The period of 2005 to 2007 saw a significant number of very large buyouts being completed at record multiples and with highly leveraged structures. At the time these deals epitomized what, ironically enough given subsequent events, was viewed as the “Golden Age” of private equity.
As we all know, the events following the collapse of Lehman Brothers fundamentally changed the outlook for, and general perception of, these deals. Still today, the large-cap and mega deals of this period, being seen as both over-levered and over-priced, are deemed by many as destined to disappoint and the large-cap segment is far from being the flavour of the month in the minds of the LP community.
However, a study by Skandia Life covering a significant share of all buyout deals with enterprise values above $2 billion that closed during the 2005-2007 period shows that, subject to the assumption that valuations of unrealised deals are on the whole reasonable, the outlook for these “Golden Age” deals is a lot less bleak than is commonly believed. The investments as a group have significantly outperformed public markets. The outperformance remains meaningful even if pre-Lehman exits are excluded. And far from exhibiting massive write-offs, while one third of the deals are held below cost, only one deal in 20 has been lost to creditors.
Furthermore, the data shows no evident relationship between leverage levels or price paid and subsequent performance. Rather, poor timing seems to be the key cause of under performance.
The sample in our study consisted of 121 separate deals with enterprise values of more than $2 billion that closed during 2005-2007. Based on input from multiple sources we believe that this constitutes around 70 percent of the relevant universe of buyout deals in the period.
Furthermore, the data covers more than 90 percent of the buyout deals posted by the 20 most active managers in this market segment during the period in question. Participants who agreed to be named in connection with this study include Apax Partners, Bain Capital, BC Partners, The Blackstone Group, CCMP Capital, Goldman Sachs, Kohlberg Kravis Roberts, Madison Dearborn Partners, Permira and TPG.
In addition, estimates based on publicly available information have been used to add Ferretti and EMI, two well publicised failed deals from this period that would otherwise not have been included.
It should be noted also that the study does not cover the rather limited number of large deals that closed in 2008, the reasoning being that the relatively short holding periods would make the analysis less relevant. The data underlying the study is current as of Sept 30 2010 and reflects third quarter valuations.
Assuming uniform investment amounts, investing in this sample would have, at constant currency rates, produced a gross multiple of 1.5x and an IRR of 11.8 percent. This compares to an IRR of -2.8 percent from matching investments and exits in the relevant public stock index, implying an annual average outperformance of 1450 basis points.
While market timing is clearly one of the levers available to a private equity manager, a case can be made for excluding those investments that were exited at the peak of the market. However, even when these pre-Lehman exits are excluded, the average annual outperformance is still 1150 basis points.
On an equity-weighted basis the outperformance is 730 basis points for the whole sample and 600 basis points if pre-Lehman exits are excluded.
One third of the deals are carried below cost. However, only 5 percent of the deals in the sample have resulted in permanent full write-offs.
High EBITDA multiples and high leverage levels are the most commonly mentioned reasons why large-cap deals from this period are perceived as likely to disappoint. Interestingly though, the data shows no obvious relationship between leverage or price paid and subsequent performance.
However, there does seem to be a relationship between earnings expectations at the time of investment and subsequent outcome. Our research shows that most of the currently challenged deals took place when earnings expectations were peaking.
A TALE OF TWO TIME PERIODS
Earnings expectations rose steadily during the 2005-2007 period and a clear pattern emerges when the deals are viewed chronologically. The average deal closed in the first 18 months of the period and still active post-Lehman exhibits a gross multiple of 2.0, whereas the average gross multiple for the subsequent period is 1.0. While differences in maturity might account for some of this gap, the correlation with peaking earnings expectations clearly points to poor timing being the key explanatory factor.
As most of the very large deals took place in the latter period, their performance lags that of the overall sample. However, when looking only at deals made in the last 18 months of the period, there is no meaningful difference between the performance of deals above $10 billion in enterprise value and those below.
Furthermore, the deals of the second half of the period – i.e. July 2006 to December 2007 – still manage to outperform the public stock market by 700 basis points annually on a uniform investment amount basis and by 200 basis points on an equity-weighted basis.
The key conclusion from this study is that, in terms of relative performance, the large-cap deals of the Golden Age have held up surprisingly well. Annual outperformance of public markets of, depending on your choice of measurement, between 600 and 1450 basis points is clearly a meaningful achievement in this environment. Given the operational and financial leverage inherent in many of the deals still remaining, one cannot help but ponder the possibility that, as GDP growth continues to recover, this market segment will continue to put distance between itself and the public markets. This is of course assuming that these companies can be successfully refinanced when the time comes and that the IPO market will be accommodating.
Given that around 80 percent of the deals in the sample are still unrealised, the conclusions in this study are highly dependent on valuations being, on the whole, realistic. It is, however, our impression from the large-cap focused GPs in our portfolio that valuations do largely stand up to scrutiny.
Clearly many mega fund managers got ahead of themselves in the euphoria of the latter half of the period and invested heavily at what proved to be the very top of the market. Still, these investments have so far outperformed the public benchmarks and it is not always clear why the average mid-market deal from this era of peak earnings expectations should ultimately meaningfully outperform its larger brethren. There is, however, no getting around the fact that the portfolios of many of the largest private equity houses are overly concentrated into this challenged period – and to a larger extent than is the case for their mid-market peers.
Overall, our take away from this exercise is that it would be wrong to conclude that investing in large-cap private equity could not provide attractive returns both relative to public equities as well as the private equity market as a whole going forward, assuming one picks the right managers to back. A stronger conviction of the merits of continuing to invest in large-cap funds will, however, require more proof in terms of attractive realisations, as the vast majority of large-cap buyouts that have been executed during the entire history of the private equity industry have in fact yet to be exited.
Adalbjorn Stefansson is head of buyout investments at Skandia Life, a Swedish life insurance company with assets under management of €30 billion and a target allocation to private equity of 10 percent.