Future Outlook and Strategies

Now that the "irrational exuberance" of the new economy has evaporated and valuations have dropped dramatically, many are asking whether the buyout deals will come back. The answer, we think, should be yes. Buyout firms are presented with many good opportunities as sellers in financial difficulties are increasingly willing to accept the more realistic, lower valuations and as investors are trying hard to find investment opportunities to beat the S&P 500 return. But will the new buyout deals be the same as the glamorous ones in the 80s? The answer is probably no. The October 2000 issue of Business Week best states the recent attention that buyout funds get: "it may not be the glory years, but buyout shops are back, raising billions - and heading into unchartered waters." The competitive environment is certainly much more challenging than that of the 80s; yet the drop in returns isn't driving investors away. This is because the top 25% of LBO funds still regularly beat the returns on the S&P 500 Index. Trying to give an estimate of future industry average return is not only difficult but also not very useful in suggesting future trends. Instead, some qualitative characteristics of the future LBO market may be suggested.

1. More Entrepreneurial Focus

One trend is that buyout deals will be more focused on younger companies rather than established ones. While traditional buyouts were likely to occur in established, cash-rich firms within a mature industry, today buyouts have increasingly become a way to unlock the entrepreneurial spirit from rigid corporate structures, with increasing attention paid to technology-related industries. The main driver behind this phenomenon is the tremendous technological advances that the last decade has witnessed. These entrepreneurial buyouts demand different skills from the traditional monitoring skills required in the 1980's buyouts. Financiers need to understand the technology sufficiently to assess the investment and to monitor it.

A recent variation of the leveraged buyout, the leveraged buildup (LBU) has facilitated wealth creation, as mid-market businesses become parts of larger enterprises. These transactions typically work in the following way: the fund buys a small company or a small unit of a big company -- usually one with no more than $ 15 million in revenues -- that serves as a ''platform'' to which smaller companies with industry synergies can be added in subsequent transactions. The screening criteria are based more on long-term productivity of synergistic assets than on simply cheap bargain price tags. The leveraged buildup strategy has demonstrated the ability of LBO or LBU funds to act as a conduit for the transfer of funding and professional skills into the small-to-middle-cap market, which historically has been less efficient and less chased after compared with the large-cap market.

2. Shifts from a Financial Focus to an Operational/Strategic Focus

The second trend is the shift from a financial focus to an operational/strategic focus. According to a 1999 report by McKinsey & Company, the LBO wave in the 80's effectively removed the financial/capital market inefficiencies, while the current wave of buyout investments addresses strategic and operational inefficiencies at both the industry and portfolio company level. One can argue that there are still considerable financial inefficiencies best indicated by the fad of public - private deals as the result of market valuation fluctuations and the many interesting unknowns in the relatively young financial research field of venture capital and private equity. Still, a growing number of buyout firms are realizing the need to incorporate operation expertise into deal process and portfolio management. In many buyout firms operating and financial partners are involved in the investment process from deal origination through due diligence and closing. After the deal is done, the operating partner serves on the board of portfolio companies to oversee important operation decisions of portfolio companies.

The trend is also evident in the increasingly blurred distinctions between different fund vehicles in the private market to which investors can avail themselves: strategic buyers, financial buyers, venture capital firms, and buyout firms, etc. For example, leveraged buildup strategy effectively allows a financial buyer to assume various functions of a strategic buyer by linking separate private equity transactions to a synergetic platform. Instead of just buying out a firm, buyout firms nowadays also invest non-controlling stakes in public companies in the form of convertible preferred or common stock (widely known as PIPE - private investment in public equity). Regardless of what format these private funds take, going forward, a successful private equity fund will have to be able to combine financial acumen with industry knowledge and hands-on management expertise.

3. Global Expansion

Finally, due to increasing competition inside the U.S. , there is a trend calling for buyout funds' global expansion to better tap the vast potential of buyout opportunities in Europe and Asia . The vision of managing director David M. Ruberstein at Carlyle Group, according to Asset Alternatives' recent survey, is that "just as there are two or three truly global investment banks, we think there will eventually be two or three global private equity firms with whom partners and investors will have the same level of comfort as when they call Goldman Sachs, Morgan Stanley, or CS First Boston on investment banking business." Whether or not the number will come down to two or three is not really important, but the abundant privatization and de-conglomeration opportunities in Europe and Asia coupled with relatively less developed local capital markets have already stimulated much interest among buyout firms to grow their international business.

For example, European private equity fundraising has grown at 53% compound annual rate from 1995 through 2000, as indicated by data from European Venture Capital and Private Equity Association. In contrast, U.S. buyout fundraising has grown only at a 32% compound rate in the same period. In addition, buyout returns have generally been substantially higher in Europe than in the U.S. during the past three years.

Asia is also experiencing an M&A boom, having recovered from its 1998 financial crisis. The need for restructuring or cash has driven Asian buyout transactions. In addition, U.S. investors are becoming more comfortable with investments in Asia . In order to gain the first mover's advantage, many law firms and buyout funds are launching their Asian acquisitions finance groups to position themselves at the forefront of the burgeoning LBO market.

Given the significant differences in legal, regulatory and accounting environments, it is important for firms that are considering international expansion to absorb more local expertise and knowledge.