Wednesday, April 26, 2006

The Cable Guys

wenn er dich verkabelt... gehoerst du ihm Back in January 2005, Blackstone and CDP Capital partners scooped back on the order of 75% of the funds they loaned to their portfolio firm, Kabal Baden-Wurttemberg, then Germany's third largest cable firm, via a Morgan Stanley, J.P. Morgan and Citigroup sponsored public offering of €170 million in debt with a coupon rate at the time of 9.504%.  It was 7.36% over the 3 month Euribor rate which was 2.144% at the time. (You can find great historical Euribor figures on Euribor.org).

They also laid bank loans of around €670 million on the firm.  All this meant that senior debt was used to cash out around €320 million in subordinated shareholder loans (by KKR and CDP) and that the Debt:EBITDA ratio was pushed to in excess of 6:1).  To put this in perspective it is a triple C rating in Europe, the default rate of which is on the order of 33%.  There is an interesting article on this in the Journal (subscription required).

Back then Blackstone held around 60% of KBW, CDP had tagged along on the deal for the remaining 40%.

Years before, in June of 2000, Blackstone arranged the acquisition of a majority stake (55%) in KBW structured with a Luxembourg entity (Callahan InvestCo Germany 1 S.A.R.L.) that was, in turn, owned by Callahan Associates International LLC and individual investment vehicles of the participating private equity funds.  Deutsche Telekom AG, the original state owned owner, held the rest.  There was also the structural involvement of Barbarossa 1 GmbH (setting aside for a moment the wisdom of naming a German acquisition vehicle "Barbarossa") that we will ignore for the moment.

Remembering that a major crash in telecom had badly depressed the European telecom industry, it is illustrative to note that almost all the major players in cable in Germany (and, indeed, Europe) are presently held at least in part by U.S. private equity firms.

To give a comparison, Goldman Sachs Capital Partners along with Apax and Providence originally tossed €663 million into Kabel Deutschland (Germany's largest) back in 2003 and had collected €1.58 billion in special dividends as of February 2005.  Quick analysis: IRR of 56.97% before the value of their equity stake is calculated.  (Though this assumes the dividends were a lump sum in February, and they probably were not).

Special dividends in action, again.

Today, the Journal is reporting (subscription required) that Blackstone has agreed to sell KBW to clear the way to acquire 4.5% of Deutsche Telekom (a competitor to KBW that probably would have caused antitrust issues for Blackstone).  I would love to get a hint at the terms and figure out what Blackstone's returns are.  On top of the 75% recapture of their loans to the unit, I suspect they've done quite well.

It is interesting, again, from a risk shifting perspective.  What was Blackstone's real exposure to loss after the public debt issuances?

Private Equity Collars

hercules and cerberus Says the fast food vendor of financial journalism, BusinessWeek of the GMAC-Cerberus deal: "Feinberg [Cerberus' manager] won the day in part by accepting risks that every major bank and marquee buyout firm that GM approached about the deal turned down."

Oh?  It is not entirely clear to me that Cerberus took on much risk here at all.  I am not alone in this view either, it seems.  The stereotypically yummy Abnormal Returns cites DealBook, citing an Institutional Investor article citing Clay Lifflander, President of New-York based hedge fund, Millbrook Capital Management who opines:

"Looking at it, people are having such trouble putting capital to work. It’s clear to me [Cerebus] is betting the ranch in terms of their reputation. They clearly didn’t get this [money] from their fund; they had to go to their limiteds and get co-investments."

He continues:

I’m starting to think about the dynamic of what’s going on in the [private equity] world: If you have a very limited downside but execute a [business] plan and make a double or triple on one of your deals when no one else would, you look like a genius.

Remember the Cerberus guys are distressed debt guys by origin. And distressed debt guys are really good at protecting their downside and buying low. If it doesn’t work out, they don’t get hurt that bad. If it does work out they get huge pops. That’s their game and this one looks like [Stephen Feinberg] did a pretty good job on it.

There was a time in the height of the 80s buyout crazes where management acumen was less important.  Financial structuring was the key to making double and triple digit returns.  Load on the debt, streamline waste, exit.  The interesting property with buyouts through, say, 2005 is that the addition of "management excellence" was required to meet the same goals.  It is beginning to look to me like this is less and less the case.  Financial structuring (along with the public debt markets, IPOs and special dividends) are all that is required to capture massive returns.

Well, there may be one other element.  As I obliquely implied out in my earlier entry today on cable acquisitions in Europe, a long view might also carry the day.  Buy in when an industry is on the outs, impose "adult supervision" even in the face of embedded cultural impediments to anyone doing "real work" (ahem, Germany, France), lend to your acquisition when no one else will to keep it afloat long enough for the recovery and then reap 50% IRRs, even in the face of a 5 year investment wait.  This is what an LBO is supposed to look like, I believe.  GMAC is a far different flavor of deal.  Why?  Hedgefund buyer?  Vegetable Capital?  The flood of cash that has poured into deals?  All three?

Art: Hercules and Cerberus, artist unknown, Musée du Louvre.

Thursday, April 27, 2006

Accelerated Decrepitude

death visits the firm early The Journal today opines predictively (subscription required) that the life cycle of firms may be accellerating in a progeriaesque compression of product cycles.  (You have to love a financial publication that uses child diseases as a primary metaphor source.  Still, since they are talking about Google, I forgive them).  They use a few "how the mighty have fallen" examples to point out that, among others, Dell, once the poster firm for speedy revenue rampups, is perhaps at its zenith and the beginnings of a slow decline are in the works.  Shades of Stephen Keppler, Michael Gort, and a revival of the Boston Consulting Group box.

Yesterday I touched on the potential benefits a long-term focused buyout firm can bring to the table in the world of short-term incentives (read: public equity markets).  While the current flap over executive pay packages might press more long-term incentives into more frequent service, that doesn't address the current ratings addiction the market seems to have for analyst calls and quarterly earnings reports.  Reading the Wall Street Journal article, titled "Management à la Google" I thought perhaps this is where its author, Gary Hamel, was heading.  Google better watch it, decline could be around the corner.  Their own CFO has warned in this direction.  Not so fast.

In many cases, companies haven't been changing as fast as the world around them. What the laggards have failed to grasp is that what matters most today is not a company's competitive advantage at a point in time, but its evolutionary advantage over time. Google gets this. While Google's growth will inevitably slow, there's a good chance that its revenues will arc upward for years. Why? Because its novel management system seems to have been designed to guard against the risk factors that so often erode an organization's evolutionary potential...

You just lost me.  And I'm not coming back.  But wait, there's more.  Hamel outlines the ways Google is superior:

Evolutionary risk factor #1: A narrow or orthodox business definition that limits the scope of innovation. Google's response: An expansive sense of purpose.

Read: A complete lack of focus driven by Google becoming a capital deployment tool, not a business, the result of having too much cash- didn't I read recently that Google is competing with venture firms to snatch up "promising firms"?  Mark Cuban, where are you?  I have finally found a purpose for you in my world.  Your second 15 minutes are here.  Surely you have some hyped crap to sell Google that is encompassed by their "expansive sense of purpose"?

Can this really be the same Gary Hamel?  The Gary Hamel who introduced the concept of "core competency" in a, quite famous, Harvard Business Review article?  The same author who defined core competency as "...an area of specialized expertise that is the result of harmonizing complex streams of technology and work activity."  Apparently Google's specialized expertise is "an expansive sense of purpose."  Ugh.

Evolutionary risk factor #2: A hierarchical organization that over-weights the views of those who have a stake in perpetuating the status quo. Google's response: An organization that is flat, transparent, and non-hierarchical.

Read: The smartest guys in the room.

Evolutionary risk factor #3: A tendency to overinvest in "what is" at the expense of "what could be." Google's response: A company-wide rule that allows developers to devote 20% of their time to any project they choose.

Read: More vaporware.  No adult supervision.  Didn't we learn our lesson on this already?

Evolutionary risk factor #4: Creeping mediocrity. Google's response: Keep the bozos out and reward people who make a difference.

I absolutely KNEW dot-bomb poster boy Guy Kawasaki was involved here somehow.  Cap this concept with the next quote:

Elitism may be out of fashion, but Google is famously elitist when it comes to hiring.

No, we're not done yet.  The unthinkable is just around the corner.  He actually moves to steal from Guy that which Guy stole and which was stolen before it was stolen before that:

A-level people want to work with A-level people. B-level people are threatened by class-A talent. So if you let a B-lister in the door, he or she will hire equally unremarkable colleagues. As the ranks of the mediocre expand, it becomes harder to attract and retain the exceptional. The process of dumbing down becomes irreversible.

Is anyone EVER going to cite Leo Rosten for this pirated bit of wisdom?  Ever?  Spare me.  Does this actually pass for management acumen today?  I was whining about this not a month ago.

Some time ago, mid to late 1990s I think, I remember seeing a picture of one of the Yahoo! senior folk (founders?) standing on the floor of the NYSE (or perhaps in NASDAQ offices but I'm pretty sure it was the NYSE, that was part of the joke) wearing jeans and a bright t-shirt with the phrase "You're shit." in big block letters on the front.  Are we back in 1995?

What is it about Google that erases memory and convinces those who should know better that "it's different this time?"  The rules no longer apply.  It's the new, new thing.  The Google reality distortion field.

Problem: Cycles are faster, threatening to leave firms behind.  Solution: Relax focus, do a lot of things marginally well, be a player everywhere, fail to be a leader anywhere.

Let's do the time warp, again.

Enron, Overhang and Private Equity

marky mark to market Truth on the Market, that I was once again led to via Abnormal Returns, discusses the quandary of interim valuation of private equity portfolio in the context of the growing clamor for private equity "regulation."  Two issues are presented as problems.  1. The lack of true time-series volatility information for private equity as an asset class.  As to this issue Bartlett cites no less than David Swensen, Chief Investment Officer of Yale's endowments, who quips:

By masking the relationship between fundamental drivers of company value and changes in market price, illiquidity causes private equity’s diversifying power to appear artificially high.

2.  Valuation during the course of the investment is difficult, because of the lack of data points to measure progress during the lifetime of the firm.  On this point Mr. Bartlett says:

Consequently, it’s not possible to obtain a current value of these securities as you would for, say, shares of IBM. Moreover, many of these companies—particularly start-up companies—lack reliable financial metrics that can be used to value the firms using other valuation techniques (e.g, discounted cash flow analysis, etc.).

Is the answer "mark to market" accounting a la Enron?  Bartlett isn't totally convinced.  I, however, am totally puzzled by this line of thinking.

As to the first point, I am not sure why the inability to value a given single fund in a mid-stream has a deleterious effect on the ability to measure standard deviation for the asset class as a whole. In the buyout example, first of all, it strikes me that results from a fund of funds composed of multiple buyout funds of multiple vintages will give a consistant stream of return information that is better representative of the asset class.  As each fund starts disbursing in its later years these returns become measurable on the upside.  On the downside, impairment is often a triggering event.  Unless you were constructing a particular portfolio of single buyout funds (which I suppose Yale may well do) I don't know why you would even want to collect individual fund data.  That makes a poor sample size if what you are looking to do is measure correlation figures for an asset class.  I would think you'd have better luck using a reach of the segment of funds you were interested in, or, perhaps, viewing returns over time for a family of funds.  If you properly layer your investment among multiple vintages you mitigate, to some extent, the lower volitility measurements of your early capital investments.  While two to three investment sis are the 1-3 year early "black hole" of zero-volitility, 4 or more others (assuming you have one of each vintage year for 7 year lifespan funds) are showing results and distributions.

As to the second point, being unable to value particular portfolio firms within, say, a buyout fund, doesn't really strike me as a severe handicap.  If you've invested in a private equity fund you are tied in for the duration with lockups anyhow.  You can't effectively exit your money so monitoring or marking your own investment "to market" is silly.  Your funds in the find are just as illiquid as the fund's investments in portfolio firms.  If you weren't comfortable with that you never should have invested in the fund.  Marky Mark to market?  Sexy, but dangerous.

Once again, this drive to make highly granular observational assessments of what are essentially long-term investment vehicles threatens to turn the buyout world into the quarterly naval gazing, short-term, noise knee-jerking morass that are the public equities markets.  This defeats the entire purpose of the private equity vehicle: A long-term investment (hence the lock-ups) for sophisticated investors in an area where long-term patience is required to realize superior returns.  It is an alternative to the what have you done for me lately public markets for a reason.

In my view two external pressures threaten to cause serious damage to a market that, properly managed, imposes significant efficiency gains.

First, the flipaholic or "div and dump" or "div and flip" or "div and shiv" (give yourself a dividend and stick a shiv in between the ribs of the public) trend in large buyout funds to quickly lock in minimal gains via public debt issuances coupled with massive special dividends and then, having significantly limited downside risk, lock the unit basically in status quo "don't fuck it up" mode until a public equity market exit can be arranged.  (I tend to think Burger King's CEO bailed because he was so disgusted with this practice, but I am probably leading myself down the prim rose path here).  This trend has turned buyouts into a very risky, short term affair.  It was never meant to be.  The era of "financial structure only" returns for buyouts is over.  In the 1980s, break-up was the exit.  Today it is the public debt issuance and IPO.  What happened to management excellence?  Too hard.  Too speculative.  To risky, I suppose.

Second, the blurring of the line between "private equity" and "hedge funds."  To my way of thinking this confusion originates on the hedge fund side.  Certainly buyout shops don't want to be associated with hedge funds.  Rather, I think the Madonnaesque hedge funds have reinvented themselves as anything but hedge funds.  Venture capital, private equity, buyouts, mezz funds.  Anything.

Both of these are symptoms of the larger problem.  Too much money in the asset classes.  Overly high expectations on return by a spoiled market saturated with Business Week articles about the super-rich managers taking billion dollar payouts.

I heard a senior person at Centre Partners Management comment that $750 million was about the upper limit for buyouts before you started to be not in the business of doing deals but rather in the business of just farming out money.  I think that's about right.  Focus.  The leveraged desk at a big hedge fund we take debt from is five people.  (That same firm has six full-time lawyers on the payroll).  They have deployed something like 1.5 billion in high yield debt in LBO deals.  How in the world are they going to monitor that?  I suppose the hedge fund would call that efficient.  For my part, I'm happy to take their debt because they don't do much monitoring.  It is not that I dislike monitoring, but they sure are easy to deal with day-to-day.

Didn't we learn in the 1980s that unfocused conglomerates don't work particularly well?  Why are we running down that road again, with hedge funds, with Google?  Management fees, perhaps?  We are long past the point where the management fee just barely pays the bills at a fund and you have to find upside to get wealthy.  The incentives to bloat assets under management are simply too significant now, I think.

All this has prompted me to start a new internal project.  How will we, at Sub Rosa, best capitalize on the detritus of large, overly diverse funds in a few years when they collapse under their own weight?

Friday, April 28, 2006

Control, Liquidity, and "The Deal"

separated control from the king Augmenting the three day blitz on private equity regulation, liquidity and valuation, DealBook today points to an article on Investment Dealers' Digest that outlines the growth in the secondary market for private equity interests.  Says IDD:

The secondary private equity market that is taking shape today is more than simply a larger version of that of five or 10 years ago. The business is in the midst of a sea change-and a shift in the balance of power between buyers and sellers. But despite increasing liquidity, the market remains extremely opaque. And for the most part, general partners prefer to keep it that way.

I think the development of a stronger secondary private market further deadens the liquidity concerns and the valuation issues I touched on yesterday.  Obviously, a well developed secondary market provides liquidity, and gives more valuation data points.  It probably does not do so in the early stages of new funds (as I doubt interests often come up for sale in those stages) so that problem remains thorny.  That is, if you think it is a problem.  Personally, I do not.

A brief review of the theory of the firm is perhaps in order.  I've done it before, but a second pass is probably a good exercise to undertake.

The background that underlies corporate structure is specialization.  Those with capital don't always possess management expertise.  Those with management expertise don't always possess capital.  This is a critical concept.  Let me say this again in another way, because it really is critical.  Just because you are rich, doesn't mean you are smart.  In fact, there might be a negative correlation.  (See e.g., Mark Cuban).  Aside a few, exceptional, dynastic Italian families that bore exceptional eldest son after exceptional eldest son for five generations in a row, a lack of specialization locks a firm into (and therefore limits a firm to) the management abilities of the capital holder.

We solve this problem today via a corporate form that separates ownership from control.  Generally, this is a "good thing."  With a healthy market for corporate control and general liquidity of investment, capital holders have a wide variety of options in which to invest.  Careful selection combined with some speculation should permit capital holders to avail themselves of the best managerial talent, and concentrate their efforts on whatever other thing it is that they do best.  It is important to note that "whatever other thing it is that they do best" could easily be professional wine drinking, collecting expensive and beautiful silk panty garments, or simply the pursuit of plain 'ole debauchery.  Their incompetence is no longer particularly relevant to the economy.  We have removed it as a drag on assets.  Their large gains on their investment, made possible by specialized and outsourced managerial talent, boost the local economy via their equally large expenditures on frivolous parties, lavish dinners, opulent estates, and etc.  Of course, if they are actually good at something, their time is freed from managing their own investments and they can be productive at what they do best or most enjoy.  (Hopefully this isn't buying and manging their own sports teams and in turn creating massive losses).  Underestimating the impact of the introduction of these sorts of economies in the seventeenth and (more so) the late eighteenth century would be a serious error.

