Up for the challenge

Large leveraged buyouts and those behind them took plenty of flak during the financial crisis. Operators in the mid-market, for so many years eclipsed by the LBO firms in terms of the speed and magnitude of returns generated, finally felt they could glance up the deal size spectrum and say: “Ha! Your time is over and history will judge your investments to be over-geared and over-priced.” The media to a greater or lesser extent joined in with this baiting, holding up LBOs alongside investment bankers’ bonuses as totems of boom year excess. Likewise the ratings agencies pointed the finger, estimating that defaults on leveraged loans would soar to historic highs.

Björklund (left) and Lister: took issues head on

As one of the largest European headquartered firms in the private equity business – and the 16th largest in the world, according to this year’s PEI 300 rankings – Permira was in line for a share of the criticism. Having raised the €11 billion Permira IV fund – known as P4 – in 2006, the firm was both blessed and cursed with a very large pool of private equity capital ready for deployment into the precipitously rising market of the pre-crisis years. The firm invested more than €5 billion of P4 between 2006 and the end of 2008. When the crisis set in during the last quarter of 2008 the firm came out early with some big write-downs to portfolio company values.

Coverage of the decline in asset values was fuelled by the fact that Permira has a large publicly listed limited partner in the form of SVG Capital, and so the portfolio is considerably more transparent than many of its peers. While the market viewed the write-downs – through the vignette provided by SVG – as being dramatic, there is in hindsight a sense that Permira was ahead of the game in terms of realistically marking to market. One market source wonders if the firm was “a victim of honesty” in terms of writing assets down early and attracting the wider market’s scrutiny.

“That’s a very interesting question,” says Tom Lister, the US-based half of the management duo. He is sitting alongside Kurt Björklund, his London-based counterpart, in a minimalistic room in Permira’s London headquarters on Pall Mall. Lister explains that – for one thing – Permira has been valuing its investments in the same way since 1996: under the IPEV valuation guidelines, based on current earnings, current multiples and an illiquidity discount. “Secondly,” he adds, “this is a long-term business”, meaning that while investors are apprised of the marks on a regular basis, in the final analysis it is all about “what we monetise the business for at the end”. Put another way, what matters is the valuation on exit.

“So were we victims?” muses Lister. “No I don’t think we were victims, but I think we dealt with some issues that maybe not everyone in the industry chose to take head on.”

TRACK RECORD

There was a reason that the firm could raise €11 billion in 2006 and still turn would-be investors away: Permira boasts one of the industry’s strongest returns records. Excluding P4, the firm has generated a 32 percent net IRR for its mature buyout funds since 1997. It has realised gross returns of 2.5 times invested capital and has since inception returned €18.3 billion to investors. Its 2003 third fund, which raised €4.9 billion, is currently showing a multiple of more than 2x, according to public filings by limited partners.

However, a walk through the P4 portfolio – based on the most up-to-date SVG valuations available, which were published in June 2010 – shows this fund has a long way to go. These numbers, it should be noted, may marginally underestimate the value of the businesses. This is because of terms accepted when SVG opted to cap its ongoing commitments to the fund in late 2008, which meant that SVG would only see 75 percent of any upside to its existing investments. Nevertheless, the numbers point to some deep unrealised losses. Hugo Boss and Valentino Group, the global fashion business Permira acquired in May 2007 for €5.3 billion, was as of June valued at 54 percent of its cost, according to SVG’s report. Arysta Life Science, a Japan-headquartered agrochemical company acquired in February 2008 for €1.9 billion, was valued at 60 percent of the cost. For Freescale Semiconductors, a stake in which Permira acquired in a $17.6 billion club deal in November 2006, the figure was 32 percent. For ProSiebenSat.1, the Germany-headquartered media group acquired in 2007, the figure was 18 percent.

