Are Those Private Equity Guysas Smart as They Say They Are?

Andrew Ross Sorkin of the New York Times questions the acumen of some of the top deal shops as they attempt to extricate themselves from recent deals:

Private equity firms have recently been reneging on their billion-dollar buyouts as if the deals came with a 30-day money-back guarantee. They don’t. But that hasn’t stopped the biggest firms from trying to bully — yes, let’s finally call it what it is — their way out of deals.

For the last few months, private equity firms have repeatedly broken their word when breaking a deal, trying to place blame on big, bad investment banks….

It was an easy narrative to follow, but it obscured the truth: Private equity firms, widely hailed as the “smart money,” made some lousy deals in the second half of this year, and some are now having a bad case of buyer’s remorse….

To be fair, the banks cut some pretty lousy deals themselves and have been applying pressure to their clients. But if you have spent time with buyout bosses, you know it’s hard to pressure them into doing something they don’t want to do in the first place.

Witness the latest broken deal: Cerberus Capital Management, run by Stephen A. Feinberg, the powerful but intensely private financier, refused to complete its $4 billion acquisition of United Rentals unless the price was renegotiated downward. Cerberus didn’t even try to claim that United Rentals had suffered a “material adverse change” — the magic words that usually permit a buyer to walk away without a financial penalty — or that the banks were preventing it from completing the transaction.

Cerberus provided no explanation other than that it was willing to forfeit its $100 million reverse breakup fee to walk away…

“Any target dealing with them in the future would now be irresponsible to agree to a reverse termination provision,” Steven M. Davidoff, a law professor at Wayne State University in Detroit, wrote of Cerberus on his blog….

Everyone repeats the same line: “There’s no question that this summer the world changed,” Leon Black, founder of Apollo Management, said this month at a conference for The Deal, a magazine.

Well, yes, Mr. Black. The credit market did change; there is no question about that. But that doesn’t explain how private equity firms, whose entire business is premised on accurately forecasting a business’s potential and risk, called it wrong.

It is almost laughable to hear the buyers of Home Depot’s supply unit contend that the housing market’s slump caused the business to deteriorate so far beyond their expectations that they had to renegotiate the deal they struck just months earlier. If the buyers didn’t see that coming — if that possibility wasn’t baked into the firms’ models — then shame on them.

The same goes for J. Christopher Flowers and his effort to wiggle out of his acquisition of Sallie Mae. It is implausible that such a smart guy did not contemplate the possibility that federal legislation affecting Sallie Mae — some of which had already been introduced — might complicate the buyout.

And then there was the aborted deal by Kohlberg Kravis Roberts and Goldman Sachs for Harman International Industries. Five months after they agreed to the deal, the firms said that Harman’s business had fallen off a cliff. This may have been the most valid of the broken deals because Harman broke certain conditions of the transaction, but it still raises the question: Unless Harman misled them — and no one has publicly claimed that — how did these blue-chip firms miss the forecast that much?

Private equity investors — known as limited partners — have been quietly applauding the firms’ attempts to squirm out of potentially bad deals….

But investors in private equity firms should still be asking why firms made some of these deals in the first place. When debt was cheap, the game was easy; everything was a good investment. But private equity investors are paying for better judgment than that. After all, most of these firms charge “success fees” for acquiring a business, in part to pay for their hard work identifying, studying and winning an auction. (A perverse incentive, I know.)

So what’s the upshot?

If broken deals haven’t hurt these firms’ reputations yet, they should. The broken deals will also dent their wallets, which may hurt more. Other fallout is sure to come. Sellers to buyout firms are going to demand higher premiums — they are already under pressure from shareholders to do so — and prohibitively high breakup fees. Contracts may be written even tighter, but they are already tight.

Despite all of this, private equity firms seem to believe they have plenty of wiggle room. In many of the recently broken deals, they appear to have relied on litigation threats rather than contractual language when telling sellers they planned to back out….

All of this is going to make outsize returns even harder to come by, at least until everyone has forgotten the lessons. As Mr. Black put it in his recent conference speech, “History has taught us that Wall Street has no institutional memory.”

Cerberus in particular looks as if it has feet of clay. At the end of October, it withdrew its bid for Affiliated Computer. It fired 10,000 workers from Chrysler when it promised to make no cuts at the time of acquisition a mere three months earlier. Oh, and there is speculation that General Motors and Cerberus will let Residential Capital LLC, the Minneapolis-based mortgage unit of GMAC LLC, go bankrupt if the mortgage market worsens. Does anyone expect it to get better any time soon?