As a consequence of the separation, managerial talent can be "poor, smart and hungry" (thank you Gordon).  They can, with no pedigree whatsoever, rise from the dust through pure merit to succeed.  Their merit is measured simply: financial returns.  Let me distinguish "financial returns" from "wealth."  Wealth requires nothing more than birthright or the selection of a certain 6 random numbers on the right day to acquire.  Accumulated wealth is the wrong (but increasingly common) measure of financial acumen.  Occasionally, large windfalls (and I mean this in the truly random sense, not the recent, politically motivated oil profit redefinition) land in the laps of total idiots.  What is important is what they do with it.  What is important is their return on assets, not the size of the assets.

I strongly suggest those interested in these underpinnings do some research into the massive sociological and cultural changes that occurred during e.g., the transition between the Baroque and Enlightenment periods.  It was the rise of individualism in the face of the centralized power of the state and the aristocracy that broke down the caste structures in a way that permitted a "mere merchant" to act as a King's agent, for instance.  It is the kind of thing that permitted Armand Jean du Plessis, born only to lesser French nobility, to become "Cardinal Richelieu," the financial and political powerhouse behind Louis XIII's dynamic reign.  Appreciating the unprecedented nature of this agency relationship is both important and difficult.  Louis XIII effectively ceded all the financial decisions of the French Empire to Richelieu at a time when the centralized power of the monarch approached absolute.  It was both a departure and counter to the social norms of the day.

A full understanding of these social changes and the rise of individualism in this context is essential, I believe, to grasping the importance of these concepts, and to understand where we might be stuck today without them.  Without an understanding of this basic premise an understanding of the theory of the firm is incomplete.  If you are a glutton for punishment you might even read Richard Evans' political biography of Caius Marius' whose reform of the Roman legions from a strictly caste based military system into a citizen army opened the way for Rome to meet the many military challenges that would follow.

There are, of course, complications related to the separation of ownership and control.  Agency costs, as they are known, are perhaps the most thorny.  Simply put, how can we be sure that the agent is acting for the principal, rather than in self-interest?  The modern answer is that we impose some duties on the agent.  The duty of care.  The duty of loyalty.  As a result the playing field looks like this:

Capital holders have a variety of fairly liquid options and a variety of illiquid options in which to invest.  They go into these investments knowing that they are appointing agents to mind their capital and direct it.  There should be no surprise to the holder of a public security that they do not have much power over the decisions to manage the firm.  They can vote on a variety of corporate actions including the election of directors.  Their vote is proportional to their holdings.  Some votes are binding.  Some are not.  All of this is fairly carefully laid out in the by-laws and other charters of the corporation.  It is not a mystery that compelling the management to change the color of the walls because you read a recent study that indicates off-pink increases productivity is not in the cards.  This arrangement is what Justice Scalia is famous for calling "The Deal."  The arrangement between holders of capital and management talent.  Don't like "The Deal"?   Don't buy the stock.  Today, with the many information sources (like ISS and such) on corporate governance and control provisions there is no "ignorance" excuse left.

Enter the market for corporate control.  Occasionally, we come across holders of significant capital who also possess superior management acumen.  Today, through the market for corporate control, these capital holders can wrest from existing managers control of the corporation.  This gets easier when management performs poorly and control (in the form of reduced stock price) gets easier to acquire.  This is the check on management incompetence.  Shareholders can vote with their feet, move their capital into another investment (creating a lower cost for the acquisition of corporate control by new managers- wonderful thing capitalism, yes?) or band together and oust the current leaders.  Very democratic, really.  Also remember, no one requires shareholders to invest in these public firms.  So long as there is liquidity there are a wealth of other opportunities.

Now enter the complications and interference.  There are a variety of modern constraints on the market for corporate control.  Usually, calls for these constraints are shrouded in evil characterizations of the character of aspiring candidates for corporate control.

Then, there are daft holders of capital like, say, Mark Cuban, who seems to believe that if you permit management to run the company in which you hold shares you are, to put it a brand of eloquence unique to him, "a Corporate Ho."  As Bonos go Cuban is on a roll.  He's got his own radio program on satellite now.  A bigger microphone to distribute his drivel on corporate America.  I suppose there might be someone less qualified to criticize "windfall profits" but I'm not sure who it is.  I guess I don't know why Cuban doesn't just mount some hostile takeovers if he is such an outstanding manager.

See, to Cuban your interest as a shareholder extends to a variety of things over and above providing capital for other managers and voting with your feet if your profits are low.  Things like "corporate responsibility," a term which has a meaning that varies depending on what is convenient to the speaker, and denying your shares to other capital holders who want to short the company you are invested in.  I constantly marvel at those who are all for free markets when they rise but whine about the inequity of short sellers when they fall.  But then, these things are to be expected from people who don't understand corporate law or the separation of ownership and control or why it is a good thing.  People who, in the manner of as many spoiled brats, want to buy shares under one set of assumptions but then change the underlying restrictions intrinsic to the corporate form once they own them.  They want to be owners and managers, suddenly.  Are they willing to forgo limited liability protection as well then, I wonder?  If they want to be managers so bad why not spur a shareholder revolt, or sell their stake and found their own corporation.  (Bet you my last dollar they will resort to the public equity markets to fund this corporation and then whine about shareholder activism too).

I speak of those who call for liquidity in private equity investments in the same breath.  It was no secret that you were going to be subject to a lock-up period when you wrote the check.  Why do you now want to change the rules?  The "have your cake and eat it too" crowd seems to get louder (if not larger) every day.  Leave the market for corporate control alone.  Stop legislating takeovers.

As for secondary markets in buyout funds?  Again, I persist in my view here, anything that shortens the investment horizon term is counter-productive to buyout endeavors.  Want liquidity?  You have many options.  Just don't expect the same returns.

Tuesday, May 02, 2006

99 Red Balloons

filled with hot air and soaring I just got off the phone with someone who told me that KKR's Amsterdam based public vehicle that is supposed to IPO any day now has raised nearly $5 billion or 300% of its original target.  Update: The Journal has an article (subscription required) on the overshoot.  Update 2: No, I won't send you a copy of the offering documentation.  Update 3: No, I definitely won't send you a copy if you are in a jurisdiction where SEC regs forbid your getting them.

Wednesday, May 03, 2006

Bought to You by the Number 16

superior management team Amusingly, Burger King's S-1/A shows the offering price for their IPO is going to be around $15-$17.  The S-1/A shows a maximum of $17.  I am amused by this only because this looks a lot like KKR's Sealy IPO.  Apparently, it is a slow day for me.  It is interesting to peruse the S-1/A and see what tumbles out.  (There is actually a section header labeled "Why We Are 'The King'" for instance).  For some reason when I see this phrase I picture the sex scene between Peter Gallagher and Annette Benning in American Beauty.

Private Equity Sponsors: "You like getting nailed by The King?"
Public Equity Markets: "Yes!  I love it!  Oh, yes!  Fuck me, your majesty!"

Is that wrong of me?

Then there is this sob story describing the sorry state Burger King faced when acquired by the brave and bold private equity sponsors:

Then in December 2002, Burger King Corporation was acquired by private equity funds controlled by Texas Pacific Group, Bain Capital Partners and the Goldman Sachs Funds, which we refer to as our sponsors. At the time of the acquisition, we faced significant challenges, including declining average restaurant sales which resulted in lower restaurant profits compared to our competitors. Additionally, the number of U.S. franchise restaurants was shrinking, many of our franchisees in the United States and Canada were in financial distress, our menu and marketing strategies did not resonate with customers, relationships with franchisees were strained and many of our restaurants had poor service.

In response to this pitch-soaked tinderbox of potential disaster?

The team quickly put in place a strategic plan, called the Go Forward Plan. The plan has four guiding principles: Grow Profitably (a market plan); Fund the Future (a financial plan); Fire-up the Guest (a product plan); and Working Together (a people plan).

Am I being arrogant if I wonder aloud if this is really the kind of work we should expect from primier private equity firms?  Even if I give this prose a big rasberry it is hard to argue with this:

Guided by our Go Forward Plan and strong executive team leadership, our accomplishments include:

Eight consecutive quarters of positive comparable sales growth in the United States as compared to negative comparable sales growth in the previous seven consecutive quarters, our best comparable sales growth in a decade;

[...]

Increasing net income from $5 million in fiscal 2004 to $47 million in fiscal 2005, with EBITDA increasing by 65%, from $136 million in fiscal 2004 to $225 million in fiscal 2005.

Maybe campy prose is important to mega-LBOs.  I was going to chide this deal as leaning mostly on financial structure for its gains, but that was before I saw these EBITDA figures.  It occurs to be that perhaps we need a Vice President of Campy Prose here at Sub Rosa.  Since this is an IPO I guess it plays well with the target audience.

What other changes can we expect?

Currently, 50% of Burger King restaurants are open later than 11:00 p.m., with 7% open 24 hours. Approximately 70-80% of the restaurants of our major competitors are open later than 11:00 p.m., with approximately 42% of McDonald’s restaurants open 24 hours. We have recently implemented a program to encourage franchisees to be open for extended hours, particularly at the drive-thru.

Whoo hoo!

Of course the S-1/A mentions the $367 million special dividend paid in Feburary along with a $33 million "compensatory make-whole payment" and a $30 million termination fee for the sponsors' management contracts.  The $33 million was used to compensate holders of restricted shares and options.  Effectively, this was a senior management bonus.  The rationale here was that the $367 million in special dividends would indirectly reduce value for any stakeholder not entitled to special dividend rights.  $33 million was a payment on the same "per share" price ($3.42) to options and restricted share holders. You can't have a senior management mutiny on your hands right before the IPO, after all.  Note that the Sealy special dividend did a similar thing. Sealy's CEO didn't leave the firm, however, right before the offering. Perhaps $3.42 a share wasn't enough for Burger King's former CEO?  Or maybe the entire dividend rubbed him the wrong way.

The management contract with the sponsors was a $9 million a year paid quarterly arrangement.  Terminating it nets them $30 million.  I love the rationale given for this payment:

Our board concluded that it was in the best interests of the company to terminate these arrangements with the sponsors and the resulting payments upon becoming a publicly-traded company because the directors believed that these affiliated-party payments should not continue after this offering.

Oh, of course.  I should have known this was the reason.

How were all these payments funded?  Three guesses.

...we also borrowed an additional $350 million under our senior secured credit facility, all the proceeds of which were used to pay, along with $50 million of cash on hand, the February 2006 dividend and the compensatory make-whole payment. We refer to this financing as the February 2006 financing. We expect to use almost all of the net proceeds from this offering to repay the $350 million borrowed....

Interestingly, this "$50 million of cash on hand" becomes "$55 million of cash on hand" later on page 63.  Woops.  Sloppy work.

Their senior credit facility had an interesting feature to compute interest rate.  I've seen it before but it tends to be rare. Specifically:

The interest rate under the senior secured credit facility for term loan A and the revolving credit facility is at our option either (a) the greater of the federal funds effective rate plus 0.50% and the prime rate, which we refer to as ABR, plus a rate not to exceed 0.75%, which varies according to our leverage ratio or (b) LIBOR plus a rate not to exceed 1.75%, which varies according to our leverage ratio.

So, the fun question is what kind of return will Texas Pacific Group pick up on this deal?  Well, though the underwriters have the option of buying 3,750,000 shares of stock from the existing shareholders, none of the private equity holders seem to be parting with significant chunks of their shares.  That makes the primary source of realized gains here the special dividend.

In December 2002, Burger King Acquisition Corporation slurped up Burger King's holding company from Diego, plc.  After adjustments and expenses and other swaps, including transaction and professional fees (these last were $62.5 million) the total outlay was on the order of $1112.5 million.  This is a quick and dirty calculation, I'm sure I've missed a thing or two.

A good guess (but by no means a certainly correct one) at the equity piece of the transaction is around $325 million.  Assuming this is correct and that the private equity sponsors got pro-rata participation for their cash outlays, Texas Pacific Group put in around $110.5 million in equity for their 34.02% share.  So how is TPG doing?  Well, most interesting in my view compared to the Sealy deal, TPG already has an 12.38% realized IRR before selling a single share, thanks to the dividend, breakup and management fee.

As for the rest?  My error-riddled model below:

Bk_2

Friday, May 05, 2006

Special Dividend III: Bride of Special Dividend

debtor's prisonCiting LBO Wire, DealBook notes that actions by Thomas H. Lee Partners, Blackstone and Bain Capital with respect to Houghton Mifflin Co., might "[presage] an exit from the company." In particular, the issuance of $300 million in "payment in kind" (PIK) notes, which pay interest in more notes rather than cash, and have a floating rate that rises from 675 basis points to 775 basis points over 3 years. This follows a $150 million dollar issuance of senior notes by the company back in 2003 used to pay, imagine this, a special dividend to the private equity sponsors.

The firms paid $1.66 billion for Houghton (really $1.28 billion and the assumption of $380 million in debt) in January 2003, $615 million of which was paid in equity. Interestingly, Vivendi, the seller back in 2003, paid $2.20 billion for the firm in June 2001 (around the same time as they bought MP3.com).

The debt to equity ratio on the deal was around 1.7:1, which seems pretty low to me. IRRs probably aren't going to be huge but I'm certain the special dividends help, since they have almost 75% of their original equity money back. So far their realized IRR is around -11.50%, not bad considering they haven't really had a major liquidity event yet.

Overhang and Exit Denial

nothing ventured nothing exited Abnormal Returns (yummy!) cites a piece in Paul Kedrosky's Infectious Greed on the growing overhang in venture capital. Part of the issue for both venture and buyouts, I think, is not that there is an overhang, or not just that there is an overhang, but that a huge number of people are in   complete denial that an overhang even exists.  As if the runups in prices we are seeing have nothing to do with the cash-up-to-the-eyeballs funds crawling out from under every banker's box.

A reader wrote me the other day to chide me for being "out of touch" with the market on this point. To quote a certain someone, "That's Absurd."

From the Kedrosky piece:

Doug Leone (Sequoia Capital): ...for some reason, there appears to be an insatiable appetite by limited partners to invest in a category (venture capital) that cannot sustain even a fraction of the capital currently within it. It is the craziest thing that LPs are willing to invest so much in a category that has yielded so little and from so few.

E&Y: Why is it crazy that LPs are willing to invest so much in venture capital?
   
Leone: The returns have been miserable. If you take away a couple of exits, such as Google and MySpace, there haven't been meaningful returns generated. There are [venture] firms that have never generated a positive return or have not even returned capital in 10 years that are raising money successfully. And that surprises the heck out of me. People talk about the top quartile-- its not about the top quartile, it's barely about the top decile, or even a smaller subset than that.

Of course, the problem in the U.S. is more severe than it is elsewhere.  I happened to come across some figures from a 2005 PriceWaterhouse/VentureEconomics report on private equity.  This little tidbit on all cumulative private equity investment and fund raising 1996 1998-2004 tumbled out:

Fr_2

That's only through 2004.  Given the massive fund raisings that have gone on in 2005 and the first quarter of 2006, overhang is beyond unreasonable at this point.  Further, I doubt very much that these figures include the multi-strategy hedge funds that are increasingly throwing their hats into the private equity rings.

It is, I feel, a sign of the general myopia on the subject that someone tried to convince me the other day that the fact that hedge funds are doubling the salaries of venture and buyout professionals to jump ship and move over the the dark side is a sure sign of the innate competence of these funds.  No, it is not anything like the dot-bomb era.  Not at all.  (Gee, I wonder if he worked for a hedge fund).

Tuesday, May 09, 2006

Sometimes You've Just Got To Say...

riskless reward? DealBook cites a Reuters article pointing out that credit sentiment and rate increases could have a deleterious effect on what Reuters calls "fast growing private equity funds."  (I think they mean buyout funds, but I suppose they could just mean buyouts and mezz).  Most of the article will strike Going Private's regular readers as a "tell me something don't already know" sort of thing, but one line caught my attention:

Jon Moulton, managing partner of Alchemy Partners, a UK-based private equity advisory firm, said the market could prove fragile because of the multiple layers of debt used in a modern private equity buyout, the huge growth in non-bank participants in the loan market and a lack of proper covenants attached to loans.

"Non-bank participants."  Sounds like hedge funds to me, but then maybe I just haven't had enough Kool Aid.

Risk Profiles

brought to you by 'risk' Continuing today's "Risk" theme, I found the diagram below from the excellent January 2004 report "The Risk Profiles of Private Equity" by Weidig and Mathonet, January 2004.  You can find the whole text via SSRN.  I highly recommend it.


Bo_3

Wednesday, May 17, 2006

Aristotelian Debt

true picture of a company's profitability I am strongly considering getting a standard graphic for "debt" given how many entries on the subject have been popping up lately.  The latest is on the wonderful Conglomerate Blog which points us to a Wall Street Journal article (subscription required) on the topic of debt laden IPOs.  Gordon Smith over at Conglomerate hits it right on the head, I believe, with this analysis:

Is debt a bad thing? We are still having the same debate about debt that was raging in the late 1980s: debt-as-burden v. debt-as-discipline. This is a silly debate in the abstract because getting the right amount of debt is the trick. Easier said than done.

Indeed.  Find some balance.

The Journal makes a point of singling out Sealy, a transaction I touched on earlier, making reference to their debt warning paragraphs in their S-1/A and 424(b)(4) filing.  Here's the passage they used:

Our ability to successfully operate our business is subject to certain risks, including those that are generally associated with operating in the bedding industry. For example,

...our level of indebtedness (approximately $961.8 million as of November 27, 2005) may adversely affect our ability to generate cash flow, pay dividends on our common stock, remain in compliance with debt covenants, make payments on our indebtedness and operate our business.

