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Private equity falls to Earth

Vaunted Blackstone and its peers are in disarray, and new deals are harder to come by.

May 26, 2008|Walter Hamilton | Times Staff Writer

NEW YORK — A year ago, private equity executives were Wall Street's new masters of the universe, riding an era of easy money to unparalleled success by pulling off record-setting buyouts and pulling down monstrous paydays.

The industry became so synonymous with making money that buyout giant Blackstone Group, a specialist in taking companies private, itself went public in June in a multibillion-dollar stock offering. And the firm's chief executive, Stephen A. Schwarzman, made a splash with the upper crust of New York society with a pledge to donate $100 million to the New York Public Library.

Those heady days seem long gone. Now the onetime world beaters are taking a beating at the hands of the credit crunch and the stumbling economy.

This month, Blackstone reported a $251-million first-quarter loss. Its stock is trading at less than half its initial public offering price. And its vaunted deal making, like that of its peers, has shriveled.

The private equity market is in "the eye of the hurricane," Hamilton James, Blackstone's president, said at a conference two weeks ago.

Scores of buyouts agreed to before the credit crunch hit have been renegotiated or fallen apart. New deals are much harder and more expensive to finance. As a result, the use of borrowed money -- the lifeblood that buyout firms employ to boost their returns -- is way down. And the mega-deals that generate the biggest profits and the most buzz have ground to a halt.

"It's sort of like the bursting of a bubble," said David Fann, chief executive of PCG Asset Management, a La Jolla-based consulting firm that advises institutions on private equity investments. "Late 2006 and early 2007 can be characterized as a bit of a private equity bubble, and clearly we won't see that again."

The business still has many things going its way, including the continued willingness of big investors to sink billions into the buyout funds managed by Blackstone and other private equity firms. In addition, the economic downturn has increased the opportunity to buy companies on the cheap. And credit markets have improved in the last several weeks, offering hope that the worst of the debt crisis is over.

But the industry must confront a changed environment in which buyout firms have to work harder and put more of their own capital into deals -- potentially crimping their outsize returns.

That's a shock to the system for a generation of private equity executives who grew accustomed to surefire profits and rock-star status.

To some in the industry, the comedown feels as if "the financial system as we know it is doomed," said Mario Giannini, CEO of private equity investment advisor Hamilton Lane.

Private equity firms typically buy publicly traded companies they view as undervalued, planning to sell them at higher prices within a few years. Sometimes the new owners take strategic or operational steps, such as cutting costs or selling assets, to speed a company's progress.

For much of this decade, the heavens were aligned in favor of buyout firms. The collapse of technology stocks in 2000 prompted pension funds to pour money into private equity. Interest rates were low. The economy was placid. And fee-hungry investment banks happily provided financing for acquisitions.

But excesses arose, experts say. The glut of money available for buyouts drove up the prices of the companies being acquired, increasing the risk of the investments. Private equity firms strong-armed investment banks into dropping provisions that had traditionally protected lenders and bondholders from the possibility of default.

Shortly after deals closed, the new owners sometimes paid themselves huge "dividends," recouping much of their investment even as the companies struggled under piles of debt.

That dynamic ended last year, as the credit crunch struck and buyouts of companies such as student-loan specialist SLM Corp. and audio-equipment maker Harman International Industries Inc. came unglued.

Banks couldn't unload billions of dollars in buyout-related loans to outside investors. Fearing deep losses, banks and buyout firms walked away from some deals, spurring an avalanche of litigation.

In the first four months of this year, there were 215 buyouts totaling $21.1 billion, well below the 255 deals for $150 billion in the same period last year, research firm Dealogic said.

Private equity firms also have had trouble cashing out by selling the acquired companies. There have been 70 such "exits" worth $11.4 billion this year, compared with 97 sales for $54.1 billion last year, according to Dealogic.

Further into the future, some experts predict that buyout funds launched in the last two years will generate poor returns because they overpaid for the companies they bought and some of those companies will run into deep problems if the economy keeps weakening.

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