Going Private

NYSE Buyout in the Works

Typically, I wouldn't be this descriptive because I really have no interest in being "outted," but this is too juicy not to share, mostly because its such a privelege to work with some of the luminaries in the business.  Starting Wednesday, a group of private equity and hedge funds, including Icahn Partners, and Sub Rosa started taking a strong position in the public stock of the NYSE.  We've worked with certain members of management and it looks like a significant transaction (or a lot of shareholder activism) is around the corner for the NYSE.  Look for press releases Monday.

Activism like this is a dangerous and exciting thing.  The poor NYSE hasn't even had a private moment to get off its feet after the IPO yet but the mistakes there have been real enough to leave a wide opening for a player who wanted to worm in.

I only found out myself after a good bit of the discussions had already taken place.  Like most such transactions, the entire thing was done with great secrecy.  If I was feeling left out it was a temporary and fleeting notion, and if you had asked me three or four months ago if I would be working today on a transaction this significantly sized or with the likes of Carl Icahn I would have counted you crazy.

Love is a dangerous thing.  I am totally in love with my job.

Stay tuned.  More details below.

Calm Before the Storm

Things are a bit slow.  It seems like there is plenty to do, but in fact, I have been spending a lot of time waiting for "trigger events" that will create work, but I'm not complaining.  Well, not really.

Project Sinister is, happily, mostly off my plate.

Project Spy looks poised to cause me a lot of combustible trouble, and a bunch of travel, but at present it is just the acidic smell of smoke.

Project Velocity looks like it's been bid up too high, and the bidding hasn't even started.

I have a LBO model on my desktop that I polished up all week, but since we are waiting on more figures from management to test some of the assumptions and flesh out things like working capital, there is very little I can do with it at this point aside from tinker with the LIBOR rate or do an interest rate sensitivity analysis.  How many ways can you slice revenue growth into different phases before you are deeply into diminishing marginal returns on your work?

I actually took all the interest rates in the model to three decimal points earlier just to experiment.

It won't last, but for now a bit of a breather is nice to have.

Closet Italian: Bono

Thank god Bono is here to rationalize Italian politics!  Thank god the BBC is here to cover it!

Speed Bump

Closing Project Velocity has taken a turn for the worse.  Or, I should say, the larger issues that have always been contained within Project Velocity have begun to emerge.

From the beginning we suspected that the involvement of other private equity firms would either price Velocity beyond the scope of reason, or make the process too prolonged and difficult to manage.  Both are now true.

Velocity's management has responded to our letter of interest, and more particularly to the pricing range we offered, with the mergers and acquisitions equivalent of a Walther Mathaeuesque grumpy frown, a long whiny letter.  It is three pages but boils down to "We think it's worth more," and is highlighted by this absolute gem of business literature:

"In our conservative estimation the cash portion of remuneration contemplated by your letter of [Date] may be in need of some adjustment."

No wonder this company pissed away so much money.  They must a committee of seven attorneys writing letters by committee or something.  What I wouldn't give one day to get a letter more like this:

April 3, 2006

Equity Private
Vice President
Sub Rosa, LLC

Re: Valuation of Velocity, Inc.


Dear Equity Private,

Too low.

Best Regards,

Velocity, Inc.

Of course, I know exactly which firm it is that's pushed Velocity's expectations into high Earth orbit.  I suspect it is pointless to pen a letter back pointing out that the cash in our offer is unlikely to shift downward much, while others are.  I'm not even really supposed to know who else is interested, but I do.  Since it's been a bit slow, I am going to write the letter anyhow.

Kierkegaard, Scientologists, Private Equity

An interesting thing happens when a sudden realization of impending doom hits a firm.  Suddenly, all those people who were "selflessly burning the candle at both ends to keep the company afloat," somehow find the capacity to "burn the candle at all three ends."  Project Sinister has managed to really boost sales of their secondary products after the dramatic crash and burn of their flagship product, on which the hopes and dreams of the firm (and the servicing of its required debt payments) were laid.

Suddenly, after a frank "all hands" disclosure by the CEO that the firm was headed for imminent ruin, along with the positions of all gathered in the room, (and that included the phrase "well and truly fucked") the sales force which was "working as hard as humanly possible" to sell "products that can never support the revenue needs of the company" has managed to "work harder than humanly possible" and return a cash-flow positive, record revenue week selling "products that can never support the revenue needs of the company."  As compelling a lecture as he gave you'd think he didn't know that he is only weeks away from being fired.  This is because he doesn't know he is weeks away from being fired.

Perhaps one of the many the lesson here is "don't provide a magic bullet if you want people to learn marksmanship."

When you see something like this it is hard not to think that some of the universal tenants about mankind forwarded by notable philosophers over the centuries have been, well, slightly off.

I've put together this convenient table to explain my new (and horribly disillusioned) position.

Group/Individual: Belief

Confucius: Man basically good.  (Significant evidence during the brutal warlord infighting of the Chou Dynasty to the contrary notwithstanding).
Rousseau: Man basically good ("Noble Savage").  Society makes man evil.  Widespread peasantry is the ideal state.
Scientologists: Man basically good, but the machinations of certain evil aliens long ago complicate matters.
Kierkegaard: Man is impossible to classify.
Puritans: Man is basically evil.  Fire purifies.  (Though this is hard to compute given how deeply carbon stains).
Baptists: Man is plagued by total, hereditary depravity.
Equity Private: Man is basically lazy.  Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior).  Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.

Much as I enjoy the work (and really, it may not sound it, but I do) I dislike the disillusionment that it breeds in me.

I suppose I might have one dirt encrusted root, sticking precariously out from the side of a sheer cliff face yet to hang onto:  If we bought the company it's partly because the personnel were in the bottom quartile and, accordingly, I'm getting a poorly representative sample of the workforce at large.  Please, oh please, let that be true.

(Artwork: William Blake, "The Good and Evil Angels" c. 1805, c/o The Tate Collection)

Patently Whiney

I really have to say that big-tech needs to give their PR groups big-raises.  The way that the patent debate has been framed in the last 90 days is both impressive and alarming.  Poor billion dollar firms crippled by their inability to perpetuate the railroading they've been glibly giving "small guy" patent holders since the late 1980s.  The latest craze seems to be a requirement that in order to enforce a patent, at least via injunction, one must have commercialized the technology (or perhaps be in the process of attempting it).  This, of course, is folly.  I grow tired of the incessant mewings that eminate from the gaping mouths of firms (like Research in Motion and, worse, EBay, which actually freely admits to having infringed on the patents in question) that have willfully and for years disregarded patents held by smaller players and now want a "pass" when the time has come to pay the piper.  Reasearch in Motion, most recently, has directed its mewing to Congress.

Recall that the purpose of the patent system is to foster innovation.  Limiting protection to entities with the resources to "commercialize" an innovation would, in my estimation, have both a chilling effect on small "garage" innovators, and destroy the (currently rather liquid) market for innovation.

With respect to the chilling effect, small innovators are suddenly confined to "trade secret" protection for their innovations, quite a burdensome thing to maintain and a more difficult thing to market. Lacking patent protection (and the upside incentive it creates) what incentive does the "little guy" who has no hope of ever commercializing something have?

The more interesting (disturbing) issue is the impact on the market for innovation.  Today, built up primarily in the 1990s, the United States possesses a highly developed market for innovation called "venture capital."  The process of matching investment funds with innovation concepts and providing large upsides for all participants is well refined and balanced.  There is a reason one of the first issues a venture capitalist focuses on when evaluating a new investment is "barriers to entry."  This brings up two questions.

1.  What will constitute "commercialization" for the purposes of allowing a patent holder to apply an injunction?  Clearly "big-tech" wants this standard to be quite high.  An actual selling product in the marketplace, probably.  The only real downward direction to go would be something more akin to "efforts reasonably likely to effect commercialization."  Which, of course, is entirely silly.

2.  How will VCs use the negotiating power implicit in the phrase, "Well, without us how are you planning to commercialize it?" in discussions with the "little guy"?  (It should be obvious that this second question is rhetorical).

