Market volatility and a rapidly changing regulatory landscape have tested the resilience of private equity firms in the United States. To weather the storm, players in the industry are exploring less conventional strategies such as going public in order to remain competitive. John Hughes of Sidley Austin recently shared his insights with Business Law Currents on the potential impact of the Volcker Rule and other current challenges for PEs and hedge funds.
Business Law Currents: Can you tell us how you got involved in your profession?
JH: I came to Washington soon after college, as the Carter Administration got underway. I was interested in public policy work, wanted to try to get a national view, and thought what better place than Washington. I first worked for a Congressman on Capital Hill. But I didn’t like that experience for a host of reasons.
After six months, I was ready to pack up and go home. But I got lucky and another job came up at what was then the Department of HEW (Health Education and Welfare). I worked in an office called the Executive Secretariat, which functioned as the immediate staff of the secretary, and was the Secretary’s nerve center. The office was run by some very talented people, and I got to be a special assistant-type to several of them. Just about everything flowed through that office, and it processed all the paper moving either up from within the department or from congressional interests and headed to the secretary’s desk for review or action, or that the secretary originated and was getting pushed out as a policy initiative. It made the trains run on time.
I also was responsible for preparing the secretary’s daily briefing book each night to help prepare him for the next day’s meetings, and by the end of my stint I was putting together a draft of the weekly report to the president that went over to the White House. I was essentially the youngest guy on the staff working with a lot of lawyers and some of the most talented people I’ve worked with to this day. After the Secretary left office, I worked with him on a book he published reviewing various domestic policy topics and life as a Cabinet secretary. The experiences reinforced an interest in going to law school. I was a summer lawyer for a large New York firm and joined another large New York firm after law school, before joining Brown & Wood, which then merged with Sidley Austin.
Business Law Currents: Did you find that your background in the secretary’s office was a good foundation or training ground for what you are doing now-or was it just something completely different from your current career?
JH: While a different entry point, it was very helpful. Whether doing a daily briefing book, drafting decision memoranda on complex policy topics, or taking a cut at a weekly report heading to the president, it taught how to look at multifaceted situations quickly, distill large quantities of information, learn the essential facts, bring many perspectives to bear as quickly as possible, see the policy implications, and get it all written down clearly to frame the issues so others could assess the information and act on it. From that perspective, it was solid training for the skill sets one needs as a lawyer. The training also allowed me to bring a perspective to transactional exercises in terms of how Washington looks at things.
Business Law Currents: With this background in government, how did you get your specific focus on PE and M&A?
JH: I found people who were on the corporate scene and who were trying to shake things up in an effort to improve them or create something new, rather than simply maintain the status quo, to be interesting. This was the mid-‘80s, during the corporate “raider” era, and there were dozens of legislative proposals being introduced to change the marketplace for corporate control transactions in response to the deals getting done. I became somewhat of an expert on the dozens of congressional proposals in the area and all the hearings taking place regularly, and was working with arbitrageurs who were closely watching what was going on in Washington and the impact on particular deals. I learned the securities laws and the takeover game from that angle initially.
One of the more prominent raiders at the time that was a firm client received an invitation to testify before Congress. This came after press accounts surfaced that he had received a large greenmail payment to exit a particular company’s stock. He took the invitation with pride and as a sign that he had arrived, and that appearing would cement his standing as a major player. One of my first assignments as a new associate was to come up with every difficult question imaginable that he would be asked by a congressional panel to prepare him for such a hearing.
Of course, the real purpose of the drill was to illustrate what he would be in for and why it was not a good idea to voluntarily testify. It worked. This married some policy background to my interest in the transactional world. I was hooked after that and learned the transactional side by working on deals. It was during this period that a number of private equity firms were being formed and the industry was beginning to take shape, and I found working with these groups to be interesting, where one’s impact could be seen quickly. That resulted in doing more work in the area.
Business Law Currents: Your background really gives you insight into the beginning of the PE boom. Can you tell us, what are you seeing in terms of trends in the PE market? Overall, it has been up, down and flat in the last three years. But we are seeing a little comeback particularly among the LBO market. What are you seeing in your practice?
JH: Certainly it has been improving in the past 18 months after the very slow 2008-09 cycle. But It’s been fascinating to have seen how the industry evolved over 25 years or so. PE started out with a very small group of people or groups who were trying to do deals. There was no real industry to speak of. When KKR started, they were the only group essentially, and then others followed. Now, there are some 2,000 PE groups. Many of those firms that started back then have become the global leaders in the industry, and global PE has been predominately led by American firms. To a certain point, there now has been a commoditization of PE, and LPs now have greater power given the evolution and market changes. PE players also often have as much if not more industry expertise and knowledge as strategic players as a result of their portfolio company activities.
The PE business is highly idiosyncratic in the sense that it does not buy the S&P 500. Instead, it’s looking each year for two-three companies that are not overvalued and evaluating where those companies are in their own life-cycle. Certain PE firms have essentially reverse engineered a broader investment banking-type model, where they have added various components to build themselves into large, multi-faceted asset management firms reaching far beyond just doing PE deals. That certainly was not what was envisioned at the outset.
