The New Deal

Investments based solely on a leverage strategy, absent of significant operational improvements, are not only passé, but also unwise.

In a week where the ongoing buyout hoopla surrounding Dell continued to make headlines, another US IT business was put forward as an appropriate private equity target.

Wednesday's Lex column in the Financial Times made a case for the buyout of BMC Software, an under-performing Texas-based listed company whose products make IT networks run more efficiently. The main attraction, the FT said, was the division that makes software for mainframe computers, which apparently last year accounted for 40 percent of BMC's revenues but two-thirds of its profits (as opposed to the lower-margin distributed software business).

One logical play for a private equity buyer, the FT suggested, was to combine this mainframe business with that of rival Compuware, thus creating a $1.2 billion platform with an operating margin of about 60 percent. Said Lex: “Such an entity would have limited growth but could support significant leverage.” Moreover, the columnist added, the deal could easily be funded by selling all the other assets owned by the two companies to strategic buyers.

Friday Letter

Financially, the logic is sound. And five years ago, this kind of investment strategy would have been par for the private equity course in the minds of many managers (and their bankers). But in today's very different market, it seems like a peculiarly unambitious – arguably, even dangerous – thesis to be advocating.

It's partly an investor relations issue. In the last couple of years, without the cheap debt and rising market of the boom years, this kind of leverage-driven strategy has necessarily gone out of fashion. Instead, GPs have had to work harder for their returns, usually by developing their operational value creation capabilities – to the extent that this has become a sine qua non for LPs, who recognise that it's the best way of generating outperformance in a flat market. So it's tricky for a GP to admit to its investors that a new billion-dollar-plus investment is going to be in a low-growth business, for which its return expectations are largely predicated on cranking up leverage.

But there's also a broader issue. Much of the industry's reputational problem stems from pre-crisis deals where the buyer did very little but pile debt onto a cash-generative business – such that the eventual return was almost entirely leverage-driven. If a GP takes this approach to BMC and things don't go to plan, the critics will have a field day; the deal will be castigated as yet another example of a private equity owner piling on debt and adding no value (not a reputation that any GP wants, particularly in the current market). Since the FT presumably wouldn't shy away from such criticism should such a scenario arise – it certainly hasn't done so in the past – it's surprising that it appears to be advocating this sort of strategy for a GP now.

Of course none of this means that BMC won't pass into private equity ownership. But we'd wager that whoever does win out will do so not just because they have a juicy debt package lined up. What’s become clear is that the pre-crisis, leverage-driven strategies just don't cut it anymore, and a credible growth plan to make a company bigger and better has to be the (right) new deal.

PEI's second Operating Partners Forum: Europe takes place on 19-20th June in London and will address the challenges of value creation beyond financial engineering. For more details, click here.