In December 2006, THL Capital co-president Scott Schoen gave a keynote speech at the Yale SOM Private Equity Conference. In it, he laid out what I began to refer to as the LBO Win-Win Model. If debt continued to be cheap and readily available, buyout shops won because they were able to buy outsized targets with someone else’s money. If debt became more expensive and scarce – a situation Schoen acknowledged was forthcoming – then LBO firms could benefit because acquisition target valuations would drop (particularly given that most firms would have lots of dry fund powder).
In other words, it would be a return to the days of buying low and selling high, as opposed to the 2006 strategy of buying high and selling higher.
Schoen’s model sounded reasonable at the time, but he clearly did not anticipate the credit markets seizing up to the magnitude which they have (not blaming him, very few saw this coming). So I’ve spent the past few days talking with buyout pros not only about the Win-Win Model, but also about the more fundamental question of LBO market viability. After all, don’t LBO firms argue that it is the very use of leverage that enables them to outperform public market indices? If they become glorified PIPE shops or focus on all-equity transactions (like Neuberger Berman), how do they still justify 2 and 20? In short, are we only left with BO once the L is removed?
The answer, I’m told, is that you’ve gotta have faith. Not faith in individual investors or firms, mind you, but faith in the economy at large.
“Our bet is that the markets and economy will grow over the next five years, despite the troubles we’re having today,” one senior private equity investor told me. “It usually does, and our fund structures give us the flexibility to wait it out.”
It’s true that the private equity industry has a special ability to handle economic downturns, because of its long-term nature. An investment can be written down 80% today and ultimately produce a positive return without much intervening pressure to liquidate. There are obviously exceptions – namely portfolio companies that can’t service their debt – but playing macro market cycles is a big part of PE investing.
Such an argument is mostly about monetizing past deals, but I also hear faith when it comes to the credit markets reopening.
“The verdict is in, and we now know that the deals done over the past few years rested on debt that was titanically mispriced,” says another senior LBO investor. “So the credit markets won’t look like that again in our working lifetimes, but buyouts were a very good business for a long time before the excesses of 2006 and 2007, so I’d guess that the credit markets will come back to a baseline level.”
That’s not quite predicting future nirvana, but still has the effect of discounting the impact of current market conditions. As such, it largely makes Schoen’s Win-Win Model irrelevant (even though the end result of “win” remains intact).
Unfortunately, I can’t accept either verdict. First, faith is just not an acceptable strategy for folks managing billions of someone else’s dollars. History is not always a good indicator of future performance, as shown by the Dow closing lower on Monday than it did on the day of President Bush’s inauguration eight years ago. Second, the Win-Win Model simply does not account for our current credit crisis. Schoen works for a firm that often does deals in excess of $1 billion, and today’s banks will simply not write commitment letters for such things.
So let me propose something new: The Win-Win-Win Model. This accepts Schoen’s initial theory, but adds a third leg for when the credit markets are tight-to-absent. In those times, LBO firms can become one of the only providers of capital to companies who have traditionally accessed the credit markets for expansion purposes. Many of the actual transactions would be equity-heavy or equity-only, but would involve strong companies that normally would steer well clear of private equity in more lenient markets (motivated sellers forced to undervalue themselves).
In other words, LBO firms get to become the capital source of first and last resort. It may sound parasitic, but it’s really more mutualistic (particularly if it doesn’t involve much new leverage).
Win-Win-Win is admittedly a shaky theory, requiring a whole stack of matchbooks to keep the stool steady. It also puts an even greater emphasis on PE firm ability to pick growing companies in growing markets (here and abroad), as opposed to picking ones whose balance sheets can be easily rearranged. Indeed, many LPs I spoke with were unconvinced, with one foundation manager blurting out that “the leveraged buyout model is dead.”
So perhaps I’m being overly optimistic in saying that the LBO market will not collapse from its excesses, at least on a grand scale (certain firms will indeed go under). To me, Schoen had it right, even though he missed a piece. And those who have faith will be rewarded, even if they don’t deserve to be.