private equity: is the bubble about to burst?
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Philip Ashdown, Altima Partners LLP presented on "Private Equity: Is the bubble about to burst?" at Warwick Business School 22/10/2007TRANSCRIPT
Private Equity - 'Is the bubble about to burst?'
Warwick Business SchoolPhilip Ashdown
22nd October 2007
Views expressed are private ones of Philip Ashdown
• Where are we now? • Where do we want to be?• How are we going to get there?
• What ‘worldview’ do we consider?• Systemic issue or a correction?• What strategy do we adopt?• What are the resource and capability gaps?
• (Anyway what is a (the) bubble? (in this context))
Key Questions
M o d e l o f th e E le m e n ts o f S tr a te g ic M a n a g e m e n t
Id e n tifyO p tio n s
E v a lu a teO p tio n s
S e le c tin gS tra te g y M a n a g in g
C h a n g e
O rg a n isa tio ns tru c tu re a n dd e s ig n
P lan n in g a n da llo c a tio n o fre so u rc e s
E x te rn a l - P o rte r e tc .M a rk e t B a se d V ie w
C u ltu re &S ta k e h o ld e rE x p e c ta tio n s In te rn a l - R e so u rc e a n d
C a p a b ility (C o re C o m p .)R e so u rc e s B a se d V ie w
E n v ir o n m e n tA n a ly s is
S tr a te g yC h o ic e
O r g a n is a tio nI m p le m e n ta t io n
Model of the Elements of Strategic Management
External – Market Forces Internal – Resources/Core CompetencesCulture and Stakeholder Expectations
Identify
Evaluate
Select
Planning and Allocation
Culture and Architecture
Managing Change
Must have consistent and high degree of congruency
Road Map
• Helicopter ride– Private Equity - some history and making superior returns– World view– Shocks and changes
• Helicopter landing – Overview of the European LBO Market• Helicopter ride
– World View implications– Private Equity implications– Can Private Equity deliver superior returns?
Private Equity - History
• Culture as ‘master of the universe’ ?• OR any fool could make money in the last 10 year bull run?• Generally minimal understanding, ‘label’ or do not care……….but its ‘centre stage’ since 2006
• Background……
– Governments and entrepreneurialism– Big Bang (1986) >hot boom > 1990-1993 recession– ‘barbarians at the gate’– Financial innovation and disintermediation– Venture capital is way too risky thanks
• TMT and dot.com boom• Economies of scale do not work in my business model
– Investors – ‘hey where do I put all my cash?’ (must have superior returns btw) – Hedge Funds and ‘alternative asset/value managers’– Bull market > 1997-2007 (BUT ‘shocks’)– Reputation– Secrecy, tax and non-doms– Political and social impact
Private Equity – Segment and Asset Class
• Sector maturity, learning/experience curves
– Historical analysis and disclosure– Barriers to entry rapidly rising– Brands and the ‘Goldman Factor’
• Consolidation and/or natural removal of poor performers; swiftly
– Nature of fund raising and business model– Emergence of ‘Alternative Fund Managers’ at meta level– Prescriptive nature of pension fund investors– Regulation etal.
• Performance vz Public equity markets (Mario Levis – Cass Business School)
– RoA, Ebit and cashflow persistently higher – factor of 50% (with PE ownership)– Debt ‘appears’ to set a tight discipline on management– PE investment cases - minimise bureaucracy and committees, lack constant public exposure– Risk/reward profile is clearly set and monitored
• Performance vz Alternative Fund Managers/Assets
– Hedge funds - $2,000bn globally, expected $500bn withdrawal Q42007 – ABCP, CDO’s and other esoteric asset classes
The Credit/Equity Cycle – it’s always in the background!
Phase 1
Phase 3
Phase 4 Phase 2
Credit Equities
Credit Equities
Credit Equities
Credit Equities
Immature Bull
Mature Bull
Source : CitiGroup Investment Research
Intervention period
Emerging Bear
Repair BSheetLeverage builds
Technology Excess
Clock Face
Let’s get in a helicopter
Virtual CirclesNew Paradigms
Financial Models and StatisticsInnovation
Regulation and DeregulationLiquidity
TaxIT
ChinaPetro-DollarsRussiaIndia
USA deficitDollar liabilitiesEmergence of EuroFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobilityGlobalisation
Sovereign wealth fundsRelative sophisticationReal Liquidity
Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs
ASSETS LIABILITIES
World View
………………..but they crash
Virtual CirclesNew Paradigms
Financial Models and StatisticsInnovation
Regulation and DeregulationLiquidityTax + IT
System Momentum
ChinaPetro-DollarsRussiaIndia
USA deficitDollar liabilitiesEmergence of EuroFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobilityGlobalisation
Sovereign wealth fundsRelative sophisticationReal Liquidity
Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs
ASSETS LIABILITIES
Shocks
Asset ValuesInflate
VAR breaks down
complexity
SpeedReaction timeMedia Power
PerceptionDollars/Euro/
Gold???
