Why private equity is in a deep freeze
Buyout firms with huge stockpiles of cash aren't making new deals. The reason? They're too focused on trying to manage the companies they've already got.
NEW YORK (Fortune) -- If the credit markets have been an iceberg over the past year, the private equity business has been frozen as solid as a prehistoric glacier. Buyout giants like KKR, Blackstone, and Bain Capital -- who just a couple of years ago were vying to one-up each other on a monthly basis with new mega-deals -- have been in a virtual hibernation for months.
In the first half of 2009, just $24 billion in deals were completed globally. That compares to $131 billion last year and an astounding $528 billion in deal volume in 2007. This year's first-half total is the lowest since 1996, when the buyout industry was much smaller. There were only three loans extended to fund leveraged buyouts through June, the fewest number since 1985 according to Dealogic.
In recent weeks, though, the stock market has begun to rally and the cost of borrowing has begun to fall. So it's natural to wonder: Is the buyout market about to heat up again?
Don't be on it, say industry insiders. Private equity is still in the early stages of a long thaw.
Digesting last cycle's deals
The problem is not that firms don't have money to spend. In fact, according to private equity research firm PitchBook, the industry is sitting on an estimated $400 billion worth of so-called dry powder, or money raised but not yet invested.
No, the reason that dealmaking isn't going to come roaring back is that private-equity firms are simply still too busy trying to digest the companies they swallowed during the boom years.
"The business has changed radically," says John Howard, head of Irving Place Capital, the former Bear Stearns Merchant Banking unit, which he helped rescue from the wreckage of Bear. "What was essentially a business of creating financial options is becoming more concerned with growth and enhancing profitability."
A survey earlier this year by the Association for Corporate Growth, a buyout industry group for consultants, found that 89% of private-equity executives said they were planning on spending a lot more time than before focusing on their portfolio companies.
Of course, private equity investors have always claimed that their business was all about "improving" the companies they buy through streamlining operations. (At least enough to service the huge debt loads they pile on in the acquisition.)
But in reality, the velocity of the business -- fueled by cheap debt to buy companies and hungry equity markets to resell them to -- typically discouraged much more than blunt-force cost-cutting. Only the very biggest firms have ever paid much attention to teaching management skills or thinking about ways to share costs among portfolio companies.
"We saw people talk a lot about building platforms," says Andrew Wilson, managing partner in divestiture services at Deloitte & Touche, referring to the industry's term for buying companies and working to combine them in creative ways. "But we didn't see so many execute them."
Despite the stock market's rally, firms don't expect much demand for their holdings any time soon. Part of the reason is that newly skeptical investors wouldn't think about investing in the debt-laden companies they own. According to Standard and Poor's, an astonishing half of all defaulting companies this year as of June were owned by private-equity firms.
"The environment has changed, and the holding period is expected to be a lot longer," says Blackstone's senior managing director in charge of portfolio management, James Quella. "The ability to use financial engineering for enhancing returns has been curtailed and limited on existing portfolios."
A survey by Coller Capital, which invests in stakes in private equity deals, found that two-thirds of people in the industry believe the environment will stay the same or even get worse next year.
Learning to manage
So in an attempt to generate some kind of returns for their investors in that time, firms are turning more aggressively to the time-honored tradition of creating value through cost savings. Such savings are being achieved by running their portfolio companies more like divisions of a parent, cutting costs across businesses and getting all the top managements in a room together more often.
It's an ironic turn of events, given that the earliest private equity deals were a response to the conglomerate booms of the 1960s and '70s, when bloated, unmanageable behemoths like Gulf + Western and ITT were built.
Gary Stibel, founder and CEO of the New England Consulting Group, has been working with private-equity firms since those days. "Traditionally, firms delegated that kind of management stuff to advisory partners, or just didn't really pay much attention," he says. "Now they're focusing on it and doing it more themselves."
One increasingly popular practice is called "leveraged sourcing," in which the many companies owned by a firm will pool their buying orders from suppliers -- ranging from telecom services to temp workers -- to get bigger bulk discounts.
"We're getting a ton of phone calls on this," says Richard Jenkins, a managing director at turnaround advisory firm Alvarez & Marsal, which recently launched a group dedicated to private-equity consulting. "Each week, we get another two or three calls asking us about what they can do to cut costs and manage more centrally."
Even mega firms that have done this in some form in the past are expanding. Blackstone (BX) has long had a group, called CoreTrust, that purchases across its businesses. It is the single largest U.S. customer to Staples (SPLS, Fortune 500), for example.
Quella recently led Blackstone into a new area for leveraged sourcing: health care. Since January, Blackstone has asked companies to participate in a group plan that is now Aetna's fifth-largest and Anthem's ninth-largest customer. The health group also runs prevention and wellness programs across its companies.
Still about selling
There are limits to the process, however. Not all business functions can be merged. Howard of Irving Place Capital says that advertising in particular is a touchy area.
"I've learned from the experience of buying an ad agency to use for all the businesses," he says, "For the head of marketing, choosing an agency is one of their most important decisions. It was emasculating to them."
Will cost savings single-handedly save private equity's returns? Consider that Blackstone's two most recent funds raised nearly $30 billion. A 10% reduction in health-care costs of $2 billion would save $200 million, or create about $1.4 billion in value, assuming they can sell the companies for seven times their earnings. Using some rough, unscientific math, that's about a 5% return on those funds.
So while private-equity firms may make a virtue of their focus on growth, it is still the selling of those assets -- not the managing of them -- that defines them.
"Private equity will always be the business of selling companies," says Stibel. "Exit timing and strategy is significantly more important for overall returns. More important than even the companies." Meanwhile, they have to manage the best they can.