Private Equity's Loss of Leverage

By Thomas Heath
Washington Post Staff Writer
Wednesday, January 2, 2008

The first six months of 2007 will be remembered as the heyday of private equity.

The second six months won't.

Blockbuster buyouts burst into the news almost daily during the first half of the year, fueled by a seemingly endless supply of cash from the big Wall Street banks. First came the gigantic $44 billion purchase of utility TXU by Wall Street giants Kohlberg Kravis Roberts, Texas Pacific Group and Goldman Sachs.

KKR bought First Data in April for $27.7 billion. TPG also teamed with Goldman for a $28 billion deal to buy Alltel in May. Carlyle Group, Bain Capital and Clayton, Dubilier & Rice agreed to buy Home Depot's supply arm for $10.3 billion in June.

Adding to the heat was an initial public offering by Blackstone Group, a private-equity giant. The good times came to a head around the Fourth of July, just as Blackstone announced its $26 billion purchase of the Hilton Hotels chain. KKR too announced it would sell stock to the public. Private-equity buyouts totaled $64 billion in July.

Then came a tectonic shift that froze the capital markets.

"All of a sudden, this thing happened called the subprime debacle," said David Rubenstein, co-founder of Carlyle Group, the private-equity giant based in the District. "That had a huge effect. Buyout people who were kings of the hill and masters of the universe were suddenly seen as normal people."

By August, private-equity deals dropped to a monthly total of $8 billion and never rebounded any higher.

As a result, some deals went through. Some got renegotiated, such as Carlyle's purchase of HD Supply, which went from $10.3 billion to $8.5 billion. And some deals were killed altogether, such as KKR's $8 billion deal to buy District-based Harman International, the maker of high-fidelity audio products. And J.C. Flowers' $25 billion offer to buy Sallie Mae, the Reston student lender.

Rubenstein and others said the days of $50 billion deals are over for the foreseeable future, and private-equity firms are retrenching. The bread-and-butter buyout business in which private-equity firms borrowed money to buy companies, then repaired the companies or broke them up for a profit, are unlikely to sustain the 30 percent annual returns that investors have demanded in the past two decades.

"The days of easy money -- buying something with a lot of leverage and flipping it in 18 months -- are over," said Frederick Malek, founder of Thayer Capital, a private-equity firm in the District.

Yet analysts see plenty of opportunities for private equity to earn money all over the world and in all kinds of businesses. Carlyle Group, Bain Capital, Blackstone and KKR may soon look more like investment conglomerates Berkshire Hathaway and General Electric rather than private-equity shops.

They may also have a different ownership profile. Giant sovereign wealth funds, which are government-owned investment firms, have their eyes on U.S. investments, including private-equity firms. Carlyle sold a 7.5 percent stake in its firm to an investment arm of the Abu Dhabi government, part of the United Arab Emirates, in the fall for $1.35 billion. The company may sell more of itself to Middle Eastern or other investors this year, or it may go public like KKR and Blackstone.

With cash-rich sovereign wealth funds investing in, as well as competing with U.S. private-equity funds, Rubenstein said Carlyle and other buyout firms will need to "focus on many more different types of areas than they did in 2006 and 2007. More creativity will be needed."

Creativity may simply mean smaller buyouts, in the $2 billion to $3 billion range, with private equity putting up more cash and less debt. Midsize firms such as District-based Halifax Group, which typically borrow $150 million or less, are primed for this economic climate.

"The next 18 months should be the best in a long time for small, nimble firms that only need to borrow at their historical levels to complete deals," said Halifax founder David Dupree.

If the U.S. buyout market looks exhausted, the big private-equity firms will continue to expand their buyout presence in such places as China, India, Brazil, the Middle East and South Africa, where some economies are growing faster than here.

Look for private equity to increase its presence in other, non-traditional lines of business such as venture capital, real estate and distressed debt. Private equity may look to buy some of the $100 billion or so in distressed debt, at a discount, that banks are holding on their balance sheets. Some of that debt is from private equity's own buyout deals in 2007.

The disruption in the financial markets will make it likely that private equity may begin trolling for investments in devalued banks and lenders, similar to the $30 billion or so in investments that Middle East and Asian governments have made in the past couple of months in ailing financial firms like Merrill Lynch, Citigroup and Bear Stearns. Carlyle already has a new team exploring that area.

Investments in big public companies are another possibility, according to Rubenstein. He said Carlyle would seek sizable minority investments in public companies. The investment would probably include a board seat, a say on major decisions and a preferred stake that would be convertible into common equity, Rubenstein said.

With oil prices nearing $100 per barrel and widespread concern that fossil-fuel economies are changing the climate, private equity is also likely to begin investing in the energy sector and in renewable energy in particular.

Carlyle launched an infrastructure fund to invest in public transportation projects such as toll roads and bridges, as well as water projects. The model is for Carlyle to put up a portion of the cash in return for a long-term lease to operate and maintain the property. The annual returns are expected to be 13 to 15 percent -- lower than what investors have historically expected. But the infrastructure fund has a corresponding low-risk profile that can offset high-risk stakes that investors have elsewhere.

"Some people in the buyout business will look back fondly on 2006 and 2007," Rubenstein said. "But we have been investing in good times and bad times for years. The most attractive deals and the highest returns come when there is uncertainty in the market."

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