PerceptionDollars/Euro/
Gold???
VAR breaks down
Rabbits +headlights
…..correction +/or systemic +/or another paradigm?
Virtual Circles INVERSENew Paradigms ‘ITS OLD AGAIN’
Financial Models and Statistics MISTRUSTInnovation EXCESS
Regulation and Deregulation CONFUSIONLiquidity REAL + FALSE
Tax TAKERIT SPEED EXPONENTIAL
System BREAKDOWN
ChinaPetro-DollarsRussiaIndia
USA deficitDollar liabilitiesEmergence of EuroSTRENGTH BY DEFAULTFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobility Globalisation
Sovereign wealth fundsRelative sophisticationReal Liquidity
Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs
ASSETS LIABILITIES
Financial Structures Leverage +Trading ?
What is my risk?
Trade deficitInterest ratesPerceptionDILEMNA
OMG what is my cap’ structure?
Where is my risk?
In/Out fast
SD is 8x!Leverage is
4*4*!
‘banana republic’
…….can this helicopter fly again?
Virtual CirclesNew Paradigms
Financial Models and StatisticsInnovation
Regulation and DeregulationLiquidityTax + IT
ChinaPetro-DollarsRussiaIndia
USA deficitDollar liabilitiesEmergence of EuroFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobilityGlobalisation
Sovereign wealth fundsRelative sophisticationReal Liquidity
Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs
ASSETS LIABILITIES
…..time and process to get control; feedback to real world
Flying the helicopter…not a problem
• System Momentum = mass * velocity (* powerful internal cultural factors)
• Even when we think we understand/see the problem we do not get behaviour change (why?)
‘When liquidity runs out it will be very complex, however, the music is still playing and we are still dancing…..(this is a great time to make superior returns)’ Head of CitiGroup early July 2007 when talking about LBO’s(Private Equity)
$5.9bn losses announced 2nd October ($20bn+ losses Q3 across the market)
PS Volatility/Shock – Citi losses increased by $600m by 15th October
Private Equity Economics
• Buy an asset at the right price
• Optimise the capital structure
• Optimise industry position and operational efficiency (…competitive advantage)
• Sell an asset at the right price
• Where are we in the helicopter today?
• Reflective of where we are
• Am I deep enough in the woods? Its very tough in here
• Where is my helicopter going and do I have enough fuel?
…….let’s land the helicopter in……..
The European Leveraged Buy-Out Market
Source : Standard & Poors LCD Debtwire Statistics as at March & June 2007
€0B
€20B
€40B
€60B
€80B
€100B
€120B
€140B
1999 2000 2001 2002 2003 2004 2005 2006 20070
40
80
120
160
200
240
280
320
1Q 2Q 3Q 4Q Deal Count*
* Deal Count counts First and Second Lien portions of a single transaction as one event; Deal Count also excludes any amendments.
Annual Senior Loan Volume Deal Count:
214
€0B
€5B
€10B
€15B
€20B
€25B
€30B
€35B
€40B
Jul-0
6Aug
-06
Sep-0
6Oct-
06Nov
-06
Dec-0
6Ja
n-07
Feb-
07Mar-
07Apr-
07May
-07Ju
n-07
Monthly Senior Loan Volume (Last Twelve Months)
European LBO Market Volume
Exponential market growth : private equity raised globally in past 5 years $551bn #
# Source : Sunday Times 29th April 2007
Avg. LBO Purchase Price as Multiple of Pro Forma Trailing EBITDA
6.97
7.81
7.276.93
6.72 6.64 6.48
7.17
7.93
8.42 8.57 8.720.350.33
0.39
0.38
0.380.38
0.40
0.35
0.33
0.41
0.380.34
5.00
6.00
7.00
8.00
9.00
10.00
1997(Observations:
14)
1998 (35) 1999 (33) 2000 (40) 2001 (37) 2002 (52) 2003 (66) 2004 (77) 2005 (87) 2006 (120) LTM 31/3/07(126)
1Q07 (30)
Purchase Price Fees/Expenses
Excluding Platform Acquisitions and Other Sponsor Driven Transactions.
