KEY POINTS:
Hellman & Friedman LLC's Capital Partners IV Fund has generated a 36 per cent return for investors since 2000. Kohlberg Kravis Roberts & Co's Millennium Fund has done even better, notching a 41 per cent take since 2002.
Investors in private equity funds who have enjoyed large returns
like these during the buyout boom should brace themselves for a fall.
Buyout firms relied on cheap debt in the past two years to finance the biggest deals of all time, often paying premiums of more than 30 per cent for companies.
Now, as the subprime mortgage meltdown rattles credit markets, firms will have to sell their companies to buyers who no longer have access to low-cost loans. That will cut the sale prices of the companies and slash the buyout funds' returns, billionaire financier Wilbur Ross says.
"When it comes time to resell these investments, we'll likely be in a very different rate environment," says Ross, whose New York-based WL Ross & Co focuses on distressed assets such as auto parts makers. "The implications for returns could be substantial."
The severity of the drop depends on whether the US economy flags further, says Colin Blaydon, director of the Centre for Private Equity and Entrepreneurship at Dartmouth College's Tuck School of Business.
Growth will slow to a pace of 2.6 per cent in the second half of the year, according to a recent Bloomberg News survey of economists. Blaydon says that sluggish expansion, which crimps companies' ability to pay back debt, may push down annual returns to as low as 10 per cent in the next three years.
"The question is how harsh it's going to be," says Blaydon, who examined returns during the economic slump in 2001 to produce his forecast.
In 2005, buyout firms began to show a swagger rarely seen in the industry's 30-year history. In the first half of this year, mega deals for TXU Corp, First Data Corp and Equity Office Properties Trust - all topping US$20 billion ($28 billion) - were part of a record US$616 billion in announced purchases.
That's just shy of 2006's all-time-high total of US$701.5 billion, data compiled by Bloomberg shows.
Cheap credit fuelled the frenzy. The extra interest that investors demanded to own high-yield, high-risk debt rather than US Treasuries fell to 2.41 percentage points in June, the lowest on record.
The rates enabled buyout firms, which use credit to finance about two-thirds of a company's purchase price, to raise their bids.
Premiums for US companies, or the percentage offered above the target's stock price, soared to 39 per cent in June compared with 23 per cent a year earlier, Bloomberg data shows.
By July, the appetite for deals, especially record-breaking ones, had evaporated.
Investors, surprised by their level of exposure to the subprime debacle, saw greater risk in the approximately US$330 billion of loans and bonds that banks had slated to fund LBOs.
Investors balked at credit terms that allowed companies to pay off debt by issuing more bonds.
Lenders had to rework or cancel at least 45 loan and bond offerings since the beginning of July, including debt to pay for Cerberus Capital Management LP's acquisition of Auburn Hills, Michigan-based automaker Chrysler LLC.
Buyout firms and sellers are also renegotiating deals in order to get financing and keep them alive.
In August, Home Depot, the world's biggest home-improvement retailer, agreed to sell its construction supply unit to Bain Capital LLC, Clayton Dubilier & Rice and Carlyle Group for US$8.5 billion. That's understood to be 18 per cent less than the price negotiated in June.
Many other deals aren't getting done. The value of announced buyouts dropped to US$18 billion from August 1 to 26.
That compares with $87.4 billion last month and $131.1 billion in June, Bloomberg data shows.
Private equity firms will also struggle to sell their holdings to corporations and other fund managers at high prices.
In 2005, Hellman & Friedman paid US$1.1 billion for internet advertising company DoubleClick and, less than two years later, agreed to sell it to Google for US$3.1 billion.
These large payoffs will be much harder to get in coming years as the cost of credit rises, says Scott Sperling, co-president of buyout firm Thomas H. Lee Partners LP.
"Prices for companies will need to adjust downward," he says. "Higher rates will definitely push toward lower returns."
-Bloomberg