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Old Mutual's breakup includes a gift to private equity

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(Bloomberg) — Private equity firms suddenly have the chance to buy an asset that hasn’t already had all the value sucked out of it by…private equity firms.

Old Mutual’s decision to break itself up means the South African financial services group’s wealth management unit is up for grabs. It’s the sort of thing private equity firms have been clamoring for — an asset that has probably been under-managed because its parent has been focused on other things, in this case surviving the financial crisis.

So there’s potential for cost savings and for performance to be driven higher. That contrasts with assets being sold by other private equity firms, where much of this work has already been done. 

Analysts reckon Old Mutual Wealth (OMW) could fetch around 4.5 billion pounds ($6.4 billion). The obstacle for a private- equity buyer would be how to load it up with debt. As a regulated financial services business, OMW could not take on leverage directly. This would have to be applied instead to a parent company, funded by dividends from OMW, but these payments are constrained by a big investment program to modernize the business, which has years to run. 

OMW could fetch a buyout price of around £4.5 billion. As a result, OMW paid only 41 percent of its net profit up to Old Mutual last year, or 109 million pounds. That payment won’t get much bigger so long as the investment program runs. 

Assume a 7 percent cost of borrowing in a leveraged buyout, and that profit would support about 1 billion pounds of debt — with about 70 million pounds of annual interest payments. That implies a buyer would need to make a big equity contribution of around 3.5 billion pounds.

While at least private equity firms are flush with cash right now, returns would suffer without the leverage. If the new owner juiced up Ebitda to 350 million pounds from today’s estimated 300 million pounds for last year, and sold at the same multiple on which the business was bought, the internal rate of return might only be mid-single digits. Buyouts are supposed to generate double-digit returns. 

How could a buyer square this circle? One answer might be that they could add the leverage later on, when OMW is able to pay higher dividends. That would enable the parent to be refinanced with more debt, increasing returns for the private equity firm. Debt markets might be more favorable later on, too.

It’s not an easy proposition, but given the dearth of primary assets available to private equity, it might be worth it.

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