Setting aside for a moment the very obvious (at least for Going Private readers) question that pops into the mind, "How is massive debt generally associated with the bedding industry'?" one has to assume that "sophisticated investors" who bought into the IPO knew what they were getting into.  They should have had no problem reading the "Use of Proceeds" section anyhow:

Of the approximately $294.2 million of net proceeds we expect to receive from this offering, we intend to use approximately $86.7 million to redeem the outstanding principal amount of our PIK notes and pay a related redemption premium thereon, approximately $54.3 million to redeem a portion of the outstanding principal amount of our 2014 notes and pay accrued interest and a related redemption premium thereon, approximately $125.0 million to pay a special dividend to our existing stockholders, approximately $17.2 million to pay a transaction-related bonus to members of management and $11.0 million to KKR in order to terminate our future obligations under our management services agreement. We will not receive any proceeds from the sale of shares of our common stock by the selling stockholders, including pursuant to the underwriters' option to purchase additional shares.

If that's the case, then they are all betting on growth to fund their gains.  They certainly aren't buying much today and, therefore, it is the continued deleveraging that will, in theory, allow the new shareholders to see some gains.  Conglomerate takes John Coyle, the JP Morgan guru quoted in the Journal article, to task for his inelegant description of this:

"As a company deleverages, it adds to its earnings capacity. So in a way, investors in these IPOs know there is some future earnings growth that is already in the bag -- as the leverage comes down, earnings will go up."

Maybe I am quibbling about semantics here, but deleveraging does not add to what I consider "earnings capacity."  There is a reason it is called Earnings Before Interest Taxes Depreciation and Amortization.  Deleveraging simply reduces interest expense.  Sheesh, even Paulie "gives the true picture of a company’s profitability" Walnuts knows that.  Of course, all that debt pulls out a lot of cushioning should the market go south.  This is part of the mindset that contributes to the wrong headed impression that financial structuring of this kind alone improves the fundamentals of a firm.  And how's that been working for investors today who bought in at $16-17?  Well, let's just take a look:

sleepy stock

And should we be surprised that someone who should know better from JP Morgan would be babbling on so?  Perhaps something in the prospectus will give us a hint?

Thursday, May 18, 2006

Yes, Oh, Yes Your Majesty!

kingly looks Burger King, the debt laden LBO IPO from prior Going Private fame, seems to be floating well.  It occurs to me, perhaps LIPO, "Leveraged Initial Public Offering" should be a new term of art, leaving "LIPO Suction" to describe that great sucking sound you hear when the market tanks your LIPO.  Yes.  Too perfect.  It is an official category now.

So how is the King doing for Texas Pacific Group?  Let's just see.

As an aside: Google Finance drops the ball again.  Using the BKC ticker gets you CPVC Blackcomb, Inc.  Yahoo Finance has no issue.  Maybe Google should just put (beta) next to its firmwide logo permanently?

(King Charles I (1600-1649), Unknown Artist, after Sir Anthony Van Dyke. Balliol College Portraits Collection).

Monday, May 22, 2006

Cable Complexity?

tangled mess or sure thing? An inscrutable reader writes in to point out a fascinating Bloomberg interview I had not yet seen of Blackstone's Hamilton James.  My reader wonders in email if private equity firms really consider these sorts of investments (Blackstone's Deutsche Telekom deal) viable.  I wondered after this transaction once before in Going Private.  It is, after all, a government-owned firm and Blackstone is only making a minority investment that lacks the control private equity firms usually demand to create the sort of change that impacts their returns.  At first blush I would agree with my reader, but further examination makes it clear why this was a pretty good move by Blackstone.  I've excerpted some passages below so we can try to get into James' head.

Blackstone's James on Deutsche Telekom (Transcript)
2006-05-18 14:51 (New York)

May 18 (Bloomberg) -- Hamilton James, president of Blackstone Group LP, responded to questions on May 17 about Blackstone's investment in Deutsche Telekom AG, the evolution of private equity funds, and the growth potential of Univision Communications Inc. James spoke at a private-equity conference in New York sponsored by the Daily Deal. Senior writer David Carey moderates.

(This is not a legal transcript.  Bloomberg LP cannot guarantee its accuracy.)

I've [...]

The reason we like Deutsche Telekom now is it's a - it's a - it's a gold-plated company. It's got massive assets. It's got great market positions in its core businesses that aren't going away. And the biggest economies in the world look at U.S., the U.K. and Germany. Frankly, I get tired of looking at companies that are mediocre, small, marginal competitors at 8.5 to 11 times EBITDA. And when I see a good, chunky, meaty company with lots of assets that I can buy at 5.5 times EBITDA, that looks pretty good to me.

So, I think, bottom line there, we just - we thought it was a good management. A company with great assets, great market positions and a compelling price. We've had a thesis in the last few years in Europe, in general, that the telecoms were undervalued and that they would be re-rated sometime over the next five years as some of the changes that are coming - flowing to the industry get worked out; as things get re-priced as - and things like that. And we still believe that thesis.

So, there's a lot to like about Deutsche Telekom in terms of just sheer fundamental value and quality of company, that has nothing to do with anything but the value. We - you're right - we were able to set this up with a very clever financial structure; such that we essentially had 85 percent leveraged to capitalization. Effectively, these days, we put up about a third of the purchase price and equity. In our - in our deal, we ended up putting about 15 percent of the purchase price up to equity. And the leverage was in the - was in the mid single digits in terms of average cost. So here we have, by comparison to most LBOs,far more leverage, far lower cost.

So we have all of this very, very positive financial and structural things working for us. If - to use to your favorite term - if the EBITDA doesn't grow at all over five years and we exit Deutsche Telekom at five times cash flow at the end of five years, number of trades we've brought in at 5.5 times, we'll still double our money, based on the cash flow of the company. If EBITDA - if EBITDA grows like it has, at a few percent a year, and we hold our multiple 3.5 times we'd expect. And if we can - and that's before we've done anything to impact the value of the company ourselves.

I've commented before on the issue I have with LBO firms that depend on leverage, or perhaps I should say, pure financial structuring, to generate their returns.  Clearly, with enough leverage massive returns almost fall out of the firm, unless revenues or costs conspire to damage earnings.  For some firms that is enough.

Herein lies what I believe is the distinction between "private equity firms" and "good private equity firms."  The structure of a deal defines the downside.  The talent of the private equity firm establishes the upside.  James says it here:  "...and that's before we've done anything to impact the value of the company ourselves." That's the key.  This attitude: Financial structure is a tool to enhance returns, not to create them outright.  The work really begins after the transaction.  After the deal guys have packed up and the lawyers and accountants signed off.  That's when you have to work to generate returns.

Blackstone has something else going for them on this deal.  Though it is a minority stake, this is still a state-owned firm. It is also "too big to fail."  Their downside risk of bankrupcy is very, very low.  The German government will probably not let it go bust and we all know how the Germans love subsidies for their state-owned ventures.

So why the minority investment?  Personally, I suspect this is a stepping stone to a larger stake by Blackstone.  They can get their toe wet here, feel the business out, sit in on board meetings and effectively have a strong option at a much larger, even a control stake down the line.

My reader points out that so far the deal looks bad, on paper:

Here's a back of the envelope calculation:
Eur 2.6 billion investment @ Eur 14.00 per share = 185.714 million shares.
85% debt = Eur 2.21 billion.
15% equity = Eur 390 million.

Since the announcement was made on 24 April, the DT shares have fallen to Eur 12.62 x 185.714 million shares = Eur 2.344 million value of holding. Less the Eur 2.21 billion of debt outstanding = Eur 134 million of equity. So in less than 1 month, the value of Blackstone's equity has fallen from Eur 390 million to Eur 134 million (66% loss).

Remembering, however, the nature of the leverage here we see that if they have this debt on a 7 year term (and I don't actually know what the terms of the debt are, except for the "single digit" rate Blackstone commanded), and they work down the debt properly, which is, of course, the point, and even if the stock sits at its present nadir, Blackstone will have paid Eur 390 million in equity for a 2.344 billion stake in DT.

Let us decide that we want to make it tough for Blackstone.  Let's see how far their downside goes.  Let us just pretend that the stock tanks by another 50%.  That means Blackstone paid Eur 390 million for Eur 1.152 billion 7 years later.  IRR: 16.73%.  Not bad for a "total failure."  That's the leverage at work.  Of course, in a bankruptcy, or even serious distress, Blackstone probably loses the entire Eur 390 million.  But then, this is a state-owned firm.  It would be interesting to do a bankruptcy risk analysis for large state owned "utilities" and see what Blackstone's risk adjusted returns are on this basis.

Bear in mind, I haven't really gone through these numbers and I don't know much about the financial structure of the deal (term of the debt, how it is being paid off, etc).

Edit: A reader, NG, suspects that Blackstone's stake doesn't bear any particular cash flows other than normal dividends, which are probably around 5-6%, less, most likely, than Blackstone's cost of debt.

If this is so, and on reflection I believe it is, then Blackstone's acquisition vehicle is going to have to service the debt out of its own pocket.

NG also points out, correctly, that in this instance Blackstone's IRR won't be anything like described above.  My analysis above only holds if the stake Blackstone stake can support its own debt (and pay down principal).  If it can't then Blackstone is going to have to fund that debt service from elsewhere, and, accordingly, pillage IRR from another investment.  The advantage of leverage is when you can get the acquired stake to service itself without using your own cash.  That's lost here if NG is correct.

I believe this makes even a stronger case for this investment being a stepping stone for an eventual majority stake in the business.  If that's the case, Blackstone's IRR will only deteriorate by the amount of interest and principal they throw in before they enjoy the free cash flows (i.e. before they take a majority stake).  Since their leverage here is so high, (15%/85%) they can afford to sit around for some years before taking a majority stake and still have a reasonable deal (perhaps the ratio will look more like their usual 33%/66%).  Not a bad option, really.  If anyone is really interested I'll recalculate the IRRs with some scenarios on the time they sit on their "option."

KKR Amsterdam

floating the offering Freed from certain legal entanglements by another one of my favorite readers, I can now comment on the KKR Amsterdam offering memorandum.  It is quite tasty reading, actually.  What struck me when I first looked at the document, and stays with me today, is how poor a deal the investors are really getting compared to traditional KKR limited partners.  To wit, the first hint something is amiss from the "risks" section:

Your rights as a unitholder will differ substantially from the rights of limited partners of KKR’s private equity funds and the potential return on your investment may not be commensurate with the returns achieved by limited partners of KKR’s private equity funds.

I will likely do a detailed analysis this weekend.  In the meantime, to tide you over The Deal has a good article (subscription required) on the subject.

Thursday, May 25, 2006

They're KKRrrreat! (Part I)

a home down the river At 319 pages the April 18, 2006 version of the KKR "Preliminary Offering Memorandum" isn't the largest such document I have ever seen, but it rivals anything I have seen for pure linguistic density (and I've read the work product of Arnold & Porter).  Note that the April 18, 2006 copy I am reviewing still anticipated only $1.5 billion in investment, that was later revised to $5 billion and may well have undergone significant structural revision in the process.

kkr structural overview Because I had to research the structure anyhow, I worked up a summary of the transaction and I'm including some diagrams for Going Private readers here.  As you will see, the structure is complex and the offering document's diagrams often omit key entities.  A overview of the structure can be viewed by clicking the thumbnail to the left.  I'll attempt to review the entire transaction and highlight the bits that I think are interesting in this, and as many as three more entries over the next many days.

The basic building blocks are KKR itself, the Delaware based U.S. general partner that we all know and love.  KKR Guernsey GP Limited, the general (managing) partner of the new entity, KKR PEI Associates, LP the general partner of the investment vehicle that is named KKR PEI Investments, LP.  I am calling KKR Delaware "KKR Proper," KKR PEI Investments, LP "KKR PEI," for now.  There's also KKR PEI SICR S.à.r.l., (or société à responsabilité limitée) Luxembourg Limited Liability Company.  We'll get to the others later.

The managing general partner that makes the investment decisions and effectively directs the investment policy of KKR PEI (here that is KKR Guernsey GP Limited, "KKR GGPL"), is co-chaired by Henry R. Kravis and George R. Roberts (no surprise there) and an unnamed CFO.  In general, KKR GGPL is toothless.  All the real decisions are made at KKR Proper.  To wit:

KKR will be responsible for selecting, evaluating, structuring, diligencing, negotiating, executing, monitoring and exiting our investments and for managing our uninvested capital in accordance with our cash management policy. These investment activities will be carried out by KKR’s investment professionals and KKR’s investment committee pursuant to our services agreement or under investment management agreements between KKR and its private equity funds. KKR will have broad discretion when making investment-related decisions under our services agreement and its investment management agreements and our Managing General Partner’s board of directors will approve specific investment decisions in only limited circumstances. Pursuant to our services agreement, our private equity and opportunistic investments will be approved by KKR’s investment committee.

Early on I, and other commentators, wondered how KKR Proper would be incentivized to invest in a separate entity that shared distributions with public investors.  As a partner in KKR you certainly would have no incentive to permit a public investment vehicle like KKR PEI to co-invest and dilute your return and your carry.  KKR devised a rather simple scheme to realign these incentives.  That structure is described in the diagram below.

By requiring a degree of reinvestment, KKR PEI manages to lock up some of the distributions to KKR Proper.  In this case an investment agreement requires KKR Proper to re-invest 25% of all pre-tax distributions it recieves from KKR PEI.  This effectively links the return fates of the two meta entites.  Says the offering document on the topic:

reinvestment and incentivesAdditionally, under an investment agreement that we will enter into with KKR, KKR will agree to cause its affiliates to acquire additional common units from us on a quarterly basis with an amount equal to 25% of the aggregate pre-tax cash distributions, if any, that are made to KKR’s affiliates pursuant to the carried interests and incentive distribution rights that are applicable to our investments. Common units that are issued to KKR’s affiliates in connection with the global offering and related transactions or pursuant to our investment agreement will be subject to a general prohibition on transfer for a period of three years from the date of issuance. We believe these arrangements will create an incentive for KKR to pursue investments that help us achieve our goal of creating long-term value for our unitholders.

KKR PEI intends to make initial investments in limited partner rights to two KKR funds, the KKR European Fund II and KKR's 2006 Fund.  Following those initial investments, KKR PEI will follow an investment policy permitting it to co-invest no less than 75% of its net adjusted assets in KKR investments as a co-investor and no more than 25% of its net adjusted assets in "opportunistic investments."  The diagram below gives a quick summary.

initial investment and policy

And what about these "opportunistic investments?"

We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities. We expect that our opportunistic investments will include long-oriented positions in publicly traded equity securities and debt securities and securities with equity-like features that we believe underestimate the asset quality or credit strength of the issuer. We expect that our opportunistic investments also will include investments made alongside the KKR Strategic Capital Fund, which is currently being formed by the manager of KKR Financial Corp. for the purposes of making investments in fixed income securities with a focus on stressed and distressed debt and investment opportunities created by market dislocation events.

There is also a planned investment of $50.6 million for a 2.5% stake in Capmark, the former GMAC commercial mortgage subsidiary.  I wonder why an LBO fund would want a commercial mortgage subsidiary.  Hmmm.

Of course, cash management is often less of an issue for LBO funds that have committed but undrawn funds from their limited partners.  This is a larger issue with KKR PEI given the fact the the public is dumping all its cash, not commitments, into the fund.  That mandates a careful cash management policy disclosure.  I think KKR PEI's falls short:

Upon completion of the global offering and related transactions, we anticipate that our temporary investments will consist of government securities, cash, cash equivalents, money market instruments, asset-backed securities and other investment grade securities. We expect that, initially, between 30% and 50% of our surplus cash will be invested in government securities, cash, cash equivalents and money market instruments, between 30% and 50% will be invested in highly rated asset-backed securities (primarily relating to credit card receivables and mortgages) and up to 25% will be invested in other investment grade securities.

Friday, May 26, 2006

They're KKRrrreat! (Part II)

euronext clears kkr Friday afternoon, what better time to delve back into KKR's Amsterdam offering memorandum and revel in its complexity, interwoven incentive structure and propensity to fleece the investing public in favor of its general and limited partners.

We left off with "opportunistic investments" and cash management, which readers will recall is a larger issue because of all the cash sitting around because this was a public offering.  On opportunistic investments the memorandum says:

We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities. We expect that our opportunistic investments will include long-oriented positions in publicly traded equity securities and debt securities and securities with equity-like features that we believe underestimate the asset quality or credit strength of the issuer. We expect that our opportunistic investments also will include investments made alongside the KKR Strategic Capital Fund, which is currently being formed by the manager of KKR Financial Corp. for the purposes of making investments in fixed income securities with a focus on stressed and distressed debt and investment opportunities created by market dislocation events.

I expect it will have occurred to most readers that this particular segment of KKR is looking a lot like a hedge fund.  If not, this passage should be a strong hint: "We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities."

It is no secret that buyout funds have been jealously looking at hedge funds and their aggressive moves into the private equity space.  This move, a little side fund, permits private equity funds to return the favor.  A careful reading of the areas they cite as investment potential for this portion of the assets sounds a lot like hedge fund strategy.  The only part missing is the short positions.  I'm not sure if this means they don't intend to take short positions, or it was just too obvious to make explicit.  The description is elaborated on later in the document:

These investments are expected to consist of investment opportunities that KKR historically has not pursued due to the fact that they tend to be inconsistent with the investment mandates of its private equity funds as a result of such factors as the relatively small size of the investment, the fact that the investment involves a public company or a debt investment or the unwillingness of the potential target to sell control of its business or pursue a possible private equity transaction.

