Many publicly traded public equity companies are trading far below their opening price when they went through an initial public offering in the heady days of 2007. Perhaps that’s just as well, suggests one private equity executive.

While banks certainly have a share of the blame in inflating asset bubbles, they’re not the only ones, says Andrew Sheiner, a managing director at buy-out firm Onex. Many buyout firms transacted for the sake of transacting, with leverage to goose the returns.

On the bank side, there is palpable culpability, Sheiner says. He made his remarks at a private equity symposium earlier this month, sponsored by the Canadian Institute of Chartered Business Valuators, the Canadian Venture Capital Association, the Canadian chapter of Financial Executives International and the Toronto CFA Society.

Sheiner recalled when the institutional private business was in its infancy more than a decade ago. The appeal was simple. ”As opposed to passive public company investing, where often you had very widespread ownership and stewardship can be sub-optimal, the private equity model offered the opportunity to have concentrated ownership and a full partnership with management.”

That model worked well for institutional investors. From 1995 to 2007, private equity yielded 17% annually, compared to an S&P 500 total return of 9%. With such attractive returns, institutional investor commitments grew from $95 billion to $1.2 trillion.

But that belies ”a fundamental change” that occurred with the banks, Sheiner says.

”Fifteen years ago, when we at Onex applied to buy a business, we’d sit down with our bankers, negotiate the terms of the loan and agree to the percentage that the bank would hold, typically 30% to 40%, and they would then syndicate the balance to a handful of other banks and the odd insurance company, with that fund. Collectively, the banks operated as a club, and they held on their books 85% to 90% of the leveraged loans originated by the banking industry. As a result, perhaps not surprisingly, they cared about the quality of the loan.”

Structured finance has changed all that. Loans were packaged together, sliced up as tranches with other receivables such as credit card or student loan or mortgage interest, and then sold on to investors as high rated bonds suitable for money market funds and fixed income investors. ”Banks went from being investors to being arrangers and syndicators and as a result, by 2007, banks held only 10% to 15% of the loans they originated,” Sheiner notes. ”They focused less on the quality of loan than whether it could be sold, less on a proven assessment of risk than the opportunity to generate fees.”

But this had an effect on the private equity industry too. It was not just a seeming availability of liquidity to finance deals. Against a backdrop of historically low interest rates, ”the availability of cheap and plentiful debt drove purchase prices to all-time highs.”

But that’s where the real culpability starts to emerge, suggests Sheiner. ”Why did the private equity managers, the people who actually make the decisions of what price to pay for a business and how much leverage to accept, pay the prices that they did and burden their businesses with so much debt.”

Answers lie in various areas, but the inescapable one is that private equity managers, by and large, were ”primarily managing someone else’s money and had too little of their own money at risk.” He argues that many private equity firms put up 1% to 2% of their own capital and leveraged the investment, convinced that the excess leverage was manageable, so long as it was cheap enough, to make questionable investments which, however, ”generated substantial transaction and management fees.”

Sheiner argues that Onex, which is publicly traded, is different from the “other people’s money” model. For fifteen years until 2002, the firm managed only its own money, guided by a number of precepts: be careful what you pay; leverage companies serially; provide management with the degrees of freedom to manage in times and good and bad; and every partner at Onex has to invest in every deal, ”with no cherry-picking allowed.”

In the funds that Onex now runs for private investors, 25% of the carried interest — the profits earned on a successful exit — are directed to purchasing Onex shares in the open market, which the partners must hold until retirement.

That management skin in the game, Sheiner says, has proven itself. Where the average debt incurred for a buyout from 2005 to 2007 was 5.6 times EBITDA, Onex did its deals at a 3.6 multiple. “We regularly took less debt than was offered,” he says. As for purchase prices, which peaked at 9.8 times EBITDA, Onex came in at 6.4.

”Why didn’t we join the party?” Sheiner asks. ”Because at the end of the day, we all treat our own money just a little bit differently than others do.”

But that’s the Onex model, and Sheiner admits that some of Onex’s investments may not work out, although they’ve only had three failed ones. Still, they are well positioned in leveraged terms, with debt at 2.5 times EBITDA. EBITDA would have to fall by half before their companies would run aground.

That is quite different from the rest of the industry, Sheiner suggests. ”There are many businesses that went into this downturn with simply too much debt.” They may have to cut costs and even still, they may run into a debt wall and fail for lack of refinancing. And as businesses fare, that determines how well the general partners make out. They may receive no carried interest or incentive fees; they may lose staff; they may no longer be able to raise new funds.

In the end, however, Sheiner thinks, the current travails of the private equity industry are not the fault of poor judgments but poor incentives that drove general partners, with easy interest rates, to make deals that would not otherwise make sense.

And yet, as credit conditions tighten, there’s still opportunity, Sheiner says.

”If we’re lucky, we will, for the first time in many years, have the opportunity to buy great businesses at historically low multiples, based on depressed earnings.”

(04/06/09)

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com
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