Philosophical Private Equity

Sometimes a post I write sticks with me for awhile and grows (festers? ferments?).  This has been the case with my post yesterday on, well, motivational inertia.  Efficient markets depend on more than just perfect information.  They require actors able to actually process that information.  The assumption that actors are rational (i.e. that they understand the information and price it accurately) is a rather huge leap to be making, in some circumstances.  Like this one:

Urgently in need of cash, Sinister moved to shift some short term compensation (bonuses) towards longer term non-cash sensitive compensation (deferred bonuses, stock and/or phantom options).  The upside was out of all proportion to the short term compensation that would be sacrificed.  For example, in exchange for voluntarily forgoing a half-year bonus on June 30th this year, employees would be contractually guaranteed 120% of that bonus at calander year-end plus 100% of any year-end bonus they were due plus some amount of stock and/or phantom options.  Coupled with this plan was the caution that if not enough people adopted the plan there might not be any year-end bonus at all (as more layoffs would likely be in the works).   Maybe I'm dense, but that looks to me like a 20% IRR over the 6 month period just on the bonus piece, and with a reduction in risk to future cashflows. 

Not one employee took the option.

This entire analysis begs the question, "What the hell is Sinister paying bonuses for given the flagging performance of the firm," which I can only answer with a shrug of my shoulders and the glib comment "I wasn't here for the transaction."  Others I ask seem to generally answer with long, run-on sentences which invariably include the phrase: "contractually assured non-discretionary bonus plan."  I've given up asking why that wasn't axed on day one after the purchase or the seller wasn't obliged to cash it out.

As if all this this wasn't enough, several employees circulated actively after the plan's unveiling attempting to dissuade anyone at all from taking the option.  Why?  What possible explanation could there be for that kind of behavior?  It's not a unionized labor force.  What could possibly cause anyone to think this a zero sum game between employees?  The only zero sum aspect is the obvious loss to the firm of 20% of the bonus pool for people who opt in.

Is there some subtle externality that I am not aware of that is pushing up the risk component of a 6 month, interest bearing bonus deferral?  Is a contractual credibility of the company so low that the beta on a 6 month loan is 3500 basis points over LIBOR?  Maybe there's a bigger bankruptcy risk than I know about.  Or, as I have come to believe, are Sinister's employees just totally unable to price these things?  Is it a corporate culture thing?  Did the previous owners just inspire such ire that any action by the firm was met with immediate and organized resistance just for the sake of "sticking it to the man?"  If so, perhaps a complete churn of the workforce is warranted.  (Or we should milk all we can out of Sinister and leave the charred, smoking wreckage to wither and die).

See, I hate that I have started to think this way, but I'm running out of charitable explanations (and charitable thoughts).

For Whom the Bell Tolls

"When you have a lot of money chasing deals, lenders may lose their appetite for enforcing covenants, and are more willing to waive them," says Bill Chew, managing director for loan and recovery ratings at Standard & Poor's, another ratings concern. Over time, fewer constraints may encourage borrowers to pile on even more debt, and that could weigh on some of these companies if interest rates rise or their businesses slow.

The Wall Street Journal sounds the covenant alarm.

KKR Real Time Returns

I'm a bit bored today, waiting on some figures from a banker and getting ready for an overseas trip so I've been watching the Sealy IPO.  (Readers will recall I wrote about the proposed IPO of Sealy and the buyout by Kohlberg Kravis & Roberts that preceeded it last month).  Wow.  Just for giggles I put together this cute spreadsheet that tracks KKR's cash v. paper return on the transaction from a tool I had used for a similar transaction (but much smaller) that we were involved in.  It pulls the current stock price and gives a nice summary of the IRR.  Cute.  Fun for the whole family.

I haven't gone deeply into the assumptions (for example, I don't know exactly what deal the shareholders cut with the underwriters, I can't tell how much of the recap fees paid to KKR and Bain were profit v. compensation for advisory expenses incurred by KKR, and the schedule for management fee payments to KKR isn't clear) but I suspect it's pretty close.  Now I can track KKR's various IRRs in real time.  (Screenshot below).

Interesting to note: Yahoo! Finance is tracking Sealy (NYSE: ZZ) just fine.  Google Finance, however, doesn't even recognize the ticker.  Tut tut.  Someone at Google is going to need job security.  I wonder if it's the same person.

Unchained Malady

Frightening.  Usually, I frown at blogs that spend a lot of time reflecting about their own existence (or putting up hit counters and that sort of thing).  It feels very self-congratulatory.  Very Bono.  So my excuse is that I'm actually quite frightened by the attention.  Today I've been linked to by DealBreaker, DealBook and The Deal.  I guess I've been "Dealed."  I will be very lucky if I don't break my TypePad quota this month (though the consequences of this are somewhat vague) so it feels very odd saying "Wow, thanks."

SarOxidized

The Conglomerate Blog points out that smaller firms aren't likely to get the SarOx exemptions that they have been asking for.  This, of course, is nice for the likes of Sub Rosa, because it means just that many more incentives for smaller firms to go private.  It also brings up a larger issue that I have been turning over in my thoughts for quite some time.  I wonder, aloud now, if the public markets have been mispriced for awhile now.

Though it may be a crass way to think of them, the 1990s demonstrated that the public equity markets can be manipulated as the "greater fools" quite easily.  SarOx, in part, is an attempt to right this "wrong."  Mutual funds (in the last 10 years) and hedge funds (more recently), in part, are a recognition that information disparities still exist and can be capitalized on (with great effect, apparently) by savvy players managing money professionally.  Lately, with all the money pouring into hedge funds, it seems almost like those information arbitrage opportunities are getting sanded down.

Back "in the day" you threw together an IPO to dump the remaining risk after development on the party most interested buying the risk (or least able to properly price it).  That party was the public markets.  That this was "wrong" in some way has to include the arugment that risk and return were out of scale in the market.  It would be interesting to look at the equity gains during the period and wonder if this could be said to be so.

Let's assume that the market was "unfair" or mispriced.  SarOx looks to me like a regulatory effort to provide more and cleaner information in the hopes that this will keep the public from stabbing themselves again.  I believe SarOx an expensive and inefficient method to accomplish either.  Given the massive amounts of funds pouring into private equity and hedge funds, I suspect that the market has gotten wise to the information disparities and put their money into professional hands.  SarOx will only push it farther in that direction.  But the fact that, despite a massive amount of private money, better deals can be had in IPOs than in private equity.  Given the much higher risks and transaction costs of being public, why would anyone go IPO who could raise the money privately?  I have to assume it is because the public markets still overprice offerings.  (I suppose private markets might underprice, but this seems less likely to me).

As for disclosure as a tool to correct what is basically a pricing error, maybe the wrong problem is being solved.  In the end who cares if there's a lot of disclosure as long as we have the D. E. Shaws and KKRs of the world ringing in 20%-60%+ returns? Imagining the public will ever be even a marginal player in the information game, piles of disclosure or not, is, I believe, fantasy.  But, as I have said before, go ahead and make it expensive to be a public firm.  Correct that price disparity by effectively taxing public market offerings.  That leaves more for us private equity types to pick up.

Just Copy-Paste It

Asked how to write executive summaries by some poor sap misdirected enough to think he's appealing to some kind of actual authority, Guy Kawasaki does what any Stanford educated, former dot-comer Bono would do.  He copy-pastes work someone else has already done (poorly). At least this time he cites the work (you're making progress since that whole "Bozo Explosion" theft, Guy), but that's probably only because it is a buddy-ole-pal who he lifted the material from in the first place.

To learn how to write a two-paged, one page executive summary of the sort that would cause me not only throw it out before I hit the first half-page mark, but also set up a permanent junk-mail filter on the off chance I might potentially be the recipient of even one more piece of blithering nonsense that might conceivably one day emanate from the sender, investigate his post here.  Thank god I'm not in the venture business or I might have to actually subject myself to the vomitous creations of Guy's many deluded disciples.

Don't despair if your expertly crafted teaser doesn't create any interest.  You can still rely on Guy to teach you how to put together roving ticker-tapes of the many pictures memorializing the numerous expense account funded sporting event outings you attend in the many hours you are not working on actually creating value for some shareholder or limited partner somewhere.  Excellent!  Your site looks just like Vegas (or perhaps the Morgan Stanley building in Times Square) now!

