Last week, we predicted that the return of club deals seemed imminent after a three-year hibernation. Not only because of the pending Fidelity National buyout, but also the coming auction fight over Royal Bank of Scotland’s payment-processing arm. Our friends at Financial News seem to agree.
Is this good news? Yes, according to some recent research from Oliver Gottschag, associate professor at HEC School of Management, and Bernd Kreuter of German consulting firm Feri Institutional Advisers.
They found that club deals deliver far better returns than do single-sponsor deals. In fact, club-deals are 30% more likely than single-sponsor deals to deliver exits within five years.
Gottschag and Kreuter compared the exits of 10,000 leveraged buyouts struck between 1980 and 2000. We, in turn, combed through their research to create a kind of DIY list for the best kind of club deals to guarantee an exit. The wisdom of science, below:
Seek safety in numbers: The more the members of the club, the better the deals do. “The size of the ‘Club’ has a positive effect, in the sense that the exit success rate of deals made by larger clubs increases further.”
In large club deals, there are fewer bankruptcies. “This may be attributed to a more effective due diligence performed by multiple parties, or to the larger combined network of large clubs that helps create exit opportunities.” We think it has to do with just plan micromanaging and meddling to create a situation where many cooks actually improve the broth.
Before Sunset: The best club deals are struck before crashes. “Club-deal buyouts were particularly more successful than non-Club Deals during years that precede times of economic downturns,” the authors say, noting deals struck in 1988, 1989 and 1999.
The authors don’t explain why, but we have a couple of theories. First is that most firms are too concerned about saving portfolio companies during downturns rather than making new investments; second is that recessions have a way of killing value – and companies. There’s also the issue of competition. The worst-performing club deals were struck in 2003, for instance; that was also the most popular year for these types of deals, with 56% of all LBOs clocking in as club deals. Once everyone has figured out an idea, it increases competition, drives up prices and is less likely to be profitable.
Beware of sector dogs: An interesting find is that some sectors were more responsive to club deals than others. “Club Deal buyouts made in the sectors such as Environmental Related, Industrial Equipment and Machinery, Consumer Products and Food and Beverages were more than twice as successful as non-Club Deal buyouts in these areas,” the authors wrote. “On the other hand, Club Deals were substantially less successful in the sectors of Computer Software, Medical Health Related Products, Computer Services and Telecommunications.”
The authors don’t explain why, but I think it has to do with two factors: the tech bust during the study years, and the increasing popularity of club deals, which filled up the field with competitors and most likely reduced returns. Consider after all, that the worst-performing club deal sectors – medical products, technology and telecommunications – were also the most crowded. The authors say that 48% of telecom buyouts studied were club deals, for instance, as were 47% of wireless deals, 38% of software acquisitions and 34% of medical products buyouts. More deals would necessarily increase the opportunity for failed investments.
In addition, the researchers say that club deals maintained a big advantage in performance when struck in 1999, 2000, 2001 and 2002 – but fell precipitously in 2003. To add a bit of context, that year – 2003 – marked the first real resurgence in private equity since the 1980s, and club deals and auctions became extremely popular and widespread. This would indicate that club deals were very profitable until everyone jumped in the pool.
Club deals don’t come in extra-large: “Very large buyouts do not benefit from the positive effect of ‘Club’ investing,” Feri said in its report. “Deals that are mega-sized are always going to raise questions about potential returns and performance, whether there is one buyer or 10.
Choose your partners carefully – or don’t partner at all: The authors theorize that many club deals are better because many firms get to do due diligence. However, there’s a big exception: “‘Star Firms’, i.e. PE Firms with a superior average historic exit success rate, fail to benefit from Club Deals. It seems as if the best PE Firms are better of making deals alone and without the watered-down decision making processes that take place when less sophisticated investors are also sitting at the table.” And when some funds push for a premature exit, returns could be hit hard for everyone. In fact, the authors found that “club deals do not increase fund IRR, which may be an indicator of coordination problems between the investing funds.”
Below is the full report: