Indian companies eyeing global and local takeover targets are increasingly taking to private equity (PE) funds like KKR, Carlyle, Goldman Sachs and Citigroup as favorable allies. But going forward, companies like Tata Steel, Welspun and Infomedia that partnered PE players for financial support and expertise in cutting through the competitive and complex global deal tables, may find these same funds turning into formidable competitors for making such strategic acquisitions. Flush with money and many in number, PE funds are chasing international deals pushing up their size and valuations, putting them well out of reach of strategic investors. Selling companies too are getting smarter and are using options like “go shop” that let them invite multiple potential bidders to review their books. The buyout firms make offers at the upper end of their limit to avoid a full-blown auction, further raising prices.
This is evident in the high valuations at many times the EBITDA of a company. Conservatively, a deal at EBITDA of 5-6.5 is considered modest with anything upwards of seven considered high. Some of the recent deals like Tata Steel’s acquisition of British steelmaker Corus at $12 billion were struck at nine times EBITDA while the Merck deal is believed to be in the 15 times EBITDA zone. International financial watchdog, the UK based Financial Services Authority (FSA), has warned about a possible default by a large PE-backed company based on these excessive valuations. This, it says, could knock the confidence of lenders and the capital markets.
Says an analyst on conditions of anonymity, “Its a case of too much money chasing too few deals. PE funds are awash with cheap low interest rate funds. Historically, we have seen that the deal sizes and valuations rise towards the end of the bull-run cycle. PE funds may just be approaching that stage. If just one big venture goes down, PE funding will dry up fast. End of the game.”
What has changed over time is the nature of PE investments. While a couple of years ago, PE players were content putting in just $ 2-3 billion for a partial stake in a company, today funds like Texas Pacific Group and Kohlberg Kravis Roberts don’t blink while buying out a firm like the US energy group TXU Corp for $45 billion. In December 2006, a battle for Equity Office Properties Trust (EOP) between Vornado Realty Trust (VNO) and PE firm Blackstone Group had the latter making a winning bid for the company at $38.9 billion or more than double the $16 billion it had quoted at the beginning of the bid process. In cases where PE players bid along with strategic investors, they often have counter bids by other such consortiums resulting in a price war.
Ranbaxy and Cipla pulling out of the race for the generic arm of European pharmaceutical major Merck KGaA is a recent example of the phenomenon closer home. Both got out when target valuations got in the $6-$6.5 billion mark, a price both found excessive. Those in reckoning include Actavis, Teva Pharmaceuticals, Mylan and a consortium of PE firms Apax Partners and Bain Capital apart from Kohlberg Kravis Roberts and Warburg Pincus who are said to be bidding together. “Globally, 70% of all auctions are bagged by PE funds. Going forward, strategic investors will find it increasingly tougher to acquire companies with prices getting out of reach, “says Desai of E&Y. Ram A Sundar, CFO Ranbaxy Laboratories also accedes that “things will get more competitive going forward.”
There are people like BTS Investment Advisors, a Switzerland-based investment banking group’s India Managing Partner K Srinivas, that say that no businessman enters a deals which it thinks is values insensibly. “They take risks but that is what businesses do,” he says.” He does accede that higher valuations put pressure on risk-reward rates, pushing them higher. Kiran Vaidya, head private capital market, Religare Securities, says that as deals get more expensive, the risk for the investors will increase. “If there is a failure of two to three deals then one may find the markets start getting jittery,” he says.
The PE fund interest in India is only rising with the deals becoming larger. In 2006, private equity funds invested a record $7.5 billion into India spread over 299 deals (excluding real estate deals also running into billions of dollars) according to Chennai based Venture Intelligence, a company that tracks private equity investments in India. This was three times as much as the investments PE firms made in India in 2005 and nearly five times the 2004 levels. Says Jayesh Desai, director, Ernst &Young, “the momentum of PE investments in India has sharply gone up since 2004. While earlier you would find funds willing to invest only two to three million dollars, today some funds do not even look at sub $20 million deals.” Those like KEC Raja Kumar, chief executive of UTI Venture fund believe that PE investments will the cross $10 billion mark in 2007.
But excessive PE based deals may not be a good thing. PE funds may see companies going under when they demand their pound of flesh in the form of asset stripping, high interests debt and its payout in their quest for above 30% returns for their investors. CVC, Texas Pacific and Merrill Lynch Private Equity’s purchase of UK’s Debenhams department stores is a classic example. These funds bought the business in 2003 at a price of £600m. They increased debt heftily to pay themselves a substantial dividend and later sold the freehold to the stores and refloated the business for £1.6bn. As per some estimates, they made over three times their initial investment.
There is also a scare of interest rates hardening on the back of the US fed looking at a soft landing for the US economy. If they do, it will put additional pressure on PE backed companies to deliver returns. Explains Vaidya, “If the present cost of debt is 12% one will have to add return on equity to arrive at a rate of return. At around 8% rate of return on equity the total returns work out to be around 20%. With interest rates going upwards, the expected return rate will become higher.” The higher the rates get, higher will be the number of funds defaulting. Vaidya adds that PE funds will continue to make larger deals and the risks will only increase. But he believes that the markets are a great leveler. “Recently, we have seen the Indian secondary markets come down on valuation mismatch, so will the PE markets if the valuations are not right,” he says.
This competition for grabbing deals is only set to get worse as new funds enter the markets. 899 funds have already been declared for 2007 with 500 expected to join in during the year. Newer funds have resulted in more multiple bids according to market research firm Dealogic. It reports that there were multiple bids for 29% of the private equity buyouts in 2006 as compared to just 4% in 2005. In the first six weeks of 2007 this figure has risen sharply with 70% of announced private equity buyouts having multiple bids. With a rise in competition for bids, the money involved is also set to get higher.
According to PWC, PE firms raised a whopping $404 billion in 2006 up over a third from 2005. “With so much cash at their disposal, private equity firms will seek deals across all industries,” says the report. PE firms also bought out companies worth $700 billion the previous year. “The real test will come when the PE companies try and take these companies public again or try and sell out for cashing out,” remarks an analyst. But if all companies try and sell out or take companies to the public market, the downward pressure will kill the market. “Firms may then have to hold their stock lowering returns which again may cause a shakeout,” he remarks. There are other worries as well. “A global slowdown, oil prices, India’s economic growth slowdown, can all affect PE funding available to Indian companies, “ says BTS’ Srinivas
There are warning signals that are getting louder by the day. Recently, rating agency Standard & Poor (S&P)’s warned that the quality of debt backing private-equity deals has fallen significantly. It said that at end of August 2006, loan backing 75% or three-quarters of European private-equity deals were rated as single “B” range of junk debt meaning that one out of five companies taken private using the loans as finance may fall into default.
When S&P began compiling figures in 2002 the risk of default stood at one in 20 with one- third of debt rated in the B range and more than half (57%) rated in the BB range (just below investment grade). The falling quality of securities may result in banks stopping funds flow for PE to cover their risk. Media reports say that banks in the US are already under pressure to do so because of worries of institutional exposure to sub-prime lending or loans to borrowers whose creditworthiness is questionable.
It may be the beginning of difficult times for PE funds. But even in their downfall, it will be the strategic investors who will feel the pinch.
Source : Financial Express