With large buyouts lacking, private equity firms downsize deals

Currently unable to finance the megabuyouts of the recent past, private equity firms are looking down market — executing buyouts of smaller companies and making more minority investments in large, distressed companies.

That promises to change the private equity landscape dramatically. Formerly heady returns are likely to fall to earth, and relationships with managers of portfolio companies may involve more give and take.

Financial sponsors have executed 631 buyouts so far this year, according to data from Dealogic, New York. That's just 40 fewer than in the same period last year, but the value of those deals was $78.1 billion, 65% less than last year.

With their coffers still overflowing — $160 billion more was raised by private equity firms in the first quarter, according to London-based Private Equity Intelligence — they need places to put the money. Increasingly, they are putting it into non-controlling stakes in public companies starved for capital.

In the year to April 9, financial sponsors made 245 minority investments totaling $12.1 billion, according to Dealogic. That compares with 204 such deals, worth $10.9 billion, in the same period last year.

Private investments in public equity have traditionally been the financing of choice for small companies unable to raise enough money in public offerings. They are becoming a more common tool for large companies. “It's an opportunity for private equity firms to put money to work when other alternatives are not available,” said Peter Gottsegen, New York-based managing partner at private equity firm CAI.

Washington Mutual Inc., the Seattle-based thrift whose subprime lending business brought it to the brink of insolvency, is the latest distressed company to tap private equity firms.

Earlier this month, WaMu closed an agreement with an investor group led by TPG to pump $7 billion into the company. The investors will purchase common stock, convertible preferred shares and warrants that when converted will result in the issuance of 891 million new WaMu common shares.

All in, the price per share will be approximately $7.85, or a discount of more than 30% to the company's share price on the day the deal was announced. TPG will reportedly have a stake of slightly more than 16% in the company.

Observers say the deal shows how much the market has changed since leverage-fueled private equity deals peaked last year. “WaMu is today's TXU deal. We'll see a lot more PIPE deals like that,” predicted Douglas A. Cifu, a partner in the New York office of Paul Weiss Rifkind, Wharton & Garrison LLP.

Other companies thrown similar lifelines include E*Trade Financial Corp., which received $2.5 billion from hedge fund Citadel Investment Group LLC in November. Citadel and other investors received 12.5% senior notes, 19.99% of the company's common stock and E*Trade's entire asset-backed securities portfolio, which had a book value of $3 billion. Citadel agreed to pay $800 million for the securities.

At Moneygram International Inc., the terms were equally hard on shareholders. The money transfer company got burned investing the float from processing money orders and wire payments into mortgage-backed securities, on which it has taken $1.6 billion in losses as of March 10.

It was saved by Thomas H. Lee and Goldman Sachs, which late last month purchased $760 million in preferred shares that are convertible into common stock at $2.50 a share. (Moneygram shares were trading at $30 last summer.) The shares pay a cash dividend of 10% or accrue at a rate of 12.5%, and if converted, would give the two firms a 79% stake in the company.

Normally the transaction would have to be approved by shareholders under New York Stock Exchange rules. But because Moneygram was teetering on the brink of insolvency, it received a “distressed company” exception from the rule.

For companies facing insolvency, PIPEs may keep them in business or save them from Chapter 11 bankruptcy protection. Where they previously might have had to raise high-interest debt in the public markets, they're now looking to private equity firms.

“The high-yield debt market is closed for a lot of companies,” said Bryan E. Davis, a partner in the Atlanta office of Jones Day.

For the buyout shops, the new deal structures will almost certainly mean lower profits. While the near-predatory terms on deals like the WaMu investment could prove to be windfalls for the private equity firms, the deals are also highly risky. And without the leverage that juiced returns in the good old days, the payoffs will likely be lower.

Nonetheless, private equity shops are preparing to operate under the new market conditions. Many are changing the mandates of funds they raise to enable them to buy debt, make minority investments and generally do things other than full-blown buyouts, said one lawyer.

While many have made minority investments before, it could be difficult for buyout shops used to calling the shots at portfolio companies. They'll now have to agitate at the board level rather than in the executive ranks.

“It's a different investment thesis, and traditional buyout funds aren't socialized that way,” the lawyer said. “They're going to have to practice the art of persuasion, not coercion.”—Financial Week