NEW YORK (Reuters) - Private equity firms will have to get comfortable with something most have been loathe to do in recent years: put more cash into deals. Higher equity levels are often seen as lowering potential profits in leveraged buyouts, which rely on debt finance to amplify returns.
During the LBO boom of the last two years, private equity firms at times financed deals with 80 percent debt or more.
The credit crunch is changing that as debt-laden banks are less willing to finance buyouts and a slowing economy threatens future cash flows.
But private equity firms focused on a single industry often take a less-leveraged approach, making strategic investments by using more equity than debt-reliant competitors which often face pressure to sell assets quickly to pay back lenders.
“Highly leveraged players are out of this market and some are stuck dealing with transactions that need refinancing,” said Richard Saltzman, president of Colony Capital, a private equity firm focused on real estate that has invested more than $30 billion since 1991. “They’re clearly on the sidelines for the moment.”
Buyout firms specializing in one space often have management teams with deep industry experience, who have navigated deals through sector cycles and economic downturns.
“We’re a part of the industry and we develop a view as a result of that,” said Will Honeybourne, managing director at First Reserve, an energy-focused private equity firm that raised its first buyout fund in 1992 and has made investments worth more than $10 billion. “We feel we have a better view to the point that we can put more equity in a deal.”
Industry-focused funds are now likely to become more active after being sidelined in recent years by more leveraged funds.
“I can see people who tend to take a more value-added approach to investments getting excited about this market,” said Mike Kelly, managing director at Hamilton Lane, a private equity asset manager with more than $10 billion. “In the prior market the most active folks relied on lots of leverage.”
The two largest pending real-estate related LBOs, the acquisition of Archstone-Smith by Lehman Brothers LEH.N and Tishman Speyer and Blackstone Group’s (BX.N) buyout of Hilton Hotels, each have lending packages amounting to more than 80 percent of the deal, according to Dealogic.
By contrast, Colony’s buyout of Station Casinos, announced in December, had loan financing of about half the total deal.
“To some degree capital had become a commodity,” said Colony’s Saltzman. “It’s more precious now and that’s the kind of environment we prefer and grew up in.”
Of all buyouts now pending, the largest five have loans arranged for about 80 percent of the total deal size, according to Dealogic, while loans arranged for First Reserve’s five largest deals amount to less than 70 percent of their value.
“To the extent that you’re relying on financial engineering, opportunities have been imperiled,” said First Reserve’s Honeybourne. “We feel there could be an opportunity here because that takes out a number of our potential competitors.”