Let go of the past

The vintage year 1998 was supposed to be a great one for US private equity investors. There was an abundance of quality companies being sold and the financing markets were aggressive.

However, assets that appeared attractive and promising during the market exuberance of the late 1990s have not aged well over time. Fast-forward five years, and investors find themselves holding not a fine vintage, but in most cases, sour grapes.

Based on analyses of industry sources, a 1998 investment in a typical $500 million (€400 million) buyout transaction is today worth only eighty-five cents on the dollar. Not surprisingly, percentage return expectations for 1998 vintage investments are in the low single-digits.

Faced with such limited prospects, the investors of the late-1990s bubble must confront a perplexing dilemma: should they sell their investments today and redeploy capital in a market that is showing signs of momentum, or should they hold and hope that their investments will recover?

THE 1998 HEYDAY
At the peak of the market, over $30 billion in equity was invested in buyout transactions. Buyout funds could hardly invest money fast enough to keep pace with the more than $180 billion of LP capital that was committed to their funds in the 1998 to 2000 timeframe.

With the US economy in good health and the financing markets eager to provide capital, the buyout sector became flush with buyers anxious to capitalise on the market's positive momentum. Lofty multiples benefited sellers who demanded rich valuations for their optimistic earnings projections. In fact, purchase multiples peaked in 1998, with the multiple paid for a middle-market ($100 million to $250 million) deal and large market (more than $500 million) deal averaging 6.91 times EBITDA and 7.93 times EBITDA, respectively. With ample leverage available, the average percentage of equity contribution was 31.6 percent, according to Portfolio Management Data (PMD).

Of course, buying a company is the easy part. Turning an acquisition into a profitable investment is the challenge. And it certainly was difficult for most investors in the years that followed. A combination of unforeseen factors in the early 2000s ranging from the bursting of the Internet bubble to the tragic events of September 11th converged to create a storm that proved difficult for many companies to ride out.

However, companies that survived are finding an improved operating environment today. With the economy recovering and strong liquidity returning to the financing markets, 2003 has seen a resurgence in buyout activity. Purchase multiples have recovered from their 2001 lows. As of 2003, the purchase multiple for middlemarket deals and large market deals averaged 6.33 times EBITDA and 6.89 times EBITDA, respectively.

While the picture in 2003 appeared rosier, does it mean that investors of the late 1990s can finally expect to see a return on their investment today? The answer depends on the size of the transaction that was completed in 1998. A typical LBO deal can be recreated using certain assumptions derived from industry data sources to determine the return of capital for both a hypothetical large and middlemarket transaction.

Based on PMD industry data, assume that a large-market deal was completed in 1998 for $500 million at the 7.93 times EBITDA average purchase multiple, and total leverage of approximately 5.5 times EBITDA, as consistent with financing levels at the time. Similarly, assume that a middle-market deal was completed in 1998 for $175 million at the 6.91 times EBITDA average purchase multiple, and total leverage of approximately 5.0 times EBITDA. Equity contribution in both cases is 31.6 percent, per industry averages for 1998.

To determine the value of the invested dollars today, assume the average exit multiple of 6.89 times EBITDA for the large market deal and 6.33 times EBITDA for the middle-market deal. To derive an exit EBITDA in 2003, the corporate earnings stream of the national industry (as provided by the National Income and Product Accounts (NIPA) can be used as a proxy to generate an EBITDA growth index for the hypothetical large and middle market buyout company. According to the national earnings data, the average EBITDA dipped to 94 percent of the 1998 level in 2001, before returning to 111 percent of 1998 levels in 2003.

The conclusion? The average equity dollar invested in a 1998 large-market deal is worth only eighty-five cents on the dollar today. Even though EBITDA grew by 11 percent relative to 1998 levels, valuation multiples in 2003 remained a full multiple below the 1998 peak level. Additionally, large buyouts were so highly levered to fund the lofty valuations at entry that the debt pay-down has not been sufficient to provide a full recovery of equity investment.

By contrast, investors in the typical middle-market transaction fared somewhat better. Valuations for middle-market deals have recovered to within one-half multiple of the 1998 peak level. As a result, the average equity dollar invested in a 1998 middle-market deal is worth $1.19 (or a 3.5 percent 5-year IRR) today, indicating that average returns are single digit at best.

TO SELL OR NOT TO SELL?
It comes as no surprise that investments made during the bubble of the late 1990s have lost value. Today, at a time when investors should be seeking a return of capital, they are instead holding onto their investments in hopes that a further market recovery will allow them to recoup the full investment value.

However, the “hold and hope” strategy underestimates the scope of the recovery needed to surpass single-digit IRRs. Even assuming that valuations improve another one-half multiple over the next couple of years, to achieve a 20 percent net IRR in a typical 1998 large market ($500 million) deal, the absolute EBITDA growth would have to reach 113.2 percent (or 46.0 percent CAGR), an astronomical number. Similarly, investors in a typical 1998 middle-market ($175 million) deal need to achieve absolute EBITDA growth of 100.2 percent (or 41.5 percent CAGR) over the next two years to garner a 20 percent net IRR. Keep in mind that even in the strongest of economic growth during the mid-1990s, the average EBITDA CAGR was no more than 12.5 percent.

Given the remote possibility of achieving double digit returns on 1998 investments, it would make sense for investors to sell their older holdings today in hopes of redeploying capital in a buyout market that is showing increased momentum. Motivation for sellers differs by investor class.

For financial sponsors, capturing current market values on 1998 and 1999 vintage funds allows them to return capital to their limited partners, and most importantly, free up valuable firm resources currently dedicated to low yielding investments. The avoidance of this “opportunity cost” further benefits GPs and LPs alike as sponsors' resources can be redirected to new, high-return investment activities.

For institutional investors in the buyout sector during the 1998 heyday, gaining liquidity on private equity investments allows them to pursue asset reallocation strategies in light of stronger reserve requirements and more stringent regulatory and auditing standards.

For corporations that embarked on acquisition sprees during the late 1990s, divesting non-strategic or nonperforming assets allows them to concentrate on core businesses as well as gain liquidity for debt pay-down.

The market for selling direct investment portfolios, while still in its infant stage, is expected to gain momentum as more investors of the late 1990s bubble decide to liquidate rather than invest additional resources into investments that may produce only marginal incremental dollars. With the private equity market gaining strength, investors who sell and redeploy their capital today may just have a chance to turn their sour grapes … into champagne.

Joseph Haviv is the managing member of Protostar Partners, a New York based middle-market leveraged buyout firm dedicated to acquiring portfolios of direct private equity investments. Protostar targets transactions ranging from $50 million to $250 million in equity value. He may be reached at joe@protostarpartners.com.