What follows is the prepared text of a speech given today by John Castle, chairman and CEO of private equity firm Castle Harlan, to the the New York Chamber of Commerce.
It is a pleasure to address an audience so knowledgeable and concerned about our current economic situation.
I think we can all agree that the economic meltdown of the past two years has been the worst since the Great Depression. Locally, nationally, internationally – everywhere we look, the economic wreckage is piled up. The causes of all this are many and often rehashed – the real estate bubble, excessive and unrealistic mortgage lending, derivatives whose risks were only dimly perceived. And all this is now compounded by consumers tightening their spending, businesses declining to invest, and banks refusing to lend.
In addition, the mess has been global, affecting literally every corner of the world, even the Middle East. In the 1970’s, the Middle East Oil countries did extraordinarily well even as the rest of the world collapsed. But even this region has been adversely impacted this time as oil prices skidded from their peak of $150 before moving back up to $70. In this recession, virtually no region in the world did well. There has been much finger-pointing as to who was responsible for this mess. Suffice it to say, there is plenty of blame to go around.
In that regard, I am reminded of the expert golfer who was playing in a two-man, alternate-shot tournament with a partner who was a bit of a duffer. On the first hole, a par 3, the expert golfer hit his tee shot onto the green, 20 feet from the pin. His partner, playing the second shot, hit his putt too hard, and the ball rolled off the green and into a bunker. Unfazed, the expert took his wedge and hit the third shot perfectly, leaving the ball just two feet from the pin. The duffer then missed the putt, leaving his fuming partner to tap it in for a double-bogey five.
“Do you realize,” he yelled at the duffer, “that we took five shots on that easy par 3?”
“Yes,” his partner retorted, “but don’t forget who took three of them!”
Rather than placing blame or detailing similarities to the Great Depression, I would like today to focus on the future – more specifically, on the future of private equity.
There have always been doubters and nay-sayers about the prospects and sustainability of private equity. A few years ago, the financial pundits were saying the private equity industry had run out of steam. They said it could no longer grow. I said it could, and it did.
Now those same so-called experts are arguing that the private equity game is over. They note that almost a trillion dollars of private equity debt will mature before 2015, but that the current market value of that debt is only about half of that amount, say, $500 to 600 billion. Therefore, the debt can’t be refinanced and the industry, and many of its investors, will be wiped out. It’s the end of the world.
As Mark Twain famously cabled the Associated Press from London in 1897, “Reports of my death are greatly exaggerated.” And so it is with private equity.
First, private equity debt in the United States comprises only a small fraction of overall national debt. Therefore, the private equity debt market will be heavily driven by other, larger markets.
To illustrate, the total net worth of the U.S. economy is approximately $51 trillion.
Residential mortgages are about $12 trillion (or about 25% of our national net worth). (And by the way, during the last year is the first time I’ve spoken about numbers with a T after them as opposed to a B or an M.)
Residential and corporate mortgages together are about $15 trillion, and comprise 30 to 35 per cent of our national net worth. In addition to that, total corporate debt is about $7.3 trillion.
On the equity side, public equity – the value of shares in publicly traded companies – is something over $11 trillion, and was as much as $20 trillion before the markets fell out of bed. In fact, just two years ago, two companies, General Electric and Citigroup, were each worth nearly three quarters of a trillion dollars respectively. Those numbers are lower now, of course.
Thus private equity constitutes a mere 1 per cent of the total net worth of the U.S. And private equity debt is only about 5 per cent of total debt. To put it another way, the whole private equity industry has about the same value as either a GE or Citi two years ago.
Clearly, the debt market for the private equity industry is going to be dominated by the availability of debt for real estate and general corporate purposes. When the banks get in trouble, as they certainly have in the U.S. financial crisis, it’s always because of real estate lending. That was the case in the 1930’s, the 1970’s, the late 1980’s and early 1990’s and it is true today.
So is the private equity business drying up because funding isn’t available?
No — far from it. For private equity still has much to offer both investors and businesses in need of financing.
First, although banks are very restrictive in the money that they will make available, some banks are prepared to make working capital loans at levels up to two times EBITDA – that is, Earnings Before Interest, Taxes, Depreciation and Amortization.
In addition, public high yield debt is available. These markets are pretty open. In fact, more public high yield debt has been placed during the last five months than in all of 2008. Further, Business Week editors have indicated that numerous IPO’s are now being teed up for offering in the next few months.
But most importantly, private equity is among the most liquid areas of our economy right now. Private equity firms currently have outstanding commitments from investors for between 400 and 500 billion dollars. That money is still callable, despite the meltdown.
Thus the private equity industry has the capability of deploying, relatively quickly, $500 billion of equity money, a substantial amount relative to other sectors of the economy.
On the minus side, most banks appear to be focused on three main goals: reducing their total outstanding loans, pushing up the interest rates they charge, and – at all costs – avoiding write-downs.
But this focus may improve the credit profile of the banks’ customer base. And their conservatism, though unhelpful now, may lead to strengthened institutions that in a few years will be able to lend more aggressively.
So in my view, private equity is open for business and is clearly capable of making deals and financing transactions.
As an illustration of this environment, my own firm, Castle Harlan, has more than $900 million of domestic equity available for investment right now. I estimate we have another $1 billion of debt available, and if we include our Australian fund, Castle Harlan Australian Mezzanine Partners, or CHAMP, the available debt and equity rises to over $3.0 billion.