This looks a lot like Blackstone's recent German dealings.  I wonder if "...the unwillingness of the potential target to sell control of its business or pursue a possible private equity transaction," means hostile takeovers or shareholder activism opportunities.  Your guess is as good as mine, probably.

Of course, one of the greatest features of a public offering involving a private equity fund is the ability of non-limited partners to get a peek at returns and internal financials.  The memorandum does not disappoint:

...the annual compounded gross and net rates of return for the seven private equity  funds that KKR sponsored prior to January 1, 1997 have ranged from a low of 12.11% and 8.83%, respectively, to a high of 48.14% and 39.18%, respectively, and the multiples of invested capital achieved by those funds have ranged from a low of 2.1x to a high of 17.1x.

A chart with pretty solid details is present in the offering memorandum, interested readers will enjoy examining it.  It can be downloaded via DealBreaker.

Of course, when you're scooping in all these unrealized gains, you need some way to pay your taxes.  Luckily, KKR PEI has thought of that problem.  Not surprising since all funds with illiquid assets and lock-in periods have wrestled with this issue.  The solution is to provide significant distributions on a quarterly basis.  In this case:

...we intend to make cash distributions (which we intend to pay to all of our unitholders on a quarterly basis) in an amount in U.S. dollars that is generally expected to be sufficient to permit our U.S. unitholders to fund their estimated U.S. tax obligations (including any federal, state and local income taxes) with respect to their distributive shares of net income or gain, after taking into account any withholding tax imposed on our  partnership.

KKR PEI does take pains to note, however, that they aren't required to make this distribution, and may decide not to.  This highlights, once again, that owning limited interests in private equity vehicles can be damn expensive.

And speaking of damn expensive, how much does KKR Proper get from this new vehicle for management fees?

Under our services agreement, we and the other service recipients have jointly and severally agreed to pay KKR a quarterly management fee in an aggregate amount equal to one-fourth of (i) our equity up to and including $3 billion multiplied by 1.25% plus (ii) our equity in excess of $3 billion multiplied by 1%.

Sounds like a Lehman formula in a way.  How much will they claim if they have a $5 billion fund?  Let us just see.  Assuming their net asset value (which should initially closely approximate the "equity" calculation that drives the fee structure) is $5 billion they should command 25% of (1.25% of $3 billion and 1.00% on $2 billion). Or around $14.375 million per quarter.

Apparently, someone thought that sounded greedy, so KKR Proper graciously agreed to waive, just for the first year after the offering, the payment of any management fee on the assets raised by the offering that are still sitting in temporary investments.  KRR PEI also gets to deduct from any management fees to KKR Proper any management fees they pay to KKR Proper or any third party as a result of investments (such as in KKR funds).  KKR gets the typical 20% carry, but not before the offering and placement fees for the offering are caught up by PEI.  Back when the offering wasn't yet $5 billion those fees were estimated at $85 million.  (I love how these offering documents always call such fees "manager commissions").  It is interesting to point out at this point that KKR PEI probably won't itself get management and monitoring fees, since it is really a fund of KKR funds with a little hedge fund hooked onto the side.

We then run into their first summary of risk factors, which are mostly to be expected.  Some, however, stand out.

• We expect returns on cash invested pursuant to our cash management policy to be lower than returns on our private equity and opportunistic investments and, as a result, we expect that the longer it takes to deploy our capital, the lower our overall returns will be.

In other words, we are sitting on a pile of cash making around 5%.  Until we can spend it on LBOs and other stuff, your returns are sitting ducks.  They elaborate later in the document:

The limited partners of KKR’s private equity funds generally are only required to make capital commitments to a fund, which are funded only when a capital call is made by the fund’s general partner, while our unitholders will be required to contribute their capital to our partnership when acquiring our securities. Because our unitholders must fully fund their investment in our partnership at the time they purchase our securities, and because our cash management strategy is likely to result in lower returns than our private equity and opportunistic investments, our unitholders may realize rates of returns on their investments that are lower than the rates of returns realized by limited partners of KKR’s private equity funds.

And, they have no preference over limited partners (particularly over existing limited partners who want to make follow-on investments) in existing KKR Proper funds.

• Although we intend to selectively acquire limited partner interests in one or more of KKR’s existing private equity funds over time, we cannot predict the extent to which limited partners of those funds will be willing to sell their limited partner interests to us on acceptable terms or at all.

I'm somewhat surprised that KKR Proper didn't agree to give a preference to KKR PEI, but then on reflection I am not.  KKR Proper, and its employees/partners, are the value driver.  Pissing off their existing or future limited partner pool by, for example, giving the public a preference, is probably the wrong idea.  Plus, the public is ravenous enough to really buy in regardless of how limited their interests are and how much they get screwed.  More on this later.

• Your rights as a unit holder will differ substantially from the rights of limited partners of KKR’s private equity funds and the potential return on your investment may not be commensurate with the returns achieved by limited partners of KKR’s private equity funds.

This deserves much attention, we will get to it presently.

• Our organizational, ownership and investment structure may create significant conflicts of interest that may be resolved in a manner which is not always in the best interests of our partnership or the best interests of our unitholders.

Welcome to private equity.

Of course, these documents never miss an opportunity to pump up the "key men."  (Interestingly, I've never seen a "Key Woman" insurance policy).

The departure of any of the members of KKR’s general partner, including Henry R. Kravis or George R. Roberts, or a significant number of its other investment professionals for any reason, or the failure to appoint qualified or effective successors in the event of such departures, could have a material adverse effect on our ability to achieve our investment objectives. The departure of some or all of those individuals could also violate certain ‘‘key man’’ retention obligations specified in the documentation governing KKR’s private equity funds.

More detail emerges on the control KKR exerts over KKR PEI:

...because our Managing General Partner’s board of directors may take action (other than with respect to the enforcement of rights under our services agreement or investment agreement with KKR) only with the approval of two-thirds of its directors, and because we expect that more than one-third of our Managing General Partner’s directors will be affiliated with KKR, our Managing General Partner generally will not be able to act on our behalf without the approval of one or more directors who are affiliated with KKR.

Read: Kravis and Roberts (and perhaps their cronies).

While our Managing General Partner will be permitted to take action with respect to the enforcement of rights under our services agreement or investment agreement with KKR with the approval of only a majority of its directors, such approval would require the approval of all of its independent directors to the extent none of the directors affiliated with KKR agree with such action. Such approval may be difficult to obtain.

Good luck.

Sticking it to the public, vis-à-vis "normal" limited partners is a bit of an art here.  Something that is really sneaky, after a fashion, is that the returns to KKR are segregated.  This means that KKR Proper will command a carry from the one buyout that returns 6.00x cash on cash after a year, but that return will NOT be netted against $70 million in losses that KKR PEI put into "Ken Lay not-guilty" futures on the online betting exchange in Bermuda via their "Opportunistic investment" strategy.  Moreover, because public investors rely on their ability to resell common units or RDU's, and those will likely be based on net asset value, public investors probably will be subject to those losses directly.  True, KKR Proper will lose to the extent their own 2,880,000 units decline in value, but that's a paper loss offset by a cash gain.  Public investors do not enjoy the same luxury.  As a result:

Due to this limited netting, KKR’s affiliates may be entitled to receive a portion of the returns generated by our investments (in addition to the management fee that will be payable to KKR under our services agreement) even though our investments as a whole do not increase in value or, in fact, decrease in value.

Then there is this little quirk related to management fees to KKR Proper:

The management fees that limited partners of KKR’s private equity funds must pay KKR, in its capacity as the investment manager of the funds, generally are based on a percentage of capital committed to the fund during the fund’s investment period and thereafter based on a reducing percentage of the cost basis of the funds’ investments, which causes the fees to decline over time. The management fee that is payable to KKR under our services agreement, on the other hand, is based on our ‘‘equity’’ and does not, by its terms, decline over time.

This means that overall unitholders pay much larger fees than limited partners.

Typically, private equity funds have provisions to "claw-back" fees paid to general partners of the fund in the event the fund closes with a net-loss.  Not so here.  To wit:

Distributions that are made to the general partners of a KKR private equity fund pursuant to a carried interest in the returns generated by the fund’s investment generally are subject to reimbursement in the event that the fund is in a net loss position upon the termination of the fund. Distributions that are payable to KKR’s affiliates in connection with our co-investments and opportunistic investments will not be subject to similar reimbursement, although such distributions will take into account prior realized and unrealized losses.

In other words, KKR PEI could be a total bust except for three big LBOs that KKR Proper was only able to complete because of the additional funds available from this public entity.  Those LBOs would pay 20% carries to KKR Proper, but the rest of KKR PEI's investments could tank and drop the fund to below the initial offering price.  Despite this, KKR Proper keeps the LBO gains, and keeps the management fees it has packed in over the last many years.

Speaking for myself, I was quite looking forward to getting a peek at the various investments KKR Proper was making via disclosures that would have to be made now that a public vehicle was attached.  So much for that idea:

We expect that limited partners of KKR’s private equity funds will receive comparatively more information concerning a fund’s portfolio company investments than will be provided to our unitholders.

These will be subject to confidentiality requirements as well.  Ugh.  More in the days ahead.

Wednesday, May 31, 2006

KKR Luxembourgeoise

very bourgeoise Why in the world would anyone want to do anything in Luxembourg?  It is a country socially divided between French and Flemish, it is filled with bankers, almost none of which are from the country itself, its small and gossipy, the local language, one of three official langauges, is a mish-mash of French, German and Flemish.  It was an important feature in the Battle of the Bulge, and is therefore the site of General George S. Patton's grave and its cliff faces and gorges are lined with the ruins of old fortresses, most of which have their origins in The Great War, but some that date back to 1000 AD.

KKR, however, like many foreign financial entities, found a more attractive use for the jurisdiction.

We expect that any investments in issuers that are based outside the United States or in private equity funds whose investments are focused outside the United States will be made through KKR PEI SICAR, a wholly-owned subsidiary of the Investment Partnership. KKR PEI SICAR qualifies as a risk capital investment company (soci´et´e d’investissement en capital `a risque), or a ‘‘SICAR,’’ under the laws of Luxembourg. A SICAR is a newly established vehicle for investment in risk-bearing capital for which the tax rules are still developing. Under Luxembourg law, distributions from SICARs are free of withholding tax and gains recognized by SICARs are not subject to capital gains tax....

Not a bad gig.  Smart development for a small EU country focused on financial services and where there are over licensed 900 banks.  But, warns KKR:

...the applicability of European Union directives and bilateral tax treaties to SICARs by certain other countries has not been definitively determined. If KKR PEI SICAR is not entitled to the benefits of European Union directives or relevant tax treaties, including Council Directive 90/435/EEC, KKR PEI SICAR could be subject to a withholding tax on distributions from portfolio companies of KKR’s private equity funds as well as a capital gains tax on dispositions of investments, any of which could have a material adverse effect on the price of our common units. Furthermore, the SICAR tax regime may be challenged by the European Commission if it is considered to have infringed upon the European Union’s state aid rules. In February 2006, a request for information was made to the Luxembourg government by the European Commission on the compatibility of the Luxembourg law SICAR vehicles with the European Union Treaty provisions on state aid. As of the date of this offering memorandum, it is not clear whether, as a consequence of this request, Luxembourg laws on SICARs and certain tax provisions thereunder as currently in force will ultimately be affected and whether the tax regime applicable to KKR PEI SICAR could ultimately be denied, with or without retroactive effect.

Wouldn't that be a rude awakening?  It is around this time that readers of the prospectus wonder "how complex is this entity... exactly?"  Luckily, a diagram about 10 pages later answers that question.

The KKR memorandum also brings to the surface something that isn't often talked about in the buyout world.  Overcommitments.  For the unwashed, investors in private equity don't typically write a check for the entire amount of their proposed investment the day they invest in the fund.  Instead, they make a "commitment" for the entire amount and tender some or none of that at closing.  The "commitment" is drawn down on by the private equity fund when it needs capital via a "capital call" to the limited partners.  Since the private equity fund cannot really invest the entire amount of its fund on day one, this makes some sense as it allows the investor to manage its own money according to its own treasury policies while the cash sits on the sidelines.  Some institutional investors, however, practice "overcommitment," whereby they commit more funds than they actually have to invest betting that enough time will pass for them to raise more, sell assets, etc., before a capital call that exhausts their free cash is made.  Overcommitment can, however, cause problems.  Specifically:

As is common with private equity investments, we expect that the Investment Partnership and its subsidiaries will generally follow an over-commitment approach when making investments in KKR’s private equity funds. When an over-commitment approach is followed, the aggregate amount of capital committed by us to private equity funds at any given time may exceed the aggregate amount of capital available for immediate investment. Depending on the circumstances, the Investment Partnership and its subsidiaries may need to dispose of investments at unfavorable prices or at times when the holding of the investments would be more advantageous in order to fund capital calls that are made by private equity funds to which they have made commitments. In addition, under such circumstances, legal, practical, contractual or other restrictions may limit the flexibility that the Investment Partnership and its subsidiaries have in selecting investments for disposal.

Thursday, June 01, 2006

Diamonds in the Rough Set in Platinum

platinum and diamonds 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.

Thursday, June 08, 2006

Corporate Cargo Cults

build it and mana will come 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

Wednesday, June 14, 2006

Cheap Money, Europe and Activism

call now, supplies limited! 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)

tick, tick, tick 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

elevated 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?

Monday, June 19, 2006

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

lex luthor? ...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

opportunity 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.

Tuesday, June 20, 2006

Tension With No End

any continent that produced airbus can't be all badIt 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....

Thursday, June 22, 2006

The Power of the Grape

not a dent 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.

Friday, June 23, 2006

I Agree With Myself

Dti "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.

Tuesday, June 27, 2006

Conspiring to Conspire

conspiracy 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.

Tuesday, July 11, 2006

The Power of Seven

a different kind of evil Occasionally, one is surprised to find, in the midst of the corporate jungle, individuals who have managed quietly, and without public fuss, to build a large and thriving corporate body.  One such is the 38 year old "Jake," who, more by luck than anything probably, managed to be in the right place and the right time for five years in a row and build a $800 million business from essentially nothing.  Unsurprisingly, Armin is somehow connected to Jake and got the first call when Jake tired of his business some months ago and decided he should buy a small airport in the islands, as it would be much more fun playing in his personal control tower (no, I am not joking) than firing admins who then sue him (probably rightfully) for sexual harassment (again, I am not joking).

As should also be unsurprising to Going Private readers familiar with such entrepreneurs, I would be substantially understating the matter to describe Jake as "eccentric."  Equally unsurprising should be the fact that he has also managed to attract a great deal of legal attention in the form of any number of lawsuits, generally involving one (but occasionally both) of two classes of plaintiff.  First, various minority partners which, despite the near certainty of litigation (or perhaps because of the near impossibility of Jake prevailing in any forum presided over by an elected official or a panel of his "peers"), he seems to have no difficulty attracting.  Second, former personal assistants (universally in their 20s, blond, formerly involved in competitive college sports and female).  In fact, so frequent are these actions that one, small and local legal office has developed a practice highly specialized in "Jakeigation" and lucratively represented 4 such plaintiffs in separate suits over the last 3 years.

According to legal counsel familiar with the matter, Jake has not only carefully salvaged defeat in every action he has become embroiled in, but he has failed to prevail, ever, on a single motion or counterclaim he has presented.  It was, at first, unclear to me if this perfect record is a function of Jake's total unsuitability as a witness for himself because of his eccentric (indeed borderline bizarre) behavior both on and off the stand (transcripts of his testimony read like the videotape "confessional" in a bad reality show wherein 7 totally incompatible 20somethings are thrown together in tight quarters and the producers sit back and record the fun) or his seemingly tenuous relationship with reality.  Then I met Jake and it all became as clear as sapphire crystal.

For reasons that should be obvious given my description, Jake and investment bankers simply do not get along.  And so it was that I was given care of Sub Rosa's new intern, "Craig," and dispatched to Greenwich to cater to the Howard Hughes understudy.

Jake has seven Blue Persian cats.  Actually, it might be more accurate to say that seven Blue Persian cats have Jake, their manservant and trustee.  They essentially have the run of the property (which is a not insubstantial plot in Greenwich) and are treated with a deference formerly reserved for tempestious dieties prone to anger quickly, raze villages and turn vast swaths of the population into pillars of salt if not lavished with constant supplicant mewings, offerings and, indeed, human sacrifice.  Indeed, many a servant running only casually afoul of one of the cats, found their lucrative tenure at the Estate du Jake to be a fickle fount.  I heard a rumor which, after reflection, has gained substantial credibility in my mind, namely that Jake's entire estate will pass in trust to his cats and the two children he fathered out of wedlock with one or another personal assistant will be left with next to nothing.

I should pause at this point to say that I am fairly neutral to positive when it comes to pets.  Frankly, any pet not able to sustain itself without direct human intervention for at least a month and unfortunate enough to be put in my care would surely expire given my work schedule.  Despite this, I mostly enjoy pets.  Or, I should say, I enjoy the freedom from responsibility afforded me by other people's pets.  I even have a mild affection, if you could call it that, for most cats.  Cats are generally unoffensive and benign.  They are usually low maintenance.  They are mostly self-sufficient.  I get along with cats.

I fucking despise Jake's cats.

Here's the thing.  One Blue Persian could, properly managed and seen but not heard, be a subtle statement of evil world domination intentions.  Two might hint at some instability beneath the evil genius layer.  Three... well.... But seven?  Loony bin.

