Private equity firms with a lot of debt put into acquisitions could be hit next by the credit crisis, some local financiers speculate.
The issue could come to a head as portfolio companies see a slowdown in sales and profits amid the recession. That stands to crimp their ability to pay down debt incurred in private equity buyouts.
Local private equity firms, which mostly focus on smaller deals with less debt, could escape the worst of the fallout.
Those that use the most debt,say five to six times the amount of cash invested,may be most vulnerable.
“You’d probably see it first in high-end mega deals,” said Murray Rudin, a partner in the Irvine office of Los Angeles-based private equity firm Riordan, Lewis & Haden.
The most dramatic example so far: last month’s bankruptcy filing of Chicago-based Tribune Co., parent company of the Los Angeles Times.
Businessman Sam Zell took the company private in 2007 in an $8.3 billion deal that relied almost entirely on debt.
The worsening newspaper downturn made it impossible for Tribune to carry its $13 billion in debt.
Debt is a double-edged sword for private equity deals, allowing buyers to make bigger deals but strangling acquired companies when their profits begin to suffer.
More than half of the companies that defaulted on bonds in 2008 had private equity investments, according to credit rating agency Standard & Poor’s. Companies are set to face more trouble in coming months, it said.
It could be too early to tell just who might be affected, according to Rudin.
“No one would admit they have a problem until it’s too late,” he said.
Riordan, Lewis & Haden is better off than some private equity firms because it didn’t use much debt for deals, according to Rudin.
Its investments include Irvine-based Cymetrix Inc., a provider of administration and financial services for hospitals, and Irvine-based employment agency Cyber-Coders Inc.
Best Time
Deals that rely on a lot of debt typically work best when interest rates are low and there’s no recession, according to Rudin.
The first sign of trouble comes when companies violate loan terms, or covenants.
That was the case late last year with Irvine-based Freedom Communications Inc., which owns the Orange County Register and is renegotiating with lenders.
Freedom was sold in a $2 billion deal in 2004 that saw Blackstone Group LP and Providence Equity Partners Inc. acquire about 45% of the company.
But at the height of the lending bubble a couple years ago, some deals were made with “covenant light” terms, according to Rudin. They added few, if any, financial benchmarks for borrowers to meet.
In many cases a good business may suffer from a bad balance sheet, said Michael Kaye, founder and managing partner of Newport Beach-based private equity firm ClearLight Partners LLC.
“It’s going to be a problem,” he said. “Some think they’re safe, but they’re not.”
The bigger issue is the economic slowdown, according to Kaye.
Even industries traditionally seen as recession resistant, such as education and healthcare, could feel the pinch if they’re holding too much debt, Kaye said.
In September ClearLight sold Mission Viejo-based vocational school operator U.S. Education Corp. to Illinois-based DeVry Inc. for $290 million.
Kaye’s past deals have involved anywhere from no debt to five times the amount of cash invested, he said.
The slow economy and fewer buyers are driving down prices for companies, according to Kaye. He said he hopes to acquire more companies.
“There’s a fear factor here,” Kaye said. “Some people can’t see past their nose.”
Locally, deals have slowed, according to Greg Presson, a senior managing director for Los Angeles-based B. Riley & Co., which brokers private equity deals and has a Newport Beach office.
Firms are doing deals with debt of two and four times cash, if they can get financing at all, he said.
And expected returns on investments have dropped to 15% to 20%, down from 30% in 2007, Presson said.
Endowments and pension funds that invest in private equity also may be less interested, he said.
Close to Home
A shakeout in private equity already is impacting companies here.
They’ve seen their valuations drop with less competition from potential acquirers. With a lifeless market for initial public offerings (see related story page 1), private equity largely had been the only game in town for business owners looking to sell their companies.
The pullback from private equity’s go-go days could bring consolidation among firms, Presson said.
The sector’s slowdown isn’t all bad, said venture capitalist Ralph Sabin, managing director of the Irvine office of Encino-based Pacific Venture Group.
At the height of the boom, venture capitalists such as Pacific Venture would sometimes find themselves competing with private equity firms for investments, particularly in healthcare, he said.
Healthcare was the strongest industry for local venture capital deals in the third quarter, as 17 deals accounted for $300 million, or 60% of the total invested in the county.
