Moody's Takes on Private Equity

♠ Posted by Emmanuel in at 7/10/2007 12:17:00 AM
Private equity appears to be under siege from all sides now--politicians, organized labor, firms--and now even rating agencies like Moody's have taken umbrage to private equity's modus operandi. (I also suggest that you take a look at the chart I posted earlier on how LBOs are booming as of late.) Let us begin with the Financial Times' take on how "Moody's slams private equity":

Moody’s, the credit rating agency, will on Monday launch an attack on the booming private equity industry, criticising its increasing use of debt to buy companies and questioning its claims that listed companies are better off in private hands.

Moody’s voice adds to the growing chorus of US critics, which includes trade unions, politicians of both parties and some company executives.

The critical position of Moody’s comes at a sensitive time for both the private equity industry and credit rating agencies. The former is facing a deterioration in debt markets just as a number of buy-out firms, including Blackstone and Kohlberg Kravis Roberts, have listed or are seeking to do so. Rating agencies have been criticised by investors for being slow in spotting credit markets problems such as the crisis in the subprime sector.

In its report, to be issued on Monday, Moody’s takes issue with the argument that private ownership frees companies from the short-term pressures of the equity markets, enabling them to invest and plan for the long term.

The claim, often repeated by buy-out executives, is central to the industry’s efforts to prove its activities benefit portfolio companies and the economy as a whole.

Moody’s report says: “The current environment does not suggest that private equity firms are investing over a longer-term horizon than do public companies despite not being driven by the pressure to publicly report quarterly earnings.”

The agency says buy-out funds’ tendency to increase a portfolio group’s indebtedness to pay themselves large dividends runs counter to their claim of being long-term investors. The report cites as examples of this trend the dividend received by Thomas H. Lee, Bain Capital and Providence Equity following their takeover of Warner Music in 2004 and the one paid to Blackstone after the purchase of Celanese.

The document also takes aim at private equity’s claim that improvements in companies’ performance are driven by more focused management teams rather than financial engineering and higher debt levels.

The private equity industry rejected Moody’s claims. “Corporate leaders who have experienced ... the positive effects of private equity ownership are quick to tell you that this structure can and does liberate management to focus on long-term growth,” said Doug Lowenstein, president of the Private Equity Council, the sector’s trade body. “We believe that real world case studies ... offer compelling evidence of private equity’s impact on making companies stronger.”

MarketWatch also plays up this story. An additional drawback noted aside from taking on too much debt while easy money conditions exist includes these firms rewarding themselves with handsome dividends:

Private-equity firms may not always invest for the long term, and the strong performance of the buyout business could be fueled by the benign credit environment rather than management expertise, rating agency Moody's Investors Service said in a report released Monday.

In theory, leveraged buyouts impose discipline on companies because they have to make higher interest payments. Going private is also supposed to help companies invest over a longer time horizon, free from the pressure of quarterly earnings targets and the costs of regulations such as Sarbanes-Oxley. Buyout firms' ability to attract and retain top executives is also often cited as a reason for higher returns, according to Moody's.

But the rating agency questioned some of those assumptions, arguing in its report that sometimes buyout firms have less incentive to inject capital into a business than strategic owners such as public companies.

"While Moody's would agree that leverage is likely to impose discipline and provide higher equity returns, the current environment does not suggest that private-equity firms are investing over a longer-term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings," Christina Padgett of Moody's wrote.

"We also question whether there is sufficient evidence to prove that the higher returns provided to private equity are driven by stronger management teams or because, in a benign and liquid credit environment, leverage by itself can provide substantial returns to shareholders," she added.

Robert Stewart, a spokesman for the Private Equity Council, a lobbying group that represents some of the world's largest buyout firms including Blackstone , the Carlyle Group and Kohlberg Kravis Roberts, disagreed.

Member firms hold companies for an average of three to five years, he said. In many cases, when these companies go public again, buyout firms retain stakes -- sometimes majority stakes, he noted, citing Hertz Global as an example...

The argument that private-equity returns come from leverage rather than management expertise may have been true 20 years ago, according to Stewart. But most companies are now acquired in an auction, so the advantage achieved by leverage is already built into the price, he said.

"Private-equity firms are bidding based on what they can add in terms of creating real economic value over and above what can be created just by leverage," Stewart added.

Moody's also highlighted some buyout firms' penchant for paying themselves dividends soon after acquiring companies.

This is usually done by borrowing more money, so it increases the leverage of the company in question while reducing or eliminating the private-equity owner's equity stake, Moody's said.

"Of concern to Moody's is the willingness of private-equity firms to issue special dividends despite commitments to reduce leverage, sometimes within 12 months of the transaction's closing," Padgett wrote in the report.

Less than a year after TimeWarner's music subsidiary was acquired by private-equity firms including Thomas H. Lee, Bain Capital and Providence Equity, the company distributed a dividend that paid off almost all the equity originally committee by the buyout group, Moody's said...

Celanese US Holdings, a chemical business bought by Blackstone, borrowed money within a year of the acquisition to pay a dividend to the private-equity firm, Moody's added, removing more than 95% of the cash equity originally invested in the deal.

When Moody's first rated the company, Blackstone told the agency that it was planning to exit the investment through an initial public offering within 18 months, so there was no need for special dividends, Moody's said.

"While companies often commit to delevering, execution is not consistent," Padgett wrote.

IPOs are often a profitable exit strategy for private-equity firms. But when that doesn't work out, some firms load up their companies with even more debt to pay themselves dividends, Moody's reported.

This sometimes happens even though the buyout firms pledged to reduce the leverage of the companies involved, the rating agency said.

Marquee Holdings planned to reduce leverage after merging its AMC subsidiary with Loews Cineplex. However, when the company's planned IPO was suspended in May 2007, it borrowed more money instead and used that to pay a $675 million special dividend to its private-equity sponsors, including JPMorgan Capital Partners, Apollo Management, Bain Capital, Carlyle Group and Spectrum Equity Investors, Moody's elaborated.

Stewart of the Private Equity Council said that this argument seems more focused on the lending institutions that facilitate this type of borrowing, rather than on private-equity firms.

This type of activity could increase risks, according to Moody's. If private-equity firms get back most the money they invested in a company quickly, making an attractive return, then there's more chance that they will then ratchet up the financial risk associated with that business, having less to lose, the rating agency said.

Companies with higher debt will also be more sensitive to any economic slowdown, Moody's also noted. "Future performance of current transactions will likely hinge on the economy remaining relatively stable and the credit markets remaining forgiving, as many of these transactions will need to be refinanced over the coming years."