Powered by Private Capital
Equity Funds Are Behind Most Local Deals, and the Buyouts Are Getting Bigger

By Terence O'Hara
Washington Post Staff Writer
Monday, April 25, 2005

Washington entrepreneur Ken S. Bajaj owes his career as much to a single Midwest investment firm as to his business acumen.

Chicago private equity firm GTCR Golder Rauner LLC bankrolled AppNet Inc., Bajaj's dot-com-era firm, then cashed out in a 1999 public stock offering and eventual sale of the company in 2000. A year later, GTCR put up $100 million for Bajaj to go into the government computer networking business. With GTCR's money, DigitalNet Holdings Inc. bought two companies, then sold them to defense contracting giant BAE Systems PLC for $595 million last year.

In the case of both AppNet and DigitalNet, Bajaj outlined a strategy to buy companies with the skill sets most in demand at that moment in industries that were hot. GTCR just provided the means to buy them quickly, and GTCR (and Bajaj) profited handsomely from it.

"In any business, it's always a matter of whether you buy or sell," Bajaj said. "If you want to buy, this is just a quicker, faster way."

That churning -- the buying, building and selling of Washington companies by private equity investors -- is on the rise, putting billions of dollars into play to help companies merge or take the all-important step of going public and selling stock.

More nimble than banks, and often willing to invest more in a business's growth than a company's existing owners could raise on their own, private equity funds have been the driving force behind most of the Washington area's mergers, acquisitions and initial stock offerings of the last year. Locally, they have helped companies like United Defense Industries Inc. vault into the ranks of the region's largest. Nationwide, they are pushing the market toward an era when the fates of more and ever-larger U.S. companies will be affected by a select group of money managers who operate largely without government regulation.

"Private equity is getting bigger, stronger, faster, and for the truly large funds they're continuing to move further and further up market," said Philip J. Facchina, a senior investment banker at Friedman, Billings, Ramsey Group Inc. in Arlington.

While the track record of corporate buyouts by private equity funds over the past 20 years is mixed, recent years have evidenced a unique confluence of good fortune. Having largely shed the corporate-raider image, the current generation of private equity funds -- large pools of capital put together by leveraged buyout firms, venture capital funds and, sometimes, hedge fund managers -- is often welcomed into deals by business owners and entrepreneurs. In some cases the funds can be credited with saving companies and jobs from oblivion.

In the Washington area, Connecticut-based First Reserve Corp. and New York's Blackstone Group helped revive more than a dozen coal mines when they teamed last year to form Foundation Coal Holdings Inc. The new company, based near Baltimore-Washington International Airport, bought the dilapidated and unprofitable U.S. mining operations of a German energy conglomerate -- just as the price of coal began to skyrocket.

Blackstone and First Reserve took Foundation public in December, and the company is now profitable. It's also sitting on nearly $500 million in cash and is hiring miners (or trying to, experienced miners being scarce these days) at its mines in West Virginia and elsewhere.

Foundation is just one local example. Other companies that have gone public in the past 18 months, such as Fieldstone Investment Corp., TNS Inc., PRA International, Collegiate Funding Services Inc. and Mercator Partners Acquisition Corp., all owe their new status to private equity firms. And more deals are on the way.

A number of mid-sized local private companies, too, are deep in the private equity cycle. N.E.W. Customer Service Cos. in Dulles last year was bought for $370 million by a group of private equity investors, and Tyco International Ltd. last year sold its Alexandria-based commercial security unit, Sonitrol Inc., for $125.5 million to a private equity consortium that includes Carlyle Venture Partners of the District.

The cycle continues: Bajaj and GTCR are ready for their third go-round. Recent securities filings indicate Bajaj and GTCR created a company in March called SystemsNet Inc., a consulting company. Bajaj declined to say what business SystemsNet will pursue but let on that GTCR has committed more acquisition capital than the $100 million in equity it put up for DigitalNet. "As yet, I haven't acquired," said Bajaj in a telephone interview last week at his Potomac home.

Ready for Bigger Deals

Nationally, private equity firms still play a relatively small role in the merger-and-acquisition market. Less than a quarter of all corporate acquisitions are by private equity firms, according to many independent studies. To the contrary, most mergers are still of the traditional, strategic variety: One telecommunications firm buys another; one bank partners with a former competitor.

But the rich returns delivered by some private equity investments in the IPO market, coupled with the huge amounts of money being raised by private equity funds and the easy availability of debt financing for acquisitions, mean that private equity firms will remain persistent competitors in the deal market, said Louis J. Bevilacqua, chairman of the corporate mergers and acquisitions group at law firm Cadwalader, Wickersham & Taft LLP in New York.

