Private equity buyouts in Asia take old risks with new money
(Reuters) A little over a month ago, a Texas power utility at the centre of the biggest leveraged buyout in history filed for bankruptcy, sunk by billions of dollars of debt that it took on after being acquired by a trio of top private equity names in 2007.
The failure of Energy Future Holdings, known as TXU Corp when it was acquired at the height of the mega-buyout boom, is a sobering reminder to investors in private equity funds that heavily leveraged deals can - and do - go wrong.
But financial markets have short memories.
In Asia, private equity firms have amassed a record stash of capital from investors seeking high returns from buyout deals amid low yields around the globe. The firms have $138 billion in unspent capital, or "dry powder" as it is known in the industry, according to management consulting firm Bain & Co.
Unlike the West, sizeable buyout targets are still rare in Asia. They represent under one-third of private equity M&A deals for the past 14 years in the region, Thomson Reuters data shows. So when assets do come up for sale, private equity firms try to outbid one another with aggressive pricing. They are also willing to take on expensive loans which are ultimately borne by their target companies.
Earlier this year, Carlyle Group bought Tyco International's South Korea home security business. In that deal, the amount of debt borne by the target company would have raised concerns with U.S. regulators had the transaction been done in the United States.
"The strong inflow of funds into private equity coffers is pressuring buyout firms to take extra risks," said Ian Ramsay, Professor of Corporate Law at the University of Melbourne.
"We are not at a tipping point yet, but some deals show that private equity investors do need to show some restraint," said Ramsay, a former corporate attorney who worked closely with banks on Australia deals.
At least $20 billion of the dry powder in Asia piled up in the last 12 months as companies like KKR & Co, Affinity Equity Partners and TPG Capital closed new funds to invest in the region.
Private equity firms, in the process of buying out targets, are also securing higher levels of loans, or leverage. The debts are borne by the companies acquired with their businesses used as collateral.
Typically, a private equity firm takes debt to finance about two-thirds of a deal. Such highly leveraged deals ensure higher returns, since private equity firms only need to tap a small portion of their own capital for the acquisition.
Carlyle's acquisition of Tyco's South Korea home security business ADT in March was significant both in terms of valuations and the debt taken on to outbid Affinity Equity Partners and KKR.
Washington D.C.-based Carlyle clinched the deal for $1.93 billion, or around 11 times ADT's earnings. In Europe and North America, private equity has acquired similar assets for around eight times earnings in recent years.
Carlyle also tapped 360 billion won ($354 million) of mezzanine debt from UBS, a costly type of finance rarely used in Asian buyouts, people familiar with the matter said. The debt was well over six times earnings, according to Basis Point, a Thomson Reuters publication, with the debt coming largely from Korean banks.Carlyle declined to comment.
HIGH DEBT MULTIPLES
Many Western banks have retreated from lending, and banks that had booked losses through lending to private equity-backed buyouts before the crisis are staying cautious.
As a result, private equity firms have started to tap U.S. capital markets, a liquid depot where institutions such as hedge funds offer large loans with relatively few covenants for the borrower.
KKR's recent $1.1 billion bid for Singapore container company Goodpack Inc features debt of well over six times EBITDA, or core earnings, much of it sourced from U.S. capital markets. Two years ago, it was rare to see a buyout in Asia backed with debt of more than 3.5 times earnings.
U.S. regulators have cautioned that debt levels of more than six times earnings would be a concern.
Because of that warning, the same three banks backing the Goodpack buyout - Credit Suisse, Goldman Sachs and Morgan Stanley - recently refused to provide debt to another KKR-owned company in the United States on concerns it was too risky to pass muster with U.S. regulators. KKR declined to comment.
The risks are clear.
During the 2008 financial crisis, many private equity-owned companies struggled to manage their debt. Some languished during the downturn, and others went broke, causing financial losses to banks who backed the buyouts, and to private equity owners.
In the Asia-Pacific region, Australian clothing and footwear retailer Colorado Group, owned by Affinity, surrendered control of its business to lenders owed $411 million in May 2011. The company failed to cope with a weak sector and folded under the weight of heavy debts.
CVC recorded Asia's biggest-ever private equity loss in 2012 when it lost Australian media company Nine Entertainment to rival funds in a debt-for-equity swap. Nine had struggled to cope with high debt levels as advertising revenue declined during the financial crisis.
So far in Asia this year, private equity-backed M&A volume is off to its fastest-ever start. Volume is at $28.1 billion year-to-date, almost three times the level a year earlier, and close to the $30.7 billion for the whole of 2006 during the buyout boom.
The costs can be high for all concerned, Ramsay warned, when private equity deals fail and companies collapse.