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Private Equity has Toolkit to Ease Troubled Market

10/10/2008 --

Industry's best practices inspire solutions in times of crisis, say experts.

ANN ARBOR, Mich.—Who are the real barbarians now?

The global economic crisis has many people playing the blame game, and private equity gets its share of the heat amid the ongoing credit crunch.

But the public perception often doesn't match the reality, argued Perry Golkin, a partner a private equity giant Kohlberg Kravis Roberts & Co. KKR was a key player in the book Barbarians at the Gate, which featured the firm's historic leveraged buyout of RJR Nabisco in the late 1980s.

The best practices of private equity -- focusing on shareholder value, actively managing assets, improving companies, and balancing risks and rewards -- can serve the financial world well at a time when liquidity is hard to come by and global stock markets are under pressure.

That was one of the key messages at the third annual Global Private Equity Conference Oct. 3 at the Michigan League, where Golkin was the keynote speaker. The conference -- hosted by the Ross School of Business, the Samuel Zell & Robert H. Lurie Institute for Entrepreneurial Studies, and the Michigan Private Equity Partnership -- drew about 175 private equity professionals, investment bankers, and alumni to campus.

Panels also outlined some new opportunities for private equity -- alternative energy, international deals, and special investment vehicles -- along with some of the potential pitfalls.

Certainly, the environment isn't pretty, and there's a lot of blame to go around. Golkin said borrowers, investors, ratings agencies, investment banks, and regulators all share responsibility for the financial crisis.

But private equity isn't always part of the problem, despite its "strip and flip" reputation. In fact, it's part of the solution more often than not, but that doesn't often get the headlines, Golkin said. While some private equity investments fail, the numbers show that companies with private equity owners outperform public indices. For the most part, private equity improves companies in terms of revenues, margins, and jobs created.

"Don't ignore the lessons of private equity," he said. "You act like an owner, you proactively manage, you do your due diligence." He noted that KRR was lambasted for running RJR Nabisco "like a business" and doing away with executive largesse, "which today is good corporate governance.

"Where is all the applause for private equity for setting the standards?" he asked.

The biggest problem facing private equity now is the lack of financing, which is the lifeblood for getting deals done. But Golkin also said prices for companies are coming down, allowing firms to land some values. Retail, however, is going to be a brutal business for some time.

Private equity firms will have to put more of their own money up to get a deal done, he noted. But a firm can still land good returns thanks to the lower prices.

"It's just going to look different," he said, adding, "It's a time to be quite cautious."

It's also a good time to learn from past miscues, said Keith Alessi, MBA '79, chairman of Westmoreland Coal Co. and an adjunct lecturer at Ross.

Alessi reminded private equity firms that they're not just investing in a business, they're investing in people.

"Do a background check on how much litigation your partner is involved in," he said during a luncheon keynote address, noting that he once got burned when he neglected that step.

Alessi, a turnaround specialist and former CEO of Jackson Hewitt Inc., said that firms tend to give managers too much equity and not enough cash in their compensation schemes.

"I understand skin in the game and upside," he said, but added, "I pay my bills with cash, not equity."

He also warned against falling in love with a deal to the point of exercising bad financial judgment. Private equity firms should avoid bidding deals up, since the whole point is to find value.

Alternative Energy, Alternative Investments

One sector garnering investor interest, even in these troubled times, is alternative energy. Political leaders and the public are hungry for renewable sources of energy that will lessen the country's dependence on foreign oil and cut down on pollution.

A plethora of new companies are seeking ways to dominate in wind power, clean coal, solar power, transmission systems, and biofuels. Venture capital and private equity has followed.

That wave of investing, even if it becomes a bubble, really helps innovation and that's what the sector needs right now, said Jon Koch, MBA'96, managing director of U.S. Renewables Group. Koch, whose fund invests in biofuels and biofuel infrastructure, was part of a panel outlining the opportunities and land mines in investing in new energy technology.

"Some (investments) will fail, but it creates a lot of innovation," he said.

But there's a misalignment of capital in the sector, said Fabricio Soares, CFO of New Gas Concepts, a company working to turn biomass into gas. The industry needs early-stage capital, but most investors are offering growth capital.

"There's a mismatch of where the capital wants to go and where the game is," he said.

He also said there's a lot of reckless investing.

"What you see a lot of right now is people who don't know the industry," he said. "They go to a conference and pick up some brochures. They don't fully understand the dangers of investing in this sector…We're going to be in a bubble soon."

For example, investors will get excited if a company finds a way to produce clean energy for a low price. But what they don't' realize is that company doesn't have a way to transmit the energy, he said.

"There's not enough attention given to turning a concept into a money-making entity," he noted.

Alessi, in his lunch address, said good private equity plays in energy would be on the supply side of the wind power industry -- hardware such as turbines, towers, and blades -- and in transmission technology.

Besides hot sectors, investors might want to consider alternative investment vehicles during a time of low liquidity.

One of the most popular is the special purpose acquisition company, or SPAC. These are shell companies (with no operations that go public) with the intent of using the proceeds to make an acquisition. It allows the public to participate in a private equity-like deal and it allows the SPAC managers to make an acquisition without tapping the credit markets or using a lot of their own cash.

A SPAC must make a deal within a certain time frame, about two years, or it has to dissolve with at least 80 percent of the money raised going back to investors. Also, 80 percent of the shareholders must agree to the acquisition.

Putting a SPAC deal together is like doing two deals at once, since there's an IPO targeting investors and an acquisition to make, said Bob Skandalaris, an author, entrepreneur, and philanthropist.

"You have to have a story," he said during a panel on alternative investment vehicles. "You cannot go out with that secondary offering without a story."

SPACs also come with their own pitfalls. They usually issue warrants, and Skandalaris said there's a lot of financial wrangling over those. Also, hedge funds can buy up shares and squeeze management, since an acquisition has a deadline and must have 80 percent of the shareholder vote.

The good news is that the credit crunch has made SPACs a more compelling story, since valuations have come down. Besides the lower valuations, the lack of financing has forced more competitors out of the market for acquisition targets, said Adam Conrad, MBA '02, vice president of RockWood Equity Partners LLC.

Over There

With growth stunted in the U.S., many private equity firms are looking to put their money to work in growing markets such as China and India. Those markets do offer great opportunities, but there are peculiarities in those countries that, if not mastered, can turn an acquisition sour.

China's economy is still growing and the government is selling off state-owned enterprises to domestic and foreign investors, said Dale Colling, founder and chairman of ALC Advisors, a firm specializing in mergers and acquisitions in China. Colling spoke during a panel on international investing.

But China is a different environment, he said. Many business owners there are making millions per year, so convincing them to sell takes some creativity. Due diligence takes longer and foreign investors are held to a higher standard.

China has enacted some legal reforms, but regulators still have wide discretion, said George Martin, partner at Faegre & Benson LLP. And companies owned by Chinese principals may have some business practices that, while not illegal, would be problematic for a foreign owner.

"You have to find out to what extent earnings are sustainable if those practices don't continue," Martin said.

India, another growing economy, is more of a free market. One stumbling block there is that 90 percent of the businesses are family-owned, with strong emotional ties that go back generations, said Daljit Doogal, a partner at Foley & Lardner LLP. He also warned that a foreign company that enters into a joint venture or buys a company in India needs government approval before it can do another deal in the same industry.

However private equity funds deal with the financial crisis, KKR's Golkin said everyone needs to think long term.

"We're always accused of quarter-to-quarter management," he said. "Hopefully, the best of private equity looks long term."

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847,