Awash in Cash

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Awash in Cash
Peter Spasov at Marlin Equity Partners in Hermosa Beach. He said private equity firms that can improve a target company’s operations will do best in the recovery.

The private-equity industry in Los Angeles has more money than it knows what to do with. Literally.

Private-equity activity across Southern California fell sharply after the financial crisis, but many local investment firms did not stop raising money or looking for deals. Now, the number of L.A. firms is on the rise and they are sitting on tens of billions of dollars in uninvested capital.

They’re ready to put the money to work. But with the still-slow economy, there’s just not an abundance of places to invest.

“There’s a lot of money out there,” said Andrew Greenberg, chief executive of GF Data Resources LLC, an industry research firm in West Conshohocken, Pa. “Financial buyers and companies have unprecedented levels of cash on hand.”

Since Mitt Romney, the co-founder of Boston investment giant Bain Capital, emerged as the presumptive Republican candidate for president, private equity has become a central issue in the campaign. It’s been alternately hailed as a job creation engine and criticized as a company killer.

The normally low-profile industry has been thrust into the national spotlight, garnering it sudden attention – and unwanted scrutiny. Regulatory pressure is on the rise and expected tax increases loom on the horizon, complicating the tentative recovery in the private-equity market.

Yet many local deal-makers are optimistic.

Many business owners that had been waiting on the sidelines during the downturn are now considering selling, which has begun to open up the deal-making environment. Though transaction sizes remain suppressed, private-equity firms headquartered in Los Angeles County closed 316 deals in the last year, about 85 percent of 2007’s total, according to data compiled for the Business Journal by Seattle research firm PitchBook Data Inc.

And with individual investors hungry for high returns in a low-interest-rate environment, many are pouring money into the private-equity industry.

Local firms now have more than $33 billion in uninvested funds ready to be deployed, near an all-time high, according to the PitchBook analysis.

Prominent local firms such as the Gores Group LLC in Westwood and West L.A.’s Leonard Green & Partners LP are among those that have recently raised substantial new funds.

After a rough couple of years during the recession, the local private-equity industry has made progress toward recovery and some experts predict a full rebound soon – if only the economy can catch up.

Greenberg, who tracks data nationwide, said the second half of this year, in particular, could see a spike in middle-market deal activity – the bread and butter of L.A.’s economy.

“For most of this year, we’ve seen a heating up in deal activity,” he said. “I wouldn’t be at all surprised if each quarter of this year features more completed transactions than the preceding quarter.”The county is home to nearly 200 private-equity firms and the industry has a wide reach.

Local firms own pieces of or majority stakes in many of the nation’s most recognizable companies, from Whole Foods to TV Guide to the Harlem Globetrotters to Petco.

Despite the recent success of the local industry, private-equity activity in Los Angeles ground to a halt when borrowing options evaporated and the market went haywire amid the financial crisis.

‘Dead in the water’

The number of deals by local firms fell from 373 in 2007 to 229 in 2009 at the bottom of the recession, and most of the latter were small investments. In fact, the average deal size plummeted more than 70 percent from $166 million in 2007 to just $48 million in 2009.

“2009 in particular was just dead in the water,” said Jeff Lovell, chief executive of Lovell Minnick Partners LLC, a private-equity firm in El Segundo with $830 million under management. “Nothing was happening.”

The market remained frozen into 2010, he noted. Despite raising a $450 million fund at the beginning of that year, Lovell Minnick entered into just one deal during all of 2010.

By 2011, many investors saw the financing markets opening up and deal activity returning to a normal level. But just as the industry was gaining momentum, a series of roadblocks slowed a full recovery. Last year, the federal debt-ceiling debate and subsequent downgrade of the U.S. credit rating upset the financing market. More recently, Europe’s debt crisis has sapped confidence.

“Most things were getting better until mid-April. Deals were becoming more feasible, particularly exits,” said Howard Marks, chairman of downtown L.A.’s Oaktree Capital Management LP, which operates the county’s largest private-equity firm. “But the last month was pretty tough in most market niches.”

The recent hurdles have kept deal sizes suppressed, with local firms investing an average of $115 million per transaction last year. Deal-makers also noted a distinct lack of large, headline-grabbing transactions.

The few major deals that were announced faced difficulties. Gores Group recently called off a planned $1 billion acquisition of the Pep Boys auto parts chain as the Philadelphia-based company’s earnings fell.

Still, a growing number of prominent local firms are attempting to get off the sidelines and make investments in spite of the tumultuous economy.

Gores Group is looking at about 1,000 prospective deals a year, nearly in line with historical averages, and has entered into about a dozen over the past 12 months, including this month’s acquisition of Menlo Park touch-screen maker Elo Touch Solutions.

“The market has slowed a little bit over the last few months (but) we’re still seeing a number of really good-looking opportunities to put capital to work,” said Steve Yager, senior managing director of the firm.

Indeed, with billions of dollars in uninvested money, many local firms have been eagerly awaiting a market stabilization, and many investors are starting to get back into the game, Yager said. With more firms looking to deploy their capital, the number of competitors looking at prospective deals is on the rise.

