Tuesday, September 04, 2012

Highly leveraged Islamic private equity will not perform differently than conventional private equity!

I saw an article about the 'promise' of Islamic private equity, which included a few claims about the differences between Islamic PE and conventional PE that I thought were not quite accurate in most cases, and important in deciding whether Islamic private equity is a worthwhile avenue for the amount of growth being forecast. 

Prior to the global financial crisis of 2008, the conventional private equity (PE) industry flourished on excessive cheap debt and this came back to haunt it when the markets collapsed.

Islamic PE avoided that trap due to the restrictions it imposed on taking conventional forms of leverage.


Such PE funds will use sukuk or Shariah-compliant leverage to finance their acquisitions.  


Most of the Islamic PE funds are domiciled in Mena and the GCC region and focus on real estate. They have suffered from the property market bust in the region.

First off, I think that including real estate transactions in private equity give the impression that Islamic PE is much bigger than it actually is, because the main similarity between real estate-based private equity and what is traditionally thought of as 'private equity' is the high leverage used in the transactions.

Let's go back and reconsider the definition of private equity.  A National Bureau of Economic Research (NBER) working paper published by Steven Kaplan and Per Stromberg (pdf) describes private equity in the context of their research, which I think provides a good description of what is generally included in the 'private equity' label and what is generally not.
In a leveraged buyout, a company is acquired by a specialized investment firm using a relatively small portion of equity and a relatively large portion of outside debt financing.  The leveraged buyout investment firms today refer to themselves (and are generally referred to) as private equity firms.  In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature firm.  This is distinct from venture capital (VC) firms that typically invest in young or emerging companies, and typically do not obtain majority control.  In this paper, we focus specifically on private equity firms and the leveraged buyouts in which they invest.

As this paper explains, private equity as it is commonly used, is just a euphemism for leveraged buy-outs; acquisitions of public companies by private investors where the buyers rely heavily upon debt to pay the purchase price.  To take one specific example of an Islamic private equity transaction, look at Arcapita's acquisition of J. Jill (notable because its debt was rated by Moody's and the rating described some of the factors that led Moody's to its final rating).  Moody's wrote: "J Jill's B2 Corporate Family Rating reflects the company's relatively small size in terms of revenue and profits and narrow product focus in the women's specialty retail apparel sector. The ratings also reflect the company's high leverage. Pro forma debt/EBITDA is about 5.7 times (incorporating Moody's standard analytical adjustments for operating leases). "

It excludes venture capital, and is not necessarily focused on the real estate sector (real-estate private equity is a different asset class).  But regardless, what defines private equity (traditional or real-estate) is that it enhances the return with debt.  It is perfectly possible to enhance returns with Shari'ah-compliant forms of debt but it is another thing entirely to support the growth of this type of asset class, done with Shari'ah-compliant tools, and then to suggest that somehow it will inherently be better than traditional private equity executed with conventional debt.  

Debt is debt, and whether or not it is structured to include or strictly avoid interest, it will bring the same type of feast-or-famine returns that conventional private equity does.  The key point is not whether the debt is interest-based or Shari'ah-compliant, but whether the debt level is high or low.  The reason is that higher debt levels can enhance returns when things go well, but have an equal connection with 'enhancing' the downside as well.  The higher the debt goes, the more upside it can provide, but the faster it can self-destruct if the value of what is bought declines. 

Consider two identical firms, both bought by a private equity firm, with different levels of debt.  

Firm 1: Acquired for $100 million, $10 million in equity and $90 million in debt
Firm 2: Acquired for $100 million, $25 million in equity and $75 million in debt

Assume for a moment that there was a fixed measurement of the value of the company, for example, 2.5 times revenue, so the revenue at the point of acquisition was $40 million per year.  

Now, assume the valuation of the firm (the 2.5 times revenue multiple) stays the same and the revenue fluctuates with the economy and the company's execution of its business strategy.  The lenders providing the debt financing want to keep some margin of safety and are going to step in before they start to take losses (through debt covenants concerning revenue, profitability, cash flow, for example).  

If the economy slows down and the company's revenue drops to $35 million (a 12% decline), then the value of the company will decline to $87.5 million.  How will it affect each company?  Firm 2 will be valued at $87.5 million with $75 million in debt, so the private equity firm will have lost some money, but will still probably be afloat.  Firm 1 on the other hand, will be in a bad situation since the company will be worth less than the debt used to buy it.  Even if it is sold without a fire sale (which would further lower the amount it would sell for), the private equity investors would have a total loss and the creditors who funded the acquisition would face a loss as well.  

It does not matter whether the $90 million in debt was taken out using an ijara sale-and-leaseback or secured bank debt.  The high degree of leverage has wiped out the private equity investors' equity, and forced the creditors to take a loss. 

The final point is, so what?  So what if Islamic private equity functions the same as conventional private equity, but just avoids interest-based debt and companies engaged in haram business activities.  Well, I don't necessarily have an issue with an Islamic version of private equity, but it has to be described accurately, and that means explaining that it has the potential to go just as badly as private equity has in the conventional space over the past few years as debt has tightened, economies have slowed and valuations from before the financial crisis no longer look reasonable.  The only thing that can make Islamic private equity different is if it does not succumb to the rosy assumptions that make private equity funds think they can succeed with highly leveraged investments often enough to offset the times when it goes badly.  

If Islamic private equity were different, it would use much less leverage than conventional private equity, and accept the lower returns that come from using less leverage.  But, it would also be a more stable, sustainable version of private equity focused on adding value to companies, rather than just slashing costs to keep the companies able to service their high levels of debt. 

1 comment:

James said...

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