The Third Private Equity Boom and the Golden Age of Private Equity (2003-2007)

Wikipeida Main Article: Private equity in the 21st century

As 2002 ended and 2003 began, the private equity sector, had spent the previous three two and a half years reeling from major losses in telecommunications and technology companies and had been severely constrained by tight credit markets. As 2003 got underway, private equity began a five year resurgence that would ultimately result in the completion of 13 of the 15 largest leveraged buyout transactions in history, unprecedented levels of investment activity and investor commitments and a major expansion and maturation of the leading private equity firms.

The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies would set the stage for the largest boom private equity had seen. The Sarbanes Oxley legislation, officially the Public Company Accounting Reform and Investor Protection Act, passed in 2002, in the wake of corporate scandals at Enron, WorldCom, Tyco, Adelphia, Peregrine Systems and Global Crossing among others, would create a new regime of rules and regulations for publicly traded corporations. In addition to the existing focus on short term earnings rather than long term value creation, many public company executives lamented the extra cost and bureaucracy associated with Sarbanes-Oxley compliance.

For the first time, many large corporations saw private equity ownership as potentially more attractive than remaining public. Sarbanes-Oxley would have the opposite effect on the venture capital industry. The increased compliance costs would make it nearly impossible for venture capitalists to bring young companies to the public markets and dramatically reduced the opportunities for exits via IPO. Instead, venture capitalists have been forced increasingly to rely on sales to strategic buyers for an exit of their investment.

Interest rates, which began a major series of decreases in 2002 would reduce the cost of borrowing and increase the ability of private equity firms to finance large acquisitions. Lower interest rates would encourage investors to return to relatively dormant high-yield debt and leveraged loan markets, making debt more readily available to finance buyouts. Additionally, alternative investments also became increasingly important as investors focused on yields despite increases in risk. This search for higher yielding investments would fuel larger funds and in turn larger deals, never thought possible, became reality.

Certain buyouts were completed in 2001 and early 2002, particularly in Europe where financing was more readily available. In 2001, for example, BT Group agreed to sell its international yellow pages directories business (Yell Group) to Apax Partners and Hicks, Muse, Tate & Furst for £2.14 billion (approximately $3.5 billion at the time),[69] making it then the largest non-corporate LBO in European history. Yell later bought US directories publisher McLeodUSA for about $600 million, and floated on London's FTSE in 2003.

Resurgence of the large buyout

Marked by the two-stage buyout of Dex Media at the end of 2002 and 2003, large multi-billion dollar U.S. buyouts could once again obtain significant high yield debt financing and larger transactions could be completed. The Carlyle Group, Welsh, Carson, Anderson & Stowe, along with other private investors, led a $7.5 billion buyout of QwestDex. The buyout was the third largest corporate buyout since 1989. QwestDex's purchase occurred in two stages: a $2.75 billion acquisition of assets known as Dex Media East in November 2002 and a $4.30 billion acquisition of assets known as Dex Media West in 2003. R. H. Donnelley Corporation acquired Dex Media in 2006. Shortly after Dex Media, other larger buyouts would be completed signaling the resurgence in private equity was underway. The acquisitions included Burger King (by Bain Capital), Jefferson Smurfit (by Madison Dearborn), Houghton Mifflin[70][71] (by Bain Capital, the Blackstone Group and Thomas H. Lee Partners) and TRW Automotive by the Blackstone Group.

In 2006 USA Today reported retrospectively on the revival of private equity:

LBOs are back, only they've rebranded themselves private equity and vow a happier ending. The firms say this time it's completely different. Instead of buying companies and dismantling them, as was their rap in the '80s, private equity firms… squeeze more profit out of underperforming companies.

But whether today's private equity firms are simply a regurgitation of their counterparts in the 1980s… or a kinder, gentler version, one thing remains clear: private equity is now enjoying a "Golden Age." And with returns that triple the S&P 500, it's no wonder they are challenging the public markets for supremacy.

