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Monday, May 01, 2006

Total Lack of Surprise

woops Loudeye, the firm run by a Microsoft "prodigy" that threw a entire block party for a self-congratulatory fest when it raised $72 million, before getting another $48 million from Microsoft, and then $25 million from a 2004 stock sale and then another $8.5 million from a recent stock sale, and who knows what other fundings inbetween that I've missed, meets all our expectations this week.  That is, it sells substantially all its assets for $11 million to Muze, Inc. 

I'm going to use this occasion to introduce a new concept.  The "Cuban Overlap Failure Index."  (COFI).  The COFI number for a failed firm is the number of Google hits that firm's name produces when "Mark Cuban" is added to the search term.  Loudeye's COFI: 221.  I'm currently testing the "Kawasaki Overlap Failure Index" (KOFI), but no one spells Guy's name right so it is probably less effective.  Still, Loudeye's KOFI: 83.


concentrate and ask again So can being connected to Mark Cuban or Guy Kawasaki be a strong indicator of impending financial doom?  I'm not sure, but it is a lot of fun to speculate.  So I ran some regressions of the Cuban Overlap Failure Index and the Kawasaki Overlap Failure Index.  (COFI v. KOFI).  Results?  It is better to be in Google searches next to Mark Cuban than next to Guy Kawasaki.  KOFI numbers have an R-Squared of .626 against the losses of some famous dot-bombs.  (Boo.com, Kozmo.com, Pets.com, Webvan, Flooz, eToys, MVP.com, Kibu).  COFI numbers don't show very good R-Squared numbers (.199).  Regression graphs below.  I wonder if these have predictive ability?  If so then Losses in $ millions at Failure = 1.296 x KOFI number.  Predictive losses for Google?  $814 billion.

neither one of them looks good

Third Time Could Be the Charm

paris hilton, blackberry lawsuit victim RIM in trouble again?  This time an "actual company" with revenues and developed products and license agreements with AT&T, Nextel and Vodaphone and everything?  Uh oh.  Guess we better start working on patent reform post-haste to prevent inventors from suing anyone to protect their interests.  I still want to LBO Research in Motion.  It is ok though.  Paris Hilton is a Blackberry fan.  All will be well.

Tuesday, May 02, 2006

Melting Offers

i am melting! Oddly, Project Velocity has not died of its own accord.  Perhaps, though I am not certain on this point, through our dire prediction, that the other interested parties were merely leading Velocity down the primrose path and that when the trap of time sprung, offers would melt under the onslaught of nickel and dime objections until a fraction of the original offer was still on the table.  I do not know for certain that this has happened, but I strongly suspect it.

Late last week one of our contacts at Velocity called up and asked after our interest in supporting a management buyout (MBO).  This puts us in something of a quandary and our first reaction was to carefully cull the non-disclosure agreement we had inked with Velocity to make sure that our discussing an MBO with a member of the management team was kosher.  It seems to be, even according to the grumpiest of our attorneys.

I can only guess at what happened, but I think I am probably close with this scenario:

Lured into the honey trap of diligence with our rivals, hopes were drawn up, but time began to wind down, assisted, no doubt, by the slow pace of progress cultivated by the interested firms.

Annoyed by senior management's blindness (how do you think they lost all their IPO money in the first place) and totally unwilling to do business with the sharks now circling, senior-middle management looks around for white knights and we are the closest approximation.

This is interesting because, depending how valued senior-middle management is to the division, the sharks might be scared off by the potential "People Pill" defense, the mass defection or non-cooperation of critical managers familiar with the product, production and etc.  If this is so then an MBO, with us as sponsors, could be the only alternative left to the parent.  Although, shut-down is always an option. 

The big question now is how badly senior-middle management, and Sub Rosa, have alienated senior management at Velocity.  Part of this depends on how much of an "us and them" dynamic exists.  Time will tell.

99 Red Balloons

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

Wednesday, May 03, 2006

Bought to You by the Number 16

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

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

Is that wrong of me?

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

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

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

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

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

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

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


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

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

What other changes can we expect?

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

Whoo hoo!

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

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

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

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

How were all these payments funded?  Three guesses.

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

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

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

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

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

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

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

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


Today in Capitalism

typecast Happy 537th birthday: Niccolò Machiavelli, Florentine, diplomat, formative figure in modern statecraft, poet, playwrite, lawyer's son, advisor to the Medicis, purported anti-Medici conspirator, convict, torture victim, exiled citizen, author of 23 works of substantial importance, including "Dell'arte della guerra" (The Art of War), "Discorsi sopra la prima deca di Tito Livio" (Discourses on the famous Roman, Titus Livy), "Del modo tenuto dal duca Valentino nell' ammazzare Vitellozzo Vitelli, Oliverotto da Fermo, il Signor Pagolo 'il duca di Gravina Orsini" (Description of the Methods Employed by the Duke Valentino when Murdering Vitellozzo Vitelli, Oliverotto da Fermo, Signor Pagolo, and the Duke di Gravina Orsini), "Asino d'oro" (The Ass of Gold), many dozen more minor works, and, oh yes, author of "Il Principe."

("Ritratto di Niccolò Macchiavelli," Ridolfo del Ghirlandaio, c. 1522; Private Collection, London)

See also: Dealscape 

Pride Goeth Before....

paris hilton failure overlap index? Honestly, Research in Motion, didn't you learn anything?  Answer: Uh, what was the question again?