I know I'm mud slinging.  I can't help it.  I keep trying to ignore Kawasaki, but his book-buddy sponsoring, self-promoting drivel is inflated with such dot-com era hype that it is impossible to avoid hitting links to the university of pure vapidity that is his American Cheese laden site.  It repeatedly sneaks up in the midst of real content like a kind of bird flu-like, viral, context driven keyword ad.  And then it just slaps you in the face with the undaunting gaudiness of its lack of substance.  It lacks substance with such clarity and perfection that it is actually offensive to those who place even a moderate value on substance.  It is operational anti-matter.  Everything that is anathema to even the basic concept of "operational excellence."

That weblog is like a construction crew outside your window on a Saturday morning.  Relentlessly annoying, smelly, gratingly loud, on union wages, totally out of touch with the rest of the world and, despite producing nothing but chipped concrete, corrosive dust and the occasional cut phone line, somehow possessed of the misguided view that early morning noise, in sufficient quantity, will be mistaken for hard work and competence.  And, you know, I suppose that if I were going to tap someone to tell me how to pen a teaser it would be an individual from a firm with a track record at least slightly more significant than that possessed by the Garage California Entrepreneurs Fund, LP.

Have I sufficiently expressed my view yet?

Perhaps I'm hard on Guy.  At least he has, for the moment, stopped blowing his own French Horn by signing his posts with the exotic locale he wrote them in.  "Posted from a flight to Bradula, Africa."  Perhaps he's been sitting quietly in San Jose for the last several weeks.  No wonder he stopped.  Who wants to brag about sitting idle in San Jose?  Let the good times roll!

Again, I need the Midol.  Guy gives me cramps.

Expensive Sox

Working on a project yesterday the question of Sarbanes Oxley costs came up.  I had modeled in some of the additional 404 costs in order to measure some of the potential "going private" benefits in a transaction.  Then I got curious about something.  Are Sarbanes Oxley costs reasonable risk-return adjusted investments?

The real way to do this would be to plug in the difference in fraud "beta" pre-Sarbanes and post-Sarbanes and see if the present value of future Sarbanes expenditures meets the value of the reduced risk.  Of course, modeling the "beta" of fraud and determining how much fraud risk is actually eliminated via Sarbanes is not a trivial task. Instead, I took audit expenses pre-Sarbanes, ran them forward 7 years with a 4.00% growth rate per year (this is quite low probably, given that in 2000, 2001 and 2002 audit fees rose an average of 10% each year) and then discounted them back at the S&P 500's rolling 10 year average return of 9.10% (which isn't really the discount rate to be using, but it is easier than computing the average cost of capital for similar firms).  The present value of those expenses for a $5 billion - $10 billion revenue firm turns out to be $16,744,097.  (This isn't really right either since the firms aren't going to stop spending on audit in year 7, I suppose I could use a perpetual growth model here but I'm just bouncing rubble at that point).

I then took the discounted value of 7 years of post-Sarbanes expenditures ($36,837,013, same growth rate issues as above however) and adjusted the discount rate until it equaled the present value calculation of normal audit expenses.  The discount rate required to even the two out was 37.95%

Maybe it is just me, but Sarbanes seems a little steep by this measure.

Passive Theft

Often the process of evaluating a firm is as educational for the firm's management as it is for the buyer.  Such is the case with Project Spy.  We descended upon Spy with a soft touch, the seller being terrified our presence might alert employees and middle management that the group is "on the block."

Spy has been the victim of borderline criminal management negligence for some time.  The head of the division head has, in my opinion anyhow, been snowing the home office with such regularity that it had become the normal course of business.  The fact that the division we looked at is operating at a loss was news to even the senior management, which had been lulled into an alarmingly placated state with respect to the performance of the division in the United Kingdom.  In this day and age of Sarbanes Oxley this is beyond astounding.  The conference call wherein we revealed this bit of news was notable chiefly for the longest sustained silence I have ever encountered on a telephone that wasn't unplugged.

Think Sarbanes has flushed out all the dirty secrets?  Think again.

Our big challenge now is to administer sufficient medical attention to the shock stricken senior management to get them to actually sell the division.

(Rembrandt, "Self-portrait" 1630, Nationalmuseum, Stockholm)

Overfunded Funds

The Wall Street Journal has an excellent letter from Michael Steinhardt (subscription required) on hedge funds.  It begins with the wonderfully encompassing phrase, "When I started out 40 years ago, a hedge fund wasn't an asset class; it was a fee structure..."  Indeed.  It continues:

Currently, thousands of funds manage $1.5 trillion in assets. But this may have more to do with the incentives to managers than the incentives for investors. Performance money management is the highest paid industry in the world. Yet you don't need a license, a degree or even experience to start a hedge fund. Average fees have risen to nearly 1.5% of assets, which means managers don't merely cover overhead, they make a profit -- before they earn their clients a dime.

Realistically, there are a limited number of truly superior fund managers. Yet legions of managers earn extraordinary compensation for what, as the indices reveal, has been ordinary performance. The numbers tell the story. Last year, hedge funds reportedly earned a record $16 billion in fees tied to assets under management alone -- even as average returns fell to almost half the average of a decade ago.

This is a different business than the one I knew. The goal of capital preservation has entered the hedge fund marketing lexicon, where it doesn't quite belong. Performance should not be measured "relatively" but in absolute terms. The goal should be beating the market -- any market -- and having positive returns. It's not about attracting assets, or boasting to clients that you only lost 5% of their money when the S&P 500 was down 15%. As a hedge fund manager, I felt an obligation to investors to consistently -- and meaningfully -- outperform. This was the only way I felt justified in collecting extraordinary compensation. In the 29 years I was in the business, the S&P 500 posted an annualized return of approximately 11%; my firm posted after-fee annualized returns of 24.5%.

Today, performance is hardly spectacular. Since the stock market bottomed in 2002, hedge funds, as measured by the Credit Suisse/Tremont Hedge Fund Index, underperformed the S&P 500 two out of three years. From 1993 to 2005, the CS/Tremont Index virtually matched the 10.5% total return generated by the S&P 500 Index.

[...]

Eventually, investors will refuse to pay high fees for average performance especially when so many better alternatives exist, including "passive investing" strategies. The growing gulf between compensation and performance is an aberration that I don't see lasting -- even if so many have so much invested in seeing that it does.

Bears Eat Blackberries, Don't They?

The Wall Street Journal slowly comes over to my way of thinking (subscription required) about Research in Motion.  Of course, they don't go as far as I have.  I think they are growing ripe for a buyout.  Then again, when all you have is a hammer access to a lot of debt....

Cash is King (for Some)

The unending focus on EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) can cause problems.  Moreover, I have been seeing more and more people with little experience in mergers and acquisitions being given more responsibility for deals.  So the encounter I had this week with an M&A type from Spy, Inc. wasn't really surprising.

If we purchase Spy, Inc., there will be significant one-time costs, the source of which isn't particularly important, just after the transaction.  Consequently, it will be 7 months before the firm is actually back in the black after these one-time charges.  Because, at least at this stage, we aren't particularly concerned with developing a discounted cash-flow valuation EBITDA with non-recurring costs removed isn't really something I care about.  What I care about is the outflows of cash in the first six months that Sub Rosa will either have to cover directly, obtaining financing or increase the existing line of credit for or get the seller to cover.  I had modeled this but on discussing our model with the Spy, Inc. people I met resistance.

EBITDA, I was matter-of-factly informed, should be exclusive of non-recurring costs when used in a financial model.  I tried to point out that I wasn't doing a valuation, I wasn't, yet, interested in the intrinsic value and theoretical profitability of the company.  I was far more interested in what Sub Rosa was going to have to stomach out of pocket to turn the division of Spy Inc. we were considering buying into a stand alone company.  I got nowhere.  I also got nowhere trying to explain that I wasn't going to amortize capital improvements for this particular model because someone was actually going to have to write a big check for the full amount of capital improvements in the first 90 days after buying the company.  Amortizing it might make for better accounting going forward, but for the moment I was worried about the first 90 days of negative cash flow.  Response: "But you have to amortize capital improvements."  Ugh.

