Going Private

Diamonds in the Rough Set in Platinum

No doubt readers of Going Private will be aware of the value of slurping up suppliers into a business, particularly those that provide high margin products or raw materials (where a steady supply is critical or the commodity is unusually scarce).  This sort of vertical integration has been a critical part of business strategy since who knows when, but was probably best typified by Standard Oil in the industrial era.  As an interesting aside, the proper use of vertical integration can have substantial anti-trust issues, as was seen with Standard Oil, but, in my view more interestingly, also with DeBeers, of diamond fame.

DeBeers, then controlled by the Cecil John Rhodes (of the notable "Rhodes Scholarship") and Charles Dunhill "C. D." Rudd (almost entirely unnoted for anything but his association with Rhodes and DeBeers), managed to establish its stranglehold on diamond mines by controlling an altogether common and bland asset: water pumps and contracts to pump water from the main mines.  Water management being critical to mining, their grip on the water pump business made them a fortune before they even began to take large mining interests.

It is easy to see why a firm like Textron would be interested in owning fastener companies.  Particularly those that make expensive, FAA certified fasteners for aircraft, like Cessnas and Bell Helicopter (both firms owned by Textron).  Wondering why they would sell Textron Fastening Systems, which makes the lion's share of their high-precision, critical fasteners, to Platinum Equity, one of the larger operation private equity firms out there is, therefore, an interesting study.

Textron had Textron Fastening Systems on the block back before December of 2005.  They even went so far as to call it a "discontinued operation" back then.  Said the firm in its recent 10-Q:

On May 4, 2006, as a result of the offers received from potential purchasers of substantially all of the business of the segment, and the additional obligations that Textron now estimates will need to be settled as part of the sale, Textron determined that the net assets of discontinued operations related to the Textron Fastening Systems business may exceed the fair value less costs to sell. Consequently, Textron determined that it will incur a non-cash impairment charge in the second quarter of 2006 in the range of $75 million to $150 million.

One wonders aloud what might have been the headache with a well vertically integrated business that supplied critical, quality dependent and expensive parts to a manufacturer.  We are given quite a hint in the 10-Q again.

PART II.
OTHER INFORMATION
Our business could be adversely affected by strikes or work stoppages and other labor issues. Approximately 18,500 of our employees are unionized, which represented approximately 40% of our employees at December 31, 2005, including employees of the discontinued business of Textron Fastening Systems. As a result, we may experience work stoppages, which could negatively impact our ability to manufacture our products on a timely basis, resulting in strain on our relationships with our customers and a loss of revenues. In addition, the presence of unions may limit our flexibility in responding to competitive pressures in the marketplace, which could have an adverse effect on our financial results of operations.

Yeah.  Ouch.  In fact, so burdensome were the capital and managerial requirements needed to make a running with a unionized manufacturing entity based in Troy, Michigan that Textron decided to just divest the unit, and take a rather substantial hit to goodwill and related write-downs ($335 million in 2005).  They also charged $289 million for restructuring, though some of that is related to their other flagging businesses, InteSys and OmniQuip.

Back in 2002 Textron Fastening Systems had sold its 60% stake Grand Blanc Processing, LLC, a wire processing firm right back to Shinsho American Corporation, its joint venture partner.  Grand Blanc had been taking raw wire and supplying Textron with wire prepared (annealed, etc.) for use in Textron's fastener manufacture.  Again, another vertical integration play unwound by Textron.  And this particular divestiture was the last bit of the rather large wire processing interests Textron had acquired earlier in a big binge that went all the way back to 1996, before Textron bought Valois, a French manufacturer of fasteners.  It was also one of three wire processing business located in Michigan that Textron dumped.  This was partly because major clients were in automotive, and therefore in Michigan, but partly because Textron Fastening is in Troy.  One wonders if Textron was wisely exiting from the automotive industry back in 2002.  Not fast enough says their annual report:

During 2005, the Textron Fastening Systems business experienced declining sales volumes and profits. Volumes were down due to soft demand in the automotive market and operating difficulties. Profits were down due to the lower volumes, a lag in the ability to recover higher steel costs and inefficiencies associated with the consolidation of manufacturing operations in North America. Due to the continuation of these conditions, further softening of demand in the North American automotive market and an expected decline in the European automotive market, Textron’s Management Committee initiated a special review at the end of August to consider strategic alternatives for the segment, including the potential sale of all or portions of its operations.

Note how this explanation, low volume and revenue, differs some from their quarterly rationale.  Notice also that the reported revenues of the unit were $1.7 billion, $1.9 billion and $1.9 billion for 2003, 2004, 2005.  Not exactly a firm in crisis on the revenue side.

Still, Textron has been divesting "non-core" businesses for several years now, and being particularly anxious to rid themselves of Michigan businesses, particularly labor intensive ones, but also carbon manufacturers, fuel management system and flow control manufacturers since 2002.

This isn't a new hunting grounds for private equity firms, large corporations that failed to properly integrate an otherwise sound vertical integration strategy.  It is also unsurprising to see union shops being dumped left and right as well as Michigan businesses (are you listening to this Governor?) given the increasingly outsourced manufacturing capacity out there.  And what about quality?  I suspect Platinum Equity won't think twice about moving manufacture of the less complex products offshore and replacing all that expensive union labor with robust (but less expensive) quality control programs.

