As we look back at the dreadful deal environment of 2008, we wonder what’s in store in 2009 and beyond? What did we learn, if anything, from our battle scars? When will we return to the good old carefree days of private equity?
Actually, my hope is never! What we saw in the so-called “golden age” resulted from a total abandonment of the great principles of private equity investing. Originally the landscape was created to operate as follows: Take an investment, provide it with capital and expertise to grow revenue and operate more efficiently, and ultimately sell it into a market that will appreciate the fruits of your efforts.
The perversion came when it was all about: buy something with as little equity as possible; look for EBITDA multiple expansion; and flip it and move on. Like the tulip craze in the seventeenth century this relied on a giant amount of collusion amongst buyers, sellers, capital providers etc.
I have heard many suggest that if only the mortgage market had not collapsed this could have gone on forever. Do you really think so? If so, you believe that the right amount of leverage is the highest leverage anyone will give you not the safest amount of leverage your company can bear. If so, you believe that those pesky covenants that did not go away entirely in the middle market, and that “so yesterday” debt service (as opposed to PIK toggle) was the only thing that stood in the way of your company weathering a recessionary environment. Straitjacketing a company at inception and crossing your fingers requires no genius but a whole lot of luck.
What does history tell us about somewhat similar strategies? In the sixties, the age of the conglomerates, strategic (or not so strategic buying was all the rage). Sheer size was the measure of financial prowess.
Conglomerates such as the famous Ling-Temco-Vought (LTV) became the predecessors of the more recent buyout strategists. There was no thought given to managing a business so long as the market would value “the buy” and the lenders and shareholders would comply. In the late sixties, LTV owned 33 companies in a wide range of industries. Eventually investors figured out that not much was being done to improve the businesses and there was a rather rapid and painful abandonment of this model.
Today, the over-leveraging of private equity acquisitions with the thought of a quick flip has surely been proved to be flawed. peHUB’s Erin Griffith reports that in 2008 there were 49 PE backed bankruptcies – a number that would be larger if hedge fund deals or PIPEs were included. To provide some context, the number in 2007 was three and it is widely expected that 2009’s number could well exceed that of 2008.
What do the vast majority of these deals have in common? Perhaps they cluster around an industry or two that just wasn’t the place to be in 2008. Well, eleven were in retail and eleven were in automotive: bad luck, bad timing for sure. Nonetheless the most pervasive reason for failure cited was “unable to service debt,” “inability to service heavy debt load,” “lack of liquidity” and, most telling to me of all, “unable to service interest payments.”
How were the bank and investment bank underwriters this level of stupid? In most cases these were deals that were not club deals where the underwriters held exposure, but rather deals where the underwriters ascribed to the mantra, “we are in the transportation business, not the storage business” and so long as we can sell the sucker, grab our fee, we will do so. Why does what happened in these larger syndicated deals matter to the middle market? Well, no surprise, they set the tone that lead to the rather erosive loosening of underwriting standards throughout the market.
Deals were no longer evaluated on historical EBITDA. Pro-forma next year, (fully adjusted excluding special charges and adding full synergies) became more and more the model. No recession was typically modeled in or perhaps a rather benign one, just enough to get past respective credit committees. Loan agreement terms were up for grabs, and purchase and sale agreements became entirely too seller friendly.
So have we learned? I wish I were absolutely positive that the answer was a resounding yes. There is so much to be gained by the old fashioned rules. Typically companies are made stronger; typically this leads to overall revenue growth which leads to jobs and a healthier economy. Investing for the long term allows decision making that benefits companies and helps managers avoid strategies that are aimed at the next earnings announcement.
Yet, I am fearful that lenders memories will be too short, that deal doers will succumb to the scrum of the market and start to bid up again, and that although the overall picture may never reach the scale of lunacy that we saw in 2007, that bad behavior will creep back into the picture.
Yet, in the here and now we can say with some certainty that not many “levered piggys” will be going to market anytime soon. We can also wish that perhaps, just perhaps, we will learn this time.
Gail Long is CEO of ACG Boston, a chapter of the Association for Corporate Growth. She previously was an Executive Vice President of specialized banking at Citizens Bank of Massachusetts, and, previously President of Citizens Capital, that company’s $500 million private equity subsidiary.