It is a symptom of the low unemployment rate in the business that you sometimes run into people who scored solid A's in their accounting or financial statements analysis classes in business school but have no idea what the issues confronting an acquirer post-transaction actually are.

London

London is a pretty dead place on Easter weekend.  I am headed home.

Precious Metals

Sub Rosa Associate: "You leave and things go to hell in a hand basket.  The 10 year is over 5%, the real estate market is tanking, oil is over $70 a barrel.  The metal in a penny is now worth more that $0.01.  What gives?"

Equity Private: "The market was unnerved by my absence?  Are you serious about that penny thing ? Sounds like an arbitrage opportunity."

Loose Lips

Project Spy has accelerated.  Somehow word has leaked out that the unit is potentially on the block.  I don't think that it is anything concrete, but rumors are swirling.  It started with a rather glaring oversight on the part of a senior Spy, Inc. employee.  At least it wasn't us.

Now matters are somewhat tense.  As soon as a unit finds out it might be on the block, fear becomes a danger.  Employees start to seek new positions, in light of the uncertainty and the assumption that mass firings will follow the acquisition.  People who never would have considered leaving before now begin to explore options and, occasionally, discover they have them.  The unit can become a "deteriorating" asset quickly.  The longer a transaction takes, the less the unit will command.

Of course, if all the talent leaves (and usually its the talent that has the most options and therefore the highest churn) the unit becomes worth less.  Time has become even more of the essence.  Time is, however, on our side in this case.  I can see the strain on Armin's face as he labors to resist taking advantage.

Executive Compensation Lies

Listen to the howls that have been eminating from anyone who was paying attention.  It is totally outrageous and shocking that Exxon's Lee Raymond got $425 $400 $350 in golden parachute payments when he retired as CEO of Exxon in January.  Well, except that Exxon's Lee Raymond did not get $350 million in golden parachute payments when he retired as CEO of Exxon in January.

ABC News, purveyor of quality facts nationwide, called it a $400 million retirement package "amid soring gas prices."  CBS was little better, calculating the per-day payment Raymond had and then lining up a university professor as comparison.  As if Bob Schieffer, the CBS Evening News anchor who announced this miscarriage of justice, isn't from Texas and drives a hybrid to work everyday or something.  As Abnormal Returns points out, The New York Times even echoed this day-by-day playback.

The problem is not with the messengers, annoying as they are.  The problem is that is they were both wrong.

Raymond got:
$48 million in 2005 salary.
A lump sum of $98.4 million.
$69.9 million in stock option profits.
$183 million in restricted share grants.

Minus the salary, that's $351.3 million dollars.  The pig.  Except it's not.

The lump sum payment of $98.4 million represents the disbursement of Raymond's accumulated pension over the last 43 years (a good bit of the appreciation of which is related to the rocket-like rise of Exxon's stock over the last 10 years, not just the last 2).  And yes, that is forty three (43) years.

$69.9 million in "stock option profits," are only paper gains.  Given where Exxon's stock is, it is not all that surprising (the company's price was in the low 30s only 3 years ago, the 20s ten years ago and is in the 60s today) even before you count the fact that these are options that have been granted as long as 10 years ago.  Remember, the value of these instruments has been growing at something like 12.5% a year for over a decade.

As for the $183 million in restricted share grants, these too have been accumulating for years.  Only $32.1 million of them are 2005 grants.  Also, these grants are issued by Exxon with particular restrictions.  Specifically, half of them cannot be sold for 5 years and the other half cannot be sold for 10.  Ouch.  Guess what, gang.  If you lock shares up for years and you grow the company in massive strides, you're going to have a big lump sum one day.

Raymond's grants from 1993 alone were worth $620,000 when issued.  Today they are worth $32.1 million.  Nicely done, Lee.  Of course, those with a bone to pick about CEO pay have been both counting these options grants as part of annual salary, and again now that he has retired.  A clever ruse, but one we have seen before and one generally cited by CEO Compensation Bonos who either shouldn't be let near a financial calculator because they might hurt themselves or others, or are "just" willfully ignorant.

Bloomberg's Graef Crystal has a good run-down of the details.

The reality that as a long-term incentives package, Exxon's isn't bad.  Raymond is getting paid obscene amounts of money, to be sure, but Exxon has been making obscene amounts of money providing a product that Americans thirstily suck down in stunning quantities without a second thought, and a lot of his eventual payout depends on the stock price of Exxon in five to ten years.  This makes the package not only long-term but future-term, incentivizing Raymond to do good for the firm even as a retired CEO.  Interesting.

Then again, if you have a CEO compensation chip on your shoulder, don't let something as irrelevant as the facts get in your way.

Sleeping Sealy

So, the hype should have worn off a little.  How is Sealy doing for KKR this week?

Ouch

What do rising interest rates mean to the buyout world?  Let's take a hypothetical firm with $250 million in revenue.  Let's also assume this firm enjoys a 15% EBITDA margin ($37.5 million).  Light manufacturing firm with mostly inspection and assembly work to do, strongest brand in the industry.  (These are pretty close to actual numbers for a deal Sub Rosa looked at).  Such a firm is likely to go for between 6 and 8 times EBITDA.  Forgetting for a moment how totally useless (and yet popular) EBITDA multiples are for judging rational pricing for an acquisition, that gives us between $225 million and $300 million in purchase price.  Let's make the math easy and pretend a deal is struck at $250 million or 6.66x EBITDA and 1x revenue.  Again, let's ignore how absolutely daft it is to be using EBITDA and revenue multiples for pricing.

This probably means that the capital structure is something like $125 million in senior secured debt.  That's 3.33x EBITDA, which is pretty conservative.  (We've been seeing 4.00x EBITDA for the senior tranche).  Add another $75 million in junior debt which is 2.00x EBITDA and $50 million in equity which puts the debt to equity ratio at 4:1. Reasonable.

Zoom the way back machine to early October, 2005.  Actually, let's make it October 1st, 2005.  Interest on the senior secured and junior debt is generally based on 3 month LIBOR rates (as payments are quarterly). Senior secured had spreads of about 375-400 basis points (3.75-4.00%) over LIBOR.  You could find LIBOR + 350 if you looked hard, but let's stick with 400 for now.  Junior was around LIBOR + 650.  October 1, 2005 3 month LIBOR for U.S. Dollar loans stood at 4.08%.  That means the interest on the senior debt was 8.08%.  The junior debt was 10.58%.

Senior debt interest per year: around $10 million.

Junior debt interest per year: around $8 million.

Total interest payments?  $18 million per year.

Then there was the principal to be paid.  Let's put that at a mandatory payment of $18 million per year.  This is light, actually, but not entirely out of the realm of what one can negotiate.  Of course, the point is that as you work down the principal, the debt payments lighten and you can work down more of the principal and the debt payments lighten even more and you can work down more of the... you get the idea.

Total debt service: $36 million or so.

This meant the company had about $1.5 million left after debt service to deal with extraordinary expenses, early debt repayment, etc.  A bit tight, but not undoable.  Let's assume the deal closes.  Everyone is happy.  Work begins.

Now run the clock forward to Feb 27, 2006.  LIBOR has hit 4.82%.  The company probably hasn't made any interest payments yet (often there is a 3-6 month gap after closing).  The interest portion of the debt payments has risen to $19,515,000.  With the mandatory payment of $18,000,000 total debt service is now $37,515,000, overwhelming EBITDA.  The company barely is able to cover its debt service.

Run the clock forward to early April.  LIBOR hits 5.01% (today it is at 5.08%).  The company is $402,500 short for its debt service.  Plus, with interest rates up, perhaps the economy is slowing a bit, depressing sales.  Uh oh.

Source: British Bankers' Association
Historic LIBOR Rates (recommended)

Think that's bad?  A year ago, 3 month USD LIBOR was at 3.14%.

