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Private Equity - 'Is the bubble about to burst?'


                    Warwick Business School
                        Phi...
Key Questions

•   Where are we now?
•   Where do we want to be?
•   How are we going to get there?




•   What ‘worldvie...
Model of the Elements of Strategic Management
M o d e l o f t h e E le m e n t s o f S t r a t e g ic M a n a g e m e n t
...
Road Map


•   Helicopter ride
     – Private Equity - some history and making superior returns
     – World view
     – S...
Private Equity - History
•   Culture as ‘master of the universe’ ?
•   OR any fool could make money in the last 10 year bu...
Private Equity – Segment and Asset Class

•   Sector maturity, learning/experience curves

     –   Historical analysis an...
The Credit/Equity Cycle – it’s always in the background!


                                                   Credit Equit...
Let’s get in a helicopter
                              World View
                                                      I...
………………..but they crash
                   Perception
                  Dollars/Euro/                               Industr...
OMG what is my
                                                                          cap’ structure?
…..correction +/o...
…….can this helicopter fly again?

                                                      Industry structures/change
  Chin...
Flying the helicopter…not a problem


•   System Momentum = mass * velocity (* powerful internal cultural factors)


•   E...
Private Equity Economics

•   Buy an asset at the right        •   Where are we in the
    price                          ...
…….let’s land the helicopter in……..


The European Leveraged Buy-Out Market




 Source : Standard & Poors LCD Debtwire St...
European LBO Market Volume

     Exponential market growth : private equity raised globally in past 5 years $551bn #

    ...
Avg. LBO Purchase Price as Multiple of Pro Forma Trailing EBITDA

        Excess supply of funds and liquidity is chasing ...
Average Total Debt Leverage Ratio for LBO’s:
                         Europe vs. US with EBITDA of €/$50M or More

7.0x
  ...
Key Ratios (Europe) – 1999-2007(Q1)
6.0x
                         c.a. 40% increase in leverage
                          ...
Who finances this growth?
Primary European LBO Market by Broad Investor Type

          Clear growth evident in institutional market away from banks...
Institutional Investor Group and Vehicle Count
                           European LBO Market

     350
                  ...
Institutional Investors’ Share of the Primary Market
       European market structure has evolved to USA model; what’s ove...
…..back for a helicopter ride
Financial Product Segments affected – August 2007 - Globally
       $6,900bn
       into
       $1,500bn           $2,670b...
Implications for the system
                           World View               Industry structures/change
 China         ...
Implications for the system

  China                   Can China keep growing at 12%p.a.+?
  Petro-Dollars           What ...
Implications for the system

                                                                   Industry structures/change...
Implications for the system



                                  What was old is new (paradigm)
                          ...
Implications for the system
…..time and process to get control; feedback to real world

•   We have an acute balance betwe...
Private Equity
External

•   Correction and back to normal………

•   Or correction into chaos then…? What time period?

•   ...
The Credit/Equity Cycle – it’s always in the background!


                                                   Credit Equit...
1
                                    Cost of (<) BBB over Credit/Equity Cycle
   4                     2
        CEq
    ...
Can Private Equity deliver superior returns?

•   Buy an asset at          Where are we in the helicopter today?   Validat...
Meaning of life…….


•   Always seek to understand the macro drivers in the financial system
    globally and its feedback...
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Private Equity: Is the bubble about to burst?

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Philip Ashdown, Altima Partners LLP presented on "Private Equity: Is the bubble about to burst?" at Warwick Business School 22/10/2007

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Private Equity: Is the bubble about to burst?

