Financial Markets and Risk

Management Summative assignment

This essay will be critically analyzing how Private equity companies have been
affected throughout the recent financial crisis. To do so, first it will identify the history
of private equity companies, their performance in the past and what their strategy
were until the crisis break out. Then it will look into the impact that this had on the
companies and what measures were taken to survive it. Finally it will look into their
current position and some vision of Private equity into the future. Dates will be added
to referencing to ease the understanding of the points of view of authors.

Private equity companies have got the title of “Barbarians at the Gate” for the last
twenty years; it came from a book with the same title released on 1990 about a battle
by Kohlberg Kravis Roberts (KKR) to buy RJR Nabisco. This book has been
considered one of the best business books ever written and it marked the end of the
first “boom and burst cycle” era. To understand the history of private equity is
important to understand these cylces. During the eighties private equity was mostly
LBOs financed by “high yield bonds” which regulators ceased and creditors such as
Michael Milken (the junk bond king) ended up in jail.

Second cycle came in the nineties with internet websites emerging everywhere and
accounting rules allowing companies to offer stock options pretending they had no
cost, seemed that everyone could become rich any day of the week through venture
capital supporting emerging companies such as Google. Burst came when the dot
com crashed, options became priced and accountable, and companies like Enron
collapsed.

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Third cycle, from 2003 until 2007 when the financial market collapsed, during this
period, private equity firms regained the title of Barbarians. Back in late 1980’s FT
ran a fictional story about a company planning to buy out General motors; obviously
it seems as a joke back then that a company would be able to buy the biggest car
manufacturer in the world. According to Preqin, 2006 private equity fundraising
broke all-time records over $401 billion worldwide. Companies like Blackstone,
purchasing Hilton for $ 26,932 M or KKR acquisition of HCA the biggest investor
owned healthcare services for $21,300 M. If FT ran the same story on 2007, it would
not surprise anyone along common offers like Virgin Media LBO in 2006 and most
recently Boots. (The Economist, Jul 5th 2007)

The following chart shows the companies which raised the highest amount of funds
back in 2006. Unsurprisingly enough, none of these have been affected by the 2007
financial crisis and all are still operating nowadays.

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 Probably most of the directors of the companies from the chart above would agree n
2006, private equity was a gold mine. By 2006 there were 2700 firms operating, not
ran by financiers but by entrepreneurs, politicians, business experts and even
celebrities, among many of them; John Mayor former PM, Jack Welch former GE
CEO, Lou Gerstner, once head of IBM. (The Economist, Feb 8 th 2007)

The main factor on the increase of PE companies was the ease of credit during the
years previous to the financial crisis. The funding came from three primary sources,
rich investors, pension funds, and Banks. Which all of them were happy lenders
expecting generous returns for their money.

Some advantages that helped create this Boom on Private equity are:

Low regulation As a private company, regulations like Sarbanes-Oxley in America

would not affect them.
Less press scrutiny The ability to pay executives whatever figure without having to make it
public.
Low taxes Once a company is sold after some years of investment, and profits
have been shared with investors, the rest of the money is considered
a “capital gain” which is taxed 15% in America and as little as 10% in
UK due to loopholes in the system.
One common goal Companies owned by private equity firms have one owner instead of
many shareholders like public companies do. This speeds up
decision process making.
Same interests In most cases the owners and managers share the same interests in
the company, both jobs depend on company performance.
Financial engineering The amount of debt generated through buy outs give the company a
different financial structure which presents an advantage over others
in the same industry
Table 1 (The Economist, Jul 7th 2007)

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On the charts above we can see a notorious increase of LBO and in investment in
the years previous to the recession

But not every Private equity firm seems to succeed, In a study generated by Steve
Kaplan of the university of Chicago and Antoinette Schoar from MIT showed that
between 1980 and 2001 of which the top 25% of them generated an annual rate of
return of 26%, while the bottom quarter only generated 4%. This study showed that
the successful companies remained top and the bottom struggle to remain in
business. (The Economist, Nov 25 th 2004) The difference between both; was the
ability to attract top executives to companies, the expertise on analysing business
opportunity, a strong network to search for deals. Also firms that were owned by a
private equity company for less than a year perform worse than those that had long
term investment “buying and Flipping” back into the market a common technique by
2006 was not always as profitable as expected. (The Economist, Feb 8 th 2007)

The top equity firms have been labelled as “new conglomerates” along with their
“barbarian” title, this is due to the complexity of business they operate and as a critic
comparison to the conglomerate companies of 1970 and 1980 such as ITT, BTR and
Hanson which were empires of different kinds of business that grew so big they
became too complex to operate and eventually disappeared. (The Economist, Jul 5 th
2007)

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During the financial crisis, like the rest of the world, private equity faced a lack of
funding, credit became tight and money would not change hands without enough
reasons to be leave it would come back. As leverage being the main part of a LBO’s,
this sector was directly affected.