Now, this is a pretty silly example, for a number of reasons not least of being that one of the first things one does in an LBO analysis is an interest rate sensitivity calculation to make sure there's enough upward room to deal with these kinds of rate hikes.  I have also cut some other corners that make this example a bit more glaring than it would probably be in the real world.  I wonder, however, with all the fast-paced deal making, how many buyout deals bet the farm on low rates.  Also, this deal isn't that highly leveraged. Debt to equity ratios hit 5:1 and even 6:1 in a few smaller deals I know about.  Watch out.  Raising a distressed and special situations fund seems like a wise thing to do just now.

Publicly Private

The Wall Street Journal today points out (subscription required) that KKR's latest efforts to raise $1.5 billion in an Amsterdam listed fund that will basically act as a public "front-end" funnel for cash into all of KKR's funds, are a "precursor" to publicly listed buyout funds.

Quoth the Journal:

"This is a precursor to public [corporate]-buyout funds," says the head of one major financial sponsors group, who cited Securities and Exchange Commission rules in declining to comment by name. "They are testing the waters. Every private-equity firm will figure out how much and how quickly they can follow. It is an important evolution."

The Journal goes on to point out, rightly in my view, that valuing a private equity firm (if, just say, they one day wanted to list themselves on a public exchange) is difficult without more consistency in the management fees.  Locking in management fees removes a big valuation issue as the stability of those cash-flows makes the firm's revenue structure much easier to model.

Still, the structure strikes me as a bit backward.  One of the major advantages of private equity funds is the ability of the general partners to ignore short-term thinking in their investments.  Leveraged buyouts in particular require a long horizon (5-7 to even 10 years )and patient approach.  While KKR's Amsterdam funnel fund (a "fund of KKR funds"?) doesn't appear to adversely impact the the ability of KKR to remain long-term focused, a publicly listed sort of approach (particularly if we start seeing the partnership broken into a more traditional share and option based compensation strategy a la Goldman Sachs after its IPO) suddenly aligns the incentives of the partnership with short term fluctuations.  This defeats the structure of a buyout firm, which is nearly entirely about avoiding short-term temptations.

Features in limited partnership terms for buyout firms, like lock-in periods, 7-10 year fund life and such are designed to give long-term focus to the general partnership.  But there are rational limits.

The Journal argues that the effect of a "funnel fund" like this enhances long-term focus, quipping that:

Because private-equity funds have limited lives, often firms are forced to sell portfolio companies to return money to their investors. With this new structure, though, KKR can keep its portfolio companies for longer if it so chooses.

I think there are limits though.  If you can't turn the firm around sufficiently in 4-7 years to hit your IRR, should you be hanging on to it for longer?  Isn't the purpose of an LBO firm to take advantage of the incentives that debt creates in order to restructure the business and then send it back on its merry way as a nice operating unit?  The steep part of the growth and efficiency gains curves should be immediately after the acquisition.  If you're still hanging onto the firm after that then you will have to be growing revenues.  How you can push those up quickly enough to meet a target IRR of 20% or more (remembering that even the same growth figures later in the IRR calculation counts for less) is a suspect analysis to me.

Slowly SarOxidized

Always yummy, Abnormal Returns (with whom we seem to be having a torrid affair involving the exchange of multiple links) notes Bobby Bartlett over at "Truth on the Market" suggesting that the pull towards private transactions that Sarbanes-Oxley exerts is perhaps less dramatic than we might think.  I think there are some flaws in his analysis.  Specifically, he comments that:

One might think that in the private equity world, there is a “perfect storm” of sorts for a robust going-private market.  As I have noted before, buyout funds have raised record amounts of cash in the last few years which they will need to deploy in a relatively short period of time (a fund generally seeks to invest most of its capital in its first 4-5 years). The downside is that a significant increase in the amount of private equity capital does not necessarily translate into a concomitant rise in going-private transactions, as the supply of buy-out “candidates” should remain the same (all other things being equal).

This ignores the pricing effect of the wash of cash out there today.  The surplus of free capital for buyout deals pushes up valuations as more cash chases more marginal deals and cash in good deals is so cheap and easy to come by that it's much easier to bid another 10%, 15% and even 20% for a firm.  Bartlett assumes here that supply stays the same but forgets to account for the marginal case firms that are "near misses" for a buyout at 7.5x EBITDA, but are "slam-dunks" when the owners can get 8.5x EBITDA.  Multiples are way up and to believe that this isn't pulling people into deals they would not otherwise have done is to put your head in the sand.  It is like any other supply-demand relationship.  When the price goes up, the incentive to enter the market with your inventory goes up as well.

(Mr. Bartlett rightly points out to me that he noted this "deal supply" assumption as just an assumption in his entry and that his comments are more geared towards debunking the silly Business Week assumption that all LBO's are about SarOx avoidance).

Multiples Multiply
Source: Securities Data Corporation

Bartlett continues:

For starters, just because a firm is “taken private” by a buyout shop does not mean the firm is no longer subject to SOX.

[...]

The problem, however, is that these major buyouts did not necessarily make the companies immune from SOX.  Only MGM is now truly a “private company” and no longer required by law to comply with the statute. Hertz, Neiman Marcus and Toys ‘R’ Us are all still subject to Section 12 of the Securities and Exchange Act of 1934, meaning that they must not only file their regular ’34 Act reports but must still comply with all of the costly SOX requirements.   Why?  Because each firm issued hundreds of millions of dollars of public debt to finance the buyout (they aren’t called “leveraged” buyouts for nothing).  Thus, it is only going to be buyouts that retire all publicly-traded securities that might have been driven by a desire to avoid SOX.  This will exclude any LBO utilizing publicly-traded debt instruments, which means it will exclude most medium and large-scale buyouts.  Because these transactions require the lions’ share of private equity capital, most private equity dollars will not be devoted towards helping firms escape SOX.

[...]

Of course, a company might let SOX compliance slide a little during its life as a private company, but the smart money will recognize the benefits of being “SOX-ready” well in advance of an anticipated liquidity event.  It is for this reason that the National Venture Capital Association has noted to the SEC that “for many private companies with no immediate plan for offering stock to the public, SOX-compliance is still a necessity."

The problem here is that none of these firms with public debt ever intended to reduce (or cared much about) SarOx costs.  To argue somehow that SarOx is not a major driving factor in buyout expansion, you have to look at firms that would not have gone private but-for SarOx, not firms that would have gone private regardless.

This argument also ignores the potential value of not committing to SarOx.  Assuming, for a moment, that "first time" SarOx costs are 150% of ongoing SarOx costs, let's do some math.

Take a $250 million LBO.  By no means does this sort of transaction require a resort to public debt (and therefore SarOx costs).  Let's assume that, unlike some of the nearly "Magic" 18-months-to-IPO deals that have floated around lately, the exit via IPO is in year 7 (a much more reasonable timeframe).  The Corporate Roundtable predicts annual 404 compliance to cost about $2 million per year for such a firm. Assuming that this additional $2 million is applied to debt service, and that SarOx compliance is begun with the 150% adjustment the year before an IPO liquidity event (first year compliance difficulities), how much is lost/saved by not SarOxing until the last minute?

Well, I threw together a VERY quick and VERY dirty model probably filled with errors but based on the following assumptions:

1.  $250 million LBO with $50 million in equity.
2.  7 year mandatory amoritization on the senior debt.
3.  No restriction on favoring junior tranches with optional repayments (some lenders prefer that all the senior be retired before the junior can be addressed).
4.  Exit is at exactly the same multiple as paid at acquisition.
5.  No revenue growth.

So how much do you save by not spending $12 million extra on SarOx for 6 years?  $26.8 million.  $19.98 million. (Thanks to JR for catching a double count).

There's Long Term, and Long Term

"People don't understand the time frame that we operate in. We operate in terms of 10-, 20-, 30-, 40-year cycles and to put that in context, that's 20 Congresses. A single quarter or a single year, which may mean everything from a political circus point of view, is not really all that significant in the time frame that we operate in."

- Former Exxon CEO Lee Raymond

Profoundly Profane

Mark Slater, over at Slater Ramblings, is trying to convince me in email that he is so humble and prudish that he was forced self-censored himself in this post to avoid exposing his delicate readers to the highly offensive word "Twit."  Seems pretty clear to me that he originally meant to call me a "Twat," but then what's a vowel or two between friends?

