When GPs go clubbing

Club deals aren't new in private equity. Venture capitalists practically always form consortia when funding early stage investments in order to modify risk. Buyout shops on the other hand used to be much less likely to partner with their peers. During most of the 1990s for instance, when risk was low, debt cheap and markets rising, there was hardly any need for financial sponsors to join together in syndicates and share the spoils with others. This has changed. Clubbed buyouts are on the rise. According to data compiled by Capital IQ, the New York-based solutions and information provider to financial professionals, 34 per cent of global buyout transactions completed so far this year had more than one equity sponsor participating. The analysis shows that syndication has been steadily increasing ever since 1999, when a mere 13 per cent of all buyouts were clubbed.

This increase is often said to worry limited partners investing in large LBO funds who allegedly fear this may reduce the level of diversification built into their private equity portfolios. However, quizzing the buyside about how concerned they really are about this issue reveals that fewer than expected LPs at present see this as a serious problem. As our brief poll of both investors and GPs reveals (see page 34 of this issue), the GPs we spoke to were actually more concerned than the LPs that club deals compromised a fund's ability to manage its own destiny [and performance). And the LP participants in our recent LP roundtable held in New York (see page 36) shared the view that although a deal's syndication can lead to greater exposure to any one transaction than an investor in buyout funds might like, private equity portfolios as a whole should be constructed in such a way that they can absorb this potential counter thrust to diversification.

Moreover, many investors in private equity appreciate the benefits that teaming GPs can achieve, for instance during an auction. ?Club deals tend to take competition out of the bidding process, which typically helps the return profile of a transaction,? says Eric Hirsch, chief investment officer at Hamilton Lane. Others point to a due diligence-related advantage: when two competent GPs co-invest in a buyout, the chance that both miss a major problem prior to the syndicate going ahead is small. (No research as yet has been carried out as to whether there is actually a performance differential between large buyouts funded by a single general partner against transactions backed by syndicates ? but watch this space.) And individual members may bring different types of skill to bear on a deal, boosting a consortium's prospects of adding value to its investment.

However, what limited partners do fret about is for a private equity syndicate to fail to emphatically determine who runs the deal and, subsequently, the investment. As one LP invested in several large buyout funds puts it: ?It's critical that there is someone driving the bus.? Not only is exercising control over the purchased assets what private equity investors are essentially paid for, more often than not it will be the effective use of this control that makes the difference between success or failure of their investments.

The presence of more than one equity sponsor in a deal inevitably makes the co-ordination of strategy and its implementation vis-à-vis a portfolio company's management more complicated. Tellingly, the majority of the LPs we polled cited this as the main drawback when a fund participates in a club deal: the ability to influence the development of acquired company is reduced. In most cases it is the general partner with the most capital in a transaction who is in charge. But when there is more than one lead investor, things can quickly become unworkable, not least for logistical reasons, especially when the deal starts going sideways. The 1998 joint buyout by Kohlberg Kravis Roberts and Hicks, Muse, Tate & Furst of Regal Cinemas (see the accompanying boxed item) is often cited as an example of a situation where two joint lead sponsors didn't see eye to eye on how to run the deal, which did little to help them rescue their investment. ?Talk to either of the firms about what went wrong at Regal, and you'll get a lot of finger pointing,? comments an LP familiar with the situation.

General partners are in little doubt as to the risks that come with being in a consortium, particularly if the terms aren't right. Therefore keeping the number of equity providers involved in a deal as small is a common objective. Capital IQ's analysis shows that of all club buyout completed in 2003 to date, 73 per cent had two sponsors, 25 per cent three and 2 per cent more than three. In 1999, although only 16 per cent had three sponsors, 9 per cent of all syndicates had more than three sponsors. The typical club deal it seems is the double-team.