Jake's Blue Persians look like a hairy ball of the dryer lint you remove from that filter thing (after 65 loads of blue jeans were dried) with a hairy pug face in the middle of which someone has stuck two big, yellow, (and beyond creepy) plastic teddy-bear eyes.  The problem is that this dryer lint ball walks, and talks.  I should say, talks incessantly.  The damn things never shut up.  I think they sleep vocally.  Often they form impromptu a capella groups, generally wherever Jake's guests have congregated, all struggling at the same time to be heard over the whinings of the others, volume progressively rising, pitch progressively raised, as they seek to drown out the others.  I can also attest with some confidence also that they are all completely tone deaf. This process is accelerated if they fail to attract the affection of guests.  And, of course, once even the slightest bit of affection is shown them, the other six flock to the issuer.  I know this because I carefully watched it happen to Craig, who, to my absolute horror, was foolish enough to intone "Here, kitty kitty kitty."  As you might imagine, this caused my opinion of our intern to slip rather dramatically.

It is a very good thing Jake can afford substantial hoards of household help to deploy an armored battalion of Oreck vacuum cleaners twice daily, or the sum of the living areas would be upholstered in "Blue Persian Wool."  Even as I write this, nearly a week on and a dry cleaning session later, I have recovered half a dozen cat hairs, which I suspect are actually viruses given their propensity to replication, from my suit.

We are invited to sit in the living room, a massively vertical space that, as there are no carpets or rugs for some reason, acts as an echo chamber, reflecting back down from the domed ceiling the voices of those below, delayed and slightly out of phase.  The effect is to double the number of cat voices audible at any moment.  To quote an Austrian Emperor: "The ear simply cannot follow so many notes."  I think at first that this effect must be intentional.  It would be trivial to dampen the sound in the room with some proper attention to fabric, after all.

Amazingly, Jake spoke in almost monotone, and without raised voice, though the entire session.  I grew so tired of straining to hear him that I finally just gave up.

I couldn't relate much of the meeting.  I spent most of it watching in horror as Craig collected five tuna smelling lint balls in his lap in the course of 20 minutes.

We walked out of the place with the beginnings of a deal framework but on the way to the waiting town-car Craig suddenly stopped and began to closely examine his laptop bag and then, to my amazement, to sniff it.

"FUCK!" he finally intoned.  "One of the fucking cats pissed on my new laptop bag."  The lack of rugs or carpeting fell suddenly and with an almost audible click into the grand order of things.

I made him sit in the front for the ride home.

Wednesday, July 26, 2006

Deal Hell

lawyer or banker? Equity Private Reader: "Where have you been?  Weeks without a post."
Answer: See Diagram


Art: Illustrations for Dante's Inferno, Gustave Doré (1861)

Thursday, July 27, 2006

Narcotrafficking and Private Equity

no spray for pe partners yet A friend of Going Private spent a lot of time studying black markets at University of Chicago and Harvard.  Among other things he devoted a lot of energy to understanding the economies of illegal drugs.  He once characterized the recent trend of private equity firms teaming up to invest in much larger deals as akin to an operational move made by the larger cocaine cartels in the 1980s and 1990s.  Specifically, splitting up cocaine loads via outsourced transportation.  If a single plane went down containing a large shipment of cocaine that all belonged to a single smuggling group, that was economically painful.  If instead the plane contained cocaine belonging to 4 different groups, the loss of a single load was distributed among the groups.  Private equity funds teaming up on deals, he argued, was the same kind of diversification strategy.  Aside from the obvious pleasure I derive from reciting apt comparisons between private equity firms and narcotrafficking cartels, there is a particular health care angle here too.  It is for this reason that this passage from a recent LBO Wire article confuses me:

While the $33 billion LBO of hospital chain HCA Inc. is being done by a consortium, it nevertheless shows that general partners are moving to soothe the fears of limited partners by cutting back on club deals.

Why cut back on club deals?  Oh sure, the returns are potentially more limited, but being able to play in one of the larger LBOs around with a lower risk profile (a significant blow up in such a large deal could cripple a firm that hadn't protected itself) should be worth the more modest returns.  (And by "modest" please keep in mind that we are talking within the LBO sphere here and that, at least in my estimation, limited partners are going to have to start getting used to more modest returns).

LBO Wire points out that many private equity partnerships have restrictions on what portion of equity can be invested in any single deal (to encourage the same risk mitigating diversity that club deals take advantage of) and that since capital levels have risen dramatically they can now form smaller consortiums.

I'm mindful of the other issue LBO Wire brings up, that you just don't want eight private equity firms on the Board at the same time, but I am not particularly convinced that is as significant a problem as others suggest.  As long as roles are clearly defined early on the Board tangles should be minimal.  When I voiced this opinion to Armin, however, his reply was, "True.  And all I have to do to solve world hunger is just get food to everyone."  I would feel slighted but I am smugly satisfied in the knowledge that he still can't get the phrase "costs and arm and a leg" down right.  He's improved from "costs a foot and a hand," and one comic "costs a foot and a mouth" incident (hoof and mouth disease perhaps?) to "costs a leg and an arm," though.

LBO Wire goes on to quote John LeClaire of Goodwin Procter in this passage: "With an eight times purchase multiple and HCA's strong historic cash flow performance, the firms 'are not looking to sell down risk....'"

With everything else going on I think it says something that we consider an 8x multiple low enough to suggest limited risk, but then maybe I'm being grouchy.

Tuesday, August 01, 2006

Terms and Conditions

break these chains of LIBOR Harris Rubinroit's tour de force survey in Bloomberg of the nuances of interest rates in large buyout transactions is a must read for Going Private mavens.  Using HCA as a foil, Rubinroit points out five key issues.  First, that KKR and Bain will likely be paying some of the highest interest rates since 2001 on the $16 billion they plan to borrow.  (Rubinroit uses some sound logic to guess they are near 2.15% over LIBOR and then points out that LIBOR is at a 13 month high).

Second, HCA already is at junk bond credit rating levels (Ba2 from Moody's) but that interest rate spreads were still at record lows for risky loans as recently as April.  (Rubinroit cites 1.59% as the spread that month compared to the 2.15% mentioned earlier in his article).

Third, even with the aggressive lending of hedge funds, rates are headed higher.  Rubinroit cites Thomas Finke at Babson Capital Management in blaming "more balance between investor demand for loans and supply" for the imminent rises.

Fourth, citing S&P, last quarter buyout firms averaged 5.19x cash flow for acquisitions (4.10x was the average for 2003).

Fifth, all these factors, and others, have contributed to the rise of "covenant lite" loans, with which Going Private readers will likely be familiar as the topic has been addressed here repeatedly.  So hooked on low restriction loans have the buyout firms become that it has become habit to simply negotiate up interest rate in favor of limited covenants right off the bat.  Interest rate spreads were so "compressed," argues Rubinroit, that covenants became the only effective way for lenders to compete.

The impact of breaking covenants is then well illustrated via reference to Six Flag Inc.'s ongoing renegotiation of $1.03 billion in debt after informing bankers they were unlikely to meet the 4.00x cash flow to interest expense ratio required by the loans and requesting that ratio be lowered to 2.50x.  Lenders are likely to extract half a percentage point of LIBOR spread and a quarter point "renegotiation fee" for the concession.  I expect this figure is substantially larger than what could have been negotiated from the banks before the covenant was broken.

Additional peeks into Bombardier and Intelsat, Ltd. are well worth the look.

Getting It From The King

the spilled lifeblood of the king The Wall Street Journal reports on Burger King's sad performance (subscription required) in its first quarter as a public company following its LIPO (Leveraged Initial Public Offering to new Going Private Readers).  Usually pointed on such subjects, the Journal is, this time, somewhat vague and forgiving of The King's regal lapse.  Maybe the Journal figures that the double digit stock price sacking would do the critical journalistic work for them.  It better, as the usual prodding over the massive dividends paid immediately prior to the offering is shamefully absent from the article.

Shares of Burger King Holdings Inc. fell 11% in midday trading as the fast-food chain reported a loss and tepid sales growth for its first quarter as a public company.

The results underscore concerns that Burger King's private-equity owners took huge payments while leaving investors with a company that has not yet turned the corner. Burger King spent $30 million on a management termination fee during the fourth quarter that ended June 30 that went to owners Texas Pacific Group, the private-equity arm of Goldman Sachs Group Inc. and Bain Capital.

I'm not sure why the $30 million break-up fee was cited and yet the massive $367 million special dividend and $33 million "make whole" payment (management bonus) prior to the IPO  was not.  Perhaps the Journal just didn't want to kick investors in LIPOs while they were 11% down.  And maybe that's important kindness for them.  If we are headed into an economic slowdown, (ahem) well, never fear.  Burger King's King will save you with his scintillating strategic acumen:

Burger King Chief Executive John W. Chidsey said Burger King will benefit from a slowdown in spending at sit-down restaurants that's prompting some consumers to trade down to fast-food chains. Burger King said its new value menu is performing above expectations.

Uh huh.  And how will we press forward into the new age, according to Chidsey as cited by the Journal?

Burger King intends to promote its breakfast menu, emphasize its Kids' Meals and encourage franchisees to remain open longer at night...

This sounds familiar.  Now where have I seen this before...?  Oh yes, of course.  Way back.  It was in their S-1/A.

Currently, 50% of Burger King restaurants are open later than 11:00 p.m., with 7% open 24 hours. Approximately 70-80% of the restaurants of our major competitors are open later than 11:00 p.m., with approximately 42% of McDonald’s restaurants open 24 hours. We have recently implemented a program to encourage franchisees to be open for extended hours, particularly at the drive-thru.

Innovation. That's what makes management teams great.  Adapting to new environments quickly and decisively.  Really, this makes me think there is more to the former CEO's departure than meets the eye.

In any event, it looks like the private equity folks timed this transaction right down to the quarter.  At the risk of saying "I told you so," do consider my musings on the transaction back in May. I had glowing things to say about management, after all, it is hard to sneeze at eight quarters of sales growth when contrasted to the seven previous quarters of dismal failure.  But even then, I wondered why the then CEO bailed, seemingly unexpectedly.  Still, back then I was already picturing the deal set to Peter Gallagher and Annette Benning's sex scene in American Beauty:

Private Equity Sponsors: "You like getting nailed by The King?"
Public Equity Markets: "Yes!  I love it!  Oh, yes!  Fuck me, your majesty!"

Now I wonder, didn't anyone bother to tell Burger King investors that you can't eat for at least eight hours before LIPO suction surgery?

(Photo: Burger King Crime Scene, September 2004, [daily dose of imagery])

Wednesday, August 02, 2006

Roles and Responsibilities

celebrate the chains of diversity My favorite financial editor takes good natured issue with my prodding of the recent criticism of "club deals" by large LBO firms.  I wondered aloud, after comparing LBO firms with narcotraffickers, what the issue was and why limited partners would whine, other than because of the potentially reduced returns, about the developing habit of larger LBO funds to go in with a number of other LBO partners to close a deal that otherwise might be too large (and too risky) for any single firm.

Club deals do not, the editor argued, reduce risk for limited partners who might be invested in multiple funds.  In this way, a single limited could be overly exposed to one buyout failure if they were invested in 4 different LBO funds all in on the deal.  I just don't buy this argument.

It is as simple as this: Any limited that fails to diversify the small LBO allocation sliver of their small alternative investment sliver of their large portfolio by investing in five large LBO funds with overlapping (if not identical) strategies is downright lazy.  The LBO fund's job is to follow the investment strategy they disclosed in their offering documentation and seek high returns for their limiteds.  Tailoring those returns for the particular portfolio quirks (or oversights) of a given limited is just not in the job description.  That's what the investment committee of the limited is for.

Honestly, can you really justify whining about a lack of diversity in your LBO investments when your idea of an alternative investment strategy consists entirely of investing in KKR, Bain, and Merrill Lynch?

Thursday, August 03, 2006

Blame The Bankers

quick, hide the ipos!Abnormal Returns points today to Daniel Gross' Slate.com article that insists the real reason behind the flight of IPOs from Capital Markets in the United States is not what should be the obvious answer, "Sarbanes Oxley."  Instead, Gross insists it is that the United States isn't any good at IPOs anymore, citing, among other reasons, the investment banking expense.  Quoth Gross referring to an Oxera Consulting report:

Raise $100 million in the United States, and you pay the New York-based bankers at Merrill Lynch or Goldman Sachs somewhere between $6.5 million and $7 million. Raise the same amount in London, and you pay the London-based bankers at Merrill Lynch or Goldman Sachs about half as much.

Setting aside for a moment my constant amusement with financial reporters who believe that $3.5 million is a lot of money; and with reading an article that asserts that the costs of SarOx are insignificant without outlining the costs of SarOx, this, of course, is silly analysis.  In my view anyone who dismisses the impact of SarOx on U.S. Capital Market competitiveness just isn't paying attention.

An absurdly conservative estimate I made some time ago based on numbers from the Corporate Roundtable showed non-adjusted expenses for SarOx for a $250 million firm at around $12 million over six years.  This is around 400% of the disparity in investment banking fees Gross cites Oxera as citing and it's only over six years.  This basic analysis also ignores the fact that a $100 million IPO is likely of a much larger firm and therefore a firm that would endure much more substantial SarOx costs than my $250 million example firm.  Assuming that 20% is floated in the IPO, a $100 million IPO might be a $500 million firm.  SarOx costs for such a firm over six years might approach more like $3-5 million per year.  It doesn't take many years to make the investment bankers look cheap compared to the raping the firm will be subjected to by the auditors.

Gross also doesn't bother to explore the connection of high underwriting fees in the United States to increased liability and compliance costs investment banks have been saddled with post-SarOx.  I've yet to see the argument made that London underwriting isn't cheaper because of looser regulatory environments and limited litigation risk.

Also bear in mind that for the ever more popular LIPO, every dollar spent yearly on SarOx is a dollar that can't be spent on debt service.  That could prove far more expensive than the naked dollar cost of SarOx.

More concerning is the first day run-up figure in offerings disparity shown by the consulting firm Gross cites, suggesting that IPO pricing is a lost art among American investment banks and that money is being left on the table as a result.  Ignoring for a moment that Gross cites the high expense of using Morgan Stanley and Goldman Sachs for underwriting (probably because they are the two most expensive), but that the report uses an average of all offerings by all investment banks in the United States to argue for the poor pricing skills of American investment bankers (a clever trick), I worry here about the statistical validity of comparing the IPO market in the United States with that in, e.g., London.  Could the same company have raised as much in London as in the United States?  How do we know?  How exactly were the many variables (taxation, regulatory costs, litigation risk) normalized in Oxera's study?  Was firm size adjusted for?  Industry?  We are not told.

Just as an aside, it would be interesting to know how Goldman compares to the rest of the U.S. when it comes to IPO pricing accuracy as measured by first day (week?) run up.

Friday, August 04, 2006

Jeff Matthews Is Driving Through Burger King

deposing the king 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 do well.

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?

8.89%

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.

Monday, August 07, 2006

Imminent Death of Private Equity Predicted

as orderly as the horae of the seasons Jeff Matthews isn't the only one predicting a shake-up in private equity.  But then, that's easy since "private equity" is a pretty expansive term.  Depending on the proclivities of the person you ask it may or may not include hedge funds, may or may not include venture capital, may or may not include real-estate partnerships, may or may not include mezzanine funds, etc. etc. etc.  I'm not particularly qualified to comment on anything other than buyouts and hedge funds (as those are the firms I have direct experience with), and I might not even be particularly qualified to comment on those, depending, again, on the proclivities of the person you ask.

Peter "The Informed Observer" Cohan joins the fray in a pair of scribes, the first back on the 2nd of August, wonders if private equity is "long in the tooth," echoing the arguments of (rising interest rates, too much cash, tough to find deals) and even sounding remarkably like Jeff Matthews' same-day missive I referenced here yesterday- right down to the dangerously inductive logic used to draw from one lawyer's quote on the Phillips deal the conclusion that firms are "stretching for deals," and a particularly interesting, if historically miopic, view; as if "private equity" (which here I take to mean buyouts, as only buyouts are used for examples) is a new invention without an active history over the last 30 years, two boom-bust cycles under its belt already and tendrils going back to the 1960s.  (Much further if you start looking at original "boot-strap" deals).

HCA is mentioned also, presumably to support this "stretching for deals" theory, but the only evidence given in that context is that debt to EBITDA ratios of the company will soar by the rather vague figure of somewhere between 200% and 600%.  (Quoting the Debt Bitch: "Of course they will, it is an LBO, duh.")  There is, the argument goes, therefore less "margin for error."  Given the similarities to the Jeff Matthews piece, I sort of wonder which one was actually written (as opposed to "published") first.

I notice also that none of these missives mention the likes of J. Crew (which is certainly at the high end of LIPOs, actually managing credit rating upgrades after submitting itself gracefully to the gentle ministrations of the public and sitting today, as it does, nearly 30% above its initial offering price).

Cohan follows in a penning dated August 5th citing an Alan Abelson article in Barron's that happily cites him in order to jump on the shake-out bandwagon.  Curiously, in this post Cohan refers to the "August 7th" Abelson article, even though the post he does it with is listed as published on August 5th.  I'm not a huge Barron's reader so I don't know how well their publication dates actually match reality, but this is certainly somewhat curious and either Barron's is careless or Cohan is a time traveler.  I suspect the former because the later would beg the question "why is Cohan wasting his time blogging?"