Excess supply of funds and liquidity is chasing higher enterprise valuationsrationalised against increasingly aggressive strategic business plans
+34%
Average Total Debt Leverage Ratio for LBO’s: Europe vs. US with EBITDA of €/$50M or More
4.74.4 4.3 4.4 4.5
4.8
5.55.8
6.1
4.9
4.34.1 4.1
4.74.9
5.4 5.55.8
0.0x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
1999 2000 2001 2002 2003 2004 2005 2006 1Q07
Europe US
Debt multiples have risen c.a. 40% since 2001
0.0x
2.0x
4.0x
6.0x
Debt/EBITDA SeniorDebt/EBITDA
EBITDA/Sr Interest EBITDA/CashInterest
EBITDA - Mainten.Capex/Cash
Interest
EBITDA -Capex/Cash
Interest
1999 (53) 2000 (80) 2001 (75) 2002 (101) 2003 (115) 2004 (149) 2005 (210) 2006 (236) 1Q 2007 (62)
Key Ratios (Europe) – 1999-2007(Q1)
c.a. 40% negative shift ofInterest cover andCore investment coverage
c.a. 40% increase in leverage
Who finances this growth?
Primary European LBO Market by Broad Investor Type
0%
25%
50%
75%
100%
1999 2000 2001 2002 2003 2004 2005 2006 LTM31/3/07
European Banks Non-European Banks Institutional Investors Securities Firms
Clear growth evident in institutional market away from banks,will drive complex outcomes as market deteriorates
10%
55%
314
53
112
3 821
3343
126
303
22
99
718
33
241
70
0
50
100
150
200
250
300
350
1999 2000 2001 2002 2003 2004 2005 2006 1H07
Manager Groups Active Loan Investment Vehicles
Note: Investor group and vehicles include CDOs that are in late stages of warehousing and exclude Finance companiesExcludes U.S. Dollar Tranches Syndicated in the US
Exponential growth inCDO/CLO funds
Institutional Investor Group and Vehicle CountEuropean LBO Market
Institutional Investors’ Share of the Primary Market
0%
20%
40%
60%
80%
100%
1999 2000 2001 2002 2003 2004 2005 2006 LTM30/6/07
LTM30/9/07
Europe US
European market structure has evolved to USA model; what’s over there is coming here
…..back for a helicopter ride
Subprime EconomyCDOs FIsLBOs Xover ABCP
Extreme SensitivityHouse Prices
Ratings Uncertainty
Limited Supply
Haircuts
Liquid hedge UnwindingLeverage
Liquidity BackStopsPB lines
Inability to refiACBPREPOsCapital scarcity
Tighter credit
Slower GDP
Genuine Liquidity Crunch – not isolated to subprime
Financial Product Segments affected – August 2007 - Globally
Source : CitiGroup Global Markets
$6,900bn into$1,500bn $2,670bn $3,000bn $5,700bn $2,400bn
Memo – June 2007Equities $23,500bnTBill $4,300bnMuni $2,500bnAgency $2,700bnMoneyMarket $4,300bnUS Capital Markets data only
Implications for the system
Virtual CirclesNew Paradigms
Financial Models and StatisticsInnovation
Regulation and DeregulationLiquidityTax + IT
ChinaPetro-DollarsRussiaIndia
USA deficitDollar liabilitiesEmergence of EuroFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobilityGlobalisation
Sovereign wealth fundsRelative sophisticationReal Liquidity
Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs
ASSETS LIABILITIES
Huge Complexity
Momentum = (Mass*Velocity)*Culture
World View
ChinaPetro-DollarsRussiaIndia
Sovereign wealth fundsRelative sophisticationReal Liquidity
ASSETS
Can China keep growing at 12%p.a.+?What happens to oil prices, liquidity flows and investment?Political influences, war mongering, terrorismSocial unrestPowerful exogenous factors impacting interest, FX ratesand asset prices
Investment is being increasingly driven directly•In house wealth funds ($8trillion+ >reserves of central banks globally by 2011)
Industry sectorsGlobally – ‘strategic assets’Hot money (+/or)…..Sustainable ‘locked’ flows
Implications for the system
USA deficitDollar liabilitiesEmergence of EuroFall of iron curtainEconomic reform/stabilityFed/Central Bank creds’Labour mobilityGlobalisation
Industry structures/changeAsia CrisisInternet bubbleLTCMROCE (Basle 11)Cash Multiples not IRRs
LIABILITIES
• Ongoing change (hetro>homogenous) but cultures• Core driver to investment activity and superior returns• Lessons will be learnt; add the 2007 credit crunch• Financial sector equity, leverage, returns re-assessed• Risk free rates, core risk skills, asset values tested• Time period will lengthen (hold periods)• Safety margin broadens
• USA not able to manage interest rates, ultimately• Equals yield curve volatility; FX volatility; asset volatility• Europe has same problem but for different reason• Economic stability will likely revert to variable • Cycles, inflation and/or Japan• Reduced credibility, intervention, monetarism returns• Consideration to controls (indirect/direct)• Core liquidity is ‘global’ and will move swiftly• Huge liquidity imbalances; funding structures are key
Implications for the system
Virtual CirclesNew Paradigms
Financial Models and StatisticsInnovation
Regulation and DeregulationLiquidityTax + IT
Implications for the system
What was old is new (paradigm)Recession (risk of) and cyclesVolatility everywhere InflationJapan experience
Innovation - excess controlled (self and external)Tight(er) regulationLiquidity – deep understanding/controls neededTax abuse (tend to eradicate)IT control and development of betterrisk models and feedback mechanismsMedia management reviewedProtection for ‘man in street’
The brakes are slammed on; there is no ABS and its very iceyI am sure we will not overreact………….much anyway!
