The Globe and Mail, Report on Business
Published July 21, 2007

My first gig in the investment industry in the early eighties was as a conglomerate analyst at Richardson Greenshields. It was while doing that job I first became sensitive to the phrase “strategic purchase.”

I bring it up now because that phrase is increasingly popping up in the context of private equity transactions. The media coverage of Blackstone Group’s acquisition of Hilton Hotels had the following quote from Jonathan Gray, a senior managing director: “It is hard to imagine a better strategic fit for us than Hilton with its world-class people, brands and network of hotels.” To add Hilton to the hotel assets it already owned, Blackstone is paying a 38-per-cent premium to where the stock was trading prior to the announcement.

In a similar vein, Apollo Management LP is in a bidding war to acquire Huntsman Corp., a specialty chemical producer. Apollo has made a few chemical acquisitions and has grouped them under the Hexion Specialty Chemicals banner. Huntsman represents another strategic purchase in that same vein.

My ears go up to the word “strategic” for two reasons. First, it often indicates that the buyer can’t justify the price on any other basis. And second, it is a reminder of an evolution taking place in the private equity world. When a company describes an acquisition as “strategic,” I translate that to mean “we’re overpaying.”

Buying companies in the same industry, putting them together, prettying it up and selling it off has been a bread and butter private equity strategy for a long time. And I realize that strategic acquisitions can provide increased opportunities for cost cutting. That’s real and concrete.

But too often “strategic” is synonymous with warm and fuzzy stuff. I am referring to indefinable benefits like a bigger market presence, a more complete portfolio of products and increased cross-selling opportunities.

The reality is that with their imperative to get their clients’ money to work, private equity firms are increasingly dependent on buying public companies at full prices. They are paying big premiums over market prices (Hilton) and are not shying away from bidding wars (Huntsman, BCE). But at the end of the day, asset managers and chief executive officers have to acquire assets at attractive valuations or they will run their business into the ground. If they overpay for an asset, their portfolio or business will generate subpar returns, no matter how many synergies they tout in the annual report.

“Strategic purchases” are also a reminder of how private equity is evolving. The big firms like Blackstone and KKR have become the conglomerates of the current era. Back in the sixties, U.S. conglomerates like ITT Corp., Litton Industries and Textron were a powerful force. In later years, we had Canadian Pacific Enterprises, the Edper empire (Brascan, Hees, Noranda) and many smaller ones in Canada.

Where are these companies today? For the most part, they have all been dismantled. It became apparent that synergies and senior management weren’t adding value to a diverse group of businesses. And at times, the corporate structure inhibited growth because of capital constraints or industry conflicts. As the aura wore off and the market paid less for senior management expertise, the conglomerates traded at a chronic discount to their asset value, which made the situation unsustainable.

Will the private equity conglomerates suffer a similar fate? Certainly they face a similar challenge with management dilution. The core of smart, aggressive and savvy business people that started these firms is having less impact on acquiring, restructuring and managing the portfolio companies.

And it will get worse as they themselves become public companies. How many deals do you think Stephen Schwarzman, Blackstone’s chairman and CEO, really got immersed in while he took his company public? For all but the biggest deals, the ”regular” guys who are two or three notches down on the talent scale are calling the shots. Management dilution happens in any business, but in an industry so dependent on brain power and moxie, it’s a bigger risk.

In all forms of asset management, it is a ticklish question as to how big you should be. How many assets or clients can you effectively manage? Does expansion dilute and distract the real talent(s) behind the firm? Or more to the point, are the great investors who built these companies still making investment decisions?

It has been interesting to watch Canada’s Onex Corp. develop over the years. It has certainly grown in size and now manages private equity pools for outside investors, but the management team is reasonably small and has been very stable. The core of senior partners, including Gerry Schwartz, are still involved in every deal. As for other distractions, Onex has been a public company for 20 years.

Are private equity firms paying too much? We should start to get indications in a year or two. Will the size of these firms dilute their brilliance? That’s a longer-term issue, but it may raise its head earlier if client returns take a dip.