Nestor, John G.

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Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 51 | Issue 32001Comment: Leveraged Buyout Funds as Point ofComparisonJohn G. NestorFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationJohn G. Nestor, Comment: Leveraged Buyout Funds as Point of Comparison, 51 Case W. Res. L. Rev. 437 (2001)Available at: https://scholarlycommons.law.case.edu/caselrev/vol51/iss3/7COMMENT: LEVERAGED BUYOUTFUNDS AS A POINT OF COMPARISONJohn G. NestortI am John Nestor, a managing partner with Kirtland CapitalPartners and the only non-lawyer speaking today. This morning Ihave been asked to make comments on the talk that John McIlwraithhas just given. John and I worked together in 1986 when I joinedKirtland Capital and John was at Jones Day. In fact, he helped mewith the first deal I did at Kirtland, and no doubt, I contributed tosome of his gray hairs.Figure 1Sources of Equity FinanceCorporate &Public PensionFundsEndowments &Foundations OhBank Holding Insurance &Companies Wealthy Families Investment& Individuals BanksSource: Federal Reservet Managing Partner, Kirtland Capital Partners, Willoughby Hills, Ohio.437CASE WESTERN RESERVE LA W REVIEWTo begin with, I would like to talk about private equity andwhere it comes from. Private equity includes both money for venturefunds and for leveraged buyout ("LBO") groups. Approximately43% of private equity is derived from corporate and public pensionfunds. The balance is split up almost equally among endowments andfoundations, bank holding companies, wealthy families and individu-als, insurance and investment banks and another 13% from varioussources.Figure 2 shows the amount of committed capital that went intoventure and buyout investments from the period 1980 to 1991. Whilestarting at very low amounts in the early 1980s, it gradually increasedand reached record levels in 1999, which most likely will be exceededin 2000. These investments and the activity in venture and buyoutfunds has been fueled by the large amount of money made availablethrough them, particularly from pension funds which have had to findways to invest the increasing amount of money they are managing.Figure 2U.S. Venture and Buyouts Investments605030III Venture D BuyoutsSources: Venture Economics/NVCA.As you can see in 1999, the amount of committed capital goinginto venture funds exceeded that for buyout funds for the first time.The reason is very simple. The return on venture funds exceeded thatof the buyout funds beginning in 1994. Figure 3 illustrates this. Allof this was a direct result of the funds being invested in the venturefirms that were backing all of the high-tech companies that we have[Vol. 51:437LEVERAGED BUYOUT FUNDSall read about. With some of the recent setbacks in the stock market,the return on some of these venture funds may, in fact, also comedown.Figure 3Fund ReturnsRolling Five Year IRRsVenture vs Buyouts49135~25/, I/, 1193 1981 1982 1983 1994 1985 19S6 19S7 1983 19 199 1 1991 199 199 199 19 19 9 199 199 1999Ye_Sources: Venture EconomicslNVCA. -What I was asked to do this morning was to comment on JohnMcllwraith's talk, which I have now done. I am going to follow thelead of Al Gore and George Bush during the televised debates inwhich they would initially and very quickly answer the question thatthey were asked, and then go off and talk about what they would like.So with that in mind, I fulfilled my obligation and now I would like tospend the rest of my time talking about LBO funds and contrast thoseinvestments with the venture funds that John talked about. Someoneonce told me that to give a successful presentation, you do not have tobe witty and stimulating and provide the audience with a lot of facts,but rather you have to give the audience good news. I do have goodnews, but you are going to have to wait until the end of my talk tohear it. So for the next ten minutes I will try to be witty and stimu-lating, keep your attention, provide a lot of facts and figures, and tellyou where I think the LBO industry has been and where it will go inthe future.LBOs have developed over time and have undergone variousphases. Phase I began in the 1970s. In the mid- to late 1970s a num-ber of people, including my partner Jack Turben, who started Kirtland2001]CASE WESTERN RESERVE LA W REVIEWCapital in 1977, realized that if you found a company that had a lot ofassets, you could purchase the company by going to a bank whichwould lend against the assets. To complete the deal, you could put ina little equity. Because of the small equity base, you could get verygood returns just by paying down debt. There were a few companieswho did this very well, including one organized by three gentlemenby the name of Kohlberg, Kravis & Roberts, who did it in increas-ingly larger deals. Typically, the target companies were mostly pri-vately held and there was little competition because there were veryfew firms doing this.Phase II encompassed most of the 1980s, with LBOs gaining