Completing the circle and reminding me once again how inbred financial "reporting" is, Cohan cites the Bloomberg HCA article by Rubinroit, which an insightful Going Private reader adroitly deconstructed last week, to pulls his facts for the HCA deal.  That posting on Going Private prompted another Going Private reader, who wished to remain comfortably anonymous, to wonder in a highly detailed and example filled email if Rubinroit's job description was merely to transcribe for Bloomberg S&P's Leveraged Commentary and Data service articles (usually written by Chris Donnelly) and then a third Going Private reader in email again to question (this time with no small amount of vitriol) the facts in the Rubinroit piece.  Then a fourth reader chimed in via email to comment in the same vein on the HCA deal, and Rubinroit by proxy, but he/she asked not to be quoted.  I haven't read enough Rubinroit yet to have an actual opinion on the topic of his reporting prowess but Going Private readers seem to have formed a consensus of sorts.  Shame on me anyhow, as I had cited the Bloomberg piece somewhat blindly and neglected the much superior and well researched July 25th work (subscription required) by The Deal's debt master, Vipal Monga that, interestingly- because she never has anything good to say about anything- meets with the Debt Bitch's seal of approval.  "He gets it," she says.  It must be love.

Far from "a stretch," Vipal said instead of the HCA deal:

HCA's financing depends on a successful closing of the deal, which is expected in the fourth quarter. The agreement between the buyout consortium and HCA allows the company to solicit superior bids from third parties for 50 days, and the hospital group plans to search actively for higher bids.

Although there have been no confirmed reports of other bidders contemplating jumping in, one source close to the deal said initial interest in HCA from other mega-buyout firms has been high.  That's not surprising, considering that the proposed deal is modestly valued, at 7.8 times HCA's Ebitda in the 12 months ended June 30, well below the double-digit multiples that have become common in today's sizzling buyout market.

Setting aside for a moment the accuracy or non-accuracy of Matthews, Cohan and Abelson, (Vipal must be right if the Debt Bitch likes him) or if we consider 7.8 times EBITDA "modestly valued" let's consider what a "shake up" in private equity looks like.  And by "private equity" I mean the rather limiting definition of: "LBOs."

My own belief is that there is a size beyond which buyout funds stop being "pure" buyout funds.  Purity is in the eyes of the beholder, of course.  My belief here is not original, but rather formed after a magnificent conversation with David Jaffe of Centre Partners who, referring to the point where buyout funds get unwieldy, quipped, near as I can remember it, that "$750 million is about the right size."  I didn't believe it then, but I remembered it.  By April, I believed it.  Back then I mused:

Didn't we learn in the 1980s that unfocused conglomerates don't work particularly well?  Why are we running down that road again, with hedge funds, with Google?  Management fees, perhaps?  We are long past the point where the management fee just barely pays the bills at a fund and you have to find upside to get wealthy.  The incentives to bloat assets under management are simply too significant now, I think.

Buyout funds were designed and have every internal incentive, save one that I will address in a moment, to be smaller, focused and disciplined.  They are long-term return vehicles with a variety of golden-handcuffs to allow for (indeed, require) that rarest of qualities in investors today, liquidity-less patience.  The patience to endure years of little liquidity in search of value.  Larger firms are poorly suited to do the kind of deals I would call "pure buyouts."  Buyouts with a turn-around component.  Buyouts that look to their management talent to provide value, not just to leverage and financial restructuring.  Focused firms.  That is not to take away from the accomplishments of larger firms.  There are many.  But the opportunities for those firms to shine are likely to be the first to dry up.

The misplaced incentive I refer to is, of course, the management fee.  The "2" of "2 and 20."  2% of assets under management which go to the fund manager, in theory, to support infrastructure until liquidity events get everyone paid (rich?).  And getting rich (the 20%) is contingent on performance.  2% has, with larger funds, become more than just infrastructure support.  Moreover, when you start seeing $5 billion, $7 billion and $11 billion funds, 2% looks downright silly.  Certainly, funds are not scaling their infrastructure up in a linear fashion after around $1 billion in managed funds.  That 2% looks more and more like pure "bonus money."  And bonus money not contingent on performance, only on fund raising capacity.  Suddenly, you have an incentive problem (the incentive is to raise a lot and develop only limited infrastructure) combined with a last round problem.  Who cares if the $11 billion fund folds.  After 7 years they've pocketed up to $1.5 billion just in management fees.  That takes some of the sting out of being unable to raise $22 billion the next year because of low IRRs.

In my view, club deals and "mega deals" have become mandates on capital structure, not "value added buyouts."  LBO capital is cheap.  Going private transactions provider better management incentives and less risk, and all the other things I've been rambling about.  But turnarounds are few and far between in these larger deals.  Also, reading certain of the commentators I cite in this article one gets the impression that "private equity" is entirely going private transactions buying out large publicly held firms.  Indeed, that's where the headlines are.  But there are those firms that have been quietly doing buyouts for 15 and 20 years and haven't bought a public company yet.

This is oft forgotten today.  LBOs were an exceptional tool to undertake turnarounds of troubled and down-and-out business that, perhaps, had just fallen out of favor.  Today many of the headline deals are using buyouts as a tool to reform capital structure.  As capital grows cheaper, however, the need to find underpriced assets is not as essential as it once was.  There is a flight from deal quality.  Instead, you just need to find firms that aren't well served by the public capital markets.  That's an easy thing to do today.

It used to be that after reaching a certain size as a corporation, you were paying opportunity costs if you didn't go to the public markets for expansion capital and the U.S. capital markets were the place to do that.  Cost of capital on equity raised in the public capital markets was such that it was the best way to go in order to really grow the firm.  Those days are over.  Well, not over, but in decline.  Adjusting your balance sheet to enjoy low costs of capital is as American as pantless investment bankers on their third martini in the First Class section of BA's nightly JFK-LHR flight.  Now that the expanded reach of cheap debt and equity comes with the added bonuses of higher management compensation and less regulatory burden in the form of mega-buyouts, what's not to like?

The problem is that the focus has shifted.  Applying carefully constructed, long-term oriented structures (LBO funds) to buyout candidates in need of management acumen and focus that were poorly served by the short-term (and increasingly costly) public markets for capital has instead become a simple financial tool.  Specifically, the shift of any company at all from a public to a private equity structure.  Notable about the HCA deal is the constant theme among interviewees commenting on the details that the existing management will basically remain untouched.  That's always nice as a buyer, to have a strong management team in place, but it suggests also that not much value is being added on the management side.  That leaves only financial structure and regulatory burden.  From this perspective, the pattern looks exactly like the conglomerate wave of the 1980s, and it will "end" in similar fashion.  The large conglomerates are today not "gone," per se.  They are instead "focused on our core business."

The advent of LIPOs (Leveraged Initial Public Offerings, or IPOs of debt-laden, private equity owned firms, for the uninitiated Going Private reader) has also had an artificially extreme impact on IRRs.  Flipping something to the public market only a few years after having bought it up (so much so that the company ends up paying "break-up" fees for the prematurely terminated management contract) really boosts IRRs and, again, works against the LBO structure's big selling point: long-term focus and turnaround management.

It was much cheaper from a cost of capital perspective for the firms scooped up in those days to be bought by corporate behemoths and managed as a part of a larger economy of scale.  That too was a capital structure shift.  Eventually, so much money (stock) poured into the takeover craze that the movement simply ran out of breath.  The last many deals were the worst for exactly the same reason.  The easy targets were bought up, the model then extended (at greater cost) to pick up firms that never should have been corporate daughters in the first place.  The result: a better, cleaner capital structure alternative emerged and had the added benefit of being able to provide more focused management guidance.

As the cycle runs, one of two things will happen, I suspect.

1.  Costs of capital and regulation in the public capital markets somewhere will once again become low enough (maybe just because private equity and debt gets dramatically more expensive) and efficiencies high enough that even struggling private equity portfolio firms will just go public again.  I tend to think that this will be a jurisdiction other than the United States unless this country gets its act together with respect to being a friendly place to want to incorporate and list oneself, though I find a sudden positive reform by the United States highly unlikely at present- and then there's the whole subject of who wins the 2008 presidential election.  Frankly, this really makes me want to be in the foreign financial exchange business.  Some careful thought about these dynamics could make an upstart non-U.S. exchange the one stop spot for the former daughters of LBO funds.  The 1990's NASDAQ of modern LBO survivors.  I am reminded a little bit of the Cayman Islands, and the timely transformation engineered thanklessly by Louis Fenma in perfect sync with changes in the United States in the early 1980s.

2.  More likely, I think, struggling private equity portfolio firms will either be bought and broken up by a new generation of raiders (though the drama of the proxy fight will be both less entertaining and more expensive when the major shareholders are all mega-funds with IRR targets) or bought piecemeal by smaller, more focused firms around $750 million in size, exact mirrors of the early LBO funds in the 1980s, except with different sellers and more focused on value as debt gets more expensive.

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.

Personally, I quite like the prospects for the high end of mid-market LBO firms.  Big, ugly buyouts gone bad are great opportunities for those of us in the buyout business.  We like train wrecks here.

Death of the industry?  Hardly.  Not any more than the demise of Drexel was the death of the industry.  There's a ton of equity overhang still sitting around.  Even if the LIBOR pops up 2.5% we are still in very healthy debt markets.  The business isn't going away any time soon.  Maybe the headlines will, but that would be fine with me, and most of the people at Sub Rosa and the hundreds of firms like us that daily go quietly about the business of buying and, more importantly, improving companies.  That mostly orderly cycles and seasons in private equity would come to pass should surprise no one.

A flight to quality is certainly in the cards.  I can't wait.

If I were a limited partner evaluating LBO funds to invest in, I would look for small, focused funds with under $3 billion, and preferably under $1.5 billion, that weren't going to get rich on their management fee, that had good turnaround talent, actual management talent and not just financial structuring gurus, on the bench.  I would focus on funds that had expertise in sectors that I thought could benefit from a lack of short-term capital pressures- sectors that have fallen into disfavor and that needed more than a pair of years to turn around.  Let's remember that that's what LBOs were designed for.  If I had to look at larger funds because I had too much money to place without violating the concentration restrictions on my investment with any one fund (or theirs for any one limited) I would be very wary of funds with a history of liquidity events peppered with 2-4 year LIPOs with management contract break-up fees.  Their IRRs are probably high because they are exiting prematurely with dumb-money, not because they deliver value.  I would ask myself daily, "Am I buying into a short-lived corporate governance, cost of capital and regulatory arbitrage opportunity, or a team able to transform businesses?"  I'd also spend more time on vacation than I do now.

(Art: "Horae Serenae," 1894, The Baronet Sir Edward John Poynter, one time President of the Royal Academy and editor of Illustrated Catalogue of the National Gallery, 1900.  Depicted are the first generation of Horae: Thallo, goddess of spring and bringer of flowers, Auxo goddess of growth, and Carpo, goddess of the harvest, were the goddesses of the seasons and orderly customs who, among other things, dressed Aphrodite as she emerged from the ocean and traveled with Persephone each year to the underworld).

Tuesday, August 08, 2006

Priced By Experts

pricing expert Recent discussion here on Going Private has led me to speculate about the "IPO expertise" in U.S. Capital Markets.  My interest is connected to a piece by Jeff Matthews or Peter Cohan (I can't tell which because both were written on the same day and are almost exactly the same) and the assertion by Daniel Gross for slate.com that with respect to global capital markets "...the United States... is more expensive and not particularly efficient at IPOs."

Poking around on the subject I found an older (August 1999)  Fernando, Krishnamurthy and Spindt paper out of Wharton's Financial Institutions Center titled "Offer price, target ownership structure and IPO performance" (.pdf file) the findings of which suggest, among other things (from the abstract):

...that firms select their IPO offer prices to target a desired ownership structure, which in turn has implications for underpricing and post-IPO performance.  Higher priced IPOs are marketed by more reputed underwriters and attract a relatively larger institutional investment.  These IPOs are relatively more underpriced, possibly as compensation for the monitoring and information benefits provided by institutional investors.  IPOs whose offer prices are below the median level seem to be targeted towards a retailed investor clientele.  These IPOs are also relatively more underpriced, possibly as a cost of adverse selection.  Our finding that long-run performance increases with offer price confirms that higher priced IPOs are better firms.

And later:

We find that instituional ownership increases with offer price. Controlling for firm size, offer fraction, underwriter reputation and other variables thought to influence IPO pricing, we find that underpricing is a U-shaped function of offer price.

Our findings are consistent with the characterization of high-priced IPOs as targeted towards institutions in which case underpricing compensates the institutions for information and future monitoring services.  Firms could choose a low offer price and discourage institutional investment to either preserve private control benefits or to avoid potentially costly investor myopia.  The resulting pooling equilibrium could lead to higher underpricing.  Our results also suggest that the offer price is positively related to the likelihood that the firm will remain viable after five years.

Of course, the authors might have drawn different conclusions had the IPO scandals and the "Friends of Frank" behaviors of the era been understood at the time, (and, in fact, other works I cite below find exactly this- that agency problems contributed to underpricing woes) but the point remains: IPO pricing is a complex dynamic among sophisticated players.  This makes me doubt the value of same-day IPO price fluxuations as a proxy for "IPO efficiency," and the paper points out nicely that many other factors not only may bring long term value to a firm, such as institutional monitoring or analyst coverage, but that players in the IPO game are aware of these nuances and that they presumably impact price.  In short, simple analysis of same day price variances are not a good proxy for "IPO efficiency." But then, if you are a consulting firm doing a study for the London Stock Exchange, the simple analysis serves you(r client) much better.

Still, let's see if we can't uncover some details about the "performance" of different IPOs by underwriter.

Opinions vary.  Koop, Lee "Valuations of IPO and SEO firms" (.pdf file) (May 2001) doubts any underwriter reputational advantage exists noting that "Theories regarding underwriter reputation or windows of opportunity for equity issuance are not supported in our empirical results."  Guner, Onder and Rhoades find that underwriter reputation seems to matter for emerging markets in "Underwriter Reputation and Short-Run IPO Returns: A Re-Evaluation for an Emerging Market." (.pdf file) confirming my suspicion at least that IPO markets vary significantly by country, and Binay, Gatchev and Pirinsky give us "How Important Are Relationships for IPO Underwriters and Institutional Investors?" (.pdf file) (January 2006) which finds, among other things that:

...underwriters favor institutions they have previously worked with when allocating Initial Public Offerings (IPOs). Regular investors benefit more than casual investors in IPOs by participating more in underpriced issues. Relationship participations are more important in the distribution of IPOs with stronger demand, IPOs of less liquid firms, and deals by less reputable underwriters. Overall, our results are consistent with book-building theories of IPOs and suggest that regular investors improve the efficiency of the IPO process. Interestingly, our results are weaker for 1999-2000, consistent with the idea that in this period other considerations (e.g., commission revenues from clients) affected the allocations of IPOs.

...and that...

Underwriter reputation, while not explicitly modeled in the book-building theories, could also be linked to relationship participations. If underwriters with higher reputation produce better information about the IPO (Carter and Manaster, 1990) then IPOs underwritten by such underwriters will have less need for the participation of relationship investors for information production. In support of this prediction, we find that IPOs underwritten by banks with higher Carter-Manaster ranks have lower relationship participation.

The implication is that higher reputation underwriters need less "regular investors" (i.e. repeat investors in IPOs by the same underwriter) and therefore need not underprice to the same extent required of underwriters who are more reliant on relationships to place IPO shares.

I've still not found scholarly work exactly on point for the issue at hand, "Does Goldman price IPOs better or worse than the rest of the world," but the search continues.

Corporate Nostalgia

you could land helos in the city back then Dealbreaker's John Carney points us to an absolutely stunning missive published today by Professor Michael S. Rozeff on the history of conglomerates, just in time, I might add, to supplement my recent musings on the topic and its connection to private equity and buyouts in particular.  Consider this passage:

How one company could create value for its shareholders by paying a big premium over market value to buy another company in an unrelated industry was a mystery, then and now. When the conglomerate sold at a price/earnings ratio of 20 and bought a company with a price/earnings ratio of 10, the combination seemed to fetch a price/earnings ratio of 20! This financial legerdemain (or was it ledger-demain?) created value, for a while. It was not permanent. By 1970 the days of reckoning arrived and the conglomerates crashed along with many other stocks.

The company heads were empire-building. They were being paid according to the revenues they managed, so they grew revenues by acquisition. If Wall Street made their paper (stock) worth a lot of money, it made good sense, they thought, to issue more of it and buy real assets. It made sense for the managers who made more money. It made less sense for the shareholders who saw companies overpay for acquisitions. For awhile the roller coaster rolled upwards before reaching the crest and speeding downwards.

The financial-historical goodness continues unabated for some time and is an absolute must-read for the erudite Going Private follower.

