In the early 1980s, when leveraged buyouts were exotic and still novel, private equity was simple. A fund would identify a company or division with stable cash flows, bloated costs and a sub-optimal capital structure. When a target meeting these criteria was identified leverage was added, management incentives were aligned with those of the new owners, costs were cut, and bountiful returns were produced (buyout funds raised between 1983 and 1985 had IRRs of 29-34%, according to research by professors Steven Kaplan and Antoinette Schoar).
Now, however, the game has changed. Private Equity funds raised enormous amounts in the years prior to the 2008-9 downturn, and for many the pressure to put that money to work is immense. But the corporate ecosystem has changed since the early 1980s.
Targets with stable cash flows are not so readily available, nor so cheap (in part due to the increasing need to win an auction against other PE firms in order to acquire them), as they once were.
Management teams are incentivized already, and are not shy about pressing their demands and/or steering a sale process toward the buyer most amenable to their needs.
Costs are no longer quite so bloated, and hence potential savings are less robust.
And benefits of financial engineering have been muted (especially in the middle market) by lenders still recovering from the painful lessons of the most recent downturn.
So what are PE firms to do? In the past few years I have worked extensively with PE portfolio companies and drawing on that experience I offer a humble suggestion: reorient your strategy from buying to one of building or fixing companies.
The best example I have seen of the build approach is Harbinger Capital Partner’s investment in LightSquared, which clearly holds out the possibility of substantial returns if successful.
Distressed investors are the biggest proponents of the fix methodology, purchasing companies out of chapter 11 via 363 sales or by forcing out-of-court restructurings that convert debt positions to majority equity stakes. These approaches and variations on them seem to me to offer greater potential for returns than simply buying healthy companies and hoping to delever and sell at a higher EBITDA multiple.