It is far cheaper to inspect the hell out of shipments from, e.g., China, in your local facility and just reject delivery of non-compliant product.  Who cares if the failure rate triples?  You just saved so much by killing off the most expensive labor on the planet (outside of Germany) that the pittance of a price you paid (something like 0.35x revenue), is going to make your IRR look quite yummy.

Asset Class Reductions

The Economist reviews (subscription required) the unusual nature of Wall Street's relationship with hedge funds, this time from the perspective of prime brokers.  Much hand wringing about the impact of hedge funds on the financial landscape (from a marketing of financial services perspective) is reviewed but, at least to my way of thinking, the take home bite of the article was this:

Increasingly, middlemen throughout the financial sector have been asked to prove their worth to their customers—or to find other ways of making money for themselves, by proprietary trading or making more use of their balance sheets.

A recent study by IBM Business Consulting Services argues that the vocabulary describing financial markets today—buy side, sell side, hedge funds—could be redundant within a decade. It suggests that, in future, firms will be classed according to whether they add value through “risk assumption” or “risk mitigation”.

Indeed.

The Economist, China and Outsourcing

"Giving a subscription to Economist.com is an ideal gift for any occasion. Choose from either a physical gift pack, including a free 32MB memory stick, or a subscription voucher sent via email. Gift subscription pack with free 32MB stick (1 year) This striking gift pack includes a 1-year subscription to Economist.com, plus a free 32MB memory stick."

-----Original Message-----
From: Sub Rosa Vice President
Sent: Friday, June 02, 2006 2:22 PM
To: Equity Private
Subject: Economist Letter

EP:

Do you think I went too far?

-VP

-----Original Message-----
From: Sub Rosa Vice President
Sent: Friday, June 02, 2006 2:13 PM
To: customerhelp@economist.com
Subject: Economist Gift Subscription

Sirs-

I am an enthusiastic print and electronic subscriber to The Economist, a
publication I view as among the most important reading I do.  Your
reputation for quality discourse compelled me to subscribe again after an
unfortunate one year lapse involving an unrelated automobile accident and
brain injury.

As I am sure you can appreciate, as a busy professional my time is short.  I
am also a directed leader of men and women and, accordingly, often prone to
vocalizing my displeasure with the current state of affairs with a mind to
inspiring change.  Tired of these repeated vocalizations, my significant
other took matters in hand and delivered to me a gift subscription of The
Economist.  As I am certain you will have access to my subscription files
and wish to look up the records for verification, please look upon the curt
gift card engraving ("Now, please shut up,") with the knowledge that we have
unrestrained lines of communication in our relationship.

Of course, I use The Economist nearly daily.  My citing one or another
Economist article during meetings on important topics is a regular
experience for my colleagues.  You can imagine their elation, therefore,
when I repeatedly announced over the 4 week waiting period that my
complimentary gift from the Economist (a thermal coffee mug colored in
Economist Red(tm) and branded in black with your elegantly simple and
familiar logo), was due any day.

You probably, however, cannot imagine the brutal mocking to which I was
subject on the arrival of said mug.

The package was opened by my assistant and the mug removed from its packing
material before being gingerly set on my desk in a prominent place, awaiting
my eventual arrival.  Because of its positioning, several of my colleagues
examined the mug before I had a chance to claim it.  Several flaws were
immediately apparent:

1.  The prominent sticker on the bottom of the mug's rubber footing read
"Made in China."  I was initially concerned by the mugs humble manufacturing
lineage, but then realized that if it stood for anything, The Economist, and
therefore its proponents, must stand for the sensible efficiency of
outsourced manufacturing.

2.  Upon attempting to remove the sticker (other less sophisticated
employees of my firm might be less conversant in the benefits of offshore
manufacture) the rubber padding on the bottom of the mug-- essential to
prevent it from slipping on slick surfaces or leaving rings on the desk of
the Senior Vice President during our morning chats-- came unglued.  Two
associates witnessed this event causing me much embarrassment.  The word of
the rubber footing issue spread about the office quickly.

3.  On first use, the safe and stable storage of the hot coffee from the
boardroom here, condensation developed inside the "vacuum chamber" of the
mug and now sloshes around visibly, (and audibly) as the outside is a
translucent red.   This makes a mockery of the thermal insulation properties
of the mug-- a flaw that is visible to all my colleagues.

4.  On washing the mug after its first use your logo immediately dissolved
in the harsh detergents employed by our outsourced office cleaning staff.  I
find it convenient that the mug has a particular plausible deniability for
The Economist directly designed into the product.

All in all my Economist subscription, which should be a source of pride and
demonstrate me to be a wise and erudite individual of exacting tastes, has
instead subjected me to ridicule and embarrassment as a victim of the evils
of outsourced manufacturing.  As a Vice President in a private equity firm I
cannot afford this sort of embarrassment.

I understand that The Economist now offers a free memory stick with gift
subscriptions.  Perhaps you could provide me delivery instructions so that
we could make an exchange of gift products.

Most Sincerely,
Vice President Sub Rosa

P.S. Can you tell me where the memory stick is manufactured?