  1. 1. Private Equity - 'Is the bubble about to burst?' Warwick Business School Philip Ashdown 22nd October 2007 Views expressed are private ones of Philip Ashdown
  2. 2. Key Questions • Where are we now? • Where do we want to be? • How are we going to get there? • What ‘worldview’ do we consider? • Systemic issue or a correction? • What strategy do we adopt? • What are the resource and capability gaps? • (Anyway what is a (the) bubble? (in this context))
  3. 3. Model of the Elements of Strategic Management M o d e l o f t h e E le m e n t s o f S t r a t e g ic M a n a g e m e n t Must have consistentu ltu r e & high degree of congruency C and S ta k e h o ld e r E x p e c ta tio n s External te rMarketoForces . Culture and Stakeholder Expectations I n te r n a l - R e Resources/Core Competences E x – n a l - P r te r e tc so u rce an d C aInternal –C o r e C o m p .) p a b ility ( M a r k e t B a s e d V ie w R e s o u r c e s B a s e d V ie w E n v ir o n m e n t A n a ly s is I d e n tify Identify O p tio n s P la n n in g a n d Planningnand Allocation a llo c a tio o f S tra teg y O r g a n is a t io n re so u rces C h o ice I m p le m e n ta tio n E v a lu a te O p tio nEvaluate s Culture a tio nArchitecture O r g a n is and s tr u c tu r e a n d S e le c tin g d e s ig n S tr a te g y M a n a g in g Select Managing C hange Change
  4. 4. Road Map • Helicopter ride – Private Equity - some history and making superior returns – World view – Shocks and changes • Helicopter landing – Overview of the European LBO Market • Helicopter ride – World View implications – Private Equity implications – Can Private Equity deliver superior returns?
  5. 5. Private Equity - History • Culture as ‘master of the universe’ ? • OR any fool could make money in the last 10 year bull run? • Generally minimal understanding, ‘label’ or do not care……….but its ‘centre stage’ since 2006 • Background…… – Governments and entrepreneurialism – Big Bang (1986) >hot boom > 1990-1993 recession – ‘barbarians at the gate’ – Financial innovation and disintermediation – Venture capital is way too risky thanks • TMT and dot.com boom • Economies of scale do not work in my business model – Investors – ‘hey where do I put all my cash?’ (must have superior returns btw) – Hedge Funds and ‘alternative asset/value managers’ – Bull market > 1997-2007 (BUT ‘shocks’) – Reputation – Secrecy, tax and non-doms – Political and social impact
  6. 6. Private Equity – Segment and Asset Class • Sector maturity, learning/experience curves – Historical analysis and disclosure – Barriers to entry rapidly rising – Brands and the ‘Goldman Factor’ • Consolidation and/or natural removal of poor performers; swiftly – Nature of fund raising and business model – Emergence of ‘Alternative Fund Managers’ at meta level – Prescriptive nature of pension fund investors – Regulation etal. • Performance vz Public equity markets (Mario Levis – Cass Business School) – RoA, Ebit and cashflow persistently higher – factor of 50% (with PE ownership) – Debt ‘appears’ to set a tight discipline on management – PE investment cases - minimise bureaucracy and committees, lack constant public exposure – Risk/reward profile is clearly set and monitored • Performance vz Alternative Fund Managers/Assets – Hedge funds - $2,000bn globally, expected $500bn withdrawal Q42007 – ABCP, CDO’s and other esoteric asset classes
  7. 7. The Credit/Equity Cycle – it’s always in the background! Credit Equities Phase 1 Repair BSheet Leverage builds Credit Equities Phase 4 Clock Face Phase 2 Credit Equities Immature Bull Emerging Bear Technology Excess Phase 3 Intervention period Credit Equities Mature Bull Source : CitiGroup Investment Research
