The Real Deal for Buyouts

Private Equity's Golden Era
Of Unreal Returns Is Gone;
Pricier Debt, Stricter Terms
Wall Street Journal August 27, 2007; Page C8

The private-equity world's best days have certainly passed. That doesn't mean the leveraged buyout is an extinct creature. Deals will get done again.

But many of the ingredients that financial alchemists like Henry Kravis and Steve Schwarzman used in recent years to cook up their riches are no longer available to them. As a result, they and their investors must adjust to a future where their investment returns suffer.

To illustrate just how different the new world of private-equity returns will look from the bygone era that Mr. Kravis himself described earlier this year as "golden," let's take the case of a hypothetical buyout of widget-maker Freewheeler Corp. A mythical buyout shop, BSD Partners, agrees to buy Freewheeler for $1 billion, or 10 times its $100 million of earnings before interest, tax, depreciation and amortization, or Ebitda.

Just a few months ago -- before the subprime-mortgage mess roiled the credit markets and the leveraged-finance market seized up -- banks would have happily extended debt equal to about 7.5 times Ebitda.

Today, a Freewheeler LBO would be lucky to obtain leverage of six times cash flow. That means BSD Partners would need to put up $400 million from its funds instead of $250 million.

Moreover, that debt has become more costly. Bonds issued by a levered-up Freewheeler will need to pay an annual interest rate of as much as 12% in the new world of private equity, or three percentage points more than securities issued, say, three months ago.

And lenders aren't just demanding juicier yields from indebted borrowers. They also want all those covenants that private-equity firms were able to avoid during the peak of the credit boom. Those covenants force borrowers to be more conservative with spending cash to ensure they meet working capital and cash-flow requirements. This may restrain Freewheeler's ability to rapidly increase its sales.

There's another consequence to the new LBO landscape that will undoubtedly hit returns: The drying up of easy credit means it will become more difficult to exit from investments. Firms like BSD Partners can't do leveraged recapitalizations, where they issue debt to pay themselves a huge dividend. And the game of "pass the parcel" -- where one buyout shop sells a company to another by easily refinancing or adding on new debt -- becomes increasingly difficult to pull off.

So what does all this mean for the payoff on a Freewheeler buyout?

Let's say that the higher financing costs and more restrictive covenants from its creditors will limit the flexibility to expand the widgets business. That could reduce the company's earnings-growth rate to 5% per year from, say, 7% in the presubprime era.

In addition, rather than selling within three years, BSD needs to factor in the possibility that it will take five years to sell out of Freewheeler at the same multiple of earnings that the private-equity firm paid for the business. Finally, it's also injecting a greater amount of its own funds into the deal because banks have pulled back.

Once you take all of this in, BSD's internal rate of return -- the primary metric that private-equity investors follow -- would be about 11% on the Freewheeler deal. That may be better than the annual return investors can expect from the stock market over the next few years. But it's a far cry from the 24% annual returns that might have been on offer from a Freewheeler deal just a few months ago.

Of course, this is merely a single hypothetical instance; every deal will be different. And history shows that the risk appetites of lenders and investors will swing with the bearish and bullish sentiments of the markets. But for now it's reasonable to expect the credit cycle's turn has taken the easy money out of the buyout business.

--Lauren Silva and Rob Cox