I admit to being a sorta-kinda fan of "Jeff Matthews Is Not Making This Up." I don't always agree with the big JM, but his entries are generally interesting. His tidbit on Burger King is just one such, right down to the point where I don't agree with the general conclusion he makes from the specific example of Burger King's Henryesque, public regal flogging.
Matthews ties the dual observations of the difficulty of finding good deals and the "fact" that private equity firms are "stretching" for good deals, to a prediction of the imminent death of private equity as we know it.
I'm not sure it is sound logic to use a random press quote referring to a single transaction (in this case from an anonymous lawyer for one of the losing bidders on the Phillips unit eventually won this week by Silver Lake Partners who, according to Matthews, quipped "...everyone lowered their expectations on returns...." First, let's try to remember that for LBO firms, lowering expectations on returns is the shift from 40.0% IRR to 26.5% IRR and second, this only sounds like every auction I've ever been in...) as a general proxy for private equity deal stress industry wide. Matthews sums this up with:
Lower margin of error + lower deal quality = recipe for disaster.
"Disaster" is, of course, not defined here. While interesting, I think this analysis ignores some factors.
First, critical mass in Private Equity. Second, fundamental environmental factors.
When I started the Going Private adventure I posted a quick, dirty and jaded primer on the evolution of the field. I pointed out that the early boom in buyouts was primarily due to flaws in the "conglomerate" theory of the firm. In particular:
Consequently, by the mid to late 1960s large corporations began to interpret the need for "diversity" to mean that they should acquire anything and everything they were able to pay for. The less relevant to their own underlying business, the better. This marked the beginning of the "conglomerate wave" where a flurry of mergers and acquisitions activity dominated thinking about how large firms should look and act. Like portfolios, it was argued. Diversified and large enough to enjoy economies of scale, of course.
It was the crash of this wave, with the slow realization that a massive corporation with no history in beverage products likely shouldn't be buying a sports drink company just "because," that fueled buyouts. There was, around this time, an amusing commercial (and I believe it was by Pace Picante Sauce) where a monolithic boardroom filled with identically appearing directors shaped the future direction of the corporation:
Chairman: Gentlemen, shall we manufacture salsa...
(The 6 directors on the left side of the room raise their hands).
Chairman: ...or oven mitts?
(The 6 directors on the right side of the room raise their hands).
The boom of buyouts waited carefully in the wings for those sorts of decisions to blow up and then applied simple factors that proved elusive to the conglomerates of the time to suceed marvelously. Specifically, focused and incentivized management teams, brutally fast accountability and merciless cost oversight. Of course, these factors, the actual management accumen, were slower to develop than the key tool for high returns: Leverage.
Itself a great motivater, the results leverage produced were outstanding, but then it was low-hanging fruit picking off the former subsidiary of a massive, unfocused corporate machine. Not a lot of management expertise was really required to double productivity.
Not all firms are LBO candidates. Some economic environments create more than others. Low interest rates, disincentives to remain in the public market or a previous period of high P/E ratios (and therefore cheap currency [stock] for acquisitions by large corporates that should leave well enough alone) all contribute to an environment where LBOs thrive. Money flows into LBOs, opportunities dry up, money is allocated elsewhere, the cycle continues. That one should consider this odd or unusual is tantamount to the admission that one is not a believer in market economies.
The prefect storm story for LBOs is not the approaching demise of the field (even after Drexel fell apart the business thrived among niche players with real advantages) but the fact that the last four years have seen such a confluence of events favorable to the business that nothing other than a massive boom could have been expected.
Record low interest rates, high
disincentives to remove firms from public hands, a five year prior period of
insanely high P/E ratios and the huge public equities growth spurred by
the tech boom all contribute to the "target rich environment" we have
been seeing in the buyout world today. But, pour enough money into it
and, like any arbitrage opportunity, returns begin to slip until you
have to have an awfully significant information disparity advantage to
In my view the act of "Going Private" is effectively the admission
that public capital markets and the corporate governance system thereof
were simply not sufficiently suitable to provide for the success of the
firm in question. At least over the last several years, the public
capital markets fail because they tend to be the among the last of the
"greater fools," and classic absentee owners. I find it hard to imagine anyone could argue that,
with the massive influx of the "casual investor" beginning in the dot-bomb era and that the market still sees, the average investment accumen of
the market has improved in the last fifteen years. (I fully include
myself in this analysis as the only public equities I believe myself
qualified to invest in- primarily because investing in public equities
would never be more than a two hour a week hobby for me- are low-fee S&P 500 index
funds). I tend to think the new rise of shareholder activist funds
supports my view in this. They too have an ecosystem of deal critical
mass that depends highly on the rest of the public markets being asleep
at the wheel. No signs of that abating, I think.
And so I ask two questions: What might actually be predictive of a "bust" in buyouts and what would a "bust" in buyouts look like?
If I am correct and the elements required to spur buyouts, or, in fact, a switch to any alternative capital structure, are two-fold:
1. An environment to generate targets for capital structure change:
- Correctable inefficiencies in:
- Management accumen. A general lack of comparable management talent in prevailing capital structures (today public equities)- and here the differences can be quite small and subtle. Correctable where small, focused management teams exist outside the prevailing capital structures.
- Management compensation. Are management incentives competitive in the prevailing capital structures (public equities)? This, of course, requires resort to analysis I haven't seen addressed anywhere other than Going Private- i.e. risk adjusted compensation to senior management. If risk adjusted compensation is inefficient (i.e. not comparable) in public firms, then the arbitrage opportunity is obvious.
- Corporate governance. Do the prevailing capital structures do a good job of culling management talent, replacing inept management quickly and installing new management? Clearly, if not, then a capital structure change might be less costly (in all senses) than a corporate governance revolt.
- Information disparity. How well can the prevailing capital structure monitor its investments and apply expertise to the data it collects? Can it take calculated risks, or does it just take risks.
- The efficient deployment of capital. Specifically, even if it has access to good information does the prevailing capital structure make smart investment decisions? So long as this is not the case one can not only profit by using the poorly spent capital to buy, at a discount, grade A infrastructure already paid for by the equity holders in the current system (since they likely overbought) but you can clean a firm up after the capital structure switch and re-inject it into the inefficient capital system at a premium (Ladies and Gentlemen, introducing the LIPO!). This works best when marketing plays a major role in the sale price of equity for the firm. Guess which capital structure suffers the worst from that state of affairs today.
- Access to buyout capital: This one should be self-explanatory.
Running over each of these briefly:
Management talent is being pressed out of public companies by the likes of Sarbanes Oxley and the general public sentiment that public company management are all idiots and crooks. (Ironically, a self-fulfilling prophecy).
As a risk-adjusted figure, management compensation in publicly held firms is falling.
Ironically, even with all the "reforms," few systems are less able to police poor management than the public equities market. The fact that special firms dedicated only to this disparity can make millions should demonstrate this well enough.
Stakeholders simply have too many filters between them and raw data to compete with, e.g., private equity shareholders.
As for the question "Are public markets 'smart money'?" I will leave this to Going Private readers to submit to their own delicate predispositions.
Access to capital? 2005 was another record breaking fund raising year for private equity. 2006 is even pretty strong so far. Jeff Matthews worries about rising interest rates with 3 month LIBOR at 5.50% today. Consider that the $20 billion buyout of RJR Nabisco was agreed to in October of 1988. Have a guess what the 3 month LIBOR was back then?
I'll try to cover the "what if" on Monday, maybe. Until then, signs of the imminent demise of buyouts as we know them? I think that Jeff Matthews is making those up.