Monday, February 25, 2013


M&A volume is on a tear at double the level for the same period last year for the first two months of 2013. There are a variety of reasons underlying that development including an improving economy and favorable financing conditions. Another largely unnoticed factor will further support the increase. Private equity firms raised record commitments for new funds formed in the 2006/2008 boom period prior to the financial crisis. Of the $700B+ raised during that period only half is invested, leaving a large amount of dry powder. The crisis caused funding to dry up and sponsors curtailed their activity during the 2009/2011 period. Most funds contain a provision limiting the time of the fund to invest to 5 years. Many of these sponsors are now facing the end of their 5 year investment period over the next 6-18 months. Commitments not invested by the end of that period expire - use it or loss it. It is estimated that almost 100B of this dry powder will expire this year alone. The loss of the commitments reduces their fee income. This can be problematic for the continued operation of many funds.

A further complication is the same difficult financing market conditions that limited their investment activities also depressed their ability to exit prior investments. Consequently, the average age of their portfolio investments now exceeds a record 5+ years. Unlike fine wine and cheese, portfolio investments do not age well. Their advancing age means investment returns (IRRs) are falling. Some large funds sponsored by well-known firms raised during the boom period register IRRs below 3%.

This complicates covering the requirement in most funds that a preferred return or hurdle rate, usually around 8%, be achieved before the fund general partners can receive their carried interest. Carried interest is the share of the gain, usually 20%, the general partners receive of any gains once an investment is sold. Thus, general partners are more reliant on fees on funds invested than carried interest.

This background suggests private equity firms will leave no stone unturned as they search for investments to make sure they fully deploy all commitments prior to the end of their investment period. This creates a potential conflict between the general partner fund managers and their limited partner investors. Therefore, we can expect to see an increase in questionable deals, especially in two areas.

The first is sponsor-to sponsor or secondary buyouts. These involve firms purchased by one PE firm and subsequently sold to another. Secondary buyouts, sometimes known as pass-the–parcel deals, now exceed the value of first time buyouts for the first time. These transactions are deemed lower quality for two reasons. First, it is difficult to squeeze additional improvements from firms that have already gone through the LBO process. Next, they raise the issue of collusion between PE firms to manufacture exits and create IRRs: buy my deals at favorable prices and I’ll buy yours. Next, mega deals, like Dell and Heinz, will become more popular to deploy funds quickly - perhaps too quickly.

The amount of dry powder, combined with the current leverage level of 30-40% equity, can support a huge amount of LBO transactions.  Consequently, we can expected the level of LBOs as a percentage of total M&A to increase from their current 10% level to pre-crisis 30% levels. Unfortunately, given the incentives, many of these deals may have a difficult ending. The noise of the ticking investment period clock may adversely influence the judgment of many PE firms.


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