  8. 8. Let’s get in a helicopter World View Industry structures/change China Asia Crisis Petro-Dollars Internet bubble Russia LTCM India Virtual Circles ROCE (Basle 11) New Paradigms Cash Multiples not IRRs Financial Models and Statistics ASSETS LIABILITIES Innovation Regulation and Deregulation Liquidity Tax IT USA deficit Dollar liabilities Sovereign wealth funds Emergence of Euro Relative sophistication Fall of iron curtain Real Liquidity Economic reform/stability Fed/Central Bank creds’ Labour mobility Globalisation
  9. 9. ………………..but they crash Perception Dollars/Euro/ Industry structures/change VAR breaks China Gold??? Shocks Asia Crisis down Petro-Dollars Internet bubble Russia VAR LTCM breaks India Virtual Circles down ROCE (Basle 11) New Paradigms Cash Multiples not IRRs ASSETS Financial Models and Statistics complexity LIABILITIES Innovation Regulation and DeregulationAsset Values Liquidity Inflate Tax + IT USA deficit System Momentum Dollar liabilities Sovereign wealth funds Speed Emergence of Euro Relative sophistication Reaction time Media Power Fall of iron curtain Real Liquidity Economic reform/stability Rabbits + Fed/Central Bank creds’ Perception headlights Labour mobility Dollars/Euro/ Globalisation Gold???
  10. 10. OMG what is my cap’ structure? …..correction +/or systemic +/or another paradigm? What is Financial my risk? Structures Industry structures/change China Leverage + Asia Crisis Petro-Dollars Trading ? Internet bubble SD is 8x! Russia LTCM Leverage is India Virtual Circles INVERSE ROCE (Basle 11)4*4*! New Paradigms ‘ITS OLD AGAIN’ Cash Multiples not IRRs Financial Models and Statistics MISTRUST ASSETS Innovation EXCESS LIABILITIES Regulation and Deregulation CONFUSION Liquidity REAL + FALSE ‘banana republic’ Tax TAKER IT SPEED EXPONENTIAL USA deficit System BREAKDOWN Dollar liabilities Sovereign wealth funds Emergence of Euro Relative sophistication STRENGTH BY DEFAULT Trade deficit Real Liquidity Interest rates Fall of iron curtain Perception DILEMNA Economic reform/stability Where is In/Out Fed/Central Bank creds’ my risk? fast Labour mobility Globalisation
  11. 11. …….can this helicopter fly again? Industry structures/change China Asia Crisis Petro-Dollars Internet bubble Russia LTCM India ROCE (Basle 11) Virtual Circles Cash Multiples not IRRs New Paradigms ASSETS Financial Models and Statistics LIABILITIES Innovation Regulation and Deregulation USA deficit Liquidity Dollar liabilities Tax + IT Emergence of Euro Fall of iron curtain Sovereign wealth funds Economic reform/stability Relative sophistication Fed/Central Bank creds’ Real Liquidity Labour mobility Globalisation …..time and process to get control; feedback to real world
  12. 12. Flying the helicopter…not a problem • System Momentum = mass * velocity (* powerful internal cultural factors) • Even when we think we understand/see the problem we do not get behaviour change (why?) ‘When liquidity runs out it will be very complex, however, the music is still playing and we are still dancing…..(this is a great time to make superior returns)’ Head of CitiGroup early July 2007 when talking about LBO’s (Private Equity) $5.9bn losses announced 2nd October ($20bn+ losses Q3 across the market) PS Volatility/Shock – Citi losses increased by $600m by 15th October
  13. 13. Private Equity Economics • Buy an asset at the right • Where are we in the price helicopter today? • Optimise the capital • Reflective of where we are structure • Optimise industry position • Am I deep enough in the and operational efficiency woods? Its very tough in (…competitive advantage) here • Sell an asset at the right • Where is my helicopter price going and do I have enough fuel?