By 2004 and 2005, major buyouts were once again becoming common and market observers were stunned by the leverage levels and financing terms obtained by financial sponsors in their buyouts. Some of the notable buyouts of this period include: Dollarama (2004), Toys "R" Us (2004), The Hertz Corporation (2005), Metro-Goldwyn-Mayer (2005) and SunGard (2005).

Age of the mega-buyout

David Rubinstein, the head of the Carlyle Group, the largest private equity firm (by investor commitments) during the 2006-07 buyout boom.

As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. Additionally, the buyout boom was not limited to the United States as industrialized countries in Europe and the Asia-Pacific region also saw new records set. In 2006, private equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003.

Additionally, U.S. based private equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22% and 33% higher than the 2005 fundraising total. However, venture capital funds, which were responsible for much of the fundraising volume in 2000 (the height of the dot-com bubble), raised only $25.1 billion in 2006, a 2% percent decline from 2005 and a significant decline from its peak. The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds.

Among the largest buyouts of this period included: Georgia-Pacific Corp (2005), Albertson's (2006), Equity Office Properties (2006 ), Freescale Semiconductor (2006), GMAC (2006), HCA (2006), Kinder Morgan (2006), Harrah's Entertainment (2006), TDC A/S (2006), Sabre Holdings (2006), Travelport (2006), Alliance Boots (2007), Biomet (2007), Chrysler (2007), First Data (2007) and TXU (2007).

Publicly traded private equity

Although there had previously been certain instances of publicly traded private equity vehicles, the convergence of private equity and the public equity markets attracted significantly greater attention when several of the largest private equity firms pursued various options through the public markets. Taking private equity firms and private equity funds public appeared an unusual move since private equity funds often buy public companies listed on exchange and then take them private. Private equity firms are rarely subject to the quarterly reporting requirements of the public markets and tout this independence to prospective sellers as a key advantage of going private. Nevertheless, there are fundamentally two separate opportunities that private equity firms pursued in the public markets. These options involved a public listing of either:

A private equity firm (the management company), which provides shareholders an opportunity to gain exposure to the management fees and carried interest earned by the investment professionals and managers of the private equity firm. The most notable example of this public listing was completed by The Blackstone Group in 2007.

A private equity fund or similar investment vehicle, which allows investors that would otherwise be unable to invest in a traditional private equity limited partnership to gain exposure to a portfolio of private equity investments.

In May 2006, Kohlberg Kravis Roberts raised $5 billion in an initial public offering for a new permanent investment vehicle (KKR Private Equity Investors or KPE) listing it on the Euronext exchange in Amsterdam (ENXTAM: KPE). KKR raised more than three times what it had expected at the outset as many of the investors in KPE were hedge funds seeking exposure to private equity but could not make long term commitments to private equity funds. Because private equity had been booming in the preceding years, the proposition of investing in a KKR fund appeared attractive to certain investors. However, KPE's first-day performance was lackluster, trading down 1.7% and trading volume was limited. Initially, a handful of other private equity firms and hedge funds had planned to follow KKR's lead but shelved those plans when KPE's performance continued to falter after its IPO. KPE's stock declined from an IPO price of €25 per share to €18.16 (a 27% decline) at the end of 2007 and a low of €11.45 (a 54.2% decline) per share in Q1 2008.[80] KPE disclosed in May 2008 that it had completed approximately $300 million of secondary sales of selected limited partnership interests in and undrawn commitments to certain KKR-managed funds in order to generate liquidity and repay borrowings.

Schwarzman's Blackstone Group completed the first major IPO of a private equity firm in June 2007.

On March 22, 2007, the Blackstone Group filed with the SEC to raise $4 billion in an initial public offering. On June 21, Blackstone swapped a 12.3% stake in its ownership for $4.13 billion in the largest U.S. IPO since 2002. Traded on the New York Stock Exchange under the ticker symbol BX, Blackstone priced at $31 per share on June 22, 2007.

