There’s nothing new about private equity firms, but the big groups are getting bigger and growing in influence. Seen by some as avaricious asset strippers with ever-increasing debt in pursuit of a quick buck, their supporters claim they are an essential part of modern capitalism and give busted companies a future. And your pension might depend on their continued success. Dave Leggett ponders their recent rise to prominence in the automotive sector.
Private equity groups (PEGs) are nothing new. They have been around for decades in one form or another. Some have even become ‘new conglomerates’ by default with sprawling corporate empires that embrace a wide range of companies with minimal synergies. They exist to make money where others have failed.
Their perceived modus operandi is controversial. They chase complacent or under-performing companies for takeover and then transform them via ruthless cost-cutting and cash generation. Assets – maybe the whole company shorn of cost, or profitable bits of it – are then sold on for a profit. It’s a form of corporate ‘invigoration’ that has always attracted some criticism from those who view their approach in terms of ‘asset stripping’ that can wreck companies in pursuit of a quick return. And they keep investment spending in the taken over companies to a bare minimum, critics say.
But PEGs counter that they have become more sophisticated in recent years and can bring a number of advantages to running a company over the traditional publicly listed model. Senior staff now include industrialists (like ex-General Electric’s Jack Welch) rather than just financial engineers, they say. And they have a culture which means they keep a close eye on the way their companies are run, they add, rejecting the notion that they are pure asset strippers, something which they say is not in their interests.
The arguments will go on, but PEGs have certainly become bigger in recent years and are involved in increasingly large mergers and acquisitions (M&A) deals or leveraged buy-out transactions, funded through mounting levels of debt.
A typical buy-out involves taking private a company which is trading on a public stockmarket. A hostile deal to take a firm over might be financed by debt that is a multiple of eight times a deposit paid by the PEG itself. And the big firms are frequently in competition with each other, bidding prices up further.
Phenomenal growth reignites concerns
Stockmarkets themselves have been propelled higher via hectic M&A activity in recent years. Hardly a week goes by without news of a big PEG deal, or PEG interest in a major public company and the PEGs appear to leave few stones unturned in the search for profitable opportunities. They’re active across the world and in many industrial and retail sectors. Standard & Poor’s estimates that private equity buy-outs in Europe and the US surged to US$440bn in 2006 from a level of US$100bn in 2003.
Just lately there have been more noises of protest echoing the ‘bad-boy’ image that PEGs had in the 1980s, a public perception shaped by the movie Wall Street and the bestselling book, ‘Barbarians at the Gate’, about the battle by Kohlberg Kravis Roberts (KKR) to buy RJR Nabisco. After the ‘greed is good’ era, the buy-out boom faltered in the recessionary times of the early 1990s when cheap credit (like ‘junk bonds’) dried up and regulators cracked down on hostile takeover bids. But PEGs never went away.
It is estimated that there are now almost 3,000 PEGs and venture capitalist firms in the US alone. What’s behind the boom in private equity? City analysts say that there is now plenty of money around looking for a home as result of a lack of good alternatives in times of historically low interest rates; PEGs offer a relatively low-risk and high return on investment. The PEGs also like to point out that big corporate scandals (like Enron) that send shock waves through stockmarkets tend to be in publicly held firms rather than private ones.
De-listing their acquisitions means that PEGs can make controversial management decisions without having to worry about shareholder reactions or the need to publicly release information under stock exchange disclosure rules. Employees tend to be fearful for their jobs and they are usually accountable to small groups of private investors and credit lenders.
In summary, their methods may be controversial but they aim to take unprofitable companies and make them profitable via reduced costs and great focus on assets that have value. Financial institutions and fund managers have flocked to them. PEGs have been able to easily finance buy-outs through huge loans; if a corporate asset is priced at a high value PEGs are increasingly the only ones able to raise sufficient cash. The deals have been getting bigger, the portfolios wider and the debts even larger. And the biggest private equity firms are now immensely powerful forces.
However, the uncomfortable and unanswered question remains: are they evolving into something new, or are they still, at heart, focussed on ‘strip and flip’?
Supplier industry opportunities for PEGs emerging
The automotive industry looks like naturally fertile ground for PEGs. It is subject to rapid structural change, relatively low returns on investment and a wide range of corporate performances; crucially, there are plenty of poor performers out there. In the US supplier industry, an opportunity on a plate seems to have arisen as suppliers have entered Chapter 11. But private equity firms haven’t exactly stampeded into the supplier sector. They may be wary that the sector is so troubled that the sell-on price will naturally be depressed.
That may be changing though. Bankrupt Tower Automotive announced earlier this year that it planned to sell most of its assets to Cerberus.
