Private Equity Stumbles

Private equity funds have been snapping up companies like there was no tomorrow... and they were right, the future does not look as rosy as before especially following US bond yields creeping past the 5.0% level again. Buyout activity in the US and Europe, and to a lesser extent in Asia, have been instrumental in keeping stock prices high as traders bet on the next buyout target, plus the spillover effects to same-industry stocks. These buyout activity, usually announced over the weekend or on a Monday morning, always seem to be reassuring the bulls that as long as buyout activity is strong, the bears cannot win the battle.

As predicted, the stumbling block for the growth in private equity will be their access to cheap debt. Cheap debt allows them to leverage and magnify returns. Higher interest rates will add a few notches in the difficulty to add value and improve performance. Rising interest rates and tough terms from investors may signal that private equity players will soon be struggling to continue reaping the outsize returns that have made the buyout business so lucrative.

As reported in IHT: "Already a raft of bond offerings for recently announced deals, including the US$7.75 billion buyout of Thomson Learning and the US$7.1 billion deal for U.S. Foodservice, have been scaled back after facing resistance from investors. This week, two other buyouts, the US$4.7 billion deal for ServiceMaster and the US$6.9 billion sale of Dollar General, are expected to price their bonds, and they may serve as an important barometer for a series of even larger deals to sell bonds to investors this summer.

Blackstone Group's shares dropped below their initial public offering price in the third day of trading on Tuesday. The stock declined US$1.67, or 5.2 percent, to US$30.80 in late trading after dipping as low as US$30.36. The stock opened at US$36.55 on Friday and closed that day at US$35.06.

(The poor performance of China's first foray into risky investments - US$3 billion (HK$23.4 billion) earmarked to buy a 9.4 percent stake in US private equity giant Blackstone Group - must be embarrassing for Beijing. The man who sealed the deal, former Hong Kong financial secretary Antony Leung Kam-chung, may find it harder than he imagined to secure further Blackstone deals in the mainland after the disappointing start to this high- profile deal. Leung was hired by Blackstone in January as a senior managing director to head up its new China office. So far, China has lost US$34 million on its purchase of more than 101 million units in the world's second-largest buyout group. China bought the units at a discount of 4.5 percent to the IPO price of US$31.)

These setbacks come as Cerberus Capital Management begins a road show this week to sell bonds for its US$7.4 billion buyout of Chrysler; it plans to raise up to US$62 billion. First Data, which was acquired by Kohlberg Kravis Roberts for US$29 billion, plans to price its bonds next month. And later this year, bonds for the buyout of TXU, the largest in history, will go on sale. TXU is likely to seek about US$24 billion.

The resistance from bondholders may already be cooling the buyout market. The proverbial Merger Monday has not been so merger-filled lately. On Monday, only seven deals were announced, compared with 43 a week ago and 84 on June 4, according to data from Thomson Financial."

Things started to be questioned when Thomson Learning scaled back the debt offering it hoped to sell to finance its buyout by two private equity firms, Apax Partners of Britain and the buyout arm of the Ontario employees' pension fund. Originally a division of the media publisher Thomson, it sought US$2.14 billion; it is now seeking US$1.6 billion. U.S. Foodservice, a division of Ahold of the Netherlands, has now twice scaled back its own debt offering to help finance its buyout by Kohlberg Kravis and Clayton Dubilier & Rice. U.S. Foodservice's offering will now also be paid back in cash, not with the issuing of more bonds.

The immediate impact will be a dramatic shying away from financing new big deals by the lenders. There will be a significant drop in private equity buyouts. There will still be buyouts but the companies involved will be a lot smaller in size. Private equity firms or big hedge funds will have to stop trying to get listed as a cashing-out exercise. Impact on equity market sentiment will be downcast - lack of deal flow, lack of market activity, which may bring forth a period of consolidation. The big US private equity firms will be making a bigger thrust in Asia to compensate for reduced US activity.