Less than two weeks after the Blackstone Group IPO, rival firm Kohlberg Kravis Roberts filed with the SEC in July 2007 to raise $1.25 billion by selling an ownership interest in its management company. KKR had previously listed its KKR Private Equity Investors (KPE) private equity fund vehicle in 2006. The onset of the credit crunch and the shutdown of the IPO market would dampen the prospects of obtaining a valuation that would be attractive to KKR and the flotation was repeatedly postponed.

Meanwhile, other private equity investors were seeking to realize a portion of the value locked into their firms. In September 2007, the Carlyle Group sold a 7.5% interest in its management company to Mubadala Development Company, which is owned by the Abu Dhabi Investment Authority (ADIA) for $1.35 billion, which valued Carlyle at approximately $20 billion.

Similarly, in January 2008, Silver Lake Partners sold a 9.9% stake in its management company to the California Public Employees' Retirement System (CalPERS) for $275 million.

Additionally, Apollo Management completed a private placement of shares in its management company in July 2007. By pursuing a private placement rather than a public offering, Apollo would be able to avoid much of the public scrutiny applied to Blackstone and KKR. In April 2008, Apollo filed with the SEC to permit some holders of its privately traded stock to sell their shares on the New York Stock Exchange. In April 2004, Apollo raised $930 million for a listed business development company, Apollo Investment Corporation (NASDAQ: AINV), to invest primarily in middle-market companies in the form of mezzanine debt and senior secured loans, as well as by making direct equity investments in companies. The Company also invests in the securities of public companies.

Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940. Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90% of their income, which may be taxable to its investors. As of the end of 2007, among the largest BDCs (by market value, excluding Apollo Investment Corp, discussed earlier) are: American Capital Strategies (NASDAQ: ACAS), Allied Capital Corp((NASDAQ:ALD), Ares Capital Corporation (NASDAQ:ARCC), Gladstone Investment Corp (NASDAQ:GAIN) and Kohlberg Capital Corp (NASDAQ:KCAP).

Private Equity Firms 'Now Biggest Force in Takeovers'

The Observer
Originally Published on September 25, 2005

Private equity firms accounted for more than half of all merger and acquisition activity in the first half of the year, according to research published today. This is the first time venture capitalists have eclipsed trade buyers and other companies in the deal tables.

'Secondary' buyouts - where one private equity firm buys from another - have also grown dramatically, accounting for 40 per cent of all deals, compared with just 5 per cent five years ago.

Four of the top five buyouts - Travelex, Priory Group, Kwik-Fit and Tussauds - were in this category, while 'traditional' buyouts from industrial companies, which used to be in the majority, accounted for just 15 per cent of deals.

Last month, the Gala bingo group was passed to its fifth private equity owner, while some private equity firms are buying back companies they have previously owned.

'It remains to be seen whether this level of secondary activity is sustainable, and indeed desirable,' said Tom Lamb, co-head of Barclays Private Equity, one of the sponsors of the research. He warned that some investors hold stakes in several buyout funds and may not be happy with investments simply being transferred between them.

Overall, the Centre for Management Buyout Research found a 24 per cent increase in private equity deals, to £17.5 billion so far this year, and it predicts that 2005 will be another record year.

The findings are likely to fuel concern about the activities of private equity firms: huge swathes of the retail, leisure and food industries are now owned by venture capitalists and a growing number of company directors are being attracted into the industry.

Univision Branches Out With Bonds

The deeply indebted company recently announced plans to sell bonds. Expect many others to follow suit.

Forbes
Originally Published on June 19, 2009

Consider it a test of the bond market's appetite. The broadcaster Univision Communications, bought by five private-equity firms in 2007, recently announced plans to sell bonds. Univision's bonds sport a CCC-rating from Standard & Poor's, near the bottom of the credit scale, and it carries $10 billion in debt -- a whopping 12 times earnings.

And like other media companies, it's struggling: Univision's first-quarter interest expenses reportedly surpassed operating income. In March, the company even stopped paying interest to holders of certain bonds and handed them more IOUs instead.

