrisk models and feedback mechanismsMedia management reviewedProtection for ‘man in street’

The brakes are slammed on; there is no ABS and its very iceyI am sure we will not overreact………….much anyway!

Implications for the system…..time and process to get control; feedback to real world

• We have an acute balance between control and chaos

The chances of a USA recession in 2008 have risen from 3-1 to 2-1 (Greenspan, October 1st); most see it as 50/50 to likely

If investors fund less $ liabilities….global liquidity flows and imbalances

Interest rates and/or asset values will shift swiftly

Euro is too strong (driven by alternative investment home) equals inflation ultimately……..

Japan has had zero interest rates and no asset growth for >13 years

System has landmines everywhere – shock and volatility to comeo Late cycle sub-prime is estimated at $700bn; $100bn found; losses could be $300bn???o LBO debt is c.a.$500bn ‘hung bridges’ plus excess growth since 2005o Corporate debt has had limited diligence for 3 yearso Property prices and leverage (residential and commercial) excessiveo Inherently unsustainable financing, liquidity and capital structure issues (innovation excess)o Will somebody explain liquidity to me!!!

Does Fed intervention get control?

Is the ECB a credible central bank or a political and naïve player?

The UK is left in the backwash?

What happens when equity markets ‘get this’? (Asymmetry between credit and equity markets)

Private Equity

External

• Correction and back to normal………

• Or correction into chaos then…? What time period?

• Sustainable industry/investor group or not?

Internal

• What strategy to adopt ?– Providers of liquidity– Fund managers– Long/short asset holders– Existing portfolio– New investments

The Credit/Equity Cycle – it’s always in the background!

Source : CitiGroup Investment Research

Phase 1

Phase 3

Phase 4 Phase 2

Credit Equities

Credit Equities

Credit Equities

Credit Equities

Credit

Equity Immature Bull

Mature Bull

Intervention period

Emerging Bear

Repair BSheetLeverage builds

Technology Excess

Cost of (<) BBB over Credit/Equity Cycle

100

300

500

700

900

1100

1300

1500

1700

01/02

/199

809

/09/1

998

5/18

/199

91/

21/2

000

9/29

/200

006

/08/2

001

2/20

/200

210

/28/2

002

07/08

/200

303

/12/2

004

11/18

/200

47/

29/2

005

04/07

/200

612

/14/2

006

8/24

/200

7

US High YieldEuropean High Yield

Phase 3 Phase 4 Phase 1 Phase 2 Phase 3

Source : Merrill Lynch data; Citi Investment Research

Immature Bull Mature BullEmerging BearMature Bull

Fed ease Fed tighter

Reduce leverage

Low volatility

Shocks

Use leverage

Bubbles ‘innovation’

LTCM Nasdaq/TMT ABCP

High Volatility

1

3

4 2Credit

Equity

Shocks

Fed ease

Can Private Equity deliver superior returns?

• Buy an asset at the right price

• Optimise the capital structure

• Optimise SCA• Sell an asset at

the right price

Where are we in the helicopter today?

Reflective of where we are

Am I deep enough in the woods?

Where is my helicopter going?

Firm and Resource competences vary materially across the sectorControl mechanisms break down; political influences drive behaviour

Validate the environment

EV off 2x minimum

Probably not, so……..

Get in it for the long term; choppy ride ahead P3/P4

Given the environment what resources and capability gaps do I have?Re-evaluate past process and procedures – formal and INFORMALExamine existing portfolio deeplyExamine and change funding structure and investor type/diversifySeek consolidation opportunities +/or stretch business modelCreate sustainable funding structures - remove M2M/NAV dynamicsSocially aware/change Overtly communicate and manage PR Main stream not ‘secret, off-shore, barbarians at the gate’Apply double-loop learning consistently – remove culture from macro strategy

Meaning of life…….

• Always seek to understand the macro drivers in the financial system globally and its feedback into ‘your (industry/sector) worldview’

• Change or die …….(+ use a helicopter and seek to be informed yet intuitive for big bets)

• Remove ‘culture’ from ‘big bet’ decision process (monitor always)

• Get lucky, cash out at the top and go to the beach…….• Stay on the beach, re-invest at the bottom but get private equity

(alternative asset) fund managers to do the work for you……..(for above average index returns)

• Q&A………………

Private Equity: Is the bubble about to burst?

Economy & Finance

Transcript of Private Equity: Is the bubble about to burst?