Despite these paper losses, the recent performance of the underlying businesses is – as the firm is working hard to communicate to investors and the wider community – giving reason for optimism. Björklund points to promising figures for the portfolio as whole, with revenues in the first half of the year up 11 percent compared to the previous year, and EBITDA up 23 percent.

P4’s 20 percent stake in China-headquartered casino operator Galaxy – for which it paid €593 million in 2007 – had been firmly on the “casualty” list of boom time investments after it saw its publicly traded shares drop in value as low as HK$2.56 (Permira had bought in at HK$8.42 a share). The strength of the business is, however, starting to be reflected in the share price. In its results for the first half of 2010 the company reported year-on-year revenue growth of 61 percent and EBITDA growth of 91 percent. A recent note from analysts at UBS described the company undergoing a “major transformation”, with a new resort scheduled to open in 2011 to turn the business into a “major operator” in Macau. As of press time the shares traded at HK$6.86.

In mid-October Hugo Boss announced it would upgrade its top and bottom line expectations for 2010, with EBITDA expected to grow by around 20 percent and net sales to increase by 5 percent. ProSiebenSat.1 recently unveiled increases in revenue and earnings growth of 9.6 percent and 31.1 percent respectively year-on-year. Freescale’s revenue in the second quarter was up 35 percent year-on-year.

REPAINTING THE PICTURE

Björklund  reflects on this crop of investments: “The likes of Galaxy and Freescale, which from the outside if you went back nine months looked like they might not be successful… today the outside world has accepted, acknowledged and absorbed what our deal teams knew some time ago,” referring to the strong market positions and strategic value in the companies.

Also among the early P4 investments is Provimi, a global producer of animal nutrition products acquired in 2007 in a €1.7 billion transaction.  The business was – as of SVG’s June numbers – valued at 121 percent of its transaction costs. In September it released first half figures for 2010 showing profit growth of 31.9 percent year-on-year. More recently it agreed to bolt on a complementary Mexican business.

Furthermore, there is the “post-recession” portfolio, as the co-managing partners describe it. For many reasons 2009 was not an easy year to put capital to work, as evidenced by the 40 percent drop in global private equity buyout activity compared to 2008, according to Mergermarket data. During ‘09, however, Permira invested around €1 billion in equity. Its investment in the $3.7 billion take-private of Nasdaq-listed technology business NDS, for which it joined forces with News Corporation was, the firm believes, the largest single capital call in Europe during 2009. It was made just months after Permira had allowed limited partners, in light of individual LP liquidity concerns, to cap their commitments to P4. Fewer than 10 percent of the LPs opted to take up the offer, shrinking the size of the fund from €11.1 billion to €9.6 billion. Permira was the first firm to make this pioneering move, before other large firms including TPG and Sun Capital Partners followed suit . Later in 2009 the firm changed P4’s terms, so that carry would be paid on a fund-as-a-whole basis rather than deal-by-deal and that all transaction fees would to be paid to the fund.

In September ’09 Permira agreed its second take-private of the year, and its first all-equity deal, in the shape of Just Retirement, a UK-headquartered company which sells financial products to people approaching or in retirement. The business recently announced record annual results, generating sales of more than £1 billion (€1.1 billion; $1.6 billion) for the first time in its history.

More recently the firm has acquired eDreams, a Spanish internet travel bookings business, and Creganna-Tactx Medical, a medical technology company, from Altaris Capital Partners.

As well as the upside promised by the “post-recession” investments, P4 still has around €2 billion in dry powder, which again should give LPs some cheer.

REPAIR WORK

Björklund and Lister refuse to be drawn on where they ultimately think – or hope – the fund will end up: understandably so, given the broad range of variables at play, such as the recovery of the early investments, the more recent ones and the performance of the unspent capital. Limited partners in the fund say they are expecting – based on information received from Permira to date – returns in the region of 1.5 times their money for the fund, although one LP admits this looks like a “challenge”. The message from the top is undeniably upbeat. “There is a lot of potential carry in P4 which we are working very hard to deliver on. We’re quite optimistic we will deliver on that,” proffers Björklund.