The corporate credit rally has lifted the prices on some of the lowest-rated and riskiest junk bonds, an encouraging sign to Univision and others with towering leverage ratios. It's also prompted some in the bond market to wonder if investors have become too indiscriminate. The KDP Investment Advisors High-Yield Index is up 22.9% this year and 1.4% in June.

Investors seem unafraid of newly issued junk bonds. Speculative-grade borrowers sold $3.5 billion in the past week, up from $1.9 billion the previous week, according to Bloomberg. Among those issuing bonds: cable company Comcast ( CMCSA - news - people ) with $700 million at 5.7%, retailer Limited Brands ( LTD - news - people ) with $500 million at 8.5% and fast-food chain Wendy's/Arby's Group with $565 million at 10%.

If Univision completes the bond sale, the cash will be used to pay off $500 million in 7.85% notes that mature in 2011, so the company may stretch its maturities and wind up with the same debt load.

It's widely expected that the debt used to finance leveraged buyouts will drive many private equity-owned companies into bankruptcy this year. Even so, some leverage-buyout debt looks surprisingly strong. Take the hospital chain HCA, which is shouldering $26 billion in debt, six times its earnings; HCA's 9.25% notes due in 2016 are trading at 99 cents on the dollar. Or SunGuard, the software services company bought by a consortium of private-equity firms in 2005, whose 9.125% notes due in 2013 trade at 96 cents on the dollar.

Defaults, however, continue to pile up. Another five U.S. companies defaulted in the past week, of which only Eddie Bauer filed for bankruptcy, according to S&P.

Companies May Sell Junk Bonds in Lieu of Payments

Reuters
Originally Published on June 6, 2008

More companies could choose to sell additional junk bonds rather than pay interest to investors as they try to conserve cash in a weakening economy.

Along with drawing down revolving lines of credit and exchanging old debt for new, this is another sign that some firms are experiencing financial distress in the current economic environment, analysts said.

The option to pay interest with debt is available to companies that sold pay-in-kind (PIK) toggle bonds when bondholders were lending money to junk companies on easier terms before the credit crunch hit.

The structure provides a lifeline to distressed firms, allowing them to preserve cash and likely avoid defaults, but bondholders are now exposed to potential losses.

"We are going to have a problem over the next couple of years because of the history of these toggle bonds that have been sold in the high yield market," said John Atkins, credit analyst at research firm IDEAglobal in New York.

"Instead of paying cash on the interest, you just issue more bonds. The debt becomes worth incrementally less over time if they continue to dump more bonds into the pool," he added.

The number of companies that are using this option is on the rise. Out of 43 bond deals that have a PIK feature totaling $23.5 billion, eight have paid interest with debt or announced plans to do so, according to Standard & Poor's Leveraged Commentary and Data.

The latest announcement came last week from silicone producer Momentive Performance Materials, which said it would pay interest on $300 million of its 10.125 percent notes due on December 1 with more debt. Momentive was the third company owned by billionaire investor Leon Black's private equity firm Apollo Management that chose to exercise its PIK option. The other two were real estate and relocation services provider Realogy Corporation and jewelry retailer Claire's Stores.

Harrah's Entertainment, the world's largest casino operator and another Apollo Management sponsored issuer, has until August 1 to make a decision on exercising the PIK option, Lehman Brothers said in a research note.

This trend "has a potential to lead to large price movements in cases where the decision to exercise the option comes as a surprise," Lehman Brothers said.

For example, Momentive's 10.125 percent notes due in 2014 dropped to 86.5 cents on the dollar on May 28 when the announcement was made from 93.375 cents on the dollar on May 20, according to MarketAxess. The yield surged to 13.29 percent from 11.6 percent.

This bond structure was popular with leveraged buyouts which proliferated before the credit crunch hit in the middle of summer 2007.