What Spaceward Ho! Taught Me

In "Making the Venture Capitalists Play by the Parent's Rules," the wonderfully Sorkinesque "Dealbook" reports:

When Invesco Private Capital managing partner Parag Saxena steps down later this month, the company will have lost, in three months, four of the six senior partners who have invested hundreds of millions of dollars in start-ups.

The departures stem from a conflict between the subsidiary, Invesco Private Capital, and its parent Invesco. The subsidiary is run by venture capitalists, the parent by corporate executives and their lawyers and accountants and Mr. Saxena’s departure highlights what can happen when members of two exclusive clubs with different rules are forced to share the same dinner table. Crabcakes and dinner rolls fly.

Venture capitalists see themselves as maverick, fast-moving entrepreneurs with a need for relatively loose hiring rules and marketing needs. The big public company has rigid standards, compliance issues and little patience for making exceptions for a relatively small subsidiary.

This quip reminded me of a concept introduced in a strange place, later taught formally in business school and that actually translates to something like useful knowledge in private equity.  The important distinction between innovative corporate cultures and operational corporate cultures.

The basic concept, that the skills and talents required for successful innovation are at odds with the drab, detail oriented, even bureaucratic bent that is required to keep the mechanism of corporate industry humming, require dramatically different management approaches.  Permitting these to co-exist under the umbrella of the same organization means that a very distinct bifurcation of the functions of innovation and operation is required.  I'm not usually a fan of business school cases but in this instance Harvard has a pretty good one on the topic ("Innovation at 3M Corp").

This dovetails nicely with the Boston Consulting Group's "BGC Box," framework for corporate portfolio management which, crudely put, dictates that the lower growth endeavors of the firm should be used to fund expansion in the high-growth entities.

When I was much, much younger, a friend of mine introduced me to the multi-hour consuming computer game "Spaceward Ho!," an already several years old, but terminally cute, galactic conquest game I still enjoy as a guilty pleasure sometimes.  Spaceward Ho! required you to compete with the computer, or other players, to develop your technology and explore (read: exploit) the universe via colonization and strip mining of the various planets you discovered.  It was a wonderfully capitalist game.  Keeping general pace in "Ho!" required a great deal of patience and orderly management of your resources (planets) and capital, which you could deploy in a variety of research projects.

One of the categories you could spend capital on was your "radical researchers."  The graphic for them still makes me crack a smile.  Big craniumed scientist with googly eyes dressed in a white lab coat who's head is exploding with radical ideas.  You could just see the senior management of the Galactic Conquest Corporation going out of their way to park their new BMWs as far away as possible from the radical researcher facility, from which evil cackling laughter, strange sulfur like smells, purple smoke and the occasional violent explosion emanated.

While your other internal projects would show slow, incremental gains consistently turn after turn, your radical researchers would return nothing for 5-10 turns at a time.  Often you began to wonder if they were doing anything at all.  (Today, I can easily see some middle manager doing a IRR calculation on them after 3 years of nothing and sacking the entire division).  But then, out of nowhere, when you had almost given up, they would announce a radical discovery.  Perhaps 15 turns worth of progress in "terraforming" or something.  You never knew what they would find, but you knew it would take a while and be very interesting.

It strikes me that the Investco has failed to grasp the "radical researcher" concept.  Venture capitalists are the crazy lab coat types.  Try to rein them in and saddle them with paperwork and corporate policy and they will not only flee, but thereafter they might work tirelessly on inventing a deadly anti-Investco device as well.  Just for spite.

(Spaceward Ho! by Delta Tao Software.  Full Guilty Geek Pleasure Disclosure: I'm a Ho! addict).

New, Now With 40% Less Covenants

I wrote not too long ago more than once, in fact, about the lack of covenants in recent deals.  The Economist now rings the warning bell again, this time with a series of hard examples.  A bit of thinking about the deeper and more subtle points in this "covenant lite" trend has me back to a common theme that keeps bopping me on the head.  Public markets just don't seem able to price buyouts well.  The question is, can hedge funds?  From the Economist piece:

Why have lenders lost interest in covenants? One explanation is that, as bank loans begin to trade in the secondary markets like ordinary bonds, the banks themselves are less interested in preventing borrowers from imploding than when they kept the debt on their books. Another is that the debt market is temporarily frothy. Mr Hirsch says there was a similar change in lending terms before the meltdown of 1998, though even then lenders earned much wider spreads. Some old hands are taking note. Many of the insurance companies and specialised institutions that used to buy these loans are now out of the market, replaced, Mr Hirsch says, by hedge and mutual funds. Must be a brave bunch.

Leveraged debt is beginning to look quite a lot like IPO flipping used to.  (And why not?  Quattrone is back in the game, after all).  By this I mean that the public market are, once again, the greater fools.  Two tools seem to have emerged lately to facilitate the dumping of risk onto the public markets, which seem less able to value them.  The first is the one-two punch of an IPO followed by a special dividend payment.  KKR's Sealy is the example I have noted the most often here, let's revisit it again:

KKR pulled out a $100 million special dividend, basically funded out of the IPO proceeds, along with some $44 million from the shares they sold.  Add to this the $11 million in breakup fees for the mangagement agreement, and some earlier fees for management oversight the first and second years after the buyout and they have locked in about 36% of their original investment of $436.1 million.  This looks suspiciously like the sort of terms preferred shareholders (read: venture capitalists) would command at the close of an IPO.  The difference is that the venture folks often had both a preference, and a liquidity multiple built in.  They usually got all their initial investment back as well as some locked in gains.  At least KKR here has some skin left in the game.  (Note their negative IRR on actual realized gains).

Of course, KKR probably didn't have much of a choice here since selling much more of their stock would have been brutal to the float for Sealy and I doubt any of the other parties involved was going to permit them to let much more out on the market.  It will be interesting to see how KKR dribbles out sales of their existing stock.  They might have some lockup agreements, I don't know what the terms of any shareholder agreements they have look like.  Or they could just be carefully waiting in the wings.

The point is this: Sealy didn't get much (if any) capital from the IPO, as it was primarily used to fund the special dividend and provide a liquidity event for KKR (and partners).  Sealy has almost nothing from the offering for operations.  KKR managed to lock in some gains at a rather substantial multiple and has a good upside basis already in the stock price of Sealy.  Unless there is a major crash in Sealy's stock, KKR has done quite well.

This is but one example.  "Special dividends" are all the rage.  One reader, "FE" comments thusly in email:

Today's greater fools are those that are allowing [private equity firms] to dividend out all the cash and then payoff the debt burden through the flip IPO - as if any actual improvement in the underlying business took place through the balance sheet games that were played through the dividend recap.

Indeed.  But consider what investors get in the Sealy IPO.  A firm with significant debt burdens, nothing like an Modigliani-Miller efficient debt ratio firm, a lot of work to do and highly short-term incentives (options and stock price) with huge expectations.  Not a formula calculated to maximize the probability of success, in my view.

The second and even more distressing tool is the resort to secondary debt markets.  Really, an agency cost that never existed in the market for leveraged finance has been introduced.  Now, unburdened by the threat that they will ever have to cope with a failed loan, finance firms cut any deal they like with financial sponsors and offload the debt (along with its covenant lite structure) onto the greater fools in the secondary market.  I cannot imagine that the secondary market is pricing these properly, but I have nothing but instinct that tells me so.  Looking at the leveraged group of a hedge fund I see 5 20-30something guys and gals writing debt.  Are these folks going to take the keys of a foreclosed light manufacturing firm when it breaks?  I doubt it.  I have a strong suspicion that the incentives structure of the professionals working in this space is tied to the amount of debt placed.  This is speculation on my part, but good speculation, I think.

To my way of thinking, the massive inflows of capital to buyout deals and hedge funds with substantial leveraged finance desks have created an interesting effect.  The overhang of these uninvested funds puts a huge lag between actual market conditions and the response of firms selling debt.  They have money to place in debt, period.  They have become placement agents.

Really, after you hit the $750 million mark in a LBO fund, I think you start heading into the waters of the "Placement Sea."

