Going Private

The Overlapping Roles of Private Equity and Activism

Going Private readers will, no doubt, be familiar with product and firm life cycles, characterized primarily by the "Introduction, growth, maturity and decline," patterns of expansion and contraction.  It will come as no surprise, then, that these life cycles apply equally to financial services firms, financial services products and capital structure driven acquisitions (LBOs).  The forces in the case of private equity are slightly different (credit availability and the existence of viable target firms and by extension of these two, available returns to LBO actors) but the cycle is equally valid.  I tend to think that there is a first derivative order to the cycle for private equity as well (as debt financing never really goes totally out of style as a product) and we should, therefore, not be surprised by the regular ebb and flow of private equity.

Perhaps we should be slightly surprised by the immense growth in the field in the last 24 months, but then again, perhaps not given the perfect storm of SarOx, low interest rates and multiple targets.  (At this point a quick pointer to the yummy Abnormal Returns' "Five C's" article and its follow-up seems in order).

Of course, it was fashionable to predict the imminent death of private equity as we know it far before I even began to pen Going Private, and the calls have continued unabated since.  (As a side note, this month is Going Private's one year anniversary).  After one of these back in August I postulated aloud that:

Mega-funds are the conglomerates of 2007.  Big, unwieldy, potentially unable to attend to their many daughters properly.  But most of them will live on.  Weathering a storm, perhaps, getting a belt tightening, but enduring.

The Economist, it seems, has quickly come over to my way of thinking as they penned this back in December:

Are private-equity firms the new conglomerates? The two look more and more alike. The dozen or so top private-equity firms have taken positions in an extraordinarily diverse range of operating companies, much as big conglomerates have done. Each week brings another batch of multi-billion-dollar deals.

But, even as these cycles work their cyclical magic on the economy, we have other forces joining in the fray.  Are poor performance issues marked by governance, inefficient capital structure and sub-optimal strategic initiatives best addressed by the harsh shocks of a surprise LBO?  Or are activist investors enough of a check on public companies to drive efficiency and solve agency cost problems?

The answer, of course, is that both play different if somewhat overlapping roles in keeping the management and/or performance of public firms in check.

With the release of Brav, Jiang, Partnoy and Thomas' paper, "Hedge Fund Activism, Corporate Governance and Firm Performance," we see both that activist hedge funds command abnormal returns of some substance (I predict a growth in start-up activist firms given the publication), and that they look far more like value investors (particularly in terms of their holding periods and target profiles) than they have been given credit for.  Their holding periods tend to be 2-3 years, in fact, before dipping back under the 5% metric.  This is, however, a far cry from the 3-10 year holding period that typifies private equity investments.

A 5% interest in a $5 billion firm is, of course, $250 million and the need to keep long-term holdings mean that borrowing is not practical for activist funds.  This means that in terms of size, all but the largest activist funds and the Carl Icahn's of the world are constrained to firms generally under $10 billion, though firms willing to press publicly and threaten proxy contests can accomplish their goals with lower stakes.  (Relational Investors only holds about 1.2% of outstanding common in Home Depot, the homebuilder store with nearly $85 billion in market capitalization, but has still managed to badger the beleaguered retailer into caving to all Relational's major demands.  Interestingly, this is over $1 billion in capital or over 15% of Relational's assets under management- a pretty serious concentration of assets in one bet).

These sorts of bets are well above all but the most determined, largest and cooperating private equity players.  The more interesting interplays exist in the > $7.5 billion market capitalization area, where the two genres have more interaction.  Reading the literature it becomes apparent that some of the highest gains in activist strategies are those where divisions or, indeed, the entire firm is sold.  Private equity buyers wait eagerly in the wings.  (Even now Home Depot struggles to shed itself of its commercial building business at the behest of Relational).  One more force to prevent the "maturity and decline" segment of the private equity life cycle.

Neiman Marcus or Needless Markup?

The Wall Street Journal points to payment in kind options on debt agreements or payment in kind (PIK) "Toggle" debt as a sign that the power in the hands of debt issuers is substantial.  The Journal wonders, are these tools helpful breathers for firms that stumble for a quarter or two, or dangerous multipliers of risk?

Both.