(Art: "Conglomerates Collide" Apple II business simulation game by Rockroy Inc., c. 1981.  Being a nostalgist for all things 1980s business- mostly due to the bitterness I experience due to the trick of fate, i.e. the late timing of my birth, that failed to permit me to be in LBOs back then- I cannot help but be totally fascinated by this ancient game.  Try your hand at it on-line, oh, would-be captain of industry.  Laughs by the dozen for the careful study of business irony.  Your managing director will surely see it as work-related study).  Consider:

GAME RULES

THIS  IS  A  GAME OF CORPORATE CONQUEST IN THE WORLD OF CONGLOMERATES.
EACH  PLAYER  CREATES  HIS  OWN  COMPANY  (BY  NAME),   SELELCTS   ITS
INTERNATIONAL  HEADQUARTERS  AND  STARTS  WITH  $20 MILLOIN IN ASSETS.
INITIALLY, EACH COMPANY HAS $10 MILLION IN CASH  AND  $10  MILLION  IN
CONTROLLED  CAPITAL  STOCK.   THE  CAPITAL  STOCK  VALUE OF 10 MILLION
REPRESENTS 1 MILLION SHARES AT $10 PAR VALUE.  THE  COMPANY  ALSO  HAS
BASE  EARNINGS OF $2 MILLION PER YEAR (TURN) WHICH REMAIN CONSTANT FOR
THE ENTIRE GAME. GIVEN THESE RESOURCES, YOU MUST INCREASE THE  EARNING
POWER  OF YOUR MULTI-NATIONAL CORPORATION BY ACQUIRING OTHER COMPANIES
KNOWN AS SUBSIDIARIES.  WHEN BUYING A SUBSIDIARY, LOANS TO  A  MAXIMUM
OF  50%  OF  THE  PRICE  ARE AVAILABLE TO FINANCE THE PURCHASE. ONCE A
SUBSIDIARY IS ACQUIRED, THE AMOUNT OF FIXED EARNINGS FROM THAT COMPANY
ARE ADDED EACH TURN TO THE BASE EARNINGS  OF  YOUR  CONGLOMERATE.  ANY
SUBSIDIARY  THAT  IS AQUIRED MAY NOT BE RESOLD-FORCING PLAYERS TO LIVE
WITH THEIR DECISIONS.  EACH YEAR (TURN) THE PRIME  RATE  WHICH  RANGES
FROM 7 TO 30% CHANGES RANDOMLY AND CAUSES THE BANK RUN BY THE COMPUTER
TO  COLLECT THE AMOUNT OF INTEREST DUE FROM EACH PLAYER'S COMPANY. THE
BANK WILL ALSO PAY INTEREST ON DEPOSITS AT A VARIABLE RATE  LESS  THAN
THE PRIME RATE WHICH PROVIDES EXTRA INCOME

Wednesday, August 09, 2006

Powerful Forces At Work

last resting place of pe? This morning, DealBook sends me to the Financial Times' latest article bemoaning the future of private equity and wherein I learn that "if one assumes that 80 percent of a buyout deal is leveraged, The FT hazards a guess of an astonishing $1.485 trillion in capital available for private takeouts." Well, I'd love to be able to get debt at 5:1 on my equity with some regularity, but it doesn't work out that way, really.

The FT calls the backlog of "uncalled capital" something like $297 billion.  I'd be more comfortable assigning a 4:1 debt to equity ratio which suggests $1.188 trillion in available buyout capital.  But that is neither half a billion here, half a billion there.  The FT goes on to point out, however, that the former sum is something like 12% of the market cap of the S&P 500.  It also pegs the "average spread on high yield bonds" at 350 basis points, that seems sort of high to me, though FT's terms are not defined here.  Concludes the FT:

By necessity, buy-outs must now be less selective. Investors can either own public equity or invest in funds that must pay large takeover premiums to own public equity – and which charge meaty fees for the privilege. If less discriminating buy-outs are the future, it is probably best to be on their receiving end.

Well, we forgot about the option to invest in funds that buy private firms, echoing the increasingly common treatment of "private equity" as purely "going private" related.

And try as I might, I still cannot get that worked up over buyouts that manage to snag assets for under 8.00x EBITDA (HCA).

All this is neither here nor there, however.  The real story is in the first reader comment on DealBook however, which finishes off with this gem from Mark Klein, M.D.:

"Too bad for us for the Baby Boomers and their progeny who govern today in their elementary schools sex education replaced thrift lessions."

Reminding us that one of the greatest conceits in the United States is the continuing demonization (or praise) of politicians conducted under the denial-laden belief that their monetary policy (and indeed their position on sex education in schools) actually influences the economics of things such as buyouts in any substantial way anymore.

(Art: "Tombstones in Whitby," Paul Townend, c. 2005)

[Edit: A watchful Dartmouth alum and Going Private Reader writes: "FT: does not suggest a 5:1 debt to equity ratio, but rather 4:1 (~300b = 20%, ~1200b=80%, ~1500b = 100% of buyout capital). 5:1 would = a 16.7% equity injection. Your sentence should read: 'I'd be more comfortable assigning a 3:1 debt to equity ratio which suggests $1.188 trillion in available buyout capital.'" Of course, our Dartmouth alum is exactly correct. Going Private regrets the error.]

Thursday, August 10, 2006

May Well Have Been Underestimated

costs in year are larger than they appear I've been posting about the cost of SarOx pretty much since I began Going Private, but with some renewed vigor these past two weeks as the debate over "the real reason" for the flight of IPO business from United States capital markets began (somewhere out there I suspect like-minded people are busy at work tracking down "the real killers" of Nicole Brown Simpson) and the imminent death of private equity as we know it becomes the theme of the week month for financial "reporters."

Regular Going Private readers will, therefore, understand my interest in some of the recent developments in the study of SarOx costs.

Corporate Tool started the trend with some personal observations about my SarOx cost calculations.  Following that, I ran into a piece on the very timely titled Conglomerate Blog pointing, in turn, to a Financial Times article which then cites a study by the law firm Foley & Lardner (subscription required) the findings of which "...confound predictions that US companies would only face a one-off increase in audit fees and other costs as a result of the legislation, introduced after the Enron and WorldCom scandals."  This suggests my calculations of SarOx costs are even more absurdly low than I suspected (and just as Corporate Tool indicated) as I assumed a trailing off of 404 compliance costs after the first year and this was clearly erroneous.  This, in turn, suggests incentives to bail on public capital markets in the United States due to SarOx are even higher than I expected and, following that logic, that certain commentators who should perhaps stick to reporting on how "Street Fashion Blogs Keep Tabs on the World's Most Stylish Pedestrians," instead of mouthpiecing for the London Stock Exchange got it awfully wrong.  (Not that there's anything wrong with the London Stock Exchange, mind you).

Conglomerate Blog goes on to cite an excellent paper by Emory Law Professor Bill Carney that I now re-cite both because of its excellent content, and because I enjoy harboring the fantasy that the paper's title ("The Costs of Being Public After Sarbanes-Oxley: The Irony of 'Going Private'") is a thinly-veiled fan-reference to my writings here.

Friday, August 11, 2006

One Plus Three

explosive inflation lines Friday means I have had at least a little time to absorb this week's Economist.  I have been hard on "financial journalists" this week, what with the Mark Cubans of the world poisoning an already flagging sector, and causing at least one to complain that I have been painting the group with a wide brush.  The Economist, which, by the way, usually leaves its articles uncredited, tends to assuage my bristles in this department.  This week is no exception.  As usual, the articles therein draw a keenly stitched thread through areas of great interest to me.  This week, however, that thread begins with DealBook, which, in turn, points to an Adam Lashinsky piece in Fortune on what might be signs of a pending correction in private equity.  Many of the old arguments are re-hashed.  LIPOs like Burger King are mentioned, J. Crew ignored (a quick reminder that the CNN/Money logo atop the Fortune webpage has deeper meanings).  New though, is the voice of University of Chicago's Steven Kaplan.  "Historically, this looks a lot like 1987 and 1998," says Kaplan.  This, at least, is concerning.  Some signs of hope exist, Lashinsky manages to admit.  Interest rate coverage is much better than "back then," and there is always the potential for well focused firms to pick up tasty morsels of any shakeout with distressed funds.

By contrast, the Economist's portion of the thread is less "pop" about its financial news.  It begins with a pointer to a survey by Hay Group, a human resources consultancy, (subscription required) that shows that, cost of living included, senior management compensation is not what you think it is, that is unless you're a Going Private reader and have been following the facts, rather than the hype.  By this measure management in India, Germany, Switzerland, Brazil, Spain, Russia, Poland, Turkey, Japan, Portugal and Ireland all turn out better than United States executives- wonderfully ironic given the amount of vitriol about executive pay spills in the direction of the United States via Europe in general and Germany specifically.

This easily sets up the observation by the Economist (subscription required) that European Leveraged Buyouts are the hot new ticket (as your humble author can attest to personally).  Ironically, the by-line reads "Paris," but then, nothing is perfect.  "Europe is behind Britain, which is behind America," the Economist quotes KKR's Europe guru Johannes Huth as saying.  Indeed.  Given the events of the last two days I suppose it would still be somewhat excessive to try to factor terrorist risk into my calculations of risk-adjusted compensation when arguing for my salary increase upon a European posting.  Can't blame a girl for trying.

Follow that with a bit on inflation worries in Europe (subscription required) and the Economist has the private equity trifecta for the day.  Typical Friday.

High Tension Cable

to the breaking point Blackstone's acquisition of a 4.5% stake in Deutsche Telekom got a lot of Going Private Headlines over the last several months, not least because of the highly atypical nature of the deal (a minority investment in a public firm by a generally control-obsessed buyout firm).  I read with interest, therefore, a self-proclamed "dilligent fan"'s email missive pointing out that the equity stake Blackstone had taken in the deal, and indeed the investment at large, has been pounded.  Bloomberg reports yesterday that:

Blackstone Group LP's stake in Deutsche Telekom AG has dropped by about 540 million euros ($689 million) in value after shares of Germany's former phone monopoly lost almost a quarter of their value in four months.

The New York-based buyout firm bought 191.7 million Deutsche Telekom shares for 14 euros apiece from KfW Group, the state bank said in April. At the time that stake was worth 2.68 billion euros. Shares of Europe's largest phone company have since dropped to 11.17 euros, cutting the value of Blackstone's 4.5 percent stake to 2.14 billion euros.

The stock sagged another 4% today, I'm told.

Blackstone's self-imposed two year lock-up prevents them from exiting, though I'm not certain why they would at this point in any event.  If they truly believe in their investment premise, and my speculation about their motives is anything near correct, now would be the time to start acquiring a larger stake.

Alternatively, perhaps rumors of their interest in a larger stake were buoying the shares, i.e. the next stage of the acquisition might have been already priced in, and the failure of such a plan to materialize with anything like speed is now weighing them down.

Certainly, given the size of the firm it would be a difficult deal to pull off without a club-like setup. Will other firms be confident enough in Blackstone's investment theory to join the party in the face of sagging shares?  More than ever, perhaps, at this new price if the balance sheet for DT looks as good to them as it sounded to Blackstone.  Still, one of the purposes of buyout funds is to structure for the long term.  If DT's assets are fundamentally sound and this is a temporary dip then it is an opportunity.

It will be interesting to see how one of the largest buyout firms responds to this very public short-term setback.  And this, in turn, highlights one of the problems with PIPE deals by private equity firms- they aren't private.  Are large buyout firms prepared to deal with foreign investor relations issues?  Charges that they are locusts?  Plagues?  A forward looking career consultant might suggest there will be a growing need for public and investor relations experts with finance backgrounds in large private equity firms as these low hanging fruit becomes harder to find, these sorts of deals become more common and this issue grows to a more significant one.

Monday, August 14, 2006

Buy High, Sell Low

airbus is looking for you The Wall Street Journal wakes me up today (subscription required) with an interesting piece on rising commodity prices and their connection to a recent return to favor of certain acquisition practices that had fallen by the wayside in recent decades, namely: vertical integration.

The Journal points out that a desire to control supply and prices has pulled vertical integration from the scrap heap of 1980s mergers and acquisition finance, where it lay quietly collecting standing water, breeding mosquitoes and rusting from the corrosion of inefficiency, before dusting it off and pressing it into use as a means to provide both for consistent and consistently priced supply in a commodity environment where neither existed.  At Sub Rosa we noticed a surge in activity in steel as early as January.  Not quite as big as the number of new ethanol plants we were asked to help finance (even though we don't really do start-ups) but close.

Other responses to pressures are also cited, namely new technologies and long-term contracts.  If, however, I am dubious about Airbus locking in Titanium prices through 2015 can be chalked up to a certain prejudice about highly subsidized, multi-nation state ventures that colors the odds I give Airbus of having much of a Titanium appetite or even surviving through 2015.

The article caught my eye for three reasons.  Firstly, it is interesting to see old, but perhaps once overused, arrows in the acquisition quiver nocked once again.  Secondly, because I spend too much time reading Abnormal Returns, which quite enjoys the topic of commodity prices.  Third, because I wonder if this is not a case of "too much, too late."  Successful supply strategy requires action before matters get out of hand.  (Think: Southwest's brilliant [.pdf] Jet A hedge that, at one time, had their costs at $26 a barrel, and unfortunately has now mostly petered out for them).  I wonder now if it isn't too late to be integrating vertically and if some firms won't be stuck with big suppliers purchased at the peak of the commodity market and which they aren't particularly good at running.  Depending on your commodity price sentiment, it could be that there will be some raw materials LBO opportunities in the next few years.  There are, after all, worse things than owning a raw material supplier in a market with sinking commodity prices, but I suspect that they all involve British dentistry.

LIPO Suction Malpractice

slurp! 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.

...before adding...

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.

Friday, August 18, 2006

Vanity or Opportunism?

the price of vanity: rebuke A combination of time constraints and (more severely) the psychology of personal reflection make it difficult for me to properly evaluate the true meaning my recent tendency to measure the passage of time by the regular arrival of The Economist.  It seems only hours since I was reading the last issue and here is another one haunting me with ridiculously relevant insight and discussion (subscription required).  The loyal Going Private reader will know this because I violate today my usual literary disdain for all subjects macro.

Most interesting, at least this hour, is the discussion on the importance of recession in economic cycles and the potential for some wholesome economicy goodness to issue forth from a slow down in the United States.  I suppose it would be too clever by half to point out that it is conveniently easy for a British publication to call for a recession in the Colonies, though I think The Economist's piece falls short of that.  I am sorely tempted to point good natured, if gently accusatory, fingers towards the red ink in The Economist's logo anyhow.  Regardless, the piece brings up several important issues besides having the appealing property, always welcome in financial journalism, of using railroads as a metaphor.  Says an uncredited Economist writer:

In 1871 America added about 6,000 miles of track to its railways, an endeavour that occupied a tenth of its industrial labour force. But by 1875 track-building had fallen by more than two-thirds, and employed less than 3% of America's workers.

According to Brad DeLong, an economic historian at the University of California, Berkeley, the violent ups and downs of the railway industry help to explain the popularity, before the Great Depression and John Maynard Keynes, of a fatalistic view of the business cycle. Recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year's 6,000th mile of track) as an essential prelude to redeploying them elsewhere. “Depressions are not simply evils, which we might attempt to suppress,” wrote Joseph Schumpeter. They represent “something which has to be done”.

Back in high school I had an economics teacher who ignored all hand wringing about the deficit or trade imbalance.  "I expect it will just eventually be inflated or recessed away," he would quip.  You would likely be forgiven today for mistaking him for Joseph Schumpeter.

In Schumpeter's day, this fatalism was shared by many at America's Federal Reserve. But today's Fed acts quickly to suppress recessions, which it recognises are mostly due to a lack of demand, not an excess of track. For the Fed, recessions are good for one thing, and one thing only: curbing inflation.

The Economist gets it exactly right, I think, in pointing out in a between-the-lines sort of way that a long brewing conflict between two schools of, if you will, recessionary thought, has come to a head.  Internationalists, with increasing volume over the last few years, point to the dangers of foreign sovereigns and financial institutions dropping the dollar wholesale in anticipation of a future recession.  Internationalists have typically been far more forward looking (at least when it came to monatary policy) than their domestic counterparts.  Now, The Economist argues, forward looking thinking has become en vogue for the domestic bunch, as recession could be the cause of a current account deficit shrink rather than the reverse.  Since, the Economist argues on behalf of domesticists (domesticates?), gross domestic purchasing is at something like 106% of GDP, there's room for a slowdown without any substantial job loss.  As if the Phillips curve didn't have enough problems already.

This rosy view fails, suggests the Economist without quite suggesting it, to contemplate the structural changes that would be required of such an eventuality.  A large shift towards tradable goods that would be required to make up for a strong slowdown in domestic spending (only 25% of goods produced in the U.S. currently are, if the Economist is to believed, tradable) would be needed to keep production stable.  Housing, therefore, might have to take it on the chin.  (Don't try to tell me you're surprised).  What, pray tell, will become of the massive infrastructure in labor and capital that has heretofore been devoted to housing?  Industry migration, or unemployment are, of course, the two options.

But let's put the macro thankfully aside for a moment to press weightier things, like Stanford grads.  I leave you with this short-term takeaway: Monetary policy has gotten more long-term.

"Venture is getting a renewed boost and is set for a major comeback," one self-professed Stanford grad recently wrote me to complain about my failure to adhere to the equal-time standards of the private equity blogging industry.  "All this buyout tallk [sic] is as much has-been bullshit.  Why don't you send your resume out to some venture shops and start covering venture capital deals more?"

This chart might help:

                                      Venture                Buyout &
                             Number   Capital     Number    Mezzanine
    Year/Quarter            of Funds    ($M)     of Funds     ($M)
    2002                      171      3847.7       88       25731.1
    2003                      144     10680.2       92       29310.4
    2004                      201     18253.3      134       50953.1
    2005                      202     26530.8      175       94669.7
    2006 YTD                  105     17972.6       73       54383.7
    2Q'05                     56       7676.0       63       26446.0
    3Q'05                     62       5608.1       60       21677.4
    4Q'05                     70       8083.8       50       32491.0
    1Q'06                     64       6762.5       46       23575.0
    2Q'06                     50      11210.1       35       30808.7

    Source: Thomson Financial & National Venture Capital Association
    *  These figures take into account the subtractive effect of downsized
       funds
    ** This category includes LBO, Mezzanine, Turnaround and
       Recapitalization-focused funds.

To put things in perspective, the three years ending 2001, probably the peak of the boom, raised $200 billion in venture money.  The three years ending 2006 are poised to bore the bank with a paulty $70 billion in venture money.  Texas Pacific Group alone raised almost a quarter of that just in Q1 2006.  Fortunately, a permanant membership to the highly exclusive club of my junk mail filter is only a mouseclick away.