Other firms in our industry have several hundred billion dollars in debt and equity financing ready to go. Okay, so debt and/or equity funding is available from private equity firms. In what situations might businesses find such funding particularly useful or appropriate?
One example might be an overleveraged corporate parent. In an economic crisis like this one, companies may find that they have excessive debt given their current earning power. The sale of a subsidiary may be the best way to resolve that situation. Over the last 40 years, I have found that this approach solves a corporate parent’s balance sheet situation while creating new companies that have great economic vibrancy. One such example is the furniture company Ethan Allen, which we bought from a overleveraged parent. Earlier in my career, a subsidiary sold by an overleveraged parent was the key component of Envirotech, a company we built into the world’s leading water pollution control company.
Another example might be a company that needs an infusion of capital to help it regain its focus on its core business. A private equity firm can not only structure and fund an effective solution but provide strategic expertise. Currently, my firm is exploring this alternative with a medical services company.
Perhaps a company just wants an input of additional equity in order to take advantage of the favorable environment for add-on acquisitions and expansion.
Sometimes a company’s ownership is simply tired of the uphill struggle and wants to be bought out. In other cases, the ownership is just plain old and looking for a way to cash out and retire.
In such instances, an investment or outright acquisition by a private equity firm may well be the best solution.
In short, there will be opportunities aplenty for private equity firms and their investors as our economy recovers.
And I believe, on the basis of long experience, that investments made now, under the current, difficult conditions, will provide some of the most attractive returns for private equity firms and their investors over the next three to five years. In a depressed market, prices tend to be lower across the board. Earnings tend to be cyclically down, meaning that price will be low. Multiples of EBITDA will also be lower than in buoyant times. But shrewd buyers know that earnings that are in the low end of their historic range today are likely to move up as the economy recovers. Rising expectations about earnings will push up prices. Typical corporate borrowing power may rise from, say, three times EBITDA today to five times EBITDA or more, also impacting the value of a given investment.
Further, these changes in the debt market will permit private equity investors to recapitalize, enhancing their return on investment.
Investing in adversity can lead to great returns. In the mid-1970s, for example, my firm made 40 times its investment in certain companies, which we bought in 1974 and later sold to a larger technology company. That was truly spectacular. Later, in the early 1990s, we made five times our money on many investments, including Truck Components, which made brake drums for trucks, and Monogram, a company that made toilets for airplanes.
In 2002-2003, we often made three to five times our investment — Horizon Lines, a Jones Act shipper, was a case in point. We bought the company in a weak market at a price that in retrospect was very low. We improved operations, increased earnings, and made out very well when the economy improved and buyer demand for shipping companies picked up.
In sum, despite the economic meltdown and the resulting mess, this is likely to be a great time to invest for those who have fresh capital and the perspicacity to see and grasp these opportunities. Private equity firms and their investors will be supplying a lot of that capital, and as in previous downturns, will do much of the investing, and reap the eventual profits.
Meanwhile, although it appears that the U.S. and global economies are beginning to turn around, some aspects of this meltdown make it different from earlier recessions, not just more severe. I think these are worthy of note.
For example, the U.S. usually leads the way out of worldwide recession. This time, the international sector is doing the leading. Several economically advanced countries have already emerged from recession, notably Germany, France, China, Japan and Australia, while our economy languishes.
American banks have traditionally been bastions of strength in international banking, but not this time. As of last spring, there were only 9 double-A rated banks worldwide — four of them Australian, none American. All have ample capital available.
Meanwhile, sovereign funds are providing leadership in investing for recovery. China’s sovereign funds have over $500 billion, of which only 10 per cent has been invested so far.
In the Middle East, $140 oil has vastly enriched the sovereign funds of oil-producing states. Although these funds had reversals last year as oil collapsed to $35, they are now strengthening as prices appreciate back to $70-plus.
In Australia, where our firm has extensive interests, the recession was shorter and less severe than elsewhere because of strong commodity purchases by China. Australia is now beginning to see some IPOs, a positive vital sign. One of the ways we are currently arranging offshore financing for some companies is through the Australian debt and equity markets. Meanwhile, bankers from HSBC are actively soliciting deals in many parts of Asia, another favorable indicator.
From an investment standpoint, then, this is an attractive time, a time of great opportunity. But, you might ask, what things could make the environment less attractive? What might create a problem in these circumstances? In my view, just two things could have that impact.
The first would be a premature tightening by the Federal Reserve. Such a tightening could snuff out the attractive growth we are just beginning to see. The second danger is the Federal Government deciding to increase taxes. Once again, such action would kill off the green shoots in our current economy.
In the meantime, the markets will continue functioning and, I believe, things will only get better from here. We will emerge from the hole we have been in.
And that reminds me of the golfer who hooked his drive into a deep, overgrown ravine. Undaunted, he took his eight-iron and clambered down through the dense underbrush in search of his ball. At the bottom, he found his ball, but also spied something white and something shiny. Looking more closely, he was horrified to find it was a human skeleton, and in its bony hand, it held an eight-iron.
“George, George!” the golfer yelled up to his caddy. “Throw down my wedge – you can’t get out of here with an eight-iron!”
And so it is with our economic ravine. Given the right tools, we can get ourselves out of trouble, and I believe that private equity capital will continue to be one of the most important of those tools.
Of course, I wouldn’t want to make it a wedge issue. Thank you very much.