Stuck With Outsourcing

-----Original Message-----
From: Sub Rosa Vice President
Sent: Monday, June 05, 2006 9:22 PM
To: Equity Private
Subject: Re: Economist Letter

I don't think I'm getting an exchange.

-VP

----- Forwarded message from customerhelp@economist.com -----
Dear Sir/Madam,

The Economist appreciates your inquiry and welcomes the opportunity to serve your needs.

The memory stick is for subscribers that place an online only subscription.

We apologize for any inconvenience this may cause. 

Sincerely,
Dana
Customer Service

Don't Cross the Debt Bitch

Laura, "The Debt Bitch" and I have been working overtime to get a deal financed.  I am supposed to be preparing things for the soon-to-be-here interns but instead I have had to delegate all that work to an associate who is now annoyed to be tasked with an internal project.

The Debt Bitch likes her martinis.  I can't say I disagree but I really can't do them at lunch like she can.  "If it is good enough for the heart-attack prone attorneys, it is good enough for me," she quips back at me when I ask after her lunchtime orders.

After a day and a half of solid meetings in the city we are sitting at a bar around 1:30 and she orders a vodka martini.  Ironically, within ten minutes of arriving she spies some young bankers doing pretty much the same thing.  I would be embarrassed to be caught sipping hard liquor on my weekday lunch hour if I were a banker in the city, but they seem to have no shame.  The scene is right out of a mid-1980s finance movie.

The Debt Bitch recognizes one of the bankers and we drift over, drinks in hand (mine is a water) to do the banking-social thing.  Things are pleasant enough and the Debt Bitch introduces me as "my Vice President," which is odd, and a thrill at the same time.  She says she has a deal for them to look at and we should all discuss it the next day.  Schedules are traded, gossip exchanged, all is well.

But things turn sour as soon as we turn to go.  I catch a snippet of not-quite whispered conversation as what I assume is an Associate banker describes me to what I assume is a Vice President in the most suggestive terms you can imagine and in a fashion that calls into question the professional nature of my relationship with Sub Rosa's Senior Partner, Armin.  I am prepared to ignore it, though I can feel my neck stiffen.

Since she was two paces in front of me I suspect the Debt Bitch's hearing is more acute than my own.  Her reaction is also more severe.  She turns around without hesitation, takes two steps towards the offending banker and unloads her entire martini (minus two sips) into his face without even cracking an expression.  The entire section is silent and at least ten people are staring.  Laura then pauses long enough to gingerly place her glass on their table before leaning forward and wordlessly delivering the best slap I have ever seen (or heard) outside of a Hollywood production to the left cheek of the already stunned Associate.

"Your firm won't see a dime of our debt needs from here on out," she deadpans to the Vice President before turning on her heel and collecting me towards our table with a "C'mon, let's go."

Not having learned the obvious lesson I hear one of the other junior bankers intone, "Woah.  She's hot."  If Laura hears this as we depart she ignores it, instead sitting down and ordering another martini, which our server, ironically, makes a point of buying for her with a wry smile on his face.  For the next ten minutes, the eyes of the entire place shift between us and the banker's table, that has now been joined by a more senior looking, and quite unhappy, banking type.

"Wow," I say.  "Thanks."
"Oh, you were only part of the equation.  The guy sitting with them now, I saw him walking in right before I tossed the vodka.  That is the VP's boss.  He knows Armin quite well and I am sure he remembers me.  I'll get an apologetic call in a few days and it will be good for some reduced covenants and maybe a half a percent one day."

Just then our server returns with two more martinis, I suppose one is for me, and points to a table across the bar.  "From the gentlemen at the table there."  They, 40somethings, nod their distant approval to Laura.

Don't cross the debt bitch.

Corporate Cargo Cults

From Idea Froth, which references a blog by Peter Klausler, an engineer at Cray, Inc., I find an interesting missive titled: Principles of the American Cargo Cult.  The reference is to so called "cargo cults" in the pacific, emulating the acts of allied soldiers in hopes of attracting the goods (cargo) that had been previously delivered by air during the second world war.  The key belief being that a certain totemistic sort of emulation (building thatched mock-ups of planes, making runways out of twigs) and not effort or commerce will cause higher powers to deliver the goods ("cargo").

Klausler's outline of the various elements of the modern equivalent got me thinking, particularly these items:

The end supports the explanation of the means

A successful person's explanation of the means of his success is highly credible by the very fact of his success

You can succeed by emulating the purported behavior of successful people

This is the key to the cargo cult.  To enjoy the success of another, just mimic the rituals he claims to follow. Your idol gets the blame if things don't work out, not you

These two certainly would seem to explain the otherwise baffling popularity of otherwise totally absurd and useless business books built around modern personality cult figures.

Klausler reflects on the origins of his outline:

I wrote these principles after reflecting on the content of contemporary newspapers and broadcast media and why that content disquieted me.  I saw that I was not disturbed so much by what was written or said as I was by what is not.  The tacit assumptions underlying most popular content reflect a worldview that is orthogonal to reality in many ways.  By reflecting this skewed weltanschauung, the media reinforces and propagates it.

