Private equity plays risky game of musical chairs
Cash-rich firms increasingly buy from each other but debt could threaten some deals
Javier Espinoza in London
© Getty
Lorraine Kelly has been going to the Gala bingo hall in Stratford most weekends for the past two decades. Even though the east London business has changed hands multiple times over that period, she says the place has stayed largely the same.
“Sometimes you get free passes to come and play when new owners take over and that encourages you to play more,” says Ms Kelly, who once won £1,000 in a single evening of bingo.
While the customers might not have seen much change, the same cannot be said for the business model. Gala, which merged with rival Coral in 2005, was at the epicentre of one of Europe’s least successful and controversial leveraged buyouts as it was passed around private equity firms in a financial game of pass the parcel that lasted over a decade.
Successive owners would pay themselves high dividends, aided by easy financing, before selling to the next private equity house. In total, Gala was bought and sold five times by different firms from 2002 to 2015. Through the whole process, the levels of debt the business carried, measured as a multiple of its earnings, kept creeping up.
The business performed well in the decade up to 2008, with strong sales growth and aggressive expansion. But Gala’s former private equity owners spent much of the past decade in retreat, cutting back on shops and laying off staff, after they were nearly overwhelmed by a toxic mix of tough market conditions and high levels of borrowing.
Over time, the debt burden became unsustainable. Gala Coral nearly went bust, before the business was eventually acquired by rival Ladbrokes in 2016, which in turn was bought by GVC Holdings earlier this year.
The Gala Coral story might have proved a salutary experience about the risks of such pass-the-parcel dealmaking. However, the opposite has been the case. Last year, the industry did a record 576 so-called secondary deals, when a company or a stake in a company is sold by one private equity firm to another, according to Preqin, the data provider. That compares with 394 such transactions in the peak of the deal boom in 2007, just before the financial crisis.
Private equity advisers are increasingly worried that the sector could see a repeat of Gala Coral’s experience as interest rates start to rise, increasing debt payments and raising the chance of a recession.
Secondary deals can often be more vulnerable when conditions change, either because they have higher debt levels or because more money has already been taken out of the business by previous owners.
A recent analysis of the performance of 2,137 companies owned by 121 PE firms by Saïd Business School at Oxford university showed that secondary transactions have lower returns than other deals when done by a firm that is under pressure to deploy capital.
Some executives liken the situation to a form of private equity “musical chairs”, where firms are exposed when the market turns against them.
“Every time a company is sold between private equity funds there is a risk that you are taking off some of the potential upside as the business may have been optimised through acquisitions or operational improvements,” says Neel Sachdev, a leveraged finance partner at the law firm Kirkland & Ellis, which advised Apollo in acquiring the debt of Gala Coral in 2009. “So there may be less potential upside every time you pass it on.”
Mr Sachdev adds: “The risk is really that there is not that much juice in the lemon to squeeze.”
Gala Coral is not the only secondary buyout where private equity groups ran out of juice to squeeze. In the US, mattress maker Simmons Bedding, which was bought and sold by private equity owners seven times in 20 years, filed for Chapter 11 bankruptcy protection in 2009 and more than 25 per cent of the workforce was laid off. Still, its former owners, which included Thomas H Lee Partners, made a profit of $750m through special dividends, according to a New York Times investigation. In Europe, Phones4U, the British mobile phone retailer, collapsed in 2014 after eight years in private equity hands.
Recent examples of pass-the-parcel deals include Cinven’s acquisition this year of laundry services business JLA from peer HG Capital, and KKR’s sale of roses supplier AfriFlora to Sun European Partners last year.
“Buyout groups like secondaries because they are buying an asset from a peer and it feels like there is not much work to do,” says Per Stromberg, a professor of finance and private equity at the Swedish House of Finance, a research centre. “But often this leads to them paying too much.
”Secondary deals often increase the incentives for private equity owners to load more debt on to a business. “If you buy a company that has been improved by one or two previous private equity owners and if there is not much to do to improve it, then one way to get returns up is to add more leverage to it,” he says.
Defenders of pass-the-parcel deals argue that the demise of Gala Coral and others under multiple private equity ownership was merely bad luck as conditions in their industries quickly deteriorated.Gala and Coral: A marathon of dealmaking
Paul Dolman, a partner at London-based law firm Travers Smith, who estimates that he has worked on approximately 60 pass-the-parcel transactions in the past 15 years, argues that secondary deals are not necessarily to blame if things go wrong.
“The key is to work out why the house is selling. If it is because they are under pressure to return money to investors, then you can understand that is a credible reason,” he says. “If it is because they think the market is about to turn and they have sweated the asset as much as they can, then that is clearly not a good reason.”
Supporters of such deals argue that buyout groups bring much-needed injections of capital to fund the growth of a business through acquisitions or expansion. They also point to successful transactions, including vehicle leaser Zenith, which has been owned by four different private equity owners and has returned strong results. In Zenith’s case, one of the owners tripled its initial investment before successfully selling to the next private equity house.
Secondary buyouts, they argue, are part of the evolution of an industry that owns more and more companies and is awash with cash to deploy on deals. Buying the businesses already owned by other private equity firms has become an attractive way to invest their funds, especially as these firms also face growing competition from corporations hungry to find new assets.
Such deals were largely non-existent at the start of the century. The Gala Coral saga offers an extreme example of how they can sometimes go sour in a short period of time.
