Is nothing too big for private equity?

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The Independent Online

Bankers too, it seems, are preoccupied with an issue that has long vexed pub philosophers: does size matter? After careful sifting of evidence and weighty deliberation, strategists at HSBC published their latest thinking on the hoary issue yesterday.

They, in antipathy to Royal Mail, found that while size may indeed have been an important consideration in the past, it is no longer.

Robert Parkes, an equity strategist at HSBC and author of the report, contends that in the post-HCA era only the 20 biggest companies in Britain look potentially out of reach for private equity predators.

Last month the Wall Street private equity house Kohlberg Kravis Roberts (with Bain Capital, Merrill Lynch Global Private Equity and the Frist family) finally toppled its own record for a leveraged buyout (LBO) with the $33bn (£17.5bn) purchase of the US healthcare group, HCA.

Unlike its dramatic 1989 buyout of the US food and tobacco group, RJR Nabisco, the HCA deal looks unlikely to inspire a best-selling novel or film.

The HCA deal was unremarkable in all but scale. Management was on board and an orderly queue of Wall Street's finest gladly stumped up finance for a takeover so structured that it failed to raise even the fustiest of eyebrows.

The consortium's borrowings may have been hefty, but they set no records against HCA's earnings. The $6bn equity portion was respectable, and while the margin for interest cover was tight it was far more generous than on Nabisco.

HCA did, however, crystallise a suspicion long held by chief executives and bankers: private equity is training its sights on ever-bigger targets.

"Private equity firms are now looking further up the food chain for potential prey," Mr Parkes said. "This is not particularly surprising given the amount of capital now at their disposal, the typically lower valuations for larger companies and a minimal pricing discrimination on credit for highly leveraged deals."

Figures from Dealogic, a provider of data to investment banks, show nine of the 10 biggest takeovers by private equity houses have been completed with a combined value of $166bn since the start of last year.

Six of the 10 biggest leveraged buyouts have taken place this year. In June, Univision Communications, the US's leading Hispanic broadcaster, fell to a group that included Texas Pacific and Providence Equity Partners for $13.6bn.

Three months earlier and closer to home, the Spanish construction group Ferrovial swallowed BAA, Britain's biggest airports operator, in a $23.9bn private equity-backed bid.

The US oil and gas pipeline operator Kinder Morgan, the supermarket chain Albertson's, the Danish telecoms group TDC and the Dutch publishing giant VNU have all also been consumed by private equity in buyouts of more than $10bn this year.

The awesome firepower private equity can deploy is burgeoning as institutional investors allocate ever-greater resources to "alternative assets" in a search of more generous returns than traditional long-only investment can deliver.

Mark O'Hare, managing director of the research company Private Equity Intelligence, calculates that the typical European buyout fund has returned 15-20 per cent a year net of fees over the past decade, easily outpacing the 2.72 per cent by the FTSE All-Share over the same period.

As a rule of thumb, pension funds now comprise about a fifth of a private equity house's clients but provide 80 per cent of capital.

Private equity fund-raisings remain comfortably oversubscribed even as the magnitude of the funds themselves swells.

Over the past 12 months, 147 buyout funds have closed, raising an aggregate $155bn. Permira, KKR and Blackstone Group are among those to have recently closed funds of $15bn. Totted up, PEI reckons private equity groups have combined funds of $460bn at their disposal.

Meanwhile, US and European investment banks are falling over themselves to supply the cheap debt that private equity uses to magnify its punching power.

This is an area of business that has grown exponentially in importance for investment banks too. Last month, Merrill Lynch revealed that much of its $700m of revenues in the second quarter were derived from private equity deals involving Debenhams and Hertz.

Ready sources of debt and cash gives private equity an eyewatering purchasing power of about $4.5 trillion.

Bigger groups are increasingly looking to bigger buys: the competition for assets is less fierce, cash flows often more predictably consistent and effort expended on one large deal often more modest than on a clutch of smaller buys.

A growing trend for private equity groups to hunt in packs to fell larger prey leaves very few companies, either in the UK or US, beyond their reach.

Taking the HCA deal as a benchmark, Mr Parkes at HSBC calculates that all but 20 UK companies have a greater market value. However, he warned that even they are not safe. The Nabisco takeover would be worth a massive $52bn today, suggesting the "real" record is actually £19bn higher than the HCA deal.

"Using this higher cut-off reduces the number of UK-listed companies with a higher market capitalisation to just 14," he said. "Names such as BT, BG and Diageo now appear on the radar screen."

Records are there to be broken and there cannot be anyone within the City who expects HCA to remain the biggest LBO for the next 17 years.

A further four companies - Rio Tinto, Lloyds TSB, Tesco and British American Tobacco - lie within an uncomfortably close 10 per cent of the "real" record.

HSBC (Britain's third-biggest company behind Royal Dutch Shell and BP, and therefore out of sight?) also noted that the 20 biggest companies are looking less expensive than smaller businesses.

The heavyweights are trading at about just 10.3 times 2006 earnings, against a median of 14.9 times for the FTSE 100 generally and 15.2 times for FTSE 250 companies.

As one private equity banker declared, the surest defence against any unwelcome LBO is to run a company well, to screw down costs and chase growth, while ensuring the interests of staff and shareholders are closely aligned.

The message from City is clear: size doesn't matter; it's all about performance.

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