I call this worldview the American Cargo Cult, after the real New Guinea cargo cults that arose after the second world war.  There are four main points, each of which has several elaborating assumptions.  I really do think that most Americans believe these things at a deep level, and that these misbeliefs constantly underlie bad arguments in public debate.

What other wisdom could be culled from Klausler's outline?  At the risk of joining the ranks of these other useless business advice pulp writers, I've taken the original and modified it to be more "useful" (read: humorous) to the private equity professional when considering the typical attitude within many portfolio firms, particularly those that have long labored under the yoke of large, uncaring and publically held parents.  My deletions in strike-through, additions in underline.

I. Ignorance is innocence

Complicated explanations (those from the customer, for instance) are suspect

The world is simple, and there must be a simple explanation for everything; The finance department, therefore, is always full of shit

Certainty is strength, doubt is weakness, except when doubt is strength and certainty is weakness (during board meetings or any other committee environment)

Admitting alternatives is undermining one's own belief position in the office-political pecking order; pointing out flaws, however, undermines other's position in the office-political pecking order

Changing one's mind means one has wasted the time spent holding coming up with the prior opinion, ergo, great effort should be expended not to hold any opinions

Your non-opinion matters as much as anyone else's

When a person has studied a topic, he has no more real knowledge than you do, just a hidden agenda; this is doubly true of management or anyone from the parent company

The herd should be followed just closely enough so that you can both avoid the tiger trap AND plausibly claim to have been the only contrarian when half the herd falls into the tiger trap

The contemplative lemming gets trampled the absentee lemming avoids disaster entirely
Popular beliefs must be true, unless they are popular with management
No bad idea can survive
People are generally smart (except management)
Even if a popular belief doesn't pan out, at least you'll be in the same boat as everyone else, that is unless you followed the herd following and absentee rules above, in which case you can laugh comfortably from a distance

II. Causality is selectable

All interconnection is apparent but the finance department cannot see it

Otherwise, complicated explanations would be necessary, and this would needlessly empower the finance department

The end supports the explanation of the means

A successful person's explanation of the means of his success is highly credible by the very fact of his success unless he is a member of management in which case success is pure luck and irreproducable through any human effort or without a large inheritance

You can succeed by emulating the purported behavior of successful non-management people; like Tony Robbins.  This is doubly true if the behavior is described in a best-selling book, or any book suggested by Oprah

This is the key to the cargo cult.  To enjoy the success of another, just mimic the rituals he claims to follow
Your idol gets the blame if things don't work out, not you

You have a right to your shares and options

You get to define the number of your shares and options
The number of your shares and options is the least you will accept without crying injustice before threatening human resources with a lawsuit
The number of your shares and options is therefore proportional to the credibility and strength of your blackmail material in the eyes of the legal and human resources departments
Celebrate getting more than your share of shares and options by emailing a how-to guide to others in your group; alternatively, sell them, buy a sports team and start a blog

III. It is not your fault so long as you aren't a member of management

If it's good for you, it's good

Society is everyone else
Good intentions suffice bad intentions can be well disguised
You can always apologize but if you were clever no one will ever know it was your fault in the first place
There is no long term unless you are computing damages for your wrongful termination lawsuit
Don't miss an opportunity to miss an opportunity to work (see absentee lemming rule)

Consequences are things that happen to others because of management

Only you can hold yourself accountable.  Don't let others make you do that
If somebody starts the blame game, you can still win it with the right attorney
There are evil people and institutions, and surely one of them, probably human resources, is more responsible than you are

You are not the problem the finance department is the problem; or maybe human resources, but probably the finance department

An ugly image means a bad mirror.

IV. Death or bankruptcy is unnatural

You're special; management is special ed
Bad things shouldn't happen to you unless you have someone to sue for them
Pain is wrong except for that girl who cost you your promotion by outperforming you
Life should not hurt anyone except for that girl who cost you your promotion by outperforming you
It's a Whiffle World

Tragedy is a synonym for calamity

Bad things are never consequences of one's own action or inaction when management is around to blame

There will be justice provided the right attorney will take your case

Bad people get punished unless they are in management
You, however, will be forgiven, even if you weren't clever enough to avoid discovery

Cheap Money, Europe and Activism

It will be no secret to Going Private readers that Sub Rosa, LLC has been frustrated lately by the absolute sea of cheap debt.  We have had four misses on auctions where EBITDA multiples have hit 9.5x and even 11x.  Quick interest rate sensitivity calculations tell me that the deal we lost at 11x had about 1.3% of headroom before the firm would have problems servicing the debt.  This still assumed some rosy projections about revenue would hold.  Given where The Fed seems headed, I just cannot see how it is rational to close a deal with that kind of interest rate risk and no margin for error.

There is always pressure to push price to close a deal, even if price gets pushed beyond the rational.  Part of the difficulty in being one of the junior people in a firm like Sub Rosa is the need to push back at the senior people who want to close a deal and rely on the junior people (like me) to "make the numbers work."  That can be a tough job when one has to confront charismas like Armin's.

The result has been a renewed focus on other opportunities.  Europe is one that Armin has been looking at for the better part of the last 18 months.  For reasons I won't go into here that particular approach has a lot of appeal for Sub Rosa.  It has less for me, as I'm not really inclined to want to move to Europe in the next 6 months, though it seems things are headed that way.