Large buyouts from the boom period in general, Björklund elaborates, were too quickly and erroneously condemned to fail by observers and commentators. When, for example, it was written that 10 big LBOs would go bust, it was “not completely indicative of how things were”, he says.

“There was a lot of flexibility in these capital structures,” Björkland asserts. “There was the ability to attract great management teams to the businesses and if you look at the management we have in the businesses

There was a lot of flexibility in these capital structures.

Kurt Björkland

today and you stack it up to what they had four or five years ago, there are very high-quality, talented people.”

The private equity governance model, he says, has always been a responsive one and, as a result, any issues Permira businesses have had with capital structures going into the crisis have been addressed. “I think we were able to do some ground-breaking stuff in the midst of the recession in terms of debt exchanges, buying back at a discount, and resetting covenants and resetting maturities throughout the portfolio … to the extent that today the balance sheets in the portfolio actually look a lot more attractive than they looked when we were heading into the recession.”

He points to Cognis Group, a chemicals and nutritional ingredient company. Among the measures taken to shore up the balance sheet, Permira used cash from the sale of non-core assets to buy back debt in the business at between 50 and 75 cents in the dollar. “And now 18 months later we’ve sold the business at a very significant premium and a big profit for us,” he says. Cognis, which was an investment in Permira Europe II, was sold in June this year for €3.1 billion.

Switching his focus back to the more general view of large buyouts, Björklund adds: “I think somebody at some point is going to write this story: that what people thought might happen actually turned out to be less dramatic because of how people across the businesses and the owners of these businesses responded.”

BAPTISM OF FIRE

The last two years have been something of a baptism of fire for Björklund and Lister, who took over the joint-leadership of Permira from Damon Buffini in late 2007. Buffini, having led the firm since 2000 and become an increasingly prominent figurehead for the firm and industry as a whole, shifted roles to chairman. He currently sits on the boards of two portfolio companies and is soon to take up a seat on another.

“We figured out a balance of how to split things up fairly early on,” says Lister. It’s a “functional split”, he says, with Björklund responsible for the people and the portfolio in the first instance, and Lister for finance, financials and risk.

When asked whether the two ever thought they had bitten off more than they could chew in taking over at such a challenging time, Lister says: “We knew that it was difficult, and it would get increasingly difficult, but I don’t remember a day when we got up and thought ‘Gee – why are we doing this?’”

Likewise, Björklund says he relished the challenge. “There is no better way to learn how to run a business like this than taking it through a proper crisis, provided you have the right support from the deep bench of partners that has been running for 25 years and have seen things like this happen before. Was it tough? Yes. Are we up for a challenge as people and as a firm? Absolutely.”

One significant challenge faced by the new team related to Pemira’s investment in Hugo Boss. Earlier this year, Hugo Boss’ management came under fire from US labour unions, as it mulled the closure of a production facility in Ohio. What was first and foremost a dialogue between Hugo Boss’ management and the representatives of the workforce became more complicated when local public pension funds from within Permira’s investor base began to raise concerns directly with the private equity firm.

In March Permira received a letter from the $50 billion Ohio Public Employees’ Retirement System, saying it may have to re-think its relationship with the firm. The $219 billion California Public Employees’ Retirement System also wrote expressing concern about the plant closure. Soon after this, the Pennsylvania State Employees’ Retirement System added its voice to the debate.

The issue raised some interesting questions about the stewardship of public pension money: how should limited partners react if a portfolio company owned by one of their fund management partners makes a decision – based purely on cost-efficiency – that will lead to up to 400 job losses for citizens in the pension’s jurisdiction? And how should they, let alone the GP, balance being a good corporate citizen at the local level with what may be financially sound for an investment on a global level, longer-term?

Lister says he is satisfied with the way Hugo Boss’ management handled the situation, but declines to comment on the issue in detail. After 12 months of dialogue between the company’s management and the unions, a solution was reached that allowed the plant to continue life in Ohio with changes to its benefits and remuneration packages.

