Tuesday, May 24, 2005

Private Equity in Europe: The Future’s So Bright, We’ve Got to Wear Shades

These days, Europe is seeing an unprecedented wave of private equity deals. Deal size, country and sector do not seem to be a deterrent factor for the large private equity houses making investment decisions. What explains this surge in the European private equity sector, which languished for a number of years? Conventional wisdom states that US private equity firms, who have encountered limited growth opportunities in the ultra-competitive US market, have increased their forays into the European markets. This idea is supported by the fact that these firms have deep and full pockets after record levels of fundraising from investors looking for successful alternatives to the post-bubble equity markets. As pension funds, endowments and wealthy individuals have become increasingly sophisticated investors, the amount of capital in private equity has soared. Concurrently, there has been a dramatic growth in both the size of private-equity funds and in the size of the top firms that manage them. Finally, macroeconomic conditions have been very positive for the private equity industry in the last two years, due to very low interest rates – which cheapen debt service and cost of capital – and a somewhat resilient equity market that still enables an “exit” of the investment through an Initial Public Offering.

However, it is Asia and Europe that are portrayed as the new promised lands. On one hand, China has shown an outstanding 10% annual growth in the last few years. The world’s most populous country has vast reserves of labor and no shortage of capital. A history of inefficiently run companies an untapped market, and an appetite for foreign direct investment are part of the explanation for the surge in growth. India, Taiwan, Thailand and other South Asian countries pose a similar landscape, with particularities to their economic fabric and with other issues that affect their attractiveness for private equity firms. Nonetheless, most of these countries lack a fundamental requirement for private equity: a stable, effective and efficient legal environment.

Is this really a factor to consider? Europe presents only moderate growth, but it offers a stable legal framework and a great deal of opportunity, especially when it comes to turning around poorly managed companies poorly. Deal size is no longer an obstacle for private equity firms in Europe. With multi-billion euro funds to invest and a ready supply of debt, these firms are ready to tap the high-end market. There has been a lot of activity across the board, but particularly in the telecom, general industrial and retail sectors. Firms are targeting companies with hard assets, such as property, which will allow them to refinance.

While the value of deals has been soaring, the number of transactions has remained the same. This implies that the average deal size is growing. Buyouts worth about €60bn were completed in the first nine months of 2004, compared with €47.2bn in the same period of 2003. The number of deals increased by 2% to 748.

The size and quantity of buyouts had a noticeable effect on the M&A business of investments banks, who provide advice to the vendors and purchasers and also assemble the debt financing and offer their own equity to hold up deals. During the first six months of 2004, private equity firms were responsible for 40% of global M&A by value.

There are at least 10 US funds with more than $5bn (€3.7bn) to invest globally. The Blackstone Group, for example, raised more than $6.4bn for its fourth fund, and Thomas H. Lee Partners raised just over $6bn. At the same time, debt is being issued at unprecedented levels. Leverage in the €2.1bn VNU World Directories buyout was more than 6x EBITDA. Private equity firms have taken advantage of the lack of interest shown by corporate in M&A in recent years.

Multi-billion euro deals were almost commonplace this year. CVC Capital Partners and Permira won control of the Automobile Association, the UK motoring organization, for €2.6bn, while Apax Partners and Cinven acquired VNU World Directories, the Dutch publications company, for €2.1bn. US-based Blackstone Group won the German chemicals group Celanese for €3bn-plus.

These aspirations are clearly reflected in the €12bn ($15.5bn) bid for Auna, a Spanish telecom company. Ten of the world's largest private equity firms have divided into four groups to bid for the cable giant. Just this week, The Blackstone Group walked out on a consortium bidding €12bn for Auna and joined rival bidders Providence Capital Partners and The Carlyle Group in an €8bn offer for the company’s mobile telephone assets. Blackstone had been bidding for the entire company as part of a consortium with UK private equity firms Apax Partners and CVC Capital Partners. To make things more complicated, Carlyle and Providence are already backing a separate €2.6bn bid for Auna's cable assets, along with Spanish cable competitor ONO. It seems that Apax and CVC are now considering their options, which may include abandoning their bid or partnering with Cinven to replace Blackstone. The consequences of this deal, for Auna, the private equity firms investing, and to a lesser extent to telecom industry in Spain, are still unclear. Only time will shed light on these important questions.

At this stage, it seems clear that the old tale of Barbarians at the Gate is just beginning in Europe. Are we going to see a wave of takeovers, LBOs, MBOs in Europe similar to that of the US 10-15 years ago? And if so, what is the implication of such a threat for corporations across Europe? One important difference is the state of the junk bond market in Europe. The European junk bond market ground to a halt after last week’s downgrade of Ford and General Motors, threatening more than €10bn ($13bn) of high- yield bond issues coming to the market. The collapse in sentiment also threatens to dent the surge in private equity by raising the cost of financing on buyouts. Leveraged buyouts have been the main driver of junk bond issuance for the past two years, which has seen record demand and levels of issuance.

After fostering the image of corporate wrecking crews, private-equity firms can now plausibly describe themselves as providers of a safe haven in which firms can pursue long-term growth, sheltered from the short-term storms of the public stock markets. This role has the most strategic importance because both venture capitalists and buyout firms work with large numbers of firms undergoing big changes. In this sense, private-equity firms can also reasonably claim to offer a solution (though an expensive one) to the corporate-governance problems that have blighted so many public companies. “If you examine all the major corporate scandals of the past 25 years, none of them occurred where a private equity firm was involved,” noted Henry Kravis, one of the founders of KKR, in a recent speech. Is this bold assertion true? Is private equity the solution to corporate governance in Europe and more broadly at a global scale?

Finally, there is an important issue to be addressed: how easily can private equity firms dispose of their investments? These firms need an exit to realize their profits, and the two likely routes are selling a firm to a large corporate buyer or offering ownership through the public stock market. Despite the improvement in equity markets during the last two years, markets now seem to lack a strong growth bias, making an initial public offering much harder to pursue. In addition, increasingly popular alternatives, such as selling to another private-equity firm, are becoming more controversial.

Marcelo Hanan

Gabrielle Lambert

Valentin Pitarque

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