Another area that Armin has been contemplating for a long while is activist investing in public firms.  Recently, I was privileged enough to meet with about as famous an activist investor as you can find nowadays.  The meeting, on the estate, was either kept very quiet, or happened to be totally spontaneous.  I suspect the former.

One minute I was hunting for an apple to eat and the next I was being introduced to, let's just agree to call him "Theodore."  I managed a weak and distracted "Hello," before we collectively endured the schizophrenic weather and the prospects of cooperation were discussed.  It took a good bit of time, or so it seemed, before it dawned on me why I felt I had seen Theodore before.  I had.  In the Wall Street Journal, Fortune, McBusiness (Business Week) and etc. etc. etc.

For all his reputation as a brazen irritant to the biggest names in the corporate world, Theodore was amazingly humble, down to earth- but also very staccato and matter of fact.  He projected a kind of confidence that is at once self-assured and subtle.  The face of a man with nothing to prove, except perhaps to himself.

I must admit that the prospect of being an activist shareholder, or working for one, appeals to the growing arrogance in me.  Core to succeeding in activism like this, hinted Theodore, is not the belief that you know better than management, but the certainty that you do.

They're KKRrrreat! (Part IV)

The Wall Street Journal pointed out yesterday (subscription required) that private equity IPOs have effectively fallen on their face after KKR's blockbuster.  The Journal also notes that KKR's share price has slid 10% since the IPO.  All in all, not surprising.  Every IPO is, to some extent, a game of hype and timing.

The interesting thing about KKR's offering is that it was quick, dirty and capitalized on the sterling brand name KKR has developed for itself.  One has to wonder some if there wasn't some early sense that the original offering size would be exceeded, and the public relations boon of having an "oversubscribed" offering was more than a little design.  "Supplies are limited, so call now."

Still, this might be a new sort of "one and done," the nimble IPO in a space on the verge of a decline while the competition isn't looking. Suddenly, in a declining and overbought market for private equity vehicles, the key feature of the IPO, a new independence from the distractions of the private equity fund raising cycle, seems to be worth far more than was, at least initially, obvious.  Locking up funding for several years right on the verge of what will likely be a continued hike in interest rates, a decline in IRRs and a downturn in fundraising prospects was a bit of genius.  If you look at it from a competitive landscape perspective it was a brilliant move, even if mostly accidential with respect to the timing.  Even the decline in the price of the KKR units plays in wonderfully.

And, of course, the KKR deal is so bad for the public investors any competition who wants to try the same thing would probably have to sweeten the deal to get it done, putting them at a distinct disadvantage with respect to KKR.

That is, if anyone else even manages to consummate an effective offering, and the Journal seems to doubt it:

Blackstone Group and Carlyle Group, which were actively pursuing initial public offerings earlier this year, have postponed any plans they had to go public in the immediate future and could abandon their IPO hopes altogether, people close to the firms said.

KKR could have slipped through another coup, as they are quite prone to do.  Quoth the Journal:

Given the poor performance of KKR and Apollo, private-equity firms are trying to determine whether investors have a lasting appetite for future offerings or whether this recent string of IPOs is merely a passing fad.

KKR's fund is trading below net asset value because the firm put a lot of capital in conservative instruments that return 2% to 3%, while charging a management fee that consumes almost as much as the return.

Getting investors to pay for your war chest, what's not to love?

The Folly of Overleveraging

As if on cue, on the topic of interest rate sensitivity and rosy assumptions, I find today a reference in The New York Time's "DealBook,"citing the always wonderful "TheDeal.com" (home to one of my favorite reporter/editor/wine guru) to a botched LBO in the form of Werner Company, a ladder maker now the victim of leverage, floating rates and the rising price of aluminum.  Says DealBook:

Werner Company, backed by private equity firm Leonard Green & Partners, also cites its “highly leveraged capital structure” as contributing to its problems, according to TheDeal.com. “Quite simply, we have too much debt,” said Steven P. Richman, the chief executive.

Sure, debt is part of it, I think to myself, but it is awfully convenient that management has a built-in failure excuse, no?

Cartoonish Opinions

I think my favorite section of the old 2005 In Re The Walt Disney Company Derivative Litigation opinion (online as a 1.95MB .pdf thanks to the Wall Street Journal) is:  "...based on my personal observations of Ovitz, he possesses such an ego, and enjoyed such a towering reputation before his employment at the Company, that he is not the type of person that would intentionally perform poorly."

Followed in amusement potential closely by:

This dichotomy places the Court in a somewhat awkward position.  By virtue of his Machiavellian (and imperial) nature as CEO, and his control over Ovitz's hiring in particular, Eisner to a large extent is responsible for the failings in process that infected and handicapped the board's decision making abilities.  Eisner stacked his (and I intentionally write "his" as opposed to "the Company's") board of directors with friends and other acquaintances who, though not necessarily beholden to him in a legal sense, were certainly more willing to accede to his wishes and support him unconditionally than truly independent directors.

My favorite passage from the recent 2006 In Re The Walt Disney Company Derivative Litigation decision (online as a 208KB .pdf thanks to the tasty Conglomerate blog) links right in with:

We conclude, for the reasons that follow, that the Chancellor’s factual findings and legal rulings were correct and not erroneous in any respect. Accordingly, the judgment entered by the Court of Chancery will be affirmed.