“There’s a lot of money on the sidelines, so there is pressure in every deal,” he said. “It seems to become more competitive every month.”

Exits up

The rise in deal-making is due, in part, to a surge in exit activity, since that frees up investors to make new acquisitions.

Private-equity firms typically cash out of their investments – ideally at a profit – a few years after the acquisition, which gives firms time to make operational changes and improve the outlook of companies. But after the financial crisis, the exit markets dried up, forcing many private-equity firms to hold on to investments longer than anticipated.

According to a PitchBook analysis, the number of exits by private-equity firms in the county fell from 62 in 2007 to just 24 in 2009.

In the past year, however, exit activity has rebounded sharply. Local firms sold out of 77 companies last year and an additional 30 in the first quarter this year.

“I’ve seen a ton of private-equity groups exit businesses recently,” said Gina Hintz, co-head of the private-equity coverage team for investment banking firm D.A. Davidson & Co. in Costa Mesa. “There are a lot of very active (firms) in the L.A. area.”

One investor that has been particularly active is Brentwood Associates, a small West L.A. firm with $650 million under management. This month, it sold three of its portfolio companies, including Seattle outdoor apparel maker Filson Holdings Inc.

“We’ve had robust interest as we sell businesses, which is great,” said Eric Reiter, a partner with Brentwood. “We’re selling a lot of businesses for very compelling values.”

Reiter said “all of them have been successful deals for us,” but would not discuss financial terms of recent sales.

One factor driving some exit activity, experts said, is the prospect of tax increases next year. There are several possible changes, including the expiration of the so-called Bush tax cuts, that could affect the capital gains rate, which applies to private-equity returns.

By taking profits this year, firms might be able to avoid paying higher taxes in the future.

“A lot of firms are trying to make exits earlier if they can, to get ahead of the curve on that,” Hintz said.

Steady exit activity is critical for the private-equity industry because it frees up the firms to enter into new deals since they can only oversee a limited number of investments at one time. In addition to investing capital in acquired businesses, many firms spend considerable time involved with their portfolio companies, including taking board seats, overseeing management changes and enacting operational overhauls. (See related story, page 28.)

Additionally, by exiting investments, firms and their stakeholders can realize returns on their original capital.

Private equity is known for generating high returns. According to a U.S. private-equity index by Cambridge Associates LLC, firms nationwide returned 11 percent on average to investors last year. By comparison, the S&P 500 was flat over the same span.

Firms that generate strong returns can often raise additional money. And a number of L.A.’s larger firms have found investors eager to give more.

Gores Group raised more than expected last year for its third flagship fund and launched a small-cap fund this March; Leonard Green & Partners, the second biggest private-equity firm in the county, closed a larger-than-anticipated $6.25 billion fund last month; and Oaktree, the county’s largest private-equity firm, is raising a new fund.

“Above-average funds are starting to see a flood of new investors,” Hintz said.

Industry shakeout

But when L.A.’s private-equity industry does fully recover, it might not look like it did before the recession.

“There is going to be a shakeout in private equity,” said Peter Spasov, a partner at private-equity firm Marlin Equity Partners in Hermosa Beach.

He said there are a number of types of firms that will not be able to survive in the current environment, including those focused on buying up cheap assets during a downturn and selling when the market recovers.

Also, he is pessimistic about firms that profit through “financial engineering.” That refers to those that earn returns primarily by loading a company with debt and selling out without any regard for the long-term health of the company.

Instead, successful investors will need to be able to “create value through operational improvements” in acquired companies, Spasov said.

Additionally, firms specializing in particular industries have an advantage over generalist funds, experts said.

Investment banks, in particular, have become more reluctant to broker the sale of companies to private-equity firms that are broadly focused.

“Investment bankers tend to look at who has experience in this sector,” said Hintz. “I think specialization is key to everyone in this industry. If you’re not specializing, you’re not going to be the one people turn to.”

Meanwhile, the industry has had to contend with a growing problem of so-called zombie funds, which have stopped making new investments but continue to collect management fees on previous investments that the firm has not exited. These funds can lock up investors’ money for years.

In the county today, 80 private-equity firms have not done any deals in at least five years, according to PitchBook. In 2007, there were just 12 such firms in the region.

Some of the firms are saddled with troubled investments and do not want to do new deals until the problems are sorted out; others may want to get out of the private-equity industry entirely, but the life of individual funds – often at least a decade – makes it difficult to simply close up shop.

“There are a few players that used to be (active) in the market that aren’t anymore,” Hintz said.

Still, despite the increasing number of dormant funds, there are a few more active private-equity firms in the county today – 106 – than there were prior to the recession, when there were 100.

And many of the players that remain said they see the market picking up and the waiting game coming to an end.

“The deal flow slowed down during the recession, (but) it’s been a nice increase from ’09,” said Brentwood’s Reiter. “You’re seeing more deals and there’s no lack of investment dollars. Buyers are eager to put cash to work.”

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