My own private equity forum in LA

Fine wine notwithstanding, private equity anticipates a brutal 2009, Kevin O'Leary writes

By Kevin O'Leary
Globe Investor Magazine Online, Jan. 9, 2009

Kevin O'Leary is the chairman of Gencap Funds LP, and the manager of the O'Leary Global Equity Fund.

LOS ANGELES--"Relax baby, you're in L.A."

These are the first words out of a twenty-something hairstylist trying to coax me into her makeup chair. One problem, I have no hair. Instead she spends the next half hour patting my head with pancake makeup to prevent it from shining under the bright lights of the CBS TV studio we are in.

I'm in Los Angeles this week working with Mark Burnett Productions on a new venture capital/private equity reality show called Shark Tank. Basically it's the same format as the CBC's monster hit Dragon's Den being remade for U.S. audiences. Mark Burnett is the king of reality TV: He created Survivor and The Apprentice so when he called and asked me to try out for the Shark Tank team I could not refuse. Besides I love Los Angeles, it's one of my favourite cities because you can amuse yourself all day long just trying to guess what is real and what is fake.

I enjoy working in TV; it's sheer chaos and so different from what I do all day long as the chairman of The O'Leary Funds. TV is a wonderful hobby and if you are trying to build a brand there is no more powerful vehicle. I am a deep value yield-oriented investor. I am always looking for new investment opportunities that fit my metrics. If you want to travel the world meeting new people and seeing new ideas, there is no substitute for a career in television.

While here in L.A. I decided to hold my own private equity forum. I keep a portion of my portfolio in private equity deals. I review my deals each Monday morning over the phone in a series of conference calls with my managers. These are stiff and formal meetings but efficient. The current financial crisis has savaged the private equity sector. The BCE deal was the most recent high-profile PE deal to blow up, so these days, trying to get a group of high-powered equity guys together for dinner is almost impossible, they are too busy putting out fires. However, financial types are drawn to Hollywood like moths to a flame. So I use my current situation as bait and invite some to visit me on the set of Shark Tank before we head out to for dinner.

I am a big believer in using Napa Valley chardonnays as truth serum. Sipping a crisp well-chilled Grgich Hills with a group of managers is going to get you a lot more information than a Monday morning conference call.

Here is what I have learned. No surprise 2009 is going to be a brutal year for private equity. Between 25 per cent and 40 per cent of top 100 private equity firms are going to disappear in this economic downturn because they will never raise another dime as a significant number of their deals are going to underperform or worse. Go to zero.

What drove the explosive growth of this sector was covenant-free cheap debt. That's over. Now many of these PE firms are loaded with portfolio companies that are way over levered. They have more debt than they can service going into a recession. These companies are going to default on their debt, and go bankrupt. As a result returns on PE funds that were launched in the last three to five years are going to be terrible. Instead of 20-per-cent annualized returns they could be negative. If you are a pension fund that bankrolled many of these PE firms you are not happy.

But wait, its gets worse. Between the years 2003 and 2007, annual leveraged buyout debt issuance for PE firms ballooned from $71-billion (U.S.) to $669-billion annually. Today the debt markets are frozen. How frigid? In November of 2008 only $6-billion was raised in the leveraged buyout market in Europe and in North America combined. If you own equity in a company that has to refinance its debt in the next 24 months welcome to the house of pain. The most likely scenario is that your refinancing is going to wash out any equity value current shareholders have. Today lenders rule and they are squeezing equity shareholders in private companies like teenage pimples.

Also, multiples have collapsed.

Between 2003 and 2007 EBITDA multiples grew by 41 per cent in public markets. (EBITDA represents earnings before interest, taxes, depreciation and amortization.) That means PE guys were able to earn a good return from this appreciation without having to improve the performance of their portfolio investment. They got fat and lazy. Along comes 2008 and a 45-per-cent compression in multiples. Now selling a portfolio company with reduced earnings into a market that will not pay up will lead to a painful loss.

I was glad when dinner was over. Dining with PE managers these days is really depressing. I walked back to my hotel in the fresh L.A. breeze and ordered a glass of Outpost Zinfandel. As I sipped this nectar I realized how much I covet liquidity and a good dividend. I bet by the time this downturn is over the private equity guys will too.

Special to the Globe and Mail