Artwork: "1967 Disneyland Memorial Orgy," Paul Krassner (1967).  Definitely NOT safe for work.

You Can Pick Your Friends, You Can Pick The Deals...

...but you can't pick the friends of the deal.  We're in the midst of a larger-than-usual deal for us and we have, therefore, latched on to another firm with whom we intend to co-invest.  The problem with co-investors is that you have to deal with co-investors who may or may not have similar ideas about how to approach winning the deal.  They may or may not want control of the deal.  They may or may not want control of the company.  They also may or may not be complete assholes.

My "counter-part" on the collaboration to buy a company that makes, let us just say, complex polyvinyl chloride pipe fittings, is a young man I will call "Phil."  Phil seems like a nice enough guy when you meet him.  Educated in the West (not Stanford, don't worry) and generally polite.  But beneath that calm exterior lurks a dark vein of bitterness, studied manipulation and jealousy.  A insidious and ugly nastiness that, contrasted from Armin's own reality distortion field that bends time and space in his immediate presence and even opens wormholes into a parallel universe where everything always works out perfectly, overwhelms even the brightest, most wise and powerful forces of good.  This makes him ideally suited to be a professional in a buyout fund.  Other than this small "absolute evil" thing, he's really not a bad guy.  Maybe he's just not my type.

Early on when staking out strategy to approach the deal with we had a 6 person conference call with 3 from Sub Rosa, including Armin and me, and 3 from "Phil is an Associate Here, LLC."  That went spinningly.  Then, Phil came into Sub Rosa's offices.  Mind you, this takes place in Sub Rosa's offices- Phil is a guest.

1.  Sub Rosa Offices - Boardroom
Elegant but functional offices punctuated by a variety of antique pieces of furniture and decor that to the trained eye will be revealed as overly valuable for their purposes, specifically, the day-to-day operations of Sub Rosa, LLC, a mid-size leveraged buyout firm.  Present are:

Equity Private, Vice President, Sub Rosa, LLC
Craig, Summer Associate, Sub Rosa, LLC

Enter from Double Doors: Phil, Associate, "Phil is an Associate Here, LLC."

Phil: "Ok, let's get moving."  To Equity Private: "Hey, can you get me a cup of coffee, honey?"
Equity Private (stunned): "Excuse me?"
Phil:  "You heard me.  Black, sugar."

The tension in the room is thick.  15 seconds of silence while Equity Private and Phil lock eyes.

Craig: "I'll get it."

Oh, dear readers, that was just the beginning....

High Anxiety

I am quietly blogging in a room where my fate (move to Europe, stay in the states) is being determined, even as I type this, via conference call.  The tension is thick.

Tension With No End

It is an alarming thing to sit through a meeting where people are busy talking about you as if you aren't there.  Well, perhaps eerie is a better descriptor.  I sat through nearly 2 hours of conference call discussing Sub Rosa's new Europe venture and, in particular, the staffing of the new office.  At one point it was hinted that the upward career path for the junior staff was in Europe.  "Exclusively."  Two or three pairs of quickly averted eyes looked my way.  I was the youngest employee in the room at the time.

Alas, there is no update.  I am still in limbo.  After the career comment I secretly hope I am sent. Armin seems to be gearing to move himself, and I have to think that means I'll be pulled along.  Another side of me, however, despises the idea.  I feel like I have just gotten settled here.  Not that I have much of a social life, but at least there are the distant hints of it.  To start over again, I just don't know.

I am not a particularly good waiter.  I have to totally sink myself into something distracting (a spa treatment sounds good right about now) to stop worrying.  Now if only I could find the time to spa....

A Remider To Going Private Readers

The email response to my recent posting including Laura "The Debt Bitch," vodka, and some bankers compels me to remind readers of the Going Private "Start Here" page that contains a list of frequently asked questions.  In particular, I think these four should prevent unneeded emailing by you and unneeded email reading by me.

Q. "Is the Debt Bitch Single?"
A. What is this, eight grade again?  Ask her yourself.

Q. "Can I have the Debt Bitch's [email address/phone number/description]?"
A. No.

Q. "Can you give me a hint where you and the Debt Bitch work?"
A. Well, it's a private equity firm.

Q. "Can't you give me a bigger hint than that?"
A. We do buyouts.

Intern! More Foundation for Mr. Rather, Quickly, Please

The Wall Street Journal points out (subscription required) that Dan Rather not only is finally cutting his ties to CBS (and complaining about how CBS gave him the finger) but is joining forces with my Vegetable Capital hero Mark Cuban, on Cuban's HDNet cable channel.  Because what we really need, aside, of course, from more vapid reporting, is a high definition broadcast of the 74 year old Dan Rather.

Rather indicated that the deal meant CBS was admitting that "...after a protracted struggle, that [CBS] had not lived up to their obligation to allow me to do substantive work there."  I guess you have to read "protracted struggle" to mean the entire 44 years of Rather's relationship with CBS.