in-creasing popularity and developing into almost a frenzy by the late1980s. The biggest difference during this period was a result of Mi-chael Milken's development of junk bonds or high-yield bonds as away to finance LBOs. This stimulated the whole industry and made itmuch easier to acquire larger and larger companies with public com-panies becoming the target of LBO firms.During the 1970s and 1980s, many conglomerates had been puttogether, but some did not yield the synergies or earnings that hadbeen intended. As a result, a corporate raider or an LBO firm couldgo in, take the company private, cut people and costs, sell assets andpay down debt, and generate very significant returns. In many casesthe parts were worth more than the whole company.During this period, the LBO industry became more structuredwith funds being raised for the express purpose of doing LBOs. Thenumber of firms involved was still relatively small, as shown in Fig-ure 4, and the dollars raised were modest compared to today's funds.Figure 4Equity Capital Raising$ 12,0)00 - ----- - -- . ....------- --- 1801 +165$1000+ 50 ZSo$8,000 I I }120 SI ii F1 Ii 105oS4,000 3.0so"ot .- , 15r-r Nm of00 00 00 00 00a, O\ O\ ! C' O1= Total Private Equity Raised -4- Number of Funds ClosedSource: Buyouts, Private Equity Analyst.[Vol. 51!:437LEVERAGED BUYOUT FUNDSThis was a result of the fact that transactions were still very highlyleveraged. Figure 5 shows that in 1987 you could put in as little as7% in equity and finance the rest. By 1989, this had almost doubledto 13%, but still represented very little equity required to complete atransaction.Figure 5Equity as a Percentage of LBO Financings03 Contributed EquitySources: Portfolio Management Data LLC, Buyouts Straight Talk.Figure 6 illustrates the amount of leverage in these transactions.Bank debt to EBITDA averaged almost five times in 1987. It wasstill almost 3.5 times in 1989. In addition, transactions were alsofunded with non-bank debt, which took total leverage on average in1987 to 8.8 times and 6.7 times in 1989. These are very high multi-ples and contrast very significantly from what is happening in today'smarket, which you will see later.2001]CASE WESTERN RESERVE LAW REVIEWFigure 6Average Debt Multiples of Highly Leveraged Loans10.090 8.8x9 .08.0 7 .2 x6.7x70 ...... ......6.0 .. . .. .. i..:...:5.0 "."'- ......lli~ ......'4.03.02.01.0 - - -0.01987 1988 1989El Bank Debt/EBITDA E5 Non-Bank Debt/EBITDASource: PMD Loan Stats.The next phase was in the 1990s, which can be divided into twophases. In the early 1990s, buyouts slowed because of the problemsin the high-yield and bank markets and the slow down in the econ-omy. Because the transactions done in the late 1980s were so highlyleveraged, when the economy slowed down there were many defaultsin both bank loans and junk bonds, resulting in a period when veryfew transactions were completed.The mid- and late 1990s reflected a turnaround in LBO activityfueled by a better economy and a large amount of capital available tobuyout funds and a proliferation of new buyout groups. Figure 7shows the history of total equity raised and, as you can see, it reacheda peak in 1998 totaling almost $55 billion. While the final numbersin 2000 are not yet in, it is likely to be close to the record set in 1998.The number of funds closed also reached new highs in the late 1990s.It is now estimated that there are over 800 LBO firms, which resultedin too many dollars chasing too few deals. This has caused the re-turns of LBO groups to go down, which was illustrated in one of theearlier charts.[Vol. 51:4372001] LEVERAGED BUYOUT FUNDSFigure 7Strong Equity Capital RaisingS60,000 180165S50.000 150S40,00012$30000 90 ~S20,000 6045$10,000 30W 15so 0$ - - - - 0 - OR[ Total Private Equity Raised -- NumerofFunds Closed ISource: Buyouts, Private Equity Analyst.Because of the competition and the amount of money available,the focus of LBOs has changed. There have been more internationaldeals done; some funds have been specifically raised to do interna-tional transactions. Many LBO firms have tried to do roll-ups in anindustry where they invest in one company and try to make acquisi-tions of similar type companies. We have seen roll-ups in everythingfrom candy stores to funeral parlors.One change has been the requirement by the banks to put inlarger equity contributions, which has also held down returns. Figure8 shows the increasing amount of equity required as compared to1987.444 CASE WESTERN RESERVE LAWREVIEW [Vol. 51:437Figure 8Strong Equity Component: Equity as a Percentage of LBOFinancings40.0%35.0%30.0%25.0%20.0%10.