Says Joshua Radler, assistant project manager at Thomson Financial in what is likely the understatement of the year: "...this liquidity will have a significant impact on the dynamics of corporate America and the US economy in the coming year."

The capital hanging over the business is staggering.  Even Henry Kravis is shocked... shocked I tell you to find there is fund raising going on in here.  (Does anyone else think he and James Carville were separated at birth?)  Consider the European impact as well:

A full quarter of all funds ever raised on the London Stock Exchange's AIM were raised in the first quarter of 2006.

Thomsons cited European private equity figures on fund raising as €72 billion in 2005, more than doubling the 2001 figures.  Some €58 billion was destined for buyouts.

It has been fashionable lately to predict the death of private equity as we know it.  Certainly, venture imploded even with substantial overhang and after record fundraising, but I just don't see the fundamentals for buyouts evaporating for reasons I've discussed here before.  That being said, what would recession do for buyouts?

Personally, I think LBO firms have their timing almost perfect.  A flurry of fund raising after several years of dynamite returns means they will be sitting on a pile of cash, much of it locked up, for years to come, waiting patiently for deployment in the right spots.  Indeed, you have seen them casting a wider net for opportunities (ahem, Blackstone) and, at least in my view, the surest sign of the approach of a bubble burst is a wholesale resort to the public equity markets, there are after all fewer "greater fools," for exit (but at super premium retail prices).  I cannot think of anything I would rather be than sitting on a pile of cash with multi-year lockups when the bubble bursts.  My big worry is that there will be so much cash floating around prices won't fall fast enough even in the face of an economic downturn.

Those LBO firms that have failed to hold true to structural and incentive models that encourage (indeed mandate) long-term holdings will likely be challenged.  The traditional LBO model, what I call the "purist" LBO model is to pick up trodden upon or out of fashion assets when their prices are low, impose cost cuts, apply consistent and disciplined management and remove the corporate form from destructive short-term accountability to shareholders (quarterly reports) so that it can be held for the long term and exited with an enhanced multiple.

Without doubt, the current environment is rife with opportunistic and highly creative examples driven by, among other things, SarOx, executive compensation, record low interest rates and public equity markets unable or unwilling to read debt ratios.  As "smart money" what else would we have private equity fund managers do but provide returns?

Coming full circle, and in the face of what must be some kind of economic adjustment (The Economist, after all, asks "recession how" not "if recession"), what can we expect?  A return to purism in LBOs?  Outstanding.  Now (or perhaps 6 months ago, depending on your temperament) would be the time to raise such a fund.

Personally, I'd put together a fund dedicated to the acquisition of firms that produce exportable goods.  Hey, Going Private reader... you in?

(Art: "Martha Rebuking Mary for Her Vanity," Guido Cagnacci, post 1660- probably during his tenure at the court of Emperor Leopold I)

Wednesday, August 23, 2006

Positive Suction?

the highest rated suction of any device Once again, Vipal Monga, the debt expert over at The Deal, scores with a review (subscription required) of dividend recapitalizations and leveraged initial public offering (LIPO) transactions data by Standard & Poor's.  Results, well, not what one would expect on first glance- dismal credit and high default rates.  Says Vipal of what the Standard & Poor's data says:

...the default rate for companies that underwent a dividend recap between 1995 and 2003 is 6%. That number compares with an 11% default rate for all companies bought by LBOs during the same period.

Why?  Self-selection.  Firms without the strong and consistent cash-flows to support the debt taken on in a recap/LIPO suction transaction don't get the loans to suction off a special dividend in the first place.  It suggests that these transactions actually tend only to be possible (due, one assumes, to bank scrutiny) in firms that are more stable in the first place.via moody's credit default histories

Though Monga doesn't say, one assumes that the 11% default rate for LBO defaults spans time frames from 3 years (2003-2006) to 11 years (1995-2006).  Looking at Moody's study of rated debt defaults versus time we see that an 11% default rate over 11 years looks about like a solid "Ba" credit rating.  A 6% default rate over 11 years creeps most of the way towards "Baa" territory.  Looking at the 3 year boundary, the trend looks more like "B" to "Ba" (though we are mixing statistics a bit).

LIPO suction cases seem to come out of the gate with around a "B" rating (see BKC / J. Crew), suggesting that this might even be low given the statistics cited in the article.  A quick look at the facts for leverage multiples would give us a better sense.  Of course, Monga picks that up too, quoting Steven Miller to show that, at least when compared to other LBOs, recap / LIPO suction deals don't look that bad:

Steven Miller, managing director of the S&P Leveraged Commentary & Data unit, says companies that have been recapped actually have lower leverage multiples on average than traditional leveraged-buyout deals.  According to LCD's numbers, the average leverage multiple of LBOs in 2004 was 4.85 times, compared with 4.39 times for those companies that were recapped. In 2005, the LBO multiple was 5.25 times, compared with 4.45 times for the recaps. So far this year, the LBO multiple is 5.39 times, with the recap multiple at 4.39 times.

Tuesday, August 29, 2006

Flattery Day

smooch In classically detailed fashion, DealBook pens an enjoyable piece about LIPOs.  Not the least because it both cites me and takes up my LIPO definition.  It seems that today is flatter Equity Private day.  Didn't you get the memo?  Sorkin's DealBook points to Thomson financial data to point out that LIPOs haven't performed at all badly in the grand scheme of the IPO markets.  (And don't miss the always absurd ramblings of Dr. Klein).  Uttered DealBook:

...what do the numbers say about buyout-backed offerings? So far this year, these kinds of offerings have performed worse — but only slightly worse — than their non-buyout-backed counterparts. Figures from Thomson Financial on the 107 I.P.O.’s (68 conventional, 39 backed by private equity) that debuted this year show that I.P.O.’s connected to buyout firms are down about 2.8 percent on average, while non-buyout offerings are down about 2.3 percent. Excluded from the figures were several I.P.O.’s from blank-check companies, which raise capital solely for acquisitions.

[...]

While the top non-buyout-backed offerings outperformed those with private-equity origins, the worst of them also lagged behind their more-leveraged counterparts. The year’s most successful I.P.O. to date has been Chipotle Mexican Grill, with a 135.5 percent return. The biggest flop has been the similarly un-leveraged Vonage, which has falled 61.8 percent since its debut. Strip away the best and worst performers in each category and the average returns grow even closer. Regular I.P.O.’s are down 3.5 percent, while private-equity-backed offerings are down 3.6 percent.

Tuesday, September 05, 2006

Voodoo Economics

anyone? anyone? You remember Ben Stein, don't you?  The host of "Win Ben Stein's Money?"  No?  He's the monotonic economics teacher in "Ferris Bueler's Day Off," you know, "Bueler...?  Bueler...?  Bueler...?"  Ah yes, now you remember.  Few things amuse me more than old episodes of "Win Ben Stein's Money."  You have to give credit to a game show host who challenges the lead contestant for the final prize (and usually wins).  It is not easy to win Ben Stein's money either.  Not when you are a contestant on "Win Ben Stein's Money," and not if he's a shareholder of the firm you are trying to take over via a management buyout (as the management of Narragansett Capital apparently discovered when Stein filed objections with the SEC and caused the commission to ask for a full review and kill the deal). I was pleased, therefore, to be pointed by an email from Abnormal Returns to a piece that Ben Stein, intriguingly penned (free but annoying NYT registration avoidable via bugmenot) for this Sunday's New York Times titled "On Buyouts, There Ought to Be a Law."  Information Arbitrage and Financial Rounds get in on the game too.

What surprised me is that therein Ben Stein, usually the champion of reason, calls for more regulation, in fact an outright ban, to correct some kind of market imbalance he sees in MBOs.  I say "surprised" because his usually deft command of logic and quick wit seems absent here.  It also seems out of character for Stein.  He was a speech writer for Richard Nixon and appears on Fox News, after all.  I even ventured to wonder, at one moment, if someone hadn't pulled a bit of a hoax on the New York Times.  (Then again, Stein is a celebrity judge for "Star Search," suggesting at least the early signs of mental defect).

Mr. Stein's main objection to MBOs seems to be a "fairness" one.  I've discussed the pitfalls of the "fairness" trap before, I fear this encounter with the concept is no different.  Stein quips:

The deals were happening because the market swooned in the mid- and late 1980’s, but asset values remained high, and so there was a major arbitrage to be realized between asset value and stock price. To me, it seems that this arbitrage belonged to us stockholders and not in any way to our trustees, the managers. But the managers wanted that money, and if they wanted it, they usually got it. There was not much of anyone to stop them.

Then the market rallied and stocks came to be worth more than their underlying assets, so the leveraged buyouts came less often. That gap between the value of the assets that managers sold after the buyout and the stock’s value before the buyout had vanished.

Now, the markets have corrected— they have been lackluster for a long time now, in fact— but inflation and immense gains in the price of oil, as well as gas and other commodities, have spawned opportunities for looting us stockholders, and management buyouts are running riot.

Stein's complaint, it seems to me, stems not from "opportunities for looting us stockholders," but rather the "arbitrage to be realized between asset value and stock price."  This, his argument implies, is unfair.  The fact that the stock price at any particular moment is below asset value is, he seems to suggest, unfair.  For a third party to take advantage of this arbitrage is unfair.  It is "looting."  This argument is just silly.

The arbitrage opportunity, i.e. the difference between the stock price and the asset price, is the result of one of two things:

1.  The public market for the securities in question is somehow inefficient.  That is, it is "mispricing" the asset (shares of the company) because of liquidity problems, incomplete information, or pure irrationality.

2.  The public market for the securities in question is efficient, and is pricing other factors (probably risk) into the stock price.  The market's appetite for risk is low, so a small premium and "cash now" sounds much better than patience and maybe cash later.

In either case, Stein's issue is with the markets, not management.  One might even suggest that by paying a premium over the current stock price (which they almost certainly will), management is doing the shareholders a favor.  Let's also remember, that a management buyout will require board and potentially shareholder approval.  If Stein, as a shareholder, wants to involve the SEC, sue, rally shareholder dissent for the deal, or force a proxy fight, he is welcome, as every shareholder is, to do that (as he did with Narragansett Capital).  If he cannot convince the rest of the market or the board that the offer is too low, then perhaps it is Stein's pricing of the risk that is off, not the market's.  Even this relies on this very flimsy concept that there is some "correct price" for an asset outside of what buyers and sellers will actually agree to pay for it.

Consider this:  Two shipwreck victims on a desert island.  4 cans of beats.  If the first shipwreck victim offers to sell her 3.5 caret flawless, colorless diamond wedding ring for a can of beats and the second shipwreck victim refuses, what is the diamond "worth?"  And this is just the point.  Just because it might be worth $80,000 in New York, it is worth less than the salt in her tears on a desert island.  They aren't standing in New York.  (The fact that the time horizon of the market participants here is measurable in weeks contributes to the low betas, will anyone actually live to actually sell/enjoy the diamond?)  Mr. Stein's stock might well be worth more than it is now in an ideal environment.  But using that as a price point is about as legitimate as using a parallel universe where the company has a parent for cold-fusion as a price point.  It is fantasy.  Pricing it accordingly is also fantasy.

Take my scenario and add some mass drama to it, like, say, an oil crisis, and we actually look at market actors who raise prices in the face of dire shortages as criminals.  This we call "price gouging."  It is illegal because it is unfair.  It is unfair that because supplies are low people should have to pay more for a scare product in high demand.  (Follow that?  Me neither.  Seems to depend on the idea that there is some intrinsic right to low prices [or high prices if you are a seller] regardless of market forces.  You will see this theme again, I promise).

Calling in the SEC to determine a "fair price" seems absurd to me as well.  A "fair price" is what you can get for it.  I am constantly suspicious of a small central group (i.e. the SEC) dictating price, particularly when the much larger and more fluid market disagrees and the centralized price is dressed up with the word "fairness."  To that point, though Stein seems to imply that Narragansett's management pulled the deal because it was a "looting," I imagine the cost of enduring a full SEC review had more to do with management's decline to pursue the deal than any fear of it being disclosed as some kind of theft or fraud.

Let's also look at Stein's position as a shareholder and the "fairness" of this "arbitrage."

Stein either bought the stock when it was higher (and therefore is underwater on the stock) or he bought it when it was lower, but thinks it should be even higher.  If the former, well, it seems to me that Stein timed the market poorly and if he isn't ready to cash out at a premium to the current price then his beta is just different from the majority of the other shareholders.  Tough cookies.

If the later, then Stein's return expectation is just higher than the majority of the other shareholders.  Tough cookies.

Either way he is swimming against the tide of the market.  What really irks Stein, it seems to me, is not that there is an arbitrage opportunity, but that he's on the wrong side of it.  The subtle implication here is that Ben Stein is smarter than the rest of the market and if only he could make them act rationally (or his in line with his view of rationality) then he could make the money he expects, nay that he deserves.

Be afraid, be very afraid, I say, of anyone who wants to pass laws to make the market "fair" because they aren't getting the returns they would like.  And that's what Stein wants.  To wit:

To my mind, these deals should be illegal on their face. That is, they should simply not be allowed at all as a matter of law. Here’s why:

The managers do these deals only to make money. It’s business, after all. They do them to make money off the assets of the stockholders. They could, if they wished, sell off the assets or otherwise manage them for the good of the stockholders. (Again, the assets of public companies do belong to the stockholders as basic law.) Instead, they buy the assets on the cheap and sell them off for their own management benefit, or they manage the company differently for the benefit of themselves and their buyout partners.

But as a matter of basic fiduciary duty law, managers are bound to put the interests of stockholders ahead of their own, in each and every situation. By buying the assets on the cheap and then reaping the benefits, management is breaching that fiduciary duty, or so it seems to me. Likewise, if the managers can run the company more profitably, they owe it to the stockholders to do that for them.

So what is Stein complaining about, exactly?  It is not a question of "if the managers can run the company more profitably," it is more a question of whether the shareholders believe management can run the company more profitably, and even if they do, if they are willing to wait that long (and thereby increase their risk to any number of external factors) to cash out rather than take a 20% premium right now.  Management gets massive returns because they adopt the risk that the public shareholders willingly sell to them.  This is what Stein seems to ignore.  As if it is a slam dunk that if we just stay the course he will pocket millions.  As if there is no general market risk to running a large public firm.

Stein's timing for this argument stinks as well.  If the firm ends up in a management buyout bid this week, it has just put itself in a very liquid and very fluid environment with a ton of competition and a tidal wave of cash floating around, not the least from hedge funds that are spending in a fashion that approximates financial retardation.  Hardly a situation where you expect shareholders to get screwed.  In fact, you only have to look at the multiples buyouts are paying these days to realize that being a shareholder in the midst of a buyout today is like getting mana from heaven.  The Financial Times and the Economist have both quipped in the last quarter that, given the prices of assets, the only beneficiaries of buyouts right now are the shareholders lucky enough to be exited by one.  Stein should really look at historical multiples rather than gripe about one or two examples back in the 1980s where no one else wanted to bid on the company he was foolish enough to invest in.  In this environment, if you can't even get two bidders then be lucky you have a way to get out of the stock at all.

As for the structural issues, there are ex ante mechanisms in the United States both to guard the shareholder in the form of fiduciary duties of the board and of management, and there are ex post mechanisms for redress if a shareholder feels an executed buyout is unfair despite these protections.  Are these somehow ineffective?  Is Stein really talking about a corporate governance issue?  Let's examine that.

Stein believes there is a conflict of interest here.  Classically, there is.  What he is pointing out is the classic so-called "agency problem."  And what is the conventional solution for the protection of shareholder interests?  Anyone...?  Anyone...?  Anyone...? B...O...A... something...?  The board of directors.  On paper the board of directors is supposed to safeguard shareholders from management.  In buyouts, their role is to review the transaction (often by appointing a special committee) and assess fairness.  In many proposed management buyouts, the board will actually fire management, or those of management proposing the buyout, or at least put the parties involved on leave and appoint an interim CEO to deal with the conflict.  One public board member I spoke with indicated that if ever approached with an MBO proposal by a CEO he quips back "well if you are serious, give us your letter of resignation and let's get the process moving."  Not many take him up on the offer, he says.  (Consider the fate of RJR Nabisco's F. Ross Johnson when he tried to mount an MBO).

If these protections are insufficient, and lawsuits challenging the board's objectivity are not sufficient the Stein's problem is with the corporate governance system in the United States, not buyouts.  And let's not forget, as a shareholder, Stein had an opportunity to make changes at the board level if he wished.  That's what shareholder voting is for.  If shareholders believe the board is not objective enough, why did they wait until after a buyout to sue rather than remove them before the problem arose?  It doesn't take a genius to see that we are in an era of very powerful shareholders right now.  The days of the Imperial CEO are over, for now.  Accordingly, I am unsympathetic to these oppression pleas.

Stein goes on to point out:

But in a management buyout, management is seeking to pay the least it can get away with for the assets of the public holders, while the public holders want the most they can get.

How exactly this differs from any buyer-seller transaction in the history of free markets is a mystery to me.

Stein does, however, in a brief flash of the superiority complex I speculated about, finally give us a hint of what drives his call for a new law:

"I want to make sure you know that I am somewhat ahead of the curve. No court has yet put all of this together and banned management buyouts. But it took a long time for courts to bar segregation or for Congress to bar residential housing discrimination."

Ah yes, the great injustices of the world.  Segregation.  Discrimination.  Management buyouts.  What WOULD we do without "ahead of the curve" Ben Stein to right these tragic wrongs?

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