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Transitioning Toward A Global LBO Market: As U.S. private equity firms shift to an investment approach, European practitioners are getting comfortable with bigger deals and more deft use of debt.

Article Excerpt
The U.S. and European Union LBO markets traditionally have functioned in very different ways. Because of sophisticated debt and equity markets, American financial buyers have pursued investment strategies based on financing structures with multiple layers of securities and arbitrages between private and public markets. The European LBO market, by contrast, long has been regarded as an area of promise but too immature to be really interesting, as demonstrated by the preponderance of small deals.

However, according to the results of extensive research on trends, deal flows, and views of LBO professionals in both geographic areas, several developments have changed the picture. The U.S. LBO market has evolved from a "deal" business to an "investment" business with partnerships of business and financial professionals becoming increasingly critical. In Europe, much larger deals have been taking place as financial buyers and capital markets have become more experienced and sophisticated.

Changes in the U.S. have been driven by an increased number of competitors, importance of auctions of subsidiaries and divisions by public companies, and the competition offered by strategic buyers. Together, they made the American LBO market more difficult.

In the 1980s, capital and financial skills were the key success factors for private equity firms, especially in larger deals. But in the 1990s, a number of additional factors were needed to gain competitive advantage, including the capabilities to:

* Escape the "auction trap" and create a flow of proprietary deals;

* Run the decisionmaking process at portfolio companies more effectively than competitors; and

* Add value through acting as a sounding board for the management of the investee companies and assisting actively in the definition of growth strategies.

To gain a competitive edge, successful private equity firms have embraced investment strategies based on industry specialization and development of in-house top management expertise This has enabled them to better manage the investment risk and close deals of greater complexity.

By contrast, private equity firms that belong to investment banking groups have established competitive advantage through strategies that take advantage of the existing in-house resources. That includes financial and transaction execution know-how and the deal-flow generation synergies with investment banking affiliates. They have chosen to focus on highly complex deals in terms of execution and structuring while keeping a generalist investment approach in terms of targeted industries.

While it is widely recognized that the target's management team is the key element in a successful investment, a common flaw in many deals that turned sour is a poor assessment of the competitive situation and prospects of the industry in which the target company operates.

As a result, industry specialization offers these advantages to private equity investors:

* Faster initial screening of an investment proposal;

* Better understanding of the key issues of a deal resulting in more focused due diligence;

* Easier assessment of the management team;

* Greater credibility with the management team and the seller;

* Better relationships with lending institutions that are more willing to support investors with track records in a specific industry, proving easier access to financing, less restrictive covenants, and faster approval times;

* Stronger ability to assist target management after the buyout and recruit additional talented professionals; and

* Quicker reactions to combat problems.

Industry specialization also provides access to a flow of proprietary deals in the targeted field, such as Carlyle Group in the defense industry. Although it is always difficult to completely escape the auction trap, recognition as a leading investor in the industry can offer a preferential position in auctions and status as the preferred buyer...

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