The evolution of the sophistication of the PE firms, with the formation of operations groups within a number of the larger and more sophisticated PE firms, is also certainly something that has been a trend over the last 10 years or so. There certainly have been slow periods in the past, and there will no doubt be slow periods in the future. It has been and will continue to be a constantly changing face in a constantly changing area.
When the recession hit and dealmaking stalled, there was a lot of talk by the pundits on how private equity was dead.
Certainly there have been challenges, and some deals failed for a variety of reasons, but PE fared pretty well. There will be a continuing shake out of firms given the explosive growth of the industry. But PE players are just about the most adaptive and resilient players in the marketplace and know how to change investment styles and strategies to accommodate changing market dynamics in any geographic region. What we are seeing is that PE firms are working hard to source proprietary deals, which generally have had higher IRRs than other deal types, and they are doing even greater diligence up-front to evaluate targets and looking for competitive advantages in bidding strategies.
Business Law Currents: One of the things I think is interesting is the large PE fund that goes public. Look at KKR or Blackstone. What is driving it? Is it a way to raise money or portfolio values?
JH: There have been a number of forces driving it, notwithstanding the oxymoronic nature of it. PE generally is taking the management company public and the management company itself isn’t investing in buyouts. Certainly part of this trend relates to generational issues that each of the big PE funds has to deal with. There is a natural interest on the part of founders or other senior members to find a pathway to liquidity that will allow them or their estates to monetize their interests in the firm when the time is right, as well as provide another source of capital to make their own contributions to their firm’s funds.
They could sell to institutions, but it’s a business where the assets can walk out the door. In addition, and perhaps more importantly, there is the attraction for the funds of having permanent money with which to recruit, maintain ownership from within, and have capital to do acquisitions themselves, especially as certain of the larger PE firms move toward a broader asset management firm model. For investors, it’s a chance to participate in the fee stream of the private equity firms.
Other firms have chosen not to go public – at least not yet. Instead, they’ve done deals with large investors, such a sovereign wealth funds, where those funds have taken a sizeable stake of 5% or 10% or so. There are a number of reasons for going that route v. the public route. The stock performances of the PE and hedge funds that have gone public has been somewhat mixed, but it should be noted that the time period within which this has occurred has been marked by high volatility. So the verdict is not in on whether the model will work.
Business Law Currents: You mentioned earlier that the regulatory environment may be impacting private equity and particularly your practice. Can you comment on Dodd-Frank here in the U.S. and some of the regulatory changes in Europe and Asia?
JH: Observing how Washington has responded to a variety of market disruptions over the years, one certainly can form a view that, in its search for remedies, Washington has the ability to over-react to market crises, or to create remedies that either do not address the root cause of the problem, or that create unintended consequences.
I don’t believe anyone other than the misinformed believes that either PE or hedge funds bears any responsibility for the market events in 2007-2009. Yet, part of the legislative “fix” following these events and the search for transparency was aimed at the PE and hedge fund communities in terms of registration requirements and a determination as to whether banking institutions should be in these businesses. This appears to address the Balzac quote that “behind every fortune must be a crime.” The recent regulatory changes in the U.S. do not appear to affect the PE or hedge fund industries in any meaningful way, and will provide for some increased transparency, although there are some hedge funds that will choose to remain private and not register. .
Dodd-Frank itself will not have a material impact on M&A or PE activity, although it could raise the cost of borrowing funds to do deals in the long run, and the availability of financing is the lifeblood of doing deals, so there could be some impact at the margins. But this in and of itself is not going to change the landscape significantly. The Volker Rule could result in perhaps some reshaping of the industry as the captive PE groups inside investment banks are either shuttered or spun out into stand-alone groups.
There have been and will continue to be efforts to adjust the tax rules around the carried interest that GPs receive. The PE industry dodged that bullet last year, but that battle will be joined again in the budget and deficit ceiling discussions.
On the European side, the EU Directive on Alternative Investment Fund Managers is going to have a far greater impact on the PE industry than changes under U.S. law. The directive will not be fully implemented for a number of years, but it will have will have an impact on the management and marketing of private equity funds in the EU and impose increases on the cost of compliance for funds and their managers.
Overall, one of the biggest factors affecting the ability of PE to get deals negotiated and closed can be the resulting effect from market volatility since it affects pricing and the financing markets. That volatility is fueled by the level of uncertainty. While there are a lot of factors in place that point toward increased general M&A and PE activity, Washington’s and Europe’s actions in addressing the fiscal and economic realities of the day will continue to swirl around the markets and be a factor in the resulting level of activity.
Business Law Currents: You have commented before, here in Currents as a matter of fact, about some investment banking challenges in this environment-specifically the Del Monte Foods Co. shareholder litigation, can you expand on those comments and what you mean by challenges?
JH: One area that continues to get close attention is conflicts surrounding financial advisors. There are any number of potential conflict scenarios that deal participants must be aware of and that may arise involving financial advisors. It’s not that all of these situation are bad, it’s just that they need to be observed ad dealt with properly. One area continuing to draw attention is where sell side financial advisors seek to provide buy side financing for transactions. That issue, among others, came up in the Del Monte transaction. Some of the facts in that case appear less than optimal.