  14. 14. …….let’s land the helicopter in…….. The European Leveraged Buy-Out Market Source : Standard & Poors LCD Debtwire Statistics as at March & June 2007
  15. 15. European LBO Market Volume Exponential market growth : private equity raised globally in past 5 years $551bn # €140B Deal 320 €40B Annual Senior Loan Volume Monthly Senior Loan Volume (Last Twelve Months) Count: 214 280 €35B €120B 240 €30B €100B 200 €25B €80B 160 €20B €60B 120 €15B €40B 80 €10B €20B 40 €5B €0B 0 €0B 1999 2000 2001 2002 2003 2004 2005 2006 2007 6 07 07 07 7 6 6 6 6 7 7 6 -0 -0 -0 -0 l-0 -0 -0 -0 -0 n- n- b- ov ar ec ug ep ay pr ct Ju Ja Ju Fe M O A N 1Q 2Q 3Q 4Q Deal Count* M D A S * Deal Count counts First and Second Lien portions of a single transaction as one event; Deal Count also excludes any amendments. # Source : Sunday Times 29th April 2007
  16. 16. Avg. LBO Purchase Price as Multiple of Pro Forma Trailing EBITDA Excess supply of funds and liquidity is chasing higher enterprise valuations rationalised against increasingly aggressive strategic business plans 10.00 9.00 0.40 0.38 0.38 0.38 8.00 0.35 0.41 0.39 +34% 0.33 0.38 7.00 0.34 0.35 8.57 8.72 0.33 8.42 7.81 7.93 7.27 7.17 6.00 6.97 6.93 6.72 6.64 6.48 5.00 1997 1998 (35) 1999 (33) 2000 (40) 2001 (37) 2002 (52) 2003 (66) 2004 (77) 2005 (87) 2006 (120) LTM 31/3/07 1Q07 (30) (Observations: (126) 14) Purchase Price Fees/Expenses Excluding Platform Acquisitions and Other Sponsor Driven Transactions.
  17. 17. Average Total Debt Leverage Ratio for LBO’s: Europe vs. US with EBITDA of €/$50M or More 7.0x Debt multiples have risen c.a. 40% since 2001 6.1 6.0x 5.8 5.8 5.5 5.5 5.4 4.9 4.9 5.0x 4.7 4.8 4.7 4.4 4.5 4.3 4.3 4.4 4.1 4.1 4.0x 3.0x 2.0x 1.0x 0.0x 1999 2000 2001 2002 2003 2004 2005 2006 1Q07 Europe US
  18. 18. Key Ratios (Europe) – 1999-2007(Q1) 6.0x c.a. 40% increase in leverage c.a. 40% negative shift of Interest cover and Core investment coverage 4.0x 2.0x 0.0x Debt/EBITDA Senior EBITDA/Sr Interest EBITDA/Cash EBITDA - Mainten. EBITDA - Debt/EBITDA Interest Capex/Cash Capex/Cash Interest Interest 1999 (53) 2000 (80) 2001 (75) 2002 (101) 2003 (115) 2004 (149) 2005 (210) 2006 (236) 1Q 2007 (62)
  19. 19. Who finances this growth?
  20. 20. Primary European LBO Market by Broad Investor Type Clear growth evident in institutional market away from banks, will drive complex outcomes as market deteriorates 100% 10% 75% 50% 55% 25% 0% 1999 2000 2001 2002 2003 2004 2005 2006 LTM 31/3/07 European Banks Non-European Banks Institutional Investors Securities Firms
  21. 21. Institutional Investor Group and Vehicle Count European LBO Market 350 303 300 Exponential growth in 250 CDO/CLO funds 241 200 150 126 112 99 100 70 53 50 43 33 33 21 18 22 8 14 3 3 7 0 1999 2000 2001 2002 2003 2004 2005 2006 1H07 Manager Groups Active Loan Investment Vehicles Excludes U.S. Dollar Tranches Syndicated in the US Note: Investor group and vehicles include CDOs that are in late stages of warehousing and exclude Finance companies
  22. 22. Institutional Investors’ Share of the Primary Market European market structure has evolved to USA model; what’s over there is coming here 100% 80% 60% 40% 20% 0% 1999 2000 2001 2002 2003 2004 2005 2006 LTM LTM 30/6/07 30/9/07 Europe US
  23. 23. …..back for a helicopter ride
  24. 24. Financial Product Segments affected – August 2007 - Globally $6,900bn into $1,500bn $2,670bn $3,000bn $5,700bn $2,400bn Subprime CDOs LBOs Xover ABCP FIs Economy Extreme Sensitivity Limited Supply Liquid hedge Unwinding Liquidity BackStops Tighter credit House Prices Leverage PB lines Haircuts Slower GDP Ratings Uncertainty Inability to refi ACBP Memo – June 2007 REPOs Equities $23,500bn Capital scarcity TBill $4,300bn Muni $2,500bn Agency $2,700bn Genuine Liquidity Crunch – not isolated to subprime MoneyMarket $4,300bn US Capital Markets data only Source : CitiGroup Global Markets
