Private Equity's Year from Hell

(page 2 of 2)

To take one example, in 2000, private equity firms CI Capital Partners and Sentinel Capital Partners bought Buffets Holdings, a U.S. restaurant chain, in a leveraged buyout valued at $645 million, of which $130 million was the sponsors' equity contribution. Two years later, in a refinancing of debt, the company made a $150 million distribution, more than covering the sponsors' initial cash contribution, according to CI Capital's Web site. But heavily leveraged Buffets was unable to shoulder its debt burden, and filed for bankruptcy in January 2008.

No More Easy Exits

Sponsors continued to withdraw cash through refinancings on assumptions that portfolio companies would continue to generate strong cash flows that would be put toward interest payments on this debt and that the public equity market would provide easy exits, either through initial public offerings, secondary buyouts, or sales to companies in the same industry.

In trying to determine by how much private equity funds reduced their exposure to losses at a given portfolio company, the key question is how much of the money they took in dividend deals was redeployed to other deals, says Brown at Concordia.

As conditions in credit markets deteriorated and credit spreads widened between corporate bonds and U.S. Treasury notes with comparable maturities, it became harder for private equity sponsors to refinance debt and take money off the table, he says. The total dollar value of recap dividends and stock buybacks plummeted almost 93% between the second and third quarters of 2007— when the effects of the credit crisis began to be felt—from $11.47 billion to $820 million, according to Standard & Poor's Leveraged Commentary & Data.

Getting Through the Holidays

Investors in retailers and other consumer-oriented businesses are expected to be hit especially hard. Specialty retailer Linens 'N Things, which was taken private by Apollo Management, filed for a prepackaged bankruptcy under Chapter 11 in May but went into liquidation in October after not being able to find a buyer to bring it out of bankruptcy as a going concern. Jeffrey Manning, managing director of Trenwith Securities in Costa Mesa, Calif., says that if you look at the company's petition to the bankruptcy court to initiate a liquidation process, you'll see it asked to be allowed to start liquidation before Christmas so as to avoid the rush of other distressed retailers selling off their assets.

Brown says he expects to see a lot more private equity-owned retailers filing for bankruptcy after the holiday season ends, when many companies' fiscal years end. "Most retailers that are having problems desperately want to get through the holiday season because that's the season that generates the most cash for them," he says. They want to file for bankruptcy with as much cash on hand as possible to be in a better position to finance a restructuring, he says.

Diane Sterthous, director of alternative investments at Glenmede Trust in Philadelphia, Pa., says that even at the height of the recent boom, buyout deals were probably levered at six to seven times cash flow rather than the more risky 10 times cash flows of the late 1980s. Even so, "some of the deals were priced to perfection for a rosy economic scenario that's obviously not prevailing right now," she says. "If revenues start to decline, if oil prices start to rise significantly, all of a sudden the arithmetic doesn't work, the projected return doesn't work anymore."

Released from Capital Commitments

While the sponsors won't be able to cash out of their deals any time soon, investors in the funds may get a break, since she foresees the possibility that investors will be released from capital commitments which require them to keep their money in the fund for a specified period, much like what occurred after the tech bubble burst in 2000.

The managers of private equity funds are likely to realize it doesn't make sense to keep putting capital to work and "they want to do right by their clients," she says.

For the private equity funds and their backers, the best returns they can hope for in the current climate may just be a portion of their original stake.

Business Exchange related topics:
Private Equity
Financial Services Industry
U.S. Financial Crisis

Bogoslaw is a reporter for BusinessWeek's Investing channel.