As a result, it placed the board in a difficult position in terms of fulfilling its fiduciary duties, and it raises an interesting question of what steps a board should take after it learns late in a transaction about some earlier events that had transpired. The earlier decision was based on a preliminary record, so it’s not clear how the facts will be developed during the full trial, unless the case is settled beforehand. But how to adequately manage the potential conflicts that will crop up in a transaction is one area that is and should l be a focus of attention by all deal participants.
Business Law Currents: We have had a lull in the marketplace over the last couple of years as you have stated. What happens when the PE market returns?
JH: Well, while the market essentially evaporated 2008-09, the PE market has been returning over the past 18 months or so. But it certainly isn’t where it was. Deal count is increasing, deal sizes are increasing, multiples have been increasing, credit markets have been open and financing has been more available in the high yield and leveraged loan markets, exits have been increasing, including secondary deals and the IPO market for sponsor-backed deals. 2011 started with a strong first half but remains to be seen what the second half looks like given the recent re-softening of the broader economic data.
With the lull in 2008-09, a number of PE funds have accumulated significant dry powder. Some $475 billion domestically and $1 trillion worldwide. So there certainly is pressure to do deals, which clearly can have a variety of effects on deal dynamics, pricing, tactics, and style-drift.
At the same time, corporations have piles of cash. Corporates are being far more aggressive in terms of competing with PE, especially given the low-growth economic environment that we are in and the need to increase top-line growth. We’ve also seen an increase in hostile takeover activity and more from activists.
Takeover defenses have come down during the past few years such that companies have lower defense profiles and are more exposed to potential takeover activity. Whether that affords more opportunities for PE in terms of potential dealmaking solutions remains to be seen. There also appears to be greater segmentation in the market, where the larger PE firms, and those with significant dry powder and solid historical performance are able to be far more active than some other firms. The data suggest large PE firms are spending their dry powder more rapidly than other PE firms. There undoubtedly will continue to be a shakeout in the industry.
Business Law Currents: You have done a good job articulating the private equity business model of buying a business at a good valuation, building up some value in the business, either by cost cutting or growing the top line or both, and flipping that business for a profit in 2 to 3 years.
JH: Well, the days of simple financial engineering by sponsors to achieve results and returns are largely gone, although isolated instances will occur. While flips were coming fast and furious a few years ago during the bubble, and holding periods shortened to two or three years (if not shorter), holding periods have elongated as it takes time to deliver value enhancements versus simply letting a frothy market move the valuation along.
Nowadays, that often includes PE firms having significant operations and/or consulting groups within the PE firm itself that get deployed to look at each portfolio company to see where improvements can be made to improve top line and bottom line metrics. These groups aren’t replacing management teams; they augment those teams and generally don’t siphon fees. And the financial engineering is happening throughout the portfolio company lifespan to capitalize on moving market conditions.
Business Law Currents: Lastly, you are a member of the ABA-and were one of the founders of the PE M&A Committee. Can you talk a little bit about your involvement there?
JH: Several years ago, I thought it made far more sense from an architectural standpoint for those aspects of Private Equity that involve transactional matters and dealmaking to fall under the M&A Committee, which is the central location within the ABA for all-things M&A. So I was involved with others in suggesting that realignment. There is another ABA committee that had and still has private equity within its ambit, but the focus there historically had been more fund formation and VC-related rather than PE dealmaking, which is certainly viewed more as an M&A exercise and is distinct from VC. The PE M&A Subcommittee was created and meets three times a year when the M&A Committee gathers.
Given what’s involved in representing financial sponsors on deal exercises, I’ve thought it important to look at not only the legal aspects that arise in PE dealmaking, but also to bring in a variety of other participants from the PE ecosystem to provide a broader perspective and context for the Subcommittee members. So I’ve tried to bring in deal lawyers, M&A bankers, financial sponsor bankers, media-types who write on PE and M&A topics, PE firm professionals, SEC representatives, representatives from other regulatory agencies, members of the judiciary, and others to talk on PE and M&A-related topics and give presentations. The Subcommittee has grown quickly to some 1,400 members, although as would be expected a smaller number are active members, and it serves as an educational tool for members. There’s been a solid reaction so far.
John K. Hughes is a partner in Sidley Austin’s M&A and Private Equity Group, practicing out of the firm’s Washington, D.C. office. He concentrates in transactional work, with an emphasis on merger and acquisition and private equity transactions, buyouts, recapitalizations and restructurings, strategic investments, and cross-border transactions. He has worked with private equity firms for more than 25 years. He is involved in all phases of the transaction process, ranging from initial planning, structuring, and negotiation, to implementation and ongoing post-acquisition advice to portfolio companies. He also works with investment banking firms in their capacity as financial advisor to parties involved in transactional matters and as providers of fairness opinions. He is a co-founder and current chair of the ABA Subcommittee on Private Equity M&A. Mr. Hughes is a member of the Thomson Reuters Accelus Partner Advisory Board.
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