  25. 25. Implications for the system World View Industry structures/change China Asia Crisis Petro-Dollars Huge Complexity Internet bubble Russia LTCM India ROCE (Basle 11) Virtual Circles Cash Multiples not IRRs New Paradigms ASSETS Financial Models and Statistics LIABILITIES Innovation Regulation and Deregulation Liquidity Tax + IT USA deficit Dollar liabilities Sovereign wealth funds Emergence of Euro Relative sophistication Fall of iron curtain Real Liquidity Economic reform/stability Momentum = (Mass*Velocity)*Culture Fed/Central Bank creds’ Labour mobility Globalisation
  26. 26. Implications for the system China Can China keep growing at 12%p.a.+? Petro-Dollars What happens to oil prices, liquidity flows and investment? Russia Political influences, war mongering, terrorism India Social unrest Powerful exogenous factors impacting interest, FX rates ASSETS and asset prices Investment is being increasingly driven directly Sovereign wealth funds •In house wealth funds ($8trillion+ >reserves of central banks globally by 2011) Relative sophistication Industry sectors Real Liquidity Globally – ‘strategic assets’ Hot money (+/or)….. Sustainable ‘locked’ flows
  27. 27. Implications for the system Industry structures/change • Ongoing change (hetro>homogenous) but cultures Asia Crisis • Core driver to investment activity and superior returns Internet bubble • Lessons will be learnt; add the 2007 credit crunch LTCM • Financial sector equity, leverage, returns re-assessed ROCE (Basle 11) • Risk free rates, core risk skills, asset values tested Cash Multiples not IRRs • Time period will lengthen (hold periods) • Safety margin broadens LIABILITIES • USA not able to manage interest rates, ultimately USA deficit • Equals yield curve volatility; FX volatility; asset volatility Dollar liabilities • Europe has same problem but for different reason Emergence of Euro • Economic stability will likely revert to variable Fall of iron curtain • Cycles, inflation and/or Japan Economic reform/stability • Reduced credibility, intervention, monetarism returns Fed/Central Bank creds’ • Consideration to controls (indirect/direct) Labour mobility • Core liquidity is ‘global’ and will move swiftly Globalisation • Huge liquidity imbalances; funding structures are key
  28. 28. Implications for the system What was old is new (paradigm) Recession (risk of) and cycles Virtual Circles Volatility everywhere New Paradigms Inflation Financial Models and Statistics Japan experience Innovation Innovation - excess controlled (self and external) Regulation and Deregulation Tight(er) regulation Liquidity Liquidity – deep understanding/controls needed Tax + IT Tax abuse (tend to eradicate) IT control and development of better risk models and feedback mechanisms Media management reviewed Protection for ‘man in street’ The brakes are slammed on; there is no ABS and its very icey I am sure we will not overreact………….much anyway!
  29. 29. Implications for the system …..time and process to get control; feedback to real world • We have an acute balance between control and chaos The chances of a USA recession in 2008 have risen from 3-1 to 2-1 (Greenspan, October 1st); most see it as 50/50 to likely If investors fund less $ liabilities….global liquidity flows and imbalances Interest rates and/or asset values will shift swiftly Euro is too strong (driven by alternative investment home) equals inflation ultimately…….. Japan has had zero interest rates and no asset growth for >13 years System has landmines everywhere – shock and volatility to come o Late cycle sub-prime is estimated at $700bn; $100bn found; losses could be $300bn??? o LBO debt is c.a.