A Rounding Error

Former Analyst: "At one point I remember explaining to one of my hedge fund clients that when you ask the CEO of a precious metals refining company where $40 million worth of refined platinum that's missing from inventory is, "somewhere in Peru" is probably not an acceptable answer."

Quickly, to the Chopper

The urgency level for Project Spy continues to increase.  Two senior sales people, including the head of all sales, have given their notice.  At some point we have to start wondering if there is going to be enough of a firm left for us to actually improve on.  At what point does a deteriorating asset slip far enough that we aren't interested anymore?  We're already beginning to feel like bottom feeders on this deal as it is.

There is this fine line between urgency and triage.  Obviously, urgency is a benefit to us up to a point.  The more issues a firm has and the faster they develop the more time pressure there is for the parent to sell quickly.  Machiavellian as it feels, that means less argument about terms and usually lower purchase price for us.  The risk the seller assumes in delaying is that the division will deteriorate so substantially that no one will want to buy it anymore.  And, of course, large corporates can be uniquely inept at restructuring small units.  It is not in their core business model (unless perhaps you are GE or something and your corporate philosophy is that constant reshuffling is the way to introduce fresh thinking and prevent internal empire building).

Generally, it is not in a buyout firm's interest to share in detail the modeling and assumptions that underpin our approach to transforming the business into a working and profitable firm.  In this case, however, we made the tactical decision to share our analysis, since it is so dismal.  The idea being that since Spy, Inc. had itself never delved into the stand-alone structure of the business it would add to the urgency once they realize how bad it actually is.  It had the quite expected result: A constant battle at every step on all the assumptions.  Since the projections are pretty bad, we have elected not to fight these at this point, but rather let Spy, Inc. put in their rather optimistic assumptions.  The result is still looking rather cash flow negative even in the face of dozens of last minute discoveries of "hidden savings."  Funny, if management had just sat down and gone through this exercise a year ago they would have probably improved profitability by 15%.  That is, if these "hidden savings" are even real.

I also wonder if the unit might have avoided the loss of the senior sales people if they had just disclosed that they were in talks with a potential acquirer (us, in other words).  The low morale seems to be mostly tied to feelings about present management and the parent.  Perhaps revealing the existence of discussions would present a glimmer of hope.  Well, on second thought, maybe not, given the reputation buyout firms have in the UK.

Well, there will be a go/no-go decision for Project Spy in the next 14 days, if not the next 7.  We will see.  A "go" probably means I have to relocate to the UK for 3-6 months.  I am not quite sure how I feel about that prospect at this point.  Then again, the UK in summer is much better than the UK in winter.

Subjectively Objective

Dealbreaker proffers an example tending towards the view that tech valuations have gone bonkers again.  (Or that they never fully pulled back into "unbonkers").  Of course, I am highly suspicious of valuations that don't get at or as close as possible to "intrinsic value" where that is possible.  What's the point if you don't have some kind of ballpark on what the business is capable of.  Ironically, a few readers have emailed me to critique my view of models, their importance and the relationship between modeling and actually operating a business.  I thought some actual statistics on the last two weeks of emails might be interesting.

Readers who indicated:

Equity Private is far too concerned with models: 3
Equity Private is not concerned enough with models: 3
Equity Private's models are not nearly robust enough: 2
Equity Private's models are over-engineered: 4
Equity Private would, in the fullness of time, come to understand how useless models are: 2
Discounted cash flow analysis is important: 4
Discounted cash flow analysis is useless: 3
Project Sinister employees are total idiots for not taking the bonus deferral: 5
Project Sinister employees are geniuses for not taking the bonus deferral: 3
Project Sinister employees are thieving villains who are at this very moment days if not hours away from smashing the drywall to salvage the copper in the Project Sinister offices: 1

Personally, I think the place of models is to introduce just a hint of rationality to what is otherwise a highly subjective analysis.  You have to take them with a grain of salt, to be sure, since their only value is predictive.  But herein lies the hitch.  When you both take models too seriously and start to impose "creative thinking" about how to model a firm, well then you get rather silly results.  This brings me back to the Dealbreaker entry:

The New York Times and New York mag both lead the week with return-of-the-dot-com boom stories about MySpace and DailyCandy, respectively.  Conclusion: it's different this time. Sort of.

It is the new, new economy, apparently.  Dealbreaker, quoting "Reporter Michael Idov" continues:

It’s nearly impossible to apply the usual valuation formulas to DailyCandy. According to the Wall Street Journal, the company projects revenue of “somewhere less than $20 million” this year. Most successful businesses go on sale valued at least ten times their yearly revenue, so by this standard, DailyCandy should cost $200 million or more.

Mr. Idov has given me some wonderful ideas:

General Electric trailing twelve months of revenue: $144.4 billion.
GE market cap (April 24, 2006): $358.8 billion.
Control premium for acquisition of GE (2005 average): 30%
Optimism factor applied to control premium: 20%
Resulting control premium: 36%
Theoretical acquisition cost of GE with control premium:  $487.9 billion.
Cost of restructuring GE to an "internet focused firm": 15% of enterprise value.
Restructuring time frame: 1 year.
Dollar cost of restructuring: $53.8 billion.
Total cost of GE acquisition and restructuring: $541.72 billion.

Potential sale price via "Idov Valuation Methodology" (patent pending): $1,444 trillion billion.  (Fortunately, I have eager Harvard beaver "LK" to correct my typos!)
Gains from sale net theoretical debt: $902.3 billion.
Time period: 1 year.
IRR on transaction: 66.56%
Cash on Cash: 1.67x

Really, as soon as people start getting creative with valuation metrics ($ per annual clicks, $ per "eye pairs," $ per paper-clips purchases) just stop listening.  It is not as if revenue multiples are even a decent way to look at things.  They just aren't.

Punishing Talent for Fun and Profit Part II

The Economist introduces (subscription required) what is, to my way of thinking, a bit of rationality into the executive pay debate with particular emphasis on Exxon's former CEO, Lee Raymond.  It is amusing to me that this particular pay package has attracted so much ire, particularly in the face of much larger and disproportionate packages recently disclosed.  (HealthSouth UnitedHealth and Yahoo, for instance).  I suspect that the current hostile climate towards "big oil" represents a good bit of the rationale.  Says the Economist:

What is more, he has a point. Exxon earned more in profit last year—over $36 billion—than any company has ever done before. True, Mr Raymond has had the good fortune to work in an industry that has benefited from the soaring oil price. But even allowing for that, Exxon under Mr Raymond has enjoyed a remarkable record of using its capital to earn high profits—one reason why it has easily outperformed most other large oil companies in terms of total shareholder returns.

And it is the shareholders, after all, who pay Mr Raymond—and who have done well out of Exxon themselves. The real executive compensation scandals are those cases when bosses do well, while their shareholders do not.

It has always been my view that whining about executive pay is akin to whining about professional athlete pay.  After all, if the seats are filled....

Oil is taking a hit all over at the moment.  Trial balloons involving a "windfall profits" tax are floating around in such numbers one wonders if we might be in the midst of an inaugural ball or something.  These talks of "windfall" tax are, I believe, even more absurd.  I guess the treasury is feeling the pinch now that a penny costs 1.4 cents to make.  Using this tax as some kind of spiked club to pressure oil firms to "lower prices" is equally daft.  "Let's tax our way to lower prices."  Excellent.  Where do I sign up for that plan?

wind-fall
'win(d)-"fol
1 : something (as a tree or fruit) blown down by the wind
2 : an unexpected, unearned, or sudden gain or advantage

To call the "good fortunes" of oil firms a "windfall," an "unexpected, unearned, or sudden gain or advantage" is a bit silly.  "Sudden," perhaps.  It seems, however, that everyone has forgotten that oil is a rather intensely capital expenditure dependent business.  To give you an idea, Exxon reported $10.3 billion in depreciation and amortization along with $13.8 billion in capital expenditures (nearly 40% of net income) in 2005.