Private equity buyers were first lured into the leisure industry in the early 2000s by the growing popularity of gambling and a relaxation in advertising restrictions.
Before the merger with Gala, Coral itself was passed around three times between financial sponsors from the late 1990s until it was sold for a fourth time to a group of private equity buyers that included Candover and Cinven in 2003. The deal was largely financed with debt and the valuation was £1.3bn or close to 9 times earnings before interest, tax, depreciation and amortisation. Among private equity deals, a price of more than 10 times ebitda is considered high.
Business was booming and the new owners went on an expansion drive. Two years later, the buyout houses returned £275m to shareholders — the equivalent of seven times the company’s debt.
Coral’s owners had banked on the British authorities further relaxing rules on advertising around gambling, and longer opening hours. Their assumptions turned out to be optimistic, while a smoking ban also damaged the prospects in an industry where many of the customers had enjoyed a cigarette during their game of bingo.
Lionel Assant of Blackstone © Bloomberg
Despite speculation about tougher regulations, the interest from private equity firms showed no signs of diminishing.
In 2005 a new private equity owner, Permira, bought a 30 per cent stake, valuing the business at 15.1 times ebitda and with debt at 9.75 times ebitda. The new owners went on a hunt for acquisitions, leading to the merger of Gala and Coral. The business was further loaded with debt. For the next two years, the company’s revenues grew in the high single digits.
But then came the financial crisis and a period of anaemic growth. By the end of 2008, the equity value of Gala Coral had been written down to zero by Candover, Cinven and Permira. Buyout groups Apollo, Cerberus and other specialist lenders spotted an opportunity and started buying up its debt at significant discounts — later becoming the company’s main creditors. Eventually, the private equity backers of the company lost ownership to the lenders and Coral and Gala demerged in 2015. Both now owned by GVC, the businesses trade separately.
The high debt levels were key to Gala Coral’s travails. Sebastien Canderle, author of The Debt Trap, a book on how leverage affects the performance of private equity deals, writes that “what brought Gala to the brink of bankruptcy was . . . [that it was] absurdly overleveraged compared to its peers”. While the other large companies in the sector suffered in the period after the financial crisis, none faced the risk of default or administration. “As Gala’s competitors demonstrated, without that much debt laden on the balance sheet the business would not have needed a financial restructuring.”
The private equity industry is now in overdrive, buoyed by record fundraisings. However, some senior figures in the industry say they are shying away from secondary transactions.
Lionel Assant, the European head of private equity at Blackstone, said only 1 per cent of global deals represent secondary transactions because of concerns that they may deliver meagre returns. One of the exceptions: earlier this year, Blackstone bought Averys, a maker of tracking and storage solutions for warehouses, from rival Equistone.
“If the economy slows a bit, the multiples contract and I think investors are going to have very average returns . . . especially on secondary deals,” he says. “The idea that because you can lever up a business at six or even seven times ebitda today at a very cheap cost of debt and that you’re going to re-lever with cheap cost of debt in five years from now is obviously ludicrous.”
What he calls “the musical chairs game”, where private equity firms do some “quick flips”, could continue for a few years if there is no recession but, he adds: “We don’t want to be in this game.”
Joana Rocha Scaff, head of European private equity at the investment management firm Neuberger Berman, warns that dealmakers are underestimating the risks of debt-heavy structures that come with secondary buyouts.
“When rates rise, pay attention because it may put significant liquidity pressures on these firms,” she says. “In some cases liquidity is not being fully understood. People are putting a great amount of focus on the capital structure. But where is the cash?”
However, few experts predict that these deals will stop any time soon. Ludovic Phalippou, a finance professor at Saïd Business School, predicts an increase in pass-the-parcel transactions. “These deals will accelerate because private equity guys have a lot of dry powder [unspent capital] and they have to keep deploying it,” he says.
Deals are becoming bigger and more expensive
Private equity groups have never had it so good: they are raising record amounts of cash at the fastest pace in a decade. Dry powder, the industry’s lingo for committed but unspent cash on deals, is now at $1.7tn and growing.
But such a large volume of funds also brings its own pressure to deploy the capital. This, in turn, has led to a string of deals with the sorts of valuations and debt levels that were seen just before the financial crisis.
This month, the UK schools group Cognita was sold in a £2bn deal that valued the business at 26 times earnings before interest, tax, depreciation and amortisation as of August 2018, according to people with direct knowledge of the transaction. Last year, Nets, a Danish payments group, was sold in a deal with more than seven times debt as a proportion of ebitda.
Deals are also getting bigger. Blackstone staged the largest leveraged buyout since the crisis with the acquisition this year of the financial terminals and data unit of Thomson Reuters in a $20bn deal. With Singapore’s sovereign wealth fund GIC, Carlyle bought Akzo Nobel’s speciality chemicals unit this year for €10.1bn, including debt — its largest ever deal in Europe.
“Private equity groups are having to become more creative,” says an adviser to large buyout groups in London. He expects to see more public companies being bought by private equity or carve-outs of large conglomerates also going private.
In such a giddy market, executives say it is important to stick to basic principles. “In a competitive market, it’s even more important to retain a disciplined focus and look for companies which will continue to grow and perform over time,” says Nikos Stathopoulos, a partner at BC Partners. “We don’t look for one-trick ponies.”
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