Private equity firms were active in the leisure businesses such as hotels, gaming and restaurants. Profits in this industry and other cyclical sectors are getting squeezed as food and oil prices soar and consumers spend less on travel and entertainment while they fear the slower economy will cost them jobs.

"The fact that issuers are taking that option to make interest payments with further debt indicates that they are suffering some financial distress," said Kenneth Emery, senior vice president at Moody's Investors Service (MCO.N) in New York.

Corporate America's credit quality is sinking at a record pace as the subprime housing crisis takes a toll.

Credit rating downgrades and warnings by Moody's are on pace to hit a record $1.6 trillion in the second quarter, topping the massive credit deterioration seen in the bankruptcy wave of 2001.

Standard & Poor's, a unit of McGraw-Hill (MHP.N), said the number of companies around the world at risk of a credit downgrade climbed to a record in May. These rates could have been even higher if weak companies could not sell more debt rather than pay out interest.

Some companies choose this PIK option because they can use cash meant for the interest payment to buy back outstanding debt in the secondary market, which could reduce the total debt burden.

"It's really affecting the default rate," said Mirko Mikelic, senior fixed income analyst at Fifth Third Asset Management in Grand Rapids, Michigan. "It's given firms a lot more leeway."

Should Private Equity Be Investing in Residential Real Estate?

By Ken Stier, TIME
January 20, 2010

When new owners took over an apartment building in the New York City borough of Queens, they promptly set about filing eviction notices, suing nearly half of the building's tenants — some of them multiple times — within the first 16 months. That amounted to 965 court proceedings against 2,124 apartments, compared with just 50 court proceedings in the final year of the previous owner. The complaints alleged that the tenants were subletting illegally or had not paid their rent or security deposits, even though the tenants often had records proving otherwise. To the tenants, it seemed as though every possible legal vulnerability was being sought out in an effort to force them out.

This kind of activity — flushing out low-rent tenants and replacing them with wealthier new renters — has been a staple of strong real estate markets for years. What was different over the past few years was how widespread this Dickensian business model had become, largely fueled by Wall Street money seeking high rates of return. Another difference was how much the general investing public — through university endowments and pension funds — became party to such morally dubious schemes. Consider it another footnote to the Gilded Age we just passed through.

This investment trend, which flourished from 2005 until the financial crisis hit in 2008, threatened a cherished pillar of urban policy — affordable housing, which has long been regarded as essential for maintaining vibrant diversity in our cities. The victims are among the huge numbers of Americans (estimated at close to 100 million before the latest housing boom promoting homeownership) who rent their primary residences — poor, working-class and even middle-class folks — who have been overshadowed in the deluge of media coverage of the debacle in single-family housing. (Affordable housing refers to that costing no more than a third of a family's income.)

But as private equity funds seized on the rental market in major cities in recent years, all this was jeopardized by the need to generate fat returns of 15%-20% per annum.

Worse, this business model was based on a dirty secret — expelling as many existing tenants as possible. This is the thuggish reality behind otherwise respectable-sounding prospectuses offered to investors to explain how they could service high debt on mortgage-backed securities.

"The borrower anticipates to recapture approximately 20%-30% of the units [roughly within the first year] and 10% a year thereafter," explained a prospectus for a portfolio of buildings in upper Manhattan being bought by Apollo Real Estate Advisers (now AREA Property Partners), with a primary mortgage from a Credit Suisse subsidiary.

The normal turnover rate in cheap or moderate rent-regulated apartments in New York City is 5.6%, according to data from the New York City Rent Guidelines Board.

"From a public policy standpoint, you can make a strong case that it is not desirable [for Wall Street money to be in this market], and equally strong you can say that housing regulators or authorities in New York and most other cities have been asleep at the wheel for the last five and 10 years — this stuff is going on everywhere," says Guy Cecala, CEO of Inside Mortgage Finance Publications, a stable of industry newsletters, who worries that the very idea of affordable housing is under threat.

But these securitized transactions were considered a legitimate business strategy by investors, who typically focus on the cash flow from these deals, not the fine points on how cash is generated.

