Loans will go bad, deals will be canceled, fortunes will be lost, and the sudden end of cheap financing is wreaking havoc on the buyout market, reported Fortune magazine.
Just open the Wall Street Journal or CNBC, and you will hear these same headlines repeated everyday. The news about the financial meltdown is all over the media, with the death toll rising by the day. First it was the sub-prime lenders, then prime mortgage lenders, then hedge funds, then investment banks. Even some money market funds, the safest of the safest, are witnessing a rush of withdrawals.
The private equity party, in its latest round in the US and Europe, was a classic bubble waiting to burst. The combination of low interest rates, depressed stock prices, and rising corporate profits created ideal conditions for private equity firms to flourish. With the abundant supply of debt and highly leveraged acquisitions, even modest improvements in the company’s profits generated huge returns for the private equity firms and their investors. With huge returns being logged in, investors piled hundreds of billions — $404 billion in 2006 according to Private Equity Intelligence — into private equity funds. Fund managers, with ever larger funds to deploy, were paying huge premiums to snap up deals.
In 2002, when markets did not recover from the 2000 hangover, buyout prices averaged just four times cash flow (defined as earnings before interest, taxes, depreciation, and amortization, or EBITDA). But by early this year the average buyout price was clocking in at 15 times cash flow. In a typical deal a private equity shop would borrow more than 80+% of the purchase price, and the rest it would put up in cash. In some deals, even that cash was supplied by the banks through an innovative scheme called “bridge equity,” where banks were putting up part of the equity, in addition to 80+% of the debt!
Lenders thought acquired companies will never default. Hedge funds bought junk bonds on the margin with a lot of debt. Junk bonds were priced at historical low levels with sometimes 2-3% spread over 10-year treasury. And private equity players piled as much debt as possible on the acquired companies’ balance sheets with no buffer for a downturn. The motto of the party was: “Buy it if you can finance it.”
What about us?
There is a structural difference between us and them. Of the 25 transactions announced or closed by MENA funds within the region in 2007, no more than five were leveraged, and only one was leveraged to the levels mentioned above. Unleveraged transactions are unthinkable outside the region, but are the norm here. Returns are not derived from financial engineering, but from relentless economic growth that will keep on humming as long as the price of oil is above $50 per barrel. The liquidity crunch grounding the global financial system is watched with amazement by the bankers in the region, who are flooded with liquidity and have minimal exposure to mortgage lending.
Nevertheless, the psychological effect will be global and will touch MENA. Now that the global case is tainted, private equity players will work harder to raise funds and finance transactions.
But economic growth will keep top and bottom lines growing at a healthy pace, creating opportunities and seducing investors. Shareholders will continue with the trend of opening up their capital for private equity or any form of intelligent capital. Governments will move unabated with their privatization programs. Bankers will pause, add 50 bps to any transaction they are pricing, and move on. And those mammoth international competitors setting up in the region probably will cut their losses and close shop.
But one lesson should be learned. Risk will show up its ugly face, it is only a matter of time. Price it right, mitigate it when possible, and manage it on continuous basis.
Imad Ghandour is Head of Strategy & Research (Gulf Capital) and Board Member of the Gulf Venture Capital Association