Payment in kind is the payment of interest on a debt instrument with more debt instruments (i.e. in kind), rather than in cash payments.  In effect, the interest accrues and is paid at a later date (usually the maturity of the instrument).  In my experience, non-switching PIK instruments usually sit below several other layers of more senior debt, and bear a higher rate of interest.  This should be intuitive to Going Private readers who will recognize that, lacking interest payments, PIK instruments are riskier for a lender to hold.  There is no canary in the mine for this layer of debt.  No missed payment to warn the holder of an impending default and therefore less of an ability to monitor the debt.

PIK Toggle instruments turn off interest payments and switch to PIK interest at a particular time, perhaps at the option of the issuer.  This was the structure of the example the Journal uses, in which Neiman Marcus was granted $700 million in PIK Toggles, the interest payments of which could be switched off at Neiman's option to reduce the debt burden on the company in a time of difficulty.  The interest would accrue at a higher rate (9.75% v. 9.00%) when the instruments mature in 2015.  Neiman would hardly be off the hook even if they flipped the toggle.  They started off with $3.2 billion in debt so turning the PIK on would increase their cushion, but not eliminate payments by any means.

One assumes that the increase in interest rate on the debt in question would provide a strong disincentive to flipping the PIK on unless the situation were dire, and we might also assume that, since the PIK would only be activated if the company were nearing default on interest payments due to collapsing revenue or unanticipated costs, the lender would expect to have the debt paid via a refinancing on maturity (or perhaps a LIPO).  (Certainly the cash would not be sitting in the company's coffers at that point).

Indeed, we can see that PIK toggle permits struggling firms to "live to fight another day" when they are staring default in the face, but this begs the question: should they be able to?  After a fashion, a PIK Toggle bypasses the events that typically signal default and, by proxy, indicate that the firm has become a distressed.  Though we may sympathize with management, giving them more rope to hang themselves and charging nearly an additional percentage point for the pleasure might not always be the best option, as opposed to taking the keys and imposing more drastic fiscal discipline via the debt recovery department of the lender.

The other thing that concerns me about the practice is exactly what Texas Pacific likes about it.  To wit: ""This innovation was one factor enabling us to pay a more aggressive price."  This should, of course, be read: "This innovation was one factor enabling us to assume much more debt that would otherwise have been prudent."  Really, what the PIK layer did for Texas Pacific and Neiman was increase the amount of debt that could be assumed to beyond what would have been prudent if the interest payments could not be turned off.

Far less safety margin seems required when PIK instruments are used and it is quickly tempting to push the limit to win auctions.  It is, perhaps, telling that, "Nearly every TPG deal since Neiman Marcus includes debt with the PIK toggle feature."  It's easy to forget that the effect of a PIK Toggle is to dramatically increase the debt burden on the company at a time when it is already showing signs of difficult with the existing levels.

The good folks at GoldenTree Asset Management are mentioned poo-pooing PIK Toggles.  Sub Rosa has done some work with GT folks and they do love their PIKs, at least in my experience, but they just don't toggle them much.

Used prudently, PIK Toggles seem like a decent tool to hurdle a speed bump or two in the road.  I suspect, however, they cause some rather severe damage to the rims of the faster driving deals out there.

Throw a PIK

R, a loyal reader, writes in to point out some other perspectives on PIKs.  Quite sophisticated perspectives, it turns out.  Readers will recall that we wondered after Payment in Kind (PIK) debt instruments which accept repayment of interest "in kind" with more debt instruments.  In effect, the interest payments accrue until the maturity of the PIK instrument.  I wondered aloud the other day if this didn't encourage more borderline lending and reduce the circuit breakers available when a firm starts to have problems paying its debt.  Let's face it, if you have to turn a PIK Toggle on, it's because you can't pay your debt.

R prefers, however, to think of PIK as equity.  Preferred stock, almost.

They don’t cross default, don’t sit round the table, are covenant free and have no security. Its equity all but for the maturity date.

R points out that the lender doesn't care if PIKs get loaded up like crazy.  She's going to be paid off before the bulk PIK becomes due anyhow.

Sponsors, however, quite like the toggle.  They want to stop, as R puts it and I paraphrase here, "sharing equity returns with that fucking PIK as soon as possible."  It's not that PIK Toggles were invented to reduce debt payments so as to leave off the company at a delicate time, but rather to start paying off that PIK early if possible so as to boost equity returns to the sponsor.

