Continuing Going Private's shamefully incestious link-sex with Abnormal Returns, today it points us to a slightly more masturbatory bit of link-sex in the form of a DealBook piece in which Andrew Ross Sorkin cites an Andrew Ross Sorkin article (registration required but entirely avoidable as Andrew Ross Sorkin has thoughtfully copy-pasted the Andrew Ross Sorkin article in the New York Times into Andrew Ross Sorkin's DealBook entry) on the often unrecognized long-term holding strategies by certain buyout shops in the private equity world.
Says Sorkin, citing Sorkin:
But while private equity firms may be larding companies with debt, they aren't dumping them as quickly as you might expect.
Buyout firms often stay at the party much longer than critics acknowledge because public offerings don’t offer an immediate way for firms to generate big returns and attract new investors for future deals.
The firms typically have lockups that prevent them from dumping their shares, and it often takes them several years to sell their shares — if they do so at all. The firms that own Hertz will retain an 80 percent stake in the company after it is public.
Few people have acknowledged just how many private equity firms have ended up remaining big investors in companies after taking them public again. Little noticed — or at least little noted — is the fact that “tens of billions” of private equity dollars, according to Thomson Financial, are now floating around the public stock market.
As with most DealBook entries, this DealBook piece is not least remarkable for the reappearance of the previous butt of thinly veiled Going Private jabs, the wonderfully bitter and disillusioned comment gabster "Dr. Mark Klein" who would offend your author more if not for his inability to conceal an unending disdain for that backbone of capital markets, the investing public. The good doctor whines:
Makes perfect sense private equity firms hang around longer. Today’s endentulous SEC allows the looting to continue until enough suckers are rounded up to buy the new common.
The John Q Publics are too sedated by sex, booze, gambling, and entertainments up the wazzoo to notice.
Modern version of Britain’s 19th century Opium Wars which enabled them to loot China.
I'm not sure which delusion of grandeur I prefer, comparisons of Google to Napoleonic France by The Economist (subscription required) or the metaphor, albeit soiled with a barely disguised reference to sodomy and poor understanding of the actual history of the Opium Wars, comparing private equity firms with rank extraterritorialism disguised as trade dispute. I suppose I have to pick the Google comparison, as the private equity / illicit drug reference is old hat around here at Going Private. (In fact, quotes from the Caryle Group's David Rubenstein referencing leveraged (read: dividend) recapitalizations as "the cocaine of private equity" tempt your author to get an even bigger head imagining the various luminaries of buyouts waiting with baited breath for the next Going Private entry, or more likely, ordering their assistants to print out the articles and leave them on the club seating in the Gulfstream V for the jaunt down to Anguilla).
Sorkin has managed, however, to hit an important point. Certainly, leveraged recapitalizations used to pay large dividends to private equity shareholders, particularly when followed by Going Private's favorite new term of art, the "Leveraged Initial Public Offering" (LIPO), are viewed as opportunistic transactions by large buyout firms. The resulting payments often, and likely this is not coincidence, look very similar in size to the initial equity outlay made by the buyout group, or (in more sophisticated cases) the initial equity outlay with the firm's targeted IRR tacked on top (see e.g., Blackstone). I've been calling these large self-payments followed by a LIPO "LIPO Suction," after the giant sucking sound employees hear if they are near the CFO's office.
Sometimes, however, what appears to be shameless profiteering is the order of the day. Sun Capital quietly leveraged daughter firm Hub Distributing Inc. and took a $71 million dollar dividend after only 16 months and on an initial equity investment of $2.3 million. On its face this is offensive, until you realize that Sun Capital managed to increase Hub's EBITDA by 300% or so. And even in the absence of such improvements to EBITDA, I believe it difficult to make logical criticisms of the practice. And, as Sorkin indicates, critics often ignore the long term interest private equity firms have in the continuing operation of the business. As if buyout firms were disinterested enough in hitting their IRR that a dividend recapitalization move that merely limits their downside without providing the targeted return would remove their incentives to attempt to grow (or salvage) the business.
Expecting private equity firms to look out for lenders or anyone else is a silly expectation. In the case of closely held LBOs, as results from most buyouts, the people with standing to complain (i.e. the shareholders) are making the dividend recap decision in the first place. I often hear the argument "yes, but the business is already on shaky ground, why would you lever it up?" I can't imagine why you wouldn't. Given the opportunity to pull risk off the table for the shareholders, i.e. return the initial investment- or even more, in the face of potentially deteriorating business, why would you ever leave the money at risk when you could protect the downside to a break-even (or better) level and still maintain upside in the continuing operation of the business? To do less would be to sacrifice the interests of the shareholders in favor of the lenders who might be harmed in a bankruptcy. This requires the assumption that these lenders need to be protected from themselves. That is, in my view, dangerously paternalistic.
There are already tools to deal with leveraged recapitalizations that "shock the senses." After Bain Capital took a $84.5 million dividend payment from KB Toys using a leveraged recapitalization for more than a 350% return on their equity investment and then tossed the firm into bankruptcy protection, lenders sued, recently got the go-ahead to make fraudulent conveyance claims against Bain and are now demanding the return of the payment. I will watch that case with interest.
Shifting the analysis to public or about to be public firms, many critics of LIPO suction complain that companies are badly weakened before they IPO. These critics strike me as even more insulting to the investing public than Going Private's occasional barbs, or the even curmudgeon "Dr. Mark Klein" (who appears ready to label Jim Cramer fans as evil drugged-out sodomites- though I suspect this suggestion means Dr. Klein owes an apology to evil drugged-out sodomites). Are we at the point where we believe the investing public unable to understand debt ratios and credit ratings? For they seem to flock to LIPOs regardless of these statistics. Are we confusing an appetite for risk with stupidity? Headlines that read "flippers leave Burger King IPO investors holding the bag" confuse me for this reason. Either the investing public is smart and some fraud involving non-disclosure of debt obligations has been committed, or they are dense and who do we blame for that? (The baby boomers and sex education, according to Dr. Mark Klein).
Comments from the likes of Standard & Poor's Steven Bavaria to the effect that "...we are trying to shine a light on an area of the market that was previously opaque," make me wonder what sort of investors S&P thinks are out there.
So are we surprised when private equity firms employ complex but entirely legal structures (say, a recapitalization with holding company preferred stock as collateral) to assure riskless profit to their limiteds (to which they owe a duty) and themselves? Are we to blame sophisticated lenders for the loose state of the credit markets? Were they unable to price the loan properly? As if they are equally inept as llamas when it comes to assessing and hedging risk? Should we point at collateralized loan obligation instruments as an evil? Surely they must be opaque and illiquid instruments that befuddle and victimize the horribly financially naive victims like
Stanford University of Chicago MBAs who studied under Eugine Fama and who hold a concentration in debt instruments.