Introduction
Jon Moulton is Managing Partner of UK-based private equity firm Alchemy Partners, which has invested £2 billion of equity and specializes in dealing with troubled companies. Alchemy also has a £300 million European special opportunities fund investing in distressed debt. Moulton previously worked with Citicorp Venture Capital (now called CVC Capital Partners) in New York and London, Permira, and Apax. He has been a director of five public companies, numerous private companies and is currently a director of the US-based Irvin parachute business, the Cedar IT business, and Sylvan (timber), amongst others.
An active angel investor, he has a chemistry degree from Lancaster University and started his career as a chartered accountant with Coopers & Lybrand. He has publicly criticized private equity firms that flatter their own income by using a loophole to avoid paying tax on management fees.
LBO Aberrations
The large buy-outs which took place in the bubble years of 2005 to mid 2007 now look like horrible aberrations. In fact, they were horrible aberrations. Many of these deals were priced at such levels that real profits now need to grow by 50% or more for equities to achieve the same value buyers paid when the deal was closed. This is a big ask in normal conditions, and is much, much harder in a recession which is moving towards a depression.
Then, of course, there are the balance sheets of most of these deals, where debt levels are high by any historic measure. Debt at eight to 10 times EBITDA (earnings before interest, taxation, depreciation, and amortization) is far from unusual—and much of this debt is now trading below 65p to the £1. Refinancing at current levels seems impossible in the tortured debt markets now prevalent, where even three times EBITDA is often impossible to fund.
Debt terms and structures vary, but very many of these large deals will run into financing problems over the next few years, indeed some are already doing so.
Deals were done with long “bullet” amortization and with few, or even no, traditional covenants. Leverage was so high that a recessionary breeze was sufficient to make cash become a real problem. We now face a recessionary gale.
Given that the original equity investment in these deals is really now an expensive and massively out-of-the-money option, investors in the large leverage buy-out (LBO) funds are going to be unenthusiastic about the refinancing of the companies owned by those funds. The notion of investing simply for the benefit of debt-holders to maintain the possibility of a company recovering is likely to be heartily disliked. The only reason to keep the companies afloat is so that the LBO firm can cynically maintain the appearance of infallibility.
A lot of time is going to be spent trying to repair the balance sheets of large LBOs in 2009 and later. Already whole industries focused on restructuring distressed debt markets have sprung up. These industries are growing fast and are likely to be sorely needed.
Given the changed world, investors will rightly be worried about the situation of funds where perhaps half of the fund has, sadly, been propelled into worthless-looking wreckage from the bubble period. Carried interest from aggregate gains is unlikely ever to emerge in such a fund, yet generous management fees will continue to be taken out by the LBO firm—in part to cover the “management” of corporate corpses.
The situation of a firm with a part invested, largely lost, fund is going to be at best uncomfortable. The firm’s ability to refinance itself will be a concern, so the firm can have a future that is precisely measurable in a few years.
So what are the options for such a private equity firm? It will probably seek to maximize its profitability by minimizing staff and costs. If there is no likely prospect of carried interest, then there is no incentive to sell portfolio companies, since their continued presence in the portfolio generates an opportunity for continued income. As regards new investments, the motivation might be to “put it all on number 36” and take a wild risk/reward bet to try to get carried interest. Individual motivation in a firm in this state is likely to be pretty low. Activity will be modest and likely to decline, promotion opportunities will be nonexistent and morale horrible.
In order to avoid some of these issues, it may well be in the interests of general partners and limited partners mutually to consider a new (lower) target for carried interest in exchange for lower fees and/or reduced commitments. It will be interesting to see if many firms promote such ideas.
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