However, eyebrows were really raised across the US supplier industry when Carl Icahn’s ‘American Real Estate Partners’ reached an agreement to acquire Lear for US$5.3bn earlier this year. Lear wasn’t even facing Chapter 11, suggesting that Icahn might see Lear as a value play.
It would seem that PEGs may be attracted to the US supplier sector on the basis that valuations are indeed very low, but that things can only get better with successfully restructured companies. It remains to be seen how PEG-owned suppliers will interact with their OEM customers, some of whom will naturally be suspicious that they will cut spending in areas like R&D.
PEGs and vehicle assemblers?
Why do PEGs think they can succeed where long-established vehicle making groups have failed? One area is the availability of funds and the cost of borrowing. Chrysler Group’s injection of cash from Cerberus will, along with an improved credit rating that reduces the cost of borrowing, help it as it looks to restructure.
In taking Chrysler Group private it can also be argued that the firm will be less encumbered by the need to please investment bank analysts and report to stock exchanges. It can, the argument goes, therefore take a much longer view, an essential part of its turnaround plan.
“We’ll be able to run the company the way we want to run it, without worrying about quarterly profit announcements,” maintained Chrysler’s CEO Tom LaSorda.
Cerberus can also argue that it takes the long-term health of Chrysler seriously, that its commitment is demonstrated by the auto industry execs on its books – such as ex-DaimlerChrysler and Volkswagen’s Wolfgang Bernhard, a man who knows Chrysler well. David Thursfield, formerly of Ford (the guy who had the run-in with Martin Leach), is there too
There may also be a sense that Cerberus can open negotiations with the UAW on healthcare from a position of strength that was unavailable to DaimlerChrysler’s management. Everything changes with the change of ownership and the UAW may make concessions in exchange for some assurances on jobs.
Thus far, Cerberus has been cautious in terms of its public statements. It says it plans to stick to the existing turnaround plan. It’s a soft and cuddly public projection. And the UAW’s Ron Gettelfinger has responded in kind, welcoming Cerberus as the new Chrysler owner in direct contradiction of UAW remarks made when DCX was assessing prospective buyers.
But how does Cerberus make money out of Chrysler and on what sort of timescale? It won’t want to hang around for long. Five years might be a kind of extended horizon. Under the recovery plan approved by Zetsche Chrysler is supposed to be profitable by 2008. If that timetable looks like slipping, or a deal on healthcare with the UAW appears elusive, the hawks at Cerberus might start to carry more weight than the doves. There may be calls to wield the job-cutting axe and think about the value inherent in the firm’s three brands – Chrysler, Jeep and Dodge (Jeep being the jewel in the crown).
And Cerberus might feel that a natural market for brands exists in China, where cash-rich firms need credible brands to push ahead with export strategies. If these brands have good distribution networks in place, even better.
Disentangling Ford and Land Rover
Such consideration on future buyers may also apply to PEGs weighing up Ford’s up-for-sale at the right price Jaguar and Land Rover brands. There is a problem though. The fact that the two brands are being offered up as a package deal (we want you to take loss-making Jag, but LR is in profit, please take that also) hints at it. The two firms share one production facility and share much else besides. Disentangling them may be problematic, costly even.
That said, medium-term prospects for both brands look reasonable. Land Rover has a young line-up after a wave of product renewals. Taking Jaguar to a lower volume but higher-margin business is already in train. The disaster that was the X-type won’t be replaced. The S-type gets replaced later this year with the XF sports saloon that may well embody design values that can, potentially, give the whole Jaguar brand image and sales a massive lift.
But if Jaguar is recalibrated as a lower volume business, what does that mean for cost? If production cost has to come down, a private equity company may want to take it on – no-one from the industry appears to want to right now.
Let’s say the PEG that buys J-LR from Ford goes in all guns blazing, drastically cuts cost and then offers both brands up – separately – to the industry in, say, three years time. The brands themselves with their heritage and iconic status, allied to a credible product line-up, good in-house engineering skills and a leaner cost-base might then be highly attractive to the industry. Asians may be queuing up.
The key thing will be making Jaguar profitable. It’s hard to see how that can be done without downsizing the manufacturing footprint. Ford’s plan to take Jaguar to core BMW/Merc high-volume territory is in ruins; better to concentrate on what Jaguar does well and reposition the brand further upmarket.
If that gives Jaguar a viable future that is otherwise not there, the PEG will have achieved what Ford has manifestly failed to do in its 17 years since acquisition. And that, in the final analysis, is where PEGs prove their worth: doing what others can’t, or won’t, do themselves.