Implications for the system…..time and process to get control; feedback to real world
• We have an acute balance between control and chaos
The chances of a USA recession in 2008 have risen from 3-1 to 2-1 (Greenspan, October 1st); most see it as 50/50 to likely
If investors fund less $ liabilities….global liquidity flows and imbalances
Interest rates and/or asset values will shift swiftly
Euro is too strong (driven by alternative investment home) equals inflation ultimately……..
Japan has had zero interest rates and no asset growth for >13 years
System has landmines everywhere – shock and volatility to comeo Late cycle sub-prime is estimated at $700bn; $100bn found; losses could be $300bn???o LBO debt is c.a.$500bn ‘hung bridges’ plus excess growth since 2005o Corporate debt has had limited diligence for 3 yearso Property prices and leverage (residential and commercial) excessiveo Inherently unsustainable financing, liquidity and capital structure issues (innovation excess)o Will somebody explain liquidity to me!!!
Does Fed intervention get control?
Is the ECB a credible central bank or a political and naïve player?
The UK is left in the backwash?
What happens when equity markets ‘get this’? (Asymmetry between credit and equity markets)
Private Equity
External
• Correction and back to normal………
• Or correction into chaos then…? What time period?
• Sustainable industry/investor group or not?
Internal
• What strategy to adopt ?– Providers of liquidity– Fund managers– Long/short asset holders– Existing portfolio– New investments
The Credit/Equity Cycle – it’s always in the background!
Source : CitiGroup Investment Research
Phase 1
Phase 3
Phase 4 Phase 2
Credit Equities
Credit Equities
Credit Equities
Credit Equities
Credit
Equity Immature Bull
Mature Bull
Intervention period
Emerging Bear
Repair BSheetLeverage builds
Technology Excess
Cost of (<) BBB over Credit/Equity Cycle
100
300
500
700
900
1100
1300
1500
1700
01/02
/199
809
/09/1
998
5/18
/199
91/
21/2
000
9/29
/200
006
/08/2
001
2/20
/200
210
/28/2
002
07/08
/200
303
/12/2
004
11/18
/200
47/
29/2
005
04/07
/200
612
/14/2
006
8/24
/200
7
US High YieldEuropean High Yield
Phase 3 Phase 4 Phase 1 Phase 2 Phase 3
Source : Merrill Lynch data; Citi Investment Research
Immature Bull Mature BullEmerging BearMature Bull
Fed ease Fed tighter
Reduce leverage
Low volatility
Shocks
Use leverage
Bubbles ‘innovation’
LTCM Nasdaq/TMT ABCP
High Volatility
1
3
4 2Credit
Equity
Shocks
Fed ease
Can Private Equity deliver superior returns?
• Buy an asset at the right price
• Optimise the capital structure
• Optimise SCA• Sell an asset at
the right price
Where are we in the helicopter today?
Reflective of where we are
Am I deep enough in the woods?
Where is my helicopter going?
Firm and Resource competences vary materially across the sectorControl mechanisms break down; political influences drive behaviour
Validate the environment
EV off 2x minimum
Probably not, so……..
Get in it for the long term; choppy ride ahead P3/P4
Given the environment what resources and capability gaps do I have?Re-evaluate past process and procedures – formal and INFORMALExamine existing portfolio deeplyExamine and change funding structure and investor type/diversifySeek consolidation opportunities +/or stretch business modelCreate sustainable funding structures - remove M2M/NAV dynamicsSocially aware/change Overtly communicate and manage PR Main stream not ‘secret, off-shore, barbarians at the gate’Apply double-loop learning consistently – remove culture from macro strategy
Meaning of life…….
• Always seek to understand the macro drivers in the financial system globally and its feedback into ‘your (industry/sector) worldview’
• Change or die …….(+ use a helicopter and seek to be informed yet intuitive for big bets)
• Remove ‘culture’ from ‘big bet’ decision process (monitor always)
• Get lucky, cash out at the top and go to the beach…….• Stay on the beach, re-invest at the bottom but get private equity
(alternative asset) fund managers to do the work for you……..(for above average index returns)
• Q&A………………