Bankruptcies reinforce LBO fears of managers

The highly publicized bankruptcies of private equity-backed companies such as Toys R Us Inc., Claire's Stores Inc. and Southeastern Grocers LLC are confirming, for some investors, the move away from classic leveraged buyout investments.

Falling expected private equity returns started investors down the road toward alternative private equity investment strategies. Some 40% of investors expect private equity to provide returns of at least 4.1 percentage points above the public markets, down from 54% in 2012, according to a December investor survey by London-based alternative investment research firm Preqin. Indeed, U.S. buyout funds provided a 17.3% net internal rate of return in 2017, underperforming the S&P 500 index's 17.9% return, according to Bain & Co.'s annual ​ private equity report. In fact, U.S. private equity underperformed the S&P 500 for the one-, three- and five-year periods ended Sept. 30, but exceeded it for the 10-year period by slightly more than 2 percentage points.

Despite the recent headlines, the number of bankruptcies of private equity-backed companies fell sharply in 2017. Before 2017, portfolio company bankruptcies had been rising or staying flat since 2012, according to PitchBook. Through March 27, 15 private equity-backed companies have filed for bankruptcy this year. In all of 2017, 76 such companies filed for bankruptcy, down from 122 in 2016, according to PitchBook.

This does not necessarily mean portfolio companies are healthier.

The decline in bankruptcies can be attributed "to various drivers, such as a relatively healthy economy and easily accessible debt to delay principal repayments," said Dylan Cox, PitchBook's private equity analyst.

In addition, "potentially problematic private equity investments" have been boosted by low interest rates, an active merger-and-acquisition market and covenant-light debt used in the pre-financial-crisis deals, said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC.

Even so, with private equity returns expected to slide downward due to the large amount of capital flooding into the asset class, many asset owners are looking for other, lower-fee ways of accessing private equity, sources said.

Institutional investors have been cutting their return expectations for private equity since the 1990s, said Christopher J. Ailman, chief investment officer of the $224.4 billion California State Teachers' Retirement System, West Sacramento.

CalSTRS' $17.2 billion private equity portfolio earned a net since-inception IRR of 13.2% as of Sept. 30, up from 12.82% as of Dec. 31, 2012, but down from 15.77% net IRR as of Dec. 31, 2008. (The portfolio's inception date is 1988.)

CalSTRS staff in May expects to propose a project that calls for devising a collaborative model for investing in alternatives, Mr. Ailman said. A collaborative model could include everything from direct investing and joint ventures to syndicates of institutional investors joining in an investment.

One example is CalSTRS' 2015 infrastructure investment alliance with APG Asset Management NV, a Dutch money manager that runs assets of the €405 billion ($498 billion) ABP pension fund, and New York-based manager Argo Infrastructure Partners, Mr. Ailman noted. The consortium's initial investment was the 2015 acquisition of U.S. electrical transmission system company Cross-Sound Cable Co.

CalSTRS is not the only asset owner to question the classic LBO model. "I don't know that it (the LBO model) is broken but it seems to have been abused in some cases," said Bob Jacksha, CIO of the $12.8 billion New Mexico Educational Retirement Board. "Excessive leverage has been placed on some companies."

In selecting private equity managers, New Mexico fund officials try to stay away from firms that use excessive leverage or those that only use leverage to improve returns, Mr. Jacksha said.

"Instead, we prefer those that can make operational improvements and who employ prudent amounts of leverage and, in some cases, rationalize the balance sheets of companies by paying down debt," Mr. Jacksha said.

The board has $1.5 billion in private equity, amounting to 11.8% of the portfolio. The pension fund has a 13% target for private equity.

Indeed, investors need to be selective when choosing their private equity managers, consultants say.

Executives at alternative investment consulting firm Cliffwater LLC prefer managers selective on commitments that can be invested effectively in this competitive environment, said Thomas K. Lynch, New York-based senior managing director.

"The headline private equity problems like Toys R Us are pre-credit recession investments. However, they do set an example for today's excessive demand for private equity," Mr. Lynch said.

Like in the days before the global financial crisis, there is too much money in the private equity ecosystem. Even so, institutional investors aren't forsaking the asset class. Last year was a record year for private equity fundraising, with $453 billion raised by 921 private equity funds, according to Preqin.

And more than $1 trillion in dry powder is held by private equity firms. This massive amount of uninvested commitments is being driven up by both investors' decisions to increase exposure to private equity for higher returns and the greater market share of sovereign wealth capital, Mr. Lynch said.

"Importantly, the dry powder amount is understated as large investors, including sovereign wealth funds, staple a co-investment expectation to their primary commitments," Mr. Lynch said.

This puts investors back to 2007, when deals like Toys R Us were consummated, he said. "We see lots of similarities," including high prices, weak covenants on the debt and high company growth expectations, Mr. Lynch said.

"The real problem is (limited partner) discipline," he said. "The old rule was to slow commitments when distributions are high and to raise commitments when distributions are slow. That was not observed in 2007 and it is not being observed today."

Instead, much like they did in 2007, investors are chasing target allocations, which are being pushed down by the denominator effect — rising stocks push down investors' exposure to private equity and other alternative investments, Mr. Lynch said.

The models that will work in this environment are ones in which the manager has unique sourcing for transactions and significant strategies for adding value to the companies once they have been acquired, industry sources said.

Reeve B. Waud, Chicago-based founder and managing partner of private equity firm Waud Capital Partners LLC, said the private equity model has continued to evolve. Most firms have come to the conclusion they have to have deep expertise in the industry in which they invest, he said.

"There are few generalists (private equity firms) now," he added.

Mr. Waud said his firm concentrates on cultivating executives who are the best in their field — those who can generate ideas for companies that can grow quickly — and backing these executives multiple times.

The private equity-backed companies that are going bankrupt are the victim of too much leverage and low growth, Mr. Waud said. "The math doesn't work. The last several years, there were a lot of deals that have been priced to perfection. If anything goes wrong, the deal will become unglued."

Carl Roston, Miami-based partner and co-chairman of the corporate group at law firm Akerman LLP, said the LBO model already has changed, even in the U.S. middle market. The old model of finding a small, bloated company, making it run more efficiently, merging it with other companies for quick growth and then selling it no longer works, he said.

Private equity managers are adding industry expertise. One New York-based middle-market firm has partnered with a digital marketing firm to assist it on retail deals, with the digital marketing firm taking a stake in the deal in lieu of a fee, he said.

Private equity managers are no longer buying the entire company or even acquiring a controlling stake, said Chris LeRoy, New York-based partner and U.S. head of private equity for transaction advisory services at Ernst & Young LLP. Recently, there have been a number of private equity deals in the technology and consumer retail sectors in which the manager is taking minority stakes, he said.

"It's a way to put a large amount of capital to work in a business that has a great growth trajectory," he said.