*0%5.0%0.0% LL0 Contributed Equity M Rollover EquitySources: Portfolio Management Data LLC, Buyouts Straight Talk.The other competitive factor for LBOs has been the IPO market.An increasing number of companies have turned to the IPO marketfor liquidity as opposed to being bought out by LBO funds.That now brings us up to the present and what we are seeing in2000, which appears to be yet another phase. The most significantdevelopment has been in the lending market, both the banks and highyield. The banks increasingly have had portfolio problems and theamount of non-performing assets, as shown in Figure 9, has increaseddramatically. At the same time, the number of corporate debt de-faults, shown in Figure 10, has also increased dramatically. As a re-sult, it is much harder to complete a transaction because of the tightercredit markets than in the past. This problem has been exacerbated bythe decreasing number of banks due to consolidation. Figure 11 il-lustrates this.LEVERAGED BUYOUT FUNDSFigure 9Nonperforming Assets at the Top Twenty BanksSource: Public Filings.Figure 10Defaults on Public Debt-= Amount -- IssuersSource: Standard & Poor's Global Fixed Income Research.1000900800700600. 50040030020010001999 6/30/001997 1998$30S25$20$15$20$5s020011CASE WESTERN RESERVE LAW REVIEWFigure 11Impact of Bank ConsolidationNowBank ofAnerica/ContinentalBarnettBoatren'sC&-S/SovanNCNBRepublic Bank of TexasBank OneFrst National Bank of ChicagoNational Bank ofDetriotCorestates Financial Corp.Dominion BanksharesFirst Fidelity BancorpFirst Union Corp.Sigmt BankBank of BostonFleet BankShawrnutSununt Bancshares. Inc.Chase Manhattan BankChenical BankManufacturers Hanover TrustJ.P. Morgan & Co.First In rstateNorwestWells FargoBank of Anerica Corp.Bank One Corp.First Union Corp.FleetBoston Financial Corp.J.P. Morgan Chase & Co.Wells Fargo & Co., Inc.Source: First Union Securities.Over the last eight years, twenty-six very large banks, most ofwhich had been active in financing LBOs, have been bought ormerged into six. Many of those on the list are currently having creditproblems, which has made the market even tighter.Because of the tight credit markets, LBO firms have been forcedto put in increasingly high levels of equity to get a bank to financeany of their transactions. This is illustrated in Figure 12.[Vol. 51:437ThenLEVERAGED BUYOUT FUNDSFigure 12Strong Equity Component: Equity as a Percentage of LBOFinancingsE3 Contributed Equity 0 Rollover EquitySources: Portfolio Management Data LLC, Buyouts Straight Talk.Earlier, I talked about how much leverage banks were willing toallow in transactions in the late 1980s and, as you can see from Figure13, they have become increasingly conservative over the last coupleof years, and particularly during 2000. I think we can expect this tocontinue through 2001. Another interesting development has beenthe slowdown in the number of IPOs. There have been some dra-matic peaks and valleys in that market, and it is likely we will see thatagain as the stock market comes down to earth. This should result,over a period of time, in an increase in the use of LBOs, as the IPOmarket is likely to diminish.The question now is, what happens to LBOs in the future? Asmany of you know, law firms have been very instrumental in thegrowth of the IPO market and have in turn grown significantly be-cause of the amount of legal expense it takes to complete a transac-tion. I think that because of the changing nature of the industry, therewill be an increasing need for legal help. More and more firms arecompleting international transactions, which require assistance in un-derstanding the legal requirements in other countries. Many firms areconsidering minority ownership in the companies they are buying orare looking to buy businesses with other LBO groups. This requiresmore complicated shareholder agreements.A more challenging financing environment requires more crea-tivity in terms of financing. Because of the declining stock market,44720011CASE WESTERN RESERVE LAW REVIEWthere are more likely to be public companies going private, whichrequires additional legal expertise. The fading IPO market will resultin more activity for LBOs, but it is likely that there will continue to bepressure on lower returns. With less room for error, this means thatthere will be more emphasis on due diligence.Figure 13Average Debt Multiples of Highly Leveraged Loans10.09.0 8.8x8.0 7.27.0 6.7x 5.8x 5.7x6.0 [I1 54x 50x 5.2x 5.3x 5.2x 525.0 l-- 4. x4.0 i3.83.0 77_772.01.00.01987 198 1 199 1 19 19 19 V L9 1998 9 Oct2000o Bark Ivbt/EBIIDA o Non,-Bm* E- lSource: PMD Loan Stats.The conclusion from all of this is that there will still be a veryvibrant LBO market, although changed from what we saw in the1980s and 1990s. It will continue to be very competitive. Returns arenot likely to be at the levels that they were in the 1980s, but they willstill be attractive.And what does this all mean for the legal community? It meansthat LBO firms will need more legal help with due diligence, an un-derstanding of international laws, more time spent with the financingside of transactions, the intricacies of public companies going private,more shareholder issues and the need for speed and help with struc-turing and tax planning. In turn this leads to more billable hours,which is the good news that I promised.[Vol. 51:437

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