A venture tactic in buyouts
GPs will do well to habitually put into place such checks and balances (see also Questions to ask before you join a club, p.30), because private equity syndicates are here to stay. Practitioners expect a flurry of very large buyouts to occur going forward, but debt capital is likely to remain scarce, forcing GPs to reach deep into their funds for equity. But the evidence garnered in recent years has demonstrated to GPs that contrary to beliefs held during the go-go years, it is in fact possible to lose money in large LBOs. As a result, sponsors are keen to keep a lid on the amount of equity they commit to any one deal. Their fund agreements also put a cap on the equity commitment (usually 20 per cent) they can make to any one transaction. Risk is a much greater concern for GPs nowadays, and venture-style spreading of bets has become more common. As one investor puts it: ?It's a smart response to history.?

To give an example of this new conservatism at work: in 2002 Blackstone, investing the largest buyout fund raised to date with $6.45bn in commitments, completed the $4.725bn buyout of TRW Automotive from Northrop Grumman. After Carlyle had pulled out of what was originally planned as a club deal ? last minute changes to who's in and who's out of a consortium are not uncommon ? the firm was the sole equity sponsor in the transaction with an initial commitment of close to 20 per cent of the fund. Blackstone then sold on a portion of the equity, partly to the vendor, partly to a number of limited partners, in order to scale back its exposure to TRW so as to avoid what it regarded as a significant franchise risk for the firm.

What the bundling up of GP resources to invest in mega-buyouts means for the buyside is that the industry's pace of investment is likely to accelerate. As one LP observes: ?It's way of cycling in faster, of putting more capital through the system over a shorter period.? As a result, GPs are likely to resume fundraising earlier than they otherwise would have. Perhaps that's the less obvious legacy of the large-scale club deal: more funds putting more money to work more quickly. And it's then up to investors to decide whether they have the appetite for more buyout exposure quite so soon.

No joy at the movies
Kohlberg Kravis Roberts (KKR) and Hicks, Muse, Tate & Furst clubbed together to go to the pictures in January 1998 hoping for the summer blockbuster but instead left empty-handed.

Some observers argue that the two firms' $1.5bn buy-andbuild investment in Regal Cinemas was an object lesson in how not to do a club deal, citing the fact that the management of the cinema chain remained in place after emerging from Chapter 11 as evidence that the firm's earlier decline should instead be attributed to the buyout firms. It is notable too that people close to the transaction make the point that members of Regal's management became adept at playing the two private equity houses off against one another. Crucially, such interpersonal dynamics can become major issues when market conditions are deteriorating, and after the deal was done, Regal certainly seemed in the wrong place at the wrong time. Comments one LP invested in the Hicks, Muse fund involved: ?It was a bad time to invest in cinemas. There was extreme over-building, which led to massive over-capacity. The product from Hollywood was terrible. Regal was just one of a number of chains that filed for bankruptcy in a short space of time.?

After making a net gain of $25m in 1997, Regal lost $73m in 1998. It spent millions in 1999 to add over 800 additional screens, ranking it number one in the US with over 4,000 screens at 400 locations. But in the first nine months of 2000, it lost $167m. When the curtain dropped, Philip Anschutz, the Denver billionaire drove a coach and horses between the equity partners, buying up Regal's debt alongside distressed specialist Oaktree Capital at a knock-down price. Regal's management team led by Michael Campbell, the company founder, backed Anschutz while the two equity houses argued over strategy. Their equity was written off.

Perhaps Regal highlights the number one concern that limited partners have with consortia deals: control. Who is holding the reins; who has the CEO's ear? KKR and Hicks, Muse each had a 46.1 per cent stake in the company and an equal number of board seats. Ponders one of the LPs involved: ?Did they have to consult each other before they could make a move? Would they have changed the management if they'd been the only firm in this deal??

The experience has not left KKR or Hicks, Muse fighting shy of club deals though. Both have gone on to participate in massive consortia transactions: KKR bought into Europe's largest ever buy-out in the €5bn buyout of Legrand alongside Wendel Investissement last August. And Hicks, Muse meanwhile teamed up with Apax Partners to acquire the yellow pages directory publisher Yell in a £2.2bn buyout from British Telecom in 2001. But the two firms have not joined forces again since Regal.