The changing world of private equity

September 2020  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2020 Issue

In his often-quoted article ‘Eclipse of the Public Corporation’, published in the 1989 September – October issue of the Harvard Business Review, Michael C. Jensen shed light on what he described as new corporate organisations which did not rely on public equity for their financing but on a mix of private and public debt. Further, management was highly incentivised by holding equity in the company, and the use and distribution of the company’s cash was pre-agreed contractually. This ‘post-LBO’ organisation, according to Mr Jensen, could, over time, challenge the public corporation. Kohlberg Kravis Roberts (KKR) and Clayton & Dubilier, together with others, established this buyout business model of better management based on financing and incentive structures.

This model fell victim to its own success and the availability of cheap money. At the beginning of the new millennium, PE investors did not have to wait for better management to add value to the portfolio company. The PE houses were so successful that investors drowned them with funds. These monies needed to be invested. Rather than turning around mismanaged companies over several years, these companies were refinanced at low cost, cash was distributed, and the company then flipped, swiftly sold on to the next PE house eagerly looking to invest. Secondary and tertiary transactions became more common. Even potential synergies strategic investors competing for the same targets could add to the purchase price were not enough to match the multiples PE houses were able and willing to pay, based on their new business model of refinancing.

In the post-Lehman world, now becoming the COVID-19 world, and in an environment that sees only a few attractive targets coming to the market, this model also has come to an end. New business models and strategies are required to achieve the return on investment PE houses are looking for. One new model is a modified version of the first one. Better management is now supported by a ‘buy and build’ strategy. PE houses allow themselves time again to add value. With bolt-on acquisitions they build around existing portfolio companies, thereby allowing for synergies only strategic investors could realise, albeit without the restrictions big corporates usually face. KKR’s acquisition of several German media companies, combined with its investment in and agreed take-private of Axel Springer, is only one example of this approach. And KKR would not be KKR if this approach was not followed through consistently. Axel Springer has just submitted a multi-billion bid for eBay’s classifieds business.

Acting under the new normal shifts perspectives. What would not have been possible in the ‘refinancing world’, requiring full control over a portfolio company, now becomes an option – minority investments. Both sides, the target company and the investing PE house, bring to the table their best assets. Market knowledge and technical expertise are combined with a new stream of funds, management expertise and a clear vision of how the company should be developed. The agreed path forward – ‘buy and build’ – and geographical expansion often play decisive roles as well. The funds that are saved by not taking full control can be invested in adding value to the company. EQT’s minority investment in prosthetic devices manufacturer Otto Bock is heading in this direction, however this requires a robust investment agreement.

With minority investments becoming acceptable, other doors also open that were previously considered closed. PE houses now investigate public takeover situations in jurisdictions where a public takeover may not necessarily lead to the acquirer taking full control of the target. Taking this hurdle has a significant advantage: more targets become eligible in times when attractive options are scarce. Other than dealing with situations in which the portfolio company cannot be controlled directly or only via business combination agreements entered with the company, public deals could yield further surprises, like the interloper role taken on by hedge funds. During the transaction, these hedge funds buy up stakes that convey control over the target, which they are more than happy to sell to the bidder at inflated prices. Further, they make use of all means allowing for arbitrage, including corporate measures that require another buyout offer to the minority shareholders or at their final squeeze-out. This is a situation that strategic investors also need to tackle in the course of public takeovers. PE houses, however, have widened their scope of possible investments without incurring competitive disadvantages.

On a more general level, PE houses will benefit from a structural advantage many strategic investors forgo. In most cases, PE houses, unlike strategic investors, will not raise foreign direct investment (FDI) concerns with the authorities. Fired up by COVID-19, the control regimes being set up and refined to address FDI in many states create significant obstacles for reliably closing a transaction. In an unpredictable environment, however, deal security becomes more valuable than ever. With a diverse investor base and without proximity to sovereign entities, PE houses will most often be perceived as the preferred acquirer by national authorities running FDI review processes. In a deal world that must accommodate the Committee on Foreign Investment in the United States (CFIUS) and the new EU FDI Screening Regulation, PE houses will often hold the key to closing a transaction.

The world is changing, probably faster now than ever, and so are PE houses. By adapting their business model and their strategy, they have found more than just their niche, and will continue doing so in the future. Nothing remains as is; neither the world, nor PE.

Michael J. Ulmer is a partner at Cleary Gottlieb Steen & Hamilton. He can be contacted on +49 69 971 030 or by email: mulmer@cgsh.com.

© Financier Worldwide

BY

Michael J. Ulmer

Cleary Gottlieb Steen & Hamilton

©2001-2024 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.