The Power of the Grape

Abnormal Returns (yummy!) had a nice piece at the beginning of the month on "megacap catalysts."  There were some good tidbits and a pointer to a June 1st Wall Street Journal article (subscription required) on the bullish prospects for management buyouts.  Though I am depressed that Abnormal Returns gave up on their lovely New York evening skyline banner, the stuff that appears on those pages often comes back to snuggle up and remind you how good that last weekend in Napa was.

Sure enough, we are in the midst of talking to management of a mid-sized (hardly a megacap) to support their unsolicited bid for the company.  A dicey thing, this.  Lots of secret meetings on the estate, which someone had the turpitude to call "neutral ground," and nearly a dozen bottles of wine, though this barely makes a dent in Armin's cellar.

A small side of me hopes that the sudden surge in domestic MBO activity might delay my purchase of expensive 220/240v converters for all my consumer electronics.  I can't yet tell how large the side that thinks time in Europe would be interesting is.  In response to reader questions: Yes, I will still blog if I move to Europe.  No, it will not be called "Going Private," it will be called "Europe on $2,500 per day."

At first I was under the impression that working directly with management where the incentives to write a good deal were aligned with management's cooperation should make diligence easier.  In fact, it is harder.

While management may well know dirt that you would never uncover in traditional diligence without their help, replacing fact-diligence with people-diligence is not an ideal trade.  The incentives are for them to get a deal done, not necessarily a good deal and ego, fear and denial are powerful weapons against full disclosure to outsides.

Often management will believe that they can overlook (or even conceal) this or that underperforming group because once the deal is inked they can resolve it before anyone is the wiser.  The peril of the MBO is the "M."  It is much more treacherous than the "L" and "M"'s are much better at looking like something they are not than are financials, leases, or "property plant and equipment."  Beware, young private equity professional.

I Agree With Myself

"Der amerikanische Finanzinvestor Blackstone plant nach einem Bericht der "WirtschaftsWoche" die komplette Übernahme der Deutschen Telekom."  After an inquiry from an inscrutable reader I speculated wildly last month about Blackstone's motivations for taking a minority stake in Deutsche Telekom.  My faithful reader wondered how the investment made sense given the traditional buyout model and pointed out that, at the time, the sink in stock price made it, at that point, a losing bet for Blackstone.

Several readers wrote in to comment, including a certain favorite editor of mine, a Deutsche Telekom employee and an anonymous Blackstone employee, which surprised even me.  The take away for me was that at such a low multiple, with "single digit" interest rates and a modest dividend that could help defray the debt service, and you have a mostly-bootstrapped option on a larger stake in Deutsche Telekom, along with what amounts to "insider" diligence access.  Plus you just bought something for under 6x EBITDA.  Not bad for the Telekom [sic] sector.

Today's news makes it hard not to gloat a little bit.

At the time it looked to me like Blackstone was paving the way for a larger stake and since their investment model calls for control stakes I made little of the various protestations from Blackstone, including from Hamilton James, that we would "be seeing more of" these unconventional investments.  Of course, Blackstone was going to give themselves a face-saving out in the event they either took a bath on or decided to exit early from Deutsche Telekom.

The most powerful argument against such a takeover, presented by my best and worst critic, is the size of Deutsche Telekom ($65.7 billion or so in market cap).  That seems to be less an issue than it appeared to be, that is if you buy the reports that Blackstone is busily out raising EUR 60 billion to mount a takeover (and apparently the Frankfurt stock exchange, at least, does).

My favorite editor feeds me the following:

Quoth the Agence France Presse, citing German McBusiness paper WirtschaftsWoche:

FRANKFURT, June 23, 2006 (AFP) -
 
The US private equity firm Blackstone is preparing to launch an offer for
the entire share capital of Deutsche Telekom, Europe's leading
telecommunications group, the weekly WirtschaftsWoche reported on Friday.
 
Blackstone, which acquired a 4.5-percent stake in Deutsche Telekom and
therefore a seat on the group's supervisory board in April, was preparing to
raise 60 billion euros (76 billion dollars) from investors by the end of
this year in order to launch a full takeover offer next spring, the magazine
said, quoting sources familiar with the matter.
 
The German government holds a direct stake of 14.62 percent in Deutsche
Telekom, plus a further 16.63 percent indirectly via the public-sector
development bank KfW, which Berlin traditionally uses as its privatisation
vehicle.
 
Both the government and KfW said Friday that they had no knowledge of any
bid by Blackstone.
 
A Deutsche Telekom spokesman said that the government and KfW had both said they intended to remain the biggest shareholders for some time to come.
 
When Blackstone acquired its stake in April, it committed itself to holding
the stake for at least two years.
 
KfW is not allowed to sell its Deutsche Telekom shares before April 2007.
 
The speculation of a possible bid by Blackstone sent Deutsche Telekom shares
up to an intraday high of 12.70 euros on the Frankfurt stock exchange, a
rise of 0.20 euros or 1.6 percent on the day.

Conspiring to Conspire

DA, a faithful reader, cites an anonymous, highly placed Blackstone source, to point out that though Blackstone only has around 4.5% of Deutsche Telekom, they have been given a proxy for something like 33% of the DT, basically the German government's entire voting stake.  If true, this would be quite interesting.  A bearish reader then writes in to point out that Dr. Ron Sommer, the former CEO of DT is on a number of Blackstone advisory boards.  The plot thickens.