The lender would far prefer to see that PIK Toggle switched off, in fact.  Less cash out to the PIK holder, more reserve and hold-back cash for the lender with a big chunk of senior debt to look at and sign to herself "ah, look at that lovely cash cushion."

A quick example might be illustrative:

Let's assume we have a Neiman like transaction.  $2.6 billion purchase price, About 25% of the debt structure is in a PIK Toggle.  Let's assume about 25% of the purchase price is paid for in equity (a 3:1 debt to equity ratio) and that, for the moment, there's interest only payment on the PIK.  Let's also assume that the PIK Toggle does not trigger an interest rate increase if switched on.  We'll set the first year to 2007 and put a 8 year maturity on all the debt instruments.  Further, let's assume that the sale price of the company is exactly the purchase price.  (In other words, no multiple increase, no revenue/earnings increases- this should isolate the effects to the financial terms).

Just pulling the interest off of the PIK over the 8 year life of the debt boosts the equity returns from an IRR of 12.25% to 15.95%.  You can see my error riddled spreadsheet on the example here.

Sayeth R:

Don’t get me wrong – I think PIKs are typically a toxic piece of paper to hold, but they are toxic only to the holder of the PIK and, if done wrong, the sponsor. The audience for such paper is a small and fully market savvy group; they know the risks – the odd cowboy hedge fund excluded.

One of These Things is Not Like the Other

It is simply amazing sometimes to compare different publications and their take on the news.  More so when international borders are thrown into the mix.  Usually, it seems to be political leanings that fix the timber of headlines, so it's amusing when it's something else.  Like cultural views on regulation.  So we aren't surprised when CNN highlights the White House connection (and the article is found just below the leader "Man With Sword Mistakes Porn for Rape"), when the Wall Street Journal points to the capitalist personality, Paulson, in its lead, when Fox News makes it all about promises and commitment, and when the Financial Times is in its own little world.

Wall Street Journal: "Paulson-led Group Suggests No New Hedge Fund Regulation."
CNN: "White House group: Hedge Funds Need No New Rules."
Fox News: "Government Pledges Vigilance Over Hedge Funds."
Financial Times: "U.S. Hedge Funds Face New Guidelines."

Why Social Investing is the New Tech Bubble

A slew of recent missives of a quantity sufficient to lead me to believe that printing ink, and not spit, issues forth from the hyperactive salivary glands of "the left," at least now that they have been stimulated, in Pavlovian fashion, by the distant ring of non-zero probabilities which suggest that they might, just might put their grubby little mitts on the magnets necessary to skew the moral compass of the United States to a direction more to their liking (but far again from magnetic north) makes it fairly clear that a massive press for "ethical investing," "social investing," "green investing," "stakeholder democracy," (quite a different animal from shareholder democracy mind you) or whatever you would like to call the new market corrosive noise, is just around the corner.  Be afraid.  Be very afraid.  You would think the likes of the UAW would have learned their lessons, but I assure you, they have not.

As a rule I avoid political discussion in the entries that comprise Going Private unless they have some direct bearing on finance.  I find it, however, almost impossible to keep ignoring the literal onslaught of anti-capitalism that glares menacingly at us from the other side of the looking glass.  I can perhaps be fairly accused of too many viewings of Richard Dawkins' work now that I have taken it upon myself to use these pages in sounding the alarm that the most palpable threat to capitalism and free market economies is poised to spring a lethal ambush in an environment well calibrated to multiply the damage.

We are faced with the most basic of conflicts.  Between rationality, reason and scientific method on one side, and the mud-like foundation of "ethical conduct" or "social responsibility," on the other.  This basic conflict, between the lighter forces of knowledge and discovery and the darkness of ignorance by design and demagoguery, is likely to be the defining cultural exchange of our era, and one that spans disciplines from economics, to politics to morality.  Or, perhaps, it is merely my intoxicating cocktail of a long hospital stay, constant pain and narcotics.

Some time ago, Jon Entine penned "What Should Bill Gates Do?" (subscription required) in the Wall Street Journal, a piece that highlights what must be the most important observation yet penned on the folly that is "social investing," namely that:

The dark secret of "social investing" is that it is neither art nor science: It's image and impulse. It reflects perceptions, not performance.