In most financial crisis, private equity has been part of the cause, and is not surprise
with examples like Cerberus buying Chrysler, just to declare it bankrupt soon after,
or Texas pacific group (TPG) purchase of Washington mutual for $1.35 billion and
going bust 5 months after the deal. Managers, who usually remain in charge after the
ownership changes hands from public to private, sell the company too cheap to have
a bigger slice of the profits when the company is sell back to the public sector, did
not help either. (The Economist, Aug 28th 2008)

By the time the crisis came on summer of 2007, private equity firms had a total of
$450 billion of funding ready to invest or “dry powder” as its known, this time they
were going to be part of the solution, instead of the problem.

Two main things changed instantly as soon as the crisis broke, first there was not
going to be any mega buyouts, if they spend all their funding their companies would
died, and with western banks having financial trouble and in the need of capital and
liquidity, it was no surprise that private equity companies have invested on buying
out debt. Instead of owing the bank, they owned the debts.

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 There is much speculation why Blackstone’s, one of the top companies issued Initial
public offerings (IPO) and decided to go Public in summer 2007. The selling prise
was $31 a share, a price that has never been reached again, being $4 in March last
year and $11 on July. KKR announce intentions of issuing IPO on summer 2008,
but after Lehman Brothers went bankrupt, this decision has been postponed. Many
analyst speculate, these companies look into diversify their business into a boarder
financial company such as Goldman Sachs, while others believe is to secure the
money they collected from wealthy investors and pension funds before the crisis, or
they just want to “cash their chips”. (The Economist, Jul 9 th 2009)

There are four main problems apart from fund raising that the financial crisis directly
affected private equity:

Selling their With share prices dropping and other companies not willing to invest,
companies to private equity’s assets are hard to sell, TPG took months to complete
produce returns Debenhams sale last October without making a loss.
Making new European attempts to regulate private equity, and surging asset price
investments makes it hard to find right options.
Investors trust After $450 billion has been kept as dry powder since 2007, investors
are not happy about where their money is.
Refinancing Burden Preqin estimates $362 billion of leveraged loans will have to be re
financed in the next five years. More debt gives managers room to
breathe, and lenders prefer to have their money away for some time
than facing more write-offs.
Table 2 (The Economist, Oct 29th 2009)

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There are three ways in which private equity can sell thir assets, IPOs a sale to a
buyer, or sell to another private equity company “secondary buy-out”. Semms that in
2010 selling among each other is the way forward, $3.9 billion in the first two
months, while last year had a total of $5.9 No surprise when IPO like New Look or
Matalan had to be canceled due to volatility.

The “dry powder” from funds has to be used, if a fund does not invest at least two
thirds of its money in five years, “Any capital not invested is returned to the
fundinvestors and the buy-out house forgoes managment fees on the uninvested
capital.”(The Economist, Feb 25th 2010).

The following will be a set of graphs produced by Preqin about the views of 4000
private equity investors.

Its clearly notisable that olthough there has been a crisis during all the years shown
in the graph, the investors are more expectant about their returns, over half of them
expect a return higher than 4.1% compared to only 17% back in 2007. Also we can
see in the next chart, that also more than half are expecting to invest on the first half
of 2010. Them are looking to invest more than in 2009, maybe due to dry powder
making 5 years, or they just believe is good time to invest. And that investments will
happen on emerging markets, like China, India and Brazil.

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To conclude, private equity like most aspects of finace, comes on cycles, regulation
gets easy and confidence grows untill the market can not take it anymore, then start
again untill the same happen. Before the banking crisis of 2007, private equity was
as big as it has ever been, with the lack of funding and other problems, investments
have decresed, but after almost three years of the crisis, slowly keeps regaining
trust.

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Word Count: 1492

Bibliography:

o The economist

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