Plastic People, Paper Money

In October of 1997, Texas Pacific Group acquired an 88% stake in J. Crew composed of $66 million in common equity, $97.4 million in preferred stock (with accruing and payment in kind dividends).  The remainder of the nearly $527 million in purchase price was financed through private placement of debt and a mish-mash of the typical sorts of instruments readers of Going Private have come to expect from such transactions.  The debt to equity ratio at the time was around 3.2:1.

The best I can decipher the unusually opaque S-1/a filing for J. Crew, they had a series of traunches as well as a refinancing or two over the years.  Now, of course, they are IPOing.

As my time this week is dedicated to real deals, my analysis here is limited and I haven't bothered to delve deeply, nor do much with the complex option plan outlined (poorly) in the S-1/a.

Back when it looked like the offering would be $16 per share, TPG assumed they would snag around $321.8 million from the underwriters with an over allotment option (and I expect the underwriters exercised).  $279.8, however, they counted on regardless.  On top of that, TPG was paying around $73.5 million to snag another block of shares and J. Crew was to borrow another $80 million.  Of this they intended to spend it, well, on themselves.  Specifically:

$319.8 million to redeem the Series A Preferred Stock.
$112.0 million to redeem the Series B Preferred Stock.
$ 22.5 million in transaction fees.

Any overages in the offering would, they claim, be used to reduce the borrowings, which I describe below.

Just prior (May 15, 2006) to the offering J. Crew used $12.7 million in cash and $285 borrowed at LIBOR plus 1.75% - 2.25% or a base rate formula plus 0.75% + 1.25%.  I don't know how their "base rate" is defined, but LIBOR today is around 5.50%, so we can assume that, since the offering was a big hit, they managed to keep their total borrowings near $285 million and, therefore, are looking at the low end of their interest band, or around 7.25 - 7.75%.  Not bad, really.

The offering, had it just simmered, would have left on the order of $352.4 million in long term debt sitting in J. Crew.  It probably didn't sink that far given the opening price ($20.00, instead of the $16.00 used to calculate the above).

This is an interesting dynamic.  If there's enough investor interest, the total long-term debt on an IPO like this (i.e. one used primarily to cash out a private equity holder and service the massive debt used to pay dividends to the private equity holder) is reduced and the offering gets more interesting, bringing in more investors and reducing the debt more and therefore... you get the idea.  I wonder if underwriters are savvy enough to point this out when pitching the deal.  "We are so oversubscribed the debt level isn't going to be that high post IPO."  Hmmm.

So how did TPG do?

Looking at their common stock, TPG had slowly worked down or diluted their 88% position and owned about 56% (17,490,899 shares) of the common stock of the company before the offering.  Afterwards, they end up with about 40%.  They let go of something like 5 million shares.  At $20 each that's a cool $100 million.  Add to that the cashing out of their preferred shares (around $431.8 million) minus their new purchase of common ($73.5 million) and they have realized gains of about $458.3 million.  Add to that something under a 40% stake in J. Crew (or about 12 million shares) and you get unrealized gains of around $299.3 million (at the current price of $24.94).

Going back to October, 1997 and ignoring some of the recaps, options and other fees (that I may revisit later) we see the following:

Assuming we allocate the cost of the original common share purchase pro-rata to the split of common that is realized (i.e. offered in the IPO) and the unrealized common gains (still held by TPG after the IPO) we see that on their preferred shares they saw realized gains of around 16.30% IRR.  Not bad given the length of the investment.  On the realized gains on the common shares they managed a 21.64% IRR. Unrealized gains on common show a 23.63% IRR.  Total gains, realized and unrealized are around 19.42% IRR.

Bear in mind that the pro-rata allocation isn't really the way I should be doing the realized v. unrealized common analysis.  I also know there are some recaps in J. Crew's history and I suspect TPG took some capital out of those years ago.  I also am not factoring in management fees and any management agreement breakup fee.  (There might not be one since this is such a long holding for TPG).

More Paper From Less Plastic

Clearly, private equity sleuths David Carey and Lisa Gewirtz over at The Deal did far more digging (subscription required, sort of) into Texas Pacific Group's recent payoff IPO than I.  Crawling around in dusty filings from J. Crew they paint a more accurate picture of Texas Pacific Group's initial investment than the poorly researched, 1997 Daily News piece I relied on.  The duo finds the following:

The figures I used actually represented a group of investors, probably including some of the limited partners of TPG who co-invested using, among other things, a bland sounding vehicle called "TPG Advisors II."  (Note to self: remember to name holding companies for mostly obscure victims in Greek tragedies so as to befuddle uneducated and entertain clever financial reporters in the event the deal goes south.  Jocasta is my current favorite.  A good name for a chain of highly overpriced coffee stores, no?  Well, that is, except for that whole "marry your own son, find out and kill yourself so he can gouge out his own eyes with your broaches" thing).

According to the Dynamic Debt Duo, TPG itself only invested in the Series A preferred and common.  They held about 77% of the preferred.  This is in addition to around $50 million they invested in the common along with "direct affiliates."

I suspect their figure for an original investment of between $115 to $125 million for TPG's initial stake is closer than mine.  The recalculation of IRRs is left as an exercise for the Going Private Reader.