Private
equity sector witnesses increase in LBO activity
September
30, 2002
By
Ketaki
Sood, Larta Research Economist
Wendy
Hall, Larta Staff Writer
The
private equity industry has witnessed tremendous growth
since 1991 and though it has recently hit a lull, there
are indications that the industry is finally picking up
with an increase in leveraged-buyout (LBO) activity. In
quarter two of 2002, not only was there an increase in deal
flow, but deal sizes increased as well. LBO firms achieved
$5.5 billion in deals in the second quarter of 2002, compared
with $3.9 billion in quarter one the same year, and $3.8
billion in quarter four of 2001.
The number of deals increased in the second quarter of 2002
to 52, up from 34 deals made in quarter one of 2002, with
the largest number of deals being made in the manufacturing
sector, followed by technology, telecommunications, and
media. Although lower than the record level of investments
of $77 billon in 1999, leveraged-buyout investments are
showing signs of recovery and strength going into 2003.
"Part
of what's going on in the private equity industry is obviously
affected by the down economy," says Garrick Ahn, of
Caltius
Private Equity, who will be speaking at the October
8 Larta Economic Research Briefing on private equity.
"When you have less people willing to loan you money,
you have to put more of your own money up, and therefore
the return goes down. If the banks aren't out there loaning
as much, you are probably not going to get a good return,
so essentially that took a lot of liquidity out of the market,
which prevented many deals from happening in 2001."
In an LBO, investors buy a company with borrowed money,
which can be a mix of loans and bonds, where the company's
assets serves as collateral for the purchased firm. The
leveraged buyout of a company with little use of the investor's
own capital can result in spectacular returns. An LBO can
increase firm profits by exploiting arbitrage opportunities
and reducing operational inefficiencies. The opportunity
for arbitrage exists when the sum of the parts of the firm
are worth more than the firm itself in which case profits
can be made by selling parts of the firm. Reducing operational
inefficiencies within the firm by for instance restructuring
or downsizing can also lead to profits. LBO's, which involve
large amounts of debt financing, also result in an increase
in the rate of return (return on equity) to compensate for
the increased risk associated with increases in leverage.
In recent years, skyrocketing share prices kept LBO'S out
of large corporate acquisitions, which were financed by
equity rather than debt, limiting LBO sponsors to small
companies and divisions. Even when share prices fell once
the recession set in, the pessimistic economic climate dissuaded
banks from providing loans for LBO's, with lower chances
that debt repayment would come from company profits. For
investors who were used to putting up less cash and borrowing
more in an acquisition, raising funds became more and more
difficult. Buyers were unable to come up with sufficient
equity and with banks hesitant to finance such deals via
loans, things didn't look good for the LBO market. Recently,
however, the deal market has made a comeback with dollar
volume of deals surging to $15.7 billion towards 109 deals
that have been completed or announced this year, compared
with 138 deals totaling $9.3 billion in the same period
last year, according to Thomson Financial.
While U.S banks are wary of providing cash for LBO's, money
for such transactions is coming in from outside the country,
with banks overseas trying to cash in on expanding their
businesses in the United States. Furthermore, as deal sizes
grow, investors are turning to the junk bond market to finance
their LBO's, a method that was adopted widely in the 1980's
in the takeover of several corporate giants. Just last week,
a $268 million dollar junk bond sale by ConAgra Foods Inc.
unit Swift & Co. constituted the financing of the $1.4
billion leveraged buyout of the company. Transactions such
as these are expected to increase as the high-yield junk
bond market strengthens and opens up. In a deal which will
be the largest since Kohlberg Kravis Roberts & Co.'s
$31.4 billon buyout of RJ Reynolds Nabisco in 1989, Qwest
Communications International Inc.'s phone book unit QwestDex
plans to sell up to $1 billion of junk bonds to help finance
its $7.05 billion takeover by two buyout firms.
Despite lean times, LBO sponsors are working together so
that they can work on bigger deals and with financially
constrained companies putting out their assets at low prices,
and conglomerates selling off their weaker divisions, there
is ample opportunity in the LBO market.
While deal flow is showing signs of picking up, the buyout
fund raising market declined for the second consecutive
quarter, failing to raise even $5 billion in new capital,
which the industry had surpassed every quarter from mid-1996
to the end of 2001. By the end of June this year, buyout
funds raised a total of $2.2 billion, $2 billion short of
the $4.3 billion raised in the first quarter of 2002, and
well below the $8 billion raised in the fourth quarter of
2001. With a decline in investments, private equity firms
are stocked with plenty of capital. LBO and venture capital
firms raised funds that exceeded investments by $51 billion
in 2001, increasing the amount of capital sitting idle to
$180 billion.
Investors don't have any incentive to invest in new buyout
vehicles as the money they have already invested is yet
to be put to use. There will soon be pressure from investors
on buyout funds to make investments or return capital.
October
8: Larta Economic Research Briefing, Future of the Private
Equity Industry
Larta's Economic Research Briefings are high-level luncheon
events drawing on financial executives and major investors
from the region's capital markets. Attendees gain insight/industry
intelligence from leading authorities on a wide variety
of significant and dynamic industries. Briefings will occur
monthly at Larta's offices. The first briefing, Future
of the Private Equity Industry, will take place on October
8.
more
information >
