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| Comment: From the Editor |
This Time It's Different
Dwight Cass
03/01/2007
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The belief that the leveraged
buyout market is in the throes of a speculative bubble has spread beyond the
journalistic head scratchers, nervous regulators and ratings agency
wonks who last year began to question the economics of
megadeals like HCA and SunGard. The bubble is now, more or less, conventional
wisdom. But many of the worries about the LBO market—such as the Justice
Department’s inquiry into whether consortia-backed (or "club") deals are
anticompetitive or worries that any economic downturn or credit cycle reversal
will send overleveraged leviathans into the abyss—are, while scary, somewhat
beside the point. The fact that will burn investors is that there have been too
many big acquisitions for LBO shops to exit them all successfully.
 There are two classic symptoms of a speculative bubble; the LBO
market exhibits both. The first is the subversion or dismissal of traditional
performance metrics. In the dot-com bubble, companies could attain billions in
market capitalization without having a penny of earnings—indeed, without any
revenues at all. In the world of LBOs, both the prices paid (now nearing an
average of 10 times earnings) and the leverage ratios (marching north of six
times earnings) are far outside the realm considered sensible only 18 months
ago.
The second symptom is a cognitive dissonance suppression
mechanism that allows market participants to abandon tried-and-true metrics. It
can be boiled down to the phrase: "This time it’s different." This bubbles up,
like crudely applied plaster, through any number of cracks in the LBO facade.
One particularly amusing example is the idea that private equity is no longer
principally an investment strategy, but is now a form of alternative ownership
embraced by companies seeking release from the twin ogres of Wall Street
earnings expectations and regulatory smothering. The heads of
multibillion-dollar LBO portfolio companies like to opine that they are now free
to set long-term objectives, unyoked from the costs of Sarbanes-Oxley. Good for
them—except that their LBO fund masters only care about returns, and those are
predicated on successfully selling a restructured business after half a dozen
years or so. So those CEOs mooning about the joys of the private life are going
to find themselves flogged on the public markets again—and they have better
beaten their behemoths into some semblance of order before they are.
Who will buy them? Carlyle Group cofounder David Rubenstein
predicted in a December 7 article in the Financial Times that there will be a $50 billion
buyout within a year and a $100 billion buyout within two. How will LBO shops
unload companies that big? The usual answer is: in bits and pieces, much like
the recent floatation by Carlyle and its partners in the Hertz LBO of
one-quarter of the rental car company’s equity. But those stocks will be
unloved. (Who would buy a stock knowing that LBO shops are waiting to unload
billions of dollars more of it?) The blob of liquidity that has allowed LBO
shops to take legions of enormous companies private in the past year will not
last forever—and the race for the exit will not be pretty.
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