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Industry Viewpoint - Fall 2009

What Next for Private Equity? - continued

THE COMMENTATOR

William Cohan

For a window into the future of private equity, look at the recent activities of longtime market-leading firm, Kohlberg Kravis & Roberts (KKR).

The firm is close to completing a public offering of its equity by constructing a complex reverse merger with a publicly-traded European affiliate. It is also busy taking public the few successful companies in which it invested during the private equity boom of 2006 and 2007.

Even more noteworthy, over the long term, KKR is building up an investment banking business – one that has started competing with Wall Street for fees in such traditional businesses as mergers and acquisitions (M&A) advisory and debt and equity underwriting. A case in point is the upcoming initial public offering (IPO) of Dollar General, a discount retailer that KKR and Goldman Sachs bought together in July 2007 for $7.2 billion. According to the IPO registration statement, Dollar General hopes to raise $750 million in new equity for the company. Assuming a typical 7% IPO underwriter’s fee, KKR could share in the honeypot of $52.5 million in fees, which once upon a time would have been Wall Street’s alone. KKR’s new role as an underwriter now ensures that it will get some of those fees while it competes with Wall Street.

If this move into investment banking succeeds, and helps to shave third-party fees along the way, expect some of the other large private equity firms, such as Blackstone and Apollo, to follow suit. After a generation in the private equity business, firms such as KKR, Blackstone and Apollo have started branching out into investment banking to try to capture more of the fees they have paid to third parties and to create fuller, less cyclical businesses. If there is collateral damage with the large banks – in the form of taking fees from them – these firms have decided they can live with it.

Another indicator of emerging private equity trends can be found by looking at Northrop Grumman’s sale of TASC, its Virginia-based information technology business. Banks are competing heavily to finance the deal at five times cash flow. While a far cry from the eight times leverage that buyout firms could get at the recent top of the market, the deal indicates that the market for leveraged deals has reopened. Private equity investors now expect the market for leveraged loans to tiptoe back to a form of normalcy where leverage remains modest with deal terms less flexible than the ridiculous levels that prevailed at the top of the recent bubble. Practitioners view this as healthy. For instance, bank covenants, which had been all but abandoned in a fit of competitive frenzy, are starting to return to traditional levels.

But not all is rosy in private equity land. A number of the big deals constructed during the boom have imploded (see the bankruptcy filing of Reader’s Digest Association, which was owned by a consortium of private equity firms led by Ripplewood Holdings). The consequences for the future? Private equity firms are likely to see their coveted ‘2 and 20’ compensation system – and in the case of Bain Capital, 2 and 30 – die away. Institutional investors are also cutting way back on their fund commitments, which means the days of $10-billion plus funds could be over as well.

It is clear that the private equity industry won’t be returning any time soon to the excessive ‘golden era’ of yesteryear. But KKR’s move into underwriting is a reminder that volatility breeds creativity and opportunity.

While private equity may be suffering from a cyclical downturn, the few rays of light now starting to emerge mean there is good reason to believe the industry will continue to loom large across the corporate landscape as a force for restructuring companies – and making money for their investors – in the United States and throughout the world.

William Cohan worked at Lazard Frères and is the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.