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Is the 2013 Private Equity Boom Sustainable?

2013 has seen an early resurgence in the volume of mergers and acquisitions conducted globally.  Since January, there have been in excess of 1000 deals with an aggregate value of over $160 billion, ((James B. Stewart, Mindful of Bubbles in a Boom for Deals, N.Y. Times (Feb. 23, 2013), at B1, available at http://www.nytimes.com/2013/02/23/business/mindful-of-bubbles-as-deal-making-boom-begins.html.)) the fastest start since 2005. ((M&A Boom, Bondholder Doom, Euromoney (Mar. 2013), http://www.euromoney.com/Article/3160625/CurrentIssue/88086/M-A-boom-bondholder-doom.html.)) This boom has been anchored by several large, and sometimes unprecedented, buyouts, including the $23 billion takeover of H. J. Heinz Company by Warren Buffet and 3G Capital and the proposed $24 billion leveraged buyout of Dell Inc. by Michael Dell and Silver Lake Partners.  This flurry of activity is due in large part to “record low debt costs and an equity market eager for companies to spend.” ((Id.)) Having easy access to cheap capital – driven by rock-bottom interest rates – has led to the “healthiest M&A boom in decades” according to Joshua Brown, VP at the asset management firm Fusion Analytics Investment Partners. ((Joshua M. Brown, The Healthiest M&A Boom in Decades, The Reformed Broker (Feb. 16, 2013), http://www.thereformedbroker.com/2013/02/16/the-healthiest-ma-boom-in-decades/.))

Highly leveraged deals allow investors to realize an appreciably higher return on their investment than if funded through equity alone.  Private equity firms consequently use leverage to help fund their buyouts and increase their earnings (or their losses should the deal sour).  The ravenous pace at which money is entering the leveraged loan market has led to demand “swamping supply and pushing pricing down for borrowers,” ((Boyd Erman, As Leveraged Loans Boom, Will Private Equity Buyouts Follow?, The Globe and Mail (Feb. 26, 2013, 2:09 PM), http://www.theglobeandmail.com/report-on-business/streetwise/as-leveraged-loans-boom-will-private-equity-buyouts-follow/article9072504/.)) boosting the returns and subsequent activity of PE funds.  This is further bolstered by the impressive pile of equity capital that these funds have amassed to seed their investments – $189.4 billion as of January 2013 in North America-focused funds. ((Is Private Equity Losing its Shine?, Zacks (Feb. 28, 2013), http://www.zacks.com/stock/news/93717/is-private-equity-losing-its-shine.))

Despite this early good fortune, there is speculation that the private equity industry’s appetite may be subsiding. The prevalence of cheap debt has undoubtedly helped fuel the incredible quantity of deals struck thus far, but given that much of this capital is in the form of high-yield high-risk junk bonds, ((Anne-Sylvaine Chassany, Private Equity Wary of New Credit Bubble, Financial Times (Feb. 26, 2013, 5:19 PM), http://www.ft.com/intl/cms/s/0/7492a6ac-8028-11e2-96ba-00144feabdc0.html.)) it has substantially increased the price tag of such deals. ((Mark Scott, Private Equity Players See Signs of Excess in Buyout Market, N.Y. Times (Feb. 26, 2013, 8:49 AM), http://dealbook.nytimes.com/2013/02/26/private-equity-players-see-signs-of-excess-in-buyout-market/.)) “Clearly money is easy, one could say too easy,” says Leon D. Black, CEO of Apollo Global Management. Speaking at the SuperReturn International 2013 conference, Mr. Black went on to note that “[w]ith easy money, there’s a temptation to pay higher prices.” ((Id.)) This systemic overvaluation has led to concern that the industry is entering yet another credit bubble. ((Chassany, supra note 7.)) Howard S. Marks, chairman of Oaktree Capital Management, recently observed that the private equity industry is “seeing some elements of precrisis behavior.” ((Scott, supra note 8.)) Funds are becoming less risk-averse given exceptionally low costs of debt capital, resulting in debt-equity ratios “approaching pre-crisis highs” ((Chassany, supra note 7.)) in LBO deals. The rise in deal values have led to increased pressure on executives who, as a result, must meet even greater expectations of growth and profitability to justify their now-inflated share prices. This circuitous quest for ever-higher returns necessitates riskier behavior, exposing investors and shareholders alike to greater risk.

To counter the unnervingly bullish behavior of fund managers today, the industry should shift its focus and investing strategy. Going back to basic valuation fundamentals, funds must pay more attention to the operational attributes of targets, rather than seek an ‘optimal’ capital structure to extract maximum gains. Put differently, managers should actively pursue “prudent financial transactions” rather than continue to rely on “the complicated financial engineering of the past.” ((Zacks, supra note 6.)) That said, there is some evidence of such a shift occurring in the industry, most recently exemplified by Richard Schulze’s failed $9 billion attempt to take Best Buy Co. private in a leveraged takeover. ((Barney Jopson, Best Buy Buyout Bid Fails, Financial Times (Mar. 1, 2013, 2:43 PM), http://www.ft.com/intl/cms/s/0/bd20220a-827b-11e2-843e-00144feabdc0.html.)) The bid had a $2 billion shortfall in required equity funding, despite interest by several leading private equity firms including Cerberus Capital Management and TPG Capital. ((Antoine Gara, Best Buy: The Buyout That Never Was, The Street (Mar. 1, 2013, 4:14 PM), http://www.thestreet.com/story/11857240/1/best-buy-the-buyout-that-never-was.html.)) This has been linked to operational concerns over the shrinking brick and mortar retail industry and highly risky turnaround plan. ((Zacks, supra note 6.)) Even if an operations-focused valuation and bidding process becomes commonplace, it is unlikely to contribute to the boom in private equity that we have seen thus far in 2013. After all, given the persistent dependence on debt-fueled strategies such as dividend recapitalizations ((Ryan Dezember & Matt Wirz, Debt Fuels a Dividend Boom, Wall St. J. (Oct. 19, 2012), http://online.wsj.com/article/SB10000872396390444592704578064672995070116.html.)) – and consequent focus on financing cash flows – private equity funds and their investors appear complacent with sticking to pre-crisis tactics.

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Sumit Gupta

Vol. 3 Tech Chair
University of Michigan JD Candidate, 2014 BBA Class of 2011