For Björklund and Lister’s part, the issue meant increased investor relations duties: calls with LPs in which questions were asked, communications sent out and one-on-one discussions. Lister describes it as a “very good model” for how they would handle a similar situation in the future, although he caveats that he would prefer not to have to.

TOUGH DEAL MARKET

Despite the firm’s relatively healthy investment pace during 2009 and 2010, Björklund says now is still a difficult time to deploy private equity capital. “Two reasons for that,” he explains. “One is that there is a large amount of uncalled commitments, so there is a lot of money chasing deals. Secondly, the macro outlook remains hazy at best.”

“Transparent assets that are marketed effectively will attract very high prices and therefore low equity returns,” adds Björklund.

He then outlines how the firm is currently seeking to deploy capital in this high-competition, low-visibility environment. Current investments fit into three categories, he says: high growth – he uses the recent acquisition of Asian Broadcast Satellites as an example in this category; consolidation plays – as evidenced by a recent €805 million bolt on by frozen food business Birds Eye Iglo; and recovery plays – businesses which have “hit the bottom” and are likely to see an upside even in a modest recovery environment.

In terms of attractive geographies, there is no singular hotspot for the firm at the moment, says Björklund. “We have never gone for a top-down allocation for the fund” he says. “We have 10 offices around the world investing and what we look to do is empower people to go and find deals and then we look at what comes up from that.”

If, as some market participants suggest, the private equity market is starting to undergo a bifurcation in its development – with giant, multi-disciplined asset management institutions at one end of the spectrum and smaller, sector- or country-focused specialist private equity funds at the other – where does Permira fit into the picture? Björklund says the firm will stick to making private equity investments in “sectors and geographies we know well”. “We have a focused integrated business model and that has worked well for us over the past 25 years. We are private equity specialists not asset managers.”

The establishment of a debt management business – Legico – is not indicative of a diversification into other asset classes, says the duo. Instead it represents a relatively small investment – made with equity from P4 – in a business, says Lister, which has the opportunity to generate “very attractive returns for P4”.

“We believe that private equity is a great model and it is what we are best at,” Lister continues. “We have made a conscious decision to focus our efforts on where we have been successful: offices, sectors, geographies. The strategic relevance of the debt business is quite clear to us and the business has actually done fairly well through the downturn.”

A separate debt fund is not, however, currently on the agenda. “We will continue to look for opportunities that we would broadly define as structured credit opportunities,” says Lister. “We think of it as a strategic business that’s ancillary to what we do and if we can find other situations or other market opportunities to invest money – both our own capital as well as our investors’ capital – we would think about doing that.”

Turning to the future, it is clear that – with around €2 billion remaining of a €9.6 billion fund – the prospect of fundraising is drawing ever nearer.  Björklund and Lister would not be drawn into a conversation on how large a Fund V potentially could be, although Björklund does note that the amount of capital available for the next round of fundraising will be smaller, so the firm will be fighting for a slice of a reduced pie. Indeed, a highly unscientific straw poll of market sources – both investors in Permira and outside observers – confirms that it is simply too early to speculate. When pressed to make a prediction, guesses ranged wildly and all were heavily caveated pending the ultimate performance of P4.

The general consensus was that “quality breeds quality” in terms of the team. One LP draws particular attention to the quality of the firm’s investor communication throughout the financial crisis: there has been “no hiding” and everyone has always known where they stand (This year the firm has started sending video updates from Björklund and Lister on significant events for the firm and the portfolio). This will surely count in the firm’s favour when a new fund (which, all market sources agree, will be smaller) comes to market.

In many ways Permira is at a defining period of its development.  Much hangs on recovering value from the early investments in its current fund. The better this challenge can be met, the more prosperous the firm’s future is going to be. More broadly , it may also help vindicate the large buyout model.