"These could have all been brothels or sweatshops underlying them, and nobody would know that either," says Cecala, who notes that "one of the reasons for buying securities ... is supposedly you don't have to worry about any of that; someone else is supposed to have signed off on the legality of the transactions, the business practices, everything."

Those packaging these investments say they regarded them as aboveboard, though their defense is less than robust. Key players included leading banks in tandem with some of the biggest names in real estate and private equity, none of whom would have missed that high tenant turnover was the main motor for profits.

"We truly went into this trying to turn housing that was run very, very poorly by slumlords into affordable working-class housing, and to be portrayed like this is somewhat upsetting, to be quite frank," says Richard Mack, who works at AREA Property Partners, a $9 billion partnership, with his father William, who got his start in 1963 with a 5-acre plot of New Jersey swampland.

The turnover targets were perhaps "more aggressive than people think they should have been," but he says, "Life is too short for us to have done this, with this small a part of our portfolio, if we didn't actually think we were doing the right thing. Whether or not we executed as perfectly as we could — I'm sure that we made mistakes — our true intention here was to make money by doing good."

Tenants pried from their homes would see it differently. In a typical Queens building, hired legal guns were able to achieve 23% turnover in the first year of new owners, or about double that of a typical building in Manhattan, where the culture of tenant rights is stronger, according to a new study by affordable-housing advocates, the Association for Neighborhood and Housing Development.

The study focused on New York City, where Wall Street money made the most inroads — capturing about 100,000 units (out of the city's 2.5 million), or about 10% of the city's rent-regulated apartments before the real estate bubble collapse.

In this process, the report explains, the investor-owners were helped by the fact that many transitional neighborhood tenants were new (and possibly undocumented) immigrants, whose lack of English fluency and legal representation put them at a disadvantage in housing court, where deals are typically hammered out with owners' lawyers before ever reaching the judges. Those actually executing these orders were often conflicted about it.

"Having a large property owner as a client is great for the volume of work, but if you ask me about it morally or ethically, well, I'd rather not say," admits a housing court attorney who asked not to be identified.

Others are inclined to give big investors the benefit of the doubt.

"If people are really stretching the law — doing outright harassment to remove tenants — that's not a good thing, but I don't think that most big institutional investors knowingly will target deals like that or knowingly target deals with partners where they think that might happen," says Andy McCulloch, senior residential analyst with Green Street Advisors, a property research shop.

In the end, though, many new owners have been unable to meet their overly ambitious rent roll increase targets, and many of these investments are in danger of buckling under the high debt servicing costs. Finance industry watch lists are already full of private-equity-financed deals in danger of default. That has local officials scrambling to find "preservation buyers" who are willing to take on these properties with the expectation of a more modest 7%-8% annual return.

"I do think it is a problem ... and that's why we are putting our resources to bear to try to correct the problem before it becomes a bigger problem than we can tackle," says Rafael Cestero, commissioner of New York's Department of Housing Preservation and Development.

"Ownership of rental properties in New York City is a long-term proposition, and if you do it right, you can make a fair profit, but trying to make a short-term investment is where you can get yourself in trouble."

Nowhere was that more true than in the ill-conceived investment to turn the twinned 11,000-unit middle-class housing complex known as Stuyvesant Town and Peter Cooper Village, built originally to accommodate World War II veterans, into luxury housing, for which limits on yearly rent increases are chucked in favor or whatever the market will bear. The prospectus offered by the lead investors, Tishman Speyer and Larry Fink's asset-management fund BlackRock, imagined evicting 50% of rent-regulated tenants in just a few years. But tenants fought back and won in a court decision that also undercut plans for using city tax abatements to further sweeten returns on apartments pushed into luxury decontrol. The upshot, according to a recent Deutsche Bank analysis, is that the property, purchased in late 2006 for $5.4 billion, "would fetch less than $2 billion if sold into the current dislocated market." It added that the most natural buyer was MetLife, the insurer and original owner, in part because it represented "patient capital."