That substantial risks, including notoriously difficult to price political risks, plague strategic decision making in the business with serious uncertainty is just "part of the job."  Oil assets are primarily on non-US soil and often the political systems in the states in which they reside are crippled for having been dependent on an "extraction model" for so long.  If all you need to do is call in foreign firms to suck magic fluid, ore or gems from the ground to give you 20%-50% of your GDP, then you never really need to develop your own economy, you are never dependent on your own citizens for substantial contributions to GDP and you, therefore, can fairly easily avoid the expense of developing their social freedoms, forming sophisticated institutions and the political systems to support them.  No surprise, then, that developed oilfields tend to reside in areas with a limited connection to free market systems.  (Venezuela and the Russian Republic are the most notable if not isolated examples of capricious extra-legal interference with oil businesses of late).

Aren't we supposed to reward firms that take substantial risks, develop capacity and are are wise enough to have it waiting in spades as demand thickens?  And why is it that the same voices I hear today calling for punitive taxes on these firms have, over the last 3 years, been shouting at top of breath to alert consumers that an oil shortage and "peak oil" is just around the corner.  Is it any wonder that hype seems to be driving oil price far more aggressively than anything like reserves, currently at something like an 8 year high, would suggest?

Well, what if the oil supply nay-sayers are correct?  What if Iran halts oil contracts to the West?  (Wouldn't be the first time).  What if peak oil is around the corner?  Well, do we want to appropriate a large portion of the funds, 40% of which would presumably be earmarked for continued exploration right when the theory has it that oil is going to get dramatically harder and more expensive to find? I love the message.  "Don't succeed too well.  We'll take it from you." Genius at work.  Perhaps the U.S. isn't so different than Venezuela after all?

Locusts No More

" A year ago, Germany’s labor minister likened foreign investment firms to a swarm of locusts — a comment that appeared to bode ill for buyout funds’ prospects in that country.  But Monday’s deal with Blackstone Group, in which Blackstone will pay $3.3 billion for a 4.5 percent stake in state-controlled Deutsche Telekom, suggests that fears of a Teutonic chill were overblown, analysts said."

Dealbook, on Germany, locusts, private equity.

Investing v. Deploying Capital

Wonderfully sinister "Under the Counter" presents a missive about hedge funds and ponders if they should really be in the venture capital space.  Is the move a sage effort to diversify or a bit of dangerous overreaching?  Says "UTC":

The Journal claims that hedge funds are often willing to pay more for stakes in new companies than the venture capitalists themselves, prompting one to wonder if the traders have any idea what they're doing.

There are some interesting properties developing with hedge funds.  Because they aren't exactly specialized, hedge funds that "hang on" to other lead investors are effectively deployers of capital, not investors of capital.  They are in the business of putting as much money "to work" as possible.  I see their diversification as a function of the lack of opportunities in their traditional investment space rather than a careful bit of asset class diversification.

What alarms me about this development is that I find it hard to imagine that they possess the monitoring abilities required to manage their investments properly.  The five guys and gals at the leveraged desk for one fund Sub Rosa occasionally taps for debt are certainly not in any position to manage a firm if they have to foreclose.  Nor do I think they are really in a position to effectively fight a long bankruptcy fight or, as should be the case, deploy resources to avert bankruptcy before it strikes.

Says the Journal in another article (subscription required):

Hedge funds often make quicker investment decisions than venture capitalists and can offer more money -- though some say they may not scrutinize private companies enough before investing.

[...]

Hedge funds now are mainly trying to deploy the enormous amounts of capital they have raised over the last several years and diversify their investments, since returns haven't been stellar for most public stocks. Hedge funds currently have an estimated $1.5 trillion under management world-wide, compared with about $261 billion for venture-capital firms in the U.S., according to data from HedgeFund Intelligence Ltd. and the U.S. National Venture Capital Association.

[...]

...hedge funds often have a more relaxed management style. A venture capitalist "might be camping out in your conference room, asking all kinds of annoying questions," says Bill Burnham, a former managing director with Mobius Venture Capital who is now a private investor. The attitude of a hedge-fund manager, he says, might be, "Here's your check -- email me when you go public."

I am reminded of the view that fostered the growth of massive, inefficient conglomerates.  Massive amounts of capital and acquisition power suggest diversification.  The problem is that financial services giant QRX Megacorp, Inc. probably shouldn't be making salsa.

I can't imagine that this will end well for the less prudent of hedge funds.  The question is, how many prudent hedge funds are there?

High Potential Energy

Financial News Online adds to today's theme: the venture capital world is awash with hedge fund money.  The cumulative collection of today's venture capital and hedge fun capital observations (venture deals, hedge fund capital, inactive and sedentary management and far too much fertilizer) prompts me to hereby coin the term "Vegetable Capital," to refer to this growing trend.

Financial News Online's take?  Average deal size is being pressed up along with everything else.

The Cable Guys

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

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.

Exxon Mobil and Politics

I don't like to get very political in here, but continuing the gratutious linkfest with Abnormal Returns (I can't help it, they have wonderful stuff almost every day) I am fascinated, and creeped out by this graph on Infectious Greed comparing Bush's approval ratings and gas prices.

Silly Correlation theories:
Dual, uncorrelated effects of a single, uncharted, independent variable (Gloom as independent variable):  People with gloomy expectations for the future drive more, pushing up gas consumption and elevating prices.  Gloominess also pushes down Bush sentiment.

Direct correlation effects between the two variables. (Bush approval as independent variable): People work off anti-Bush steam by driving fast.  Increased consumption tightens supply and drives up prices.

Accelerated Decrepitude

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.

When Focused, Isn't

What is it today with the alternative definition of focus?  First that noise with Google and now Chairman and Chief Executive of Bank of America, Kenneth D. Lewis, is claiming (Wall Street Journal, subscription required) that after $80 billion in acquisitions over the last 24 months, the firm is more efficient and focused on customers than ever.

Enron, Overhang and Private Equity

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?

Control, Liquidity, and "The Deal"

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.

Dumb Movie Money

The Wall Street Journal reports (subscription required) on the increasing role of hedge funds in the movie business.  It is not immeidately clear if they picked Ryan Kavanaugh, famous primarily for having made a series of missteps in the dot-bomb venture capital business that got him sued more than once, because he is a likely rags-to-riches story, or to gently remind the reader of the meaning of "dumb money."  Either way, it makes for outstanding "Vegetable Captial" material here.

Certainly, funding films must feel a lot like the venture business.  Reading the Journal article it becomes clear that all the people in line in front of an equity investor when it comes time to pay out, including exhibitors, the studio distribution fees, payback for production and marketing costs, actors and directors, make up for a pretty large black hole that has to be filled before investors see a dime.  It must feel quite like being a later stage investor coming in behind a massive wall of pre-existing preferences.  (That sounds redundant).  The Journal gives "Batman Begins" as an example.  $150 million in budgeted costs, $372 million in worldwide ticket sales and Kavanaugh's investment entity, "Legendary Pictures LLC," is still in the red by "several million dollars."

Considering that Legendary put up 50% of the budget for the film (the standing arrangement) and that even if a film has is a pretty big hit in the box office Legendary has to make their money back on notoriously fickle DVD sales, even a slight downturn in the film world could be pretty lethal.

And that's not all.  Studios seem to be smart enough to keep the good stuff for themselves, either funding the "sure things," (Harry Potter is the Journal's example) internally, or using debt rather than parsing out equity.  This locks in the upside for studios, who don't have to share a percentage of the take on these big franchise hits.  Instead they are looking to outside money to fund their riskier capital needs.

Nope, that's not even all.  Even McBusiness Week has figured out that the trend today is away from the box office.  The industry has been pushing up ticket prices and dumbing down theater size and the experience of going to the cinema for years.  Consumers are beginning to grow annoyed.  Luckily for us we have Mark Cuban to tell us that the studios should just release for DVD, Video on Demand and theaters on the same day.  As if the compression of the "lag time" between theater release and DVD release wasn't already headed that way on its own.  Less time to work off those preferences before investors get their take.  As a percentage of revenue for a film the box office has gone down to 17.5%.  Robust DVD sales might buoy the stakes of the likes of Legendary.  We'll see.

So how does Legendary intend to add value and pick winners?  Monte Carlo simulations.