Why?  Because:

The social investing community also suffers from the hubris that it can separate the good guys from the bad guys.

We would do well to remember that when capital allocation decisions are made on criteria other than underlying economic prospects or value that it is the mob, more than economics, that rule returns.  That which was popular (though impractical) as a business cause last year may well find itself out of favor and without any economic merit this year.  (Some of the denser ethanol projects I have seen recent come to mind).

I ask you, where is my political party?  The fiscally conservative party with the goal of reducing government size by 25% in ten years?  The party that has absolutely no position on religion at all, and doesn't intend to discover one in my lifetime or that of my children to be?  The party that doesn't care who I sleep with or how.  The party that isn't dense enough to start taxing "windfall profits" on the firms that seek out the scarce energy supplies required for the country to grow at a reasonable pace over the next 20 years?  The party that won't regulate the United States out of global capital markets?  The party that won't fuel the Social Investing bubble?

The Benefits of Ruthlessness

A loyal reader, "S," joins with me in frowning on "social investing," and backs up the collective distaste in our mouths with some interesting data on portfolios borrowed from the always entertaining Long or Short Capital.  Long or Short's semi-famous "Satan's Portfolio" is the hedge against the Pax World Funds nonsense, and a good thing too.  Looking at the graphic S forwarded me, it is pretty obvious that "investing" in Pax World Funds amounts to giving your money to charity, but without the tax deduction.  Still, perhaps you need some capital losses to carry forward?

Reader Mail

Self-confessed Stanford Grad (first step in getting better is admitting you have a problem) writes:

I noticed your general disdain for "social investing" and wasn't sure if you were condemning the entire industry.  While "socially-responsible investing" is mostly counter-productive, a new group of investors are trying to fund social goals (priority #1) and generate above market - 10%-15% - returns (priority #2).

Good luck.

Drama Queens to the Floor, Please

I recognize that it was a dramatic day for some people yesterday (mostly, I expect, the people who had forgotten- or perhaps are too young to have ever seen- what a dramatic correction looks like and those without anything resembling a hedge against dramatically long equity positions) but DealBreaker points us to a bit of dramatic evidence that a few of us are ill-prepared for anything like a dramatic (or, indeed, a moderately dramatic) financial shock.  In response to dramatic fluctuations today in shares of Goldman Sachs (which, do remember dear reader, was trading dramatically between $194 and $210 at the time) one (mercifully, self-preservingly anonymous) floor trader moans:

Goldman fell six bucks. People were going nuts. There were no bids for five or six points. We haven't seen that kind of thing for years. This was no high-flying tech stock. It was Goldman-fucking-Sachs.  For a minute I wondered if they had blown up Broad Street. Maybe Goldman Sachs no longer existed.

A six dollar drop in Goldman?  How perfectly ghastly!  It is positively enough to give a girl the vapours!  I mean really, what can have been expected of you in a moment like that?

One would suppose- erroneously, it would now seem- that those on The Street were made of sterner stuff than this.  The testicles on the famous bull are, after all, made of bronze last I checked- no?  Perhaps, oh, anonymous aspirant to big swinging schmuck status, you better run out and get some duct-tape and plastic sheets for the imminent biological attack, too.  I am certain, however, that once you recover from the shock, say, Friday afternoon or, perhaps, Monday morning, it might be a good time to go long on Anthrax remedies and buy those ethanol stocks "on the dip," right?

Well, I suppose it is for the best.  A 4% correction to wake people up a little might have been a good idea if this is the kind of propensity to lightheadedness that lurks out there.  After all, it could have been something serious.

I should like it quite a bit if we saw some nicely public (but controlled) hedge fund blow ups.  Great time to filter out some of the lightweights and see who was paying attention (or more interestingly, who wasn't).  What faces the U.S. markets today remains to be seen but, I assure you, from the midst of my convalescence here on the other side of the pond and fast in the grips of the warm enveloping anesthetic of my morphine drip machine (yuuuuummmmmy...) I eagerly await the early dispatches- any hint you detect of efforts on my part to avoid looking smug is entirely the result of your overactive imagination.

Oh, and that reminds me.  I think I will cover my Goldman short today.