Private equity looks for life beyond the leveraged buyout

Private equity executives are not generally known for lying awake at night with worry - nor for talking about it in public.

But when Thomas von Koch, managing partner of Swedish buyout group EQT, spoke at a conference at the Institute of Directors in London's well-heeled Pall Mall last month, he was happy to admit that he had not been sleeping well.

"The world is changing and many of us are too old to see it," he said. "'Paranoia' is the word at the top of the whiteboards in our office."

Mr von Koch warned his audience that small online rivals were increasingly snapping at the heels of established businesses backed by private equity, causing his sleepless nights.

One of those affected was EQT's own holding, Scandic, the Nordic hotel chain. It had come under threat from Booking.com, he said.

He added that EQT had started hiring entrepreneurs to help its companies deal with disruption.

Mr von Koch's listeners would be unlikely to demur. They were at a forum for private equity's operating partners: the specialists in a buyout group who work most closely with the companies in its portfolio.

More than 900 operating partners now work in the industry globally, a near-doubling in three years, according to the data provider Preqin.

Their swelling numbers suggest there is even more upheaval heading for Mr von Koch's industry.

The leveraged buyout - the 30 year-old model under which private equity groups use debt to buy and remodel a company, then cut costs to raise cash to pay it back - is itself showing signs of being disrupted.

Groups such as EQT, Permira, and Warburg Pincus are instead advertising their ability to drive expansion in companies as a way of creating value, especially in Europe where economic growth is low.

"If you are investing in Europe today and you are growth-oriented, you'd better get comfortable with disruption . . . or you are unlikely to get the growth," says Joe Schull, Head of Europe at Warburg.

This comes as a long-benign financial environment for buyouts could be turning.

Overall buyout volumes have already begun this year at their weakest level since the first quarter of 2009.

LBOs have traditionally relied on both falling borrowing rates and a cheap purchase price for the equity to enhance profits.

However, debt may only become more expensive to pay back from here for companies under private equity ownership.

Nearly four-fifths of fixed income in Europe now trades with a yield of less than 1 per cent, Citi analysts recently noted. It prompted them to declare that "the end of the world as we know it is approaching" as a three decade-long decline in interest rates finally runs out of room.

Prices paid for companies are also back to pre-crisis highs. The average LBO in Europe last year valued the target at 10 times its earnings before interest, tax, depreciation and amortisation, according to S&P Capital IQ data.

That may leave little room in the future for multiple arbitrage, sitting on investments to offload once public market valuations for them have risen higher.

Then there is the indignity of being trampled by a herd of unicorns.

Unicorns are start-ups that rocket to $1bn in value under venture capital ownership.

By contrast, European buyouts - which often target established industrial firms - rarely boast similar increases in value, despite using more leverage than VC.

Warburg is one traditionally growth-focused group hoping that the shifts in the industry favour its approach.

Six of its last 10 deals in Europe were carried out under its "executive and entrepreneur in residence" programme, which for many years has brought figures from industry to the group to identify new investments and serve on boards.

"Historically it wasn't a reaction to underlying pressures . . . but it has become more relevant given the relentless commoditisation of the private equity industry," Mr Schull says.

"We all [as private equity investors] look and sound more or less the same to managers. When you work with entrepreneurs, managers look at you differently across the table."

However, it may still be private equity's expertise with leverage which its investors are paying their fees for.

Negotiating debt packages or thinking about efficient capital structures for several companies in a portfolio are not trivial skills, and may be difficult for investors to replicate individually compared to buyout groups.

"They should actually get credit for levering up smartly," says Ludovic Phalippou, an associate professor of finance at Oxford university's Said Business School.

The tax benefits of using debt may look like low-hanging fruit, but tend to be reflected in the prices shareholders demand for being bought out, according to a 2011 study by Mr Phalippou's colleagues. That means working to find value elsewhere.

"Financial engineering shouldn't be a dirty word," Mr Phalippou says.

Yet for now it is not a word groups are using much - in place of extolling other benefits of their model.

"Private equity is a superior ownership model," Mr von Koch also told his listeners. "This is my belief and no one can take that away from me."

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