$500bn ‘hung bridges’ plus excess growth since 2005 o Corporate debt has had limited diligence for 3 years o Property prices and leverage (residential and commercial) excessive o Inherently unsustainable financing, liquidity and capital structure issues (innovation excess) o Will somebody explain liquidity to me!!! Does Fed intervention get control? Is the ECB a credible central bank or a political and naïve player? The UK is left in the backwash? What happens when equity markets ‘get this’? (Asymmetry between credit and equity markets)
  30. 30. Private Equity External • Correction and back to normal……… • Or correction into chaos then…? What time period? • Sustainable industry/investor group or not? Internal • What strategy to adopt ? – Providers of liquidity – Fund managers – Long/short asset holders – Existing portfolio – New investments
  31. 31. The Credit/Equity Cycle – it’s always in the background! Credit Equities Phase 1 Repair BSheet Leverage builds Credit Equities Phase 4 Phase 2 Credit Equities Cre Equ Immature Bull dit Emerging Bear ity Technology Excess Phase 3 Intervention period Credit Equities Mature Bull Source : CitiGroup Investment Research
  32. 32. 1 Cost of (<) BBB over Credit/Equity Cycle 4 2 CEq re uity dit 3 Mature Bull Emerging Bear Immature Bull Mature Bull Phase 3 Phase 4 Phase 1 Phase 2 Phase 3 1700 Fed ease Fed tighter US High Yield 1500 European High Yield Shocks 1300 1100 Reduce leverage Use leverage 900 Shocks 700 High Volatility Low volatility Fed ease 500 300 100 98 98 01 02 03 04 04 06 06 9 0 0 2 5 7 99 00 00 00 00 00 19 19 20 20 20 20 20 20 20 /1 /2 /2 /2 /2 /2 2/ 9/ 8/ 8/ 8/ 2/ 8/ 7/ 4/ 18 21 29 20 29 24 /0 /0 /0 /2 /0 /1 /1 /0 /1 5/ 1/ 9/ 2/ 7/ 8/ 01 09 06 10 07 03 11 04 12 LTCM Nasdaq/TMT ABCP Source : Merrill Lynch data; Citi Investment Research Bubbles ‘innovation’
  33. 33. Can Private Equity deliver superior returns? • Buy an asset at Where are we in the helicopter today? Validate the environment the right price • Optimise the Reflective of where we are EV off 2x minimum capital structure • Optimise SCA Am I deep enough in the woods? Probably not, so…….. • Sell an asset at the right price Where is my helicopter going? Get in it for the long term; choppy ride ahead P3/P4 Firm and Resource competences vary materially across the sector Control mechanisms break down; political influences drive behaviour Given the environment what resources and capability gaps do I have? Re-evaluate past process and procedures – formal and INFORMAL Examine existing portfolio deeply Examine and change funding structure and investor type/diversify Seek consolidation opportunities +/or stretch business model Create sustainable funding structures - remove M2M/NAV dynamics Socially aware/change Overtly communicate and manage PR Main stream not ‘secret, off-shore, barbarians at the gate’ Apply double-loop learning consistently – remove culture from macro strategy
  34. 34. Meaning of life……. • Always seek to understand the macro drivers in the financial system globally and its feedback into ‘your (industry/sector) worldview’ • Change or die …….(+ use a helicopter and seek to be informed yet intuitive for big bets) • Remove ‘culture’ from ‘big bet’ decision process (monitor always) • Get lucky, cash out at the top and go to the beach……. • Stay on the beach, re-invest at the bottom but get private equity (alternative asset) fund managers to do the work for you……..(for above average index returns) • Q&A………………

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