If anything, the deals are expected to get larger. Leveraged buyouts have rarely been more than $5 billion. But Bevilacqua said a $20 billion-plus deal is within reach.

"You are likely to see those deals in the next year," he said. Private equity firms "are flush with money and want to compete for the mega deals. The increased size of funds will be an advantage, as it will take only a few private equity firms partnering together in order to raise the necessary equity for very significant transactions."

"The relative aggressiveness of lenders and consequent cheapness of debt has augmented the size of the transactions that private equity can do," Facchina said.

The District's Carlyle Group recently raised a $7.8 billion U.S. buyout fund. With borrowing, that single fund has more than $35 billion in buyout power.

According to research by the Buyouts newsletter, 158 leveraged buyout funds are in the market trying to raise $117 billion from investors, and have so far raised $36.6 billion. Combine that with low interest rates and the eagerness of lenders to finance the big deals, and buyout firms are operating in a kind of Elysian sweet spot.

Throughout the 1990s, a $1 billion-plus buyout fund was rare. The vast majority of the estimated 1,200 active private equity funds had far less than that in funding and plied their trade among small and mid-sized target companies in industries the fund's managers specialized in.

That is still the case today, but a growing number of funds are making a specialty of their size and ability to do larger buyouts. In addition to Carlyle, Blackstone Group, Goldman Sachs Capital Partners and several other major private equity players have raised or will raise funds of $8 billion-plus this year.

What's more, by joining with other big funds in so-called "club" deals, the major funds could easily do a $30 billion buyout. To give an idea of what that would mean: Lockheed Martin Corp., the Washington area's biggest industrial company, was worth $27 billion two weeks ago.

In March, seven funds agreed to buy Pennsylvania financial software maker SunGard Data Systems Inc. for $11.3 billion, 44 percent more than SunGard was worth before word of the deal leaked. SunGard's purchasers will borrow a whopping $8.5 billion from five institutions to finance the deal.

"The mega funds are getting more and more mega," said Perry W. Steiner, managing director at Arlington Capital Partners, a mid-sized District-based buyout firm whose investors have committed $450 million in equity capital. "And these mega funds have been returning very well, from an investor standpoint. So their fundraising capabilities seem to be endless at this stage. The lending markets are as strong as possibly they've ever been. So you'll continue to see these large transactions."

IPOs, the Favored Exit

While getting into a leveraged buyout is easier than ever, getting out of one is another matter. The method of choice these days is the initial public stock offering, and leveraged buyout shops have joined venture capital firms in using the IPO as the cash-out of choice. According to Buyouts, 15 companies backed by leveraged buyout firms went public in the first quarter of this year, raising more than $6 billion. That's 84 percent higher than the previous record, set in the fourth quarter of last year.

The biggest IPOs in the Washington area in the past year are all companies owned by private equity firms. Topping that list is Foundation Coal, which raised $519 million in an IPO in December. Most of that money was paid as a special dividend to Blackstone and First Reserve.

On tap is Neustar Inc., a Sterling-based telecommunications services company owned by three private equity firms: Warburg Pincus LLC, MidOcean Partners (both of New York) and Baltimore's ABS Capital Partners. Warburg bought Neustar from Lockheed Martin in 1999 for an undisclosed price and later brought in MidOcean and ABS for expansion capital. According to Securities and Exchange Commission documents, the three private equity firms will receive all of the proceeds of the stock offering: $690 million.

Of course, the key links in this cycle from private to public ownership are high-yield debt and investor appetite for it. Though equity firms commit substantial amounts of their own money when they buy companies -- usually anywhere from 10 percent to 40 percent of the purchase price -- they must borrow the rest, usually at a big interest rate premium.

Eventually that debt has to be replaced with further investment, either through a public stock offering or a sale to another buyer. Some economists worry about the ability of private equity firms to sustain the process at a time when the sizes of the deals are increasing and stock markets may be growing fickle.

For now, though, the cycle is working.

Bevilacqua said there is plenty of money around, and markets have responded well to new stock offerings.

"Investors and lenders continue to believe the economy is going to remain strong," he said. "The one big issue that could cause a chill would be if interest rates spike dramatically."

Is it a bubble? Steiner doesn't think so. In his view, private equity is merely ramping up its role as an intermediary, providing private, debt-financed companies with more stable ownership and capital structures. And purchase multiples -- the buyout prices paid for companies relative to their core earnings -- have remained in check, according to recent studies.

"There is so much capital available," Steiner said. "These deals are going to continue for some time. I don't believe there is a bubble, based on the purchase multiples we're seeing. If there's a bubble, it may be a bubble only in size, not in the underlying fundamentals of the deals. You don't see anybody saying, 'Oh my God, can you believe the price they paid for that company?' ''

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