How Sharper than a Serpent's Tooth

louis rukeyser (1933-2006) I admit it.  I used to watch Louis Rukeyser in "Wall Street Week" all the time when I was younger.  When I started, I was far too young (11) to be watching Louis Rukeyser, or anything remotely related to Wall Street.  My parents thought I was more than a little "off."  I can't even vaguely remember how I got started watching it, but I do remember that the show immediately adjacent to it in the schedule, "Washington Week in Review" had an ubercool opening clip that involved a spinning graphical representation of the Capital Dome, but the content of that show was boring.  Real boring.  A portent of things to come.  Today, about any news about Washington or politics bores me to tears.  I can't get enough of the Journal.

I lost heart, a little, when the pinheads at Maryland Public Television decided to "modernize" Wall Street Week and add some "fresh blood."  What they failed to understand was that the regular Friday appearance of the grandfatherly (I swear, he reminded me of my grandfather quite a lot) and calming figure of Rukeyser, complete with sophistication, poise, complete calm, wit and charm, was just what the country needed after a turbulent week.  I always remember his view as a long one, emphasizing optimism, long-term returns in equities and reminding us to ignore short-term volatility.

Then there was the "Elves Index," I always used to think of the Gnomes of Zurich when I heard that.

Not surprisingly, even though offered a guest spot on the new show, Rukeyser was having none of it, and he wasn't quiet about it either.  "Don't worry folks," he quipped, "I've always said that I wouldn't retire until I was old enough to be an anchor on 60 Minutes. And I've got a long way still to go!"  He was summarily dismissed immediately after.  Occidental Petroleum, long time sponsor, pulled their support of the show, which was pulling in over $6 million in advertising yearly on $2 million in production costs.  They wore formal evening wear on his year-end program every year.  Playboy named him "Best Dressed."  Talk about a class act.

"How sharper than a serpent's tooth to have an ungrateful child- in this case an ungrateful producer," he told Larry King, in reference to Maryland Public Television after his sacking.  But we shouldn't at all be surprised that he was the kind who could quote King Lear to Larry King at the drop of a hat, and throw in a double entendre to boot, I think.  It is not hard to understand why he was mad, and not surprising the pinheads at MPT didn't expect what came next.  As he told King:

We would have had a graceful exit, we'd have said nice things about each other, we would have gone our separate ways. Instead they totally deceived me, deceived my viewers, and then they apparently were astonished that Friday night that I did what I always did, and in my opening personal commentary- and I control the content of the show contractually, plus I have the same First Amendment rights that you and everybody else do- I told people what really had happened, leveled with the viewers, which I've always done for 32 years, part of the strength of the show, I think....

Was it over for him?  Never.

...Ernest Hemingway crashed in the jungle. People thought he was dead. All over the world there were obituaries praising Ernest Hemingway. Then the guy comes out of the jungle, unexpectedly, carrying a bunch of bananas and a bottle of gin and he said, "my luck, she is running good."

He left and moved to CNBC and topped their ratings.  I lost track of him there.  I suppose it was hard to watch a serious financial program on the likes of CNBC.

I never got to go on one of his Investment Cruises, they sounded a little corny, but so did his puns sometimes.  ("If all your money seems to be hair today and gone tomorrow, we'll try to make it grow by giving you the bald facts on how to get your investments toupee.")  I bet the cruise would have been a blast.  And I suspect I am not the only one to think so.

There was just something about him.

But a lot of people of all ages don't want just an MTV approach to life. They want a little more thoughtful program. They want the kind of discussion program you do. They want a little commentary that makes sense and doesn't put them to sleep. So I think there's always going to be room for quality programming, and those who say everything's got to be faster, shorter, jazzier have been around forever, and they usually come and go pretty fast.

We aren't going to find this again soon.

I would like to be remembered as a guy who always leveled with his audience, who tried to represent the customer and nobody else, and who gave it to people straight, no matter who it offended.

- Louis Rukeyser

Thursday, May 04, 2006

Punishing Talent for Fun and Profit III

maybe i should have held outMy favorite reader and Bain Capital guru, sent me an interesting missive on executive pay. With all the mewing about the payment of decades of accumulated long-term compensation to Exxon's former CEO Lee Raymond, have we looked at what private equity compensation structures look like? Perhaps we should.

Let's pretend, for a moment, that Exxon was Burger King in December 2002. Exxon was hardly distressed in 2002, but Exxon stock was quite near a five year low. If you were going to do a buyout, that would be probably be the time. Let's also assume that the transaction adopted Burger King's compensation structure for management. How might that look?

Well, it's not a perfect comparison, of course, and not only because the former CEO of Burger King bailed before the IPO for reasons unknown. He probably would have gotten a much nicer bit of compensation than I suggest below. Ignoring this, Gregory D. Brenneman had 3,025,724 shares, some of these underlying options grants before he forfeited a good chunk by leaving. This is about 2.23% of the firm, after the offering and I'm not sure it counts some of the restricted share grants. At $16 per share that values his stake at something like $48 million. Deducting for the options price and strike, he'd probably be sitting at around $38 million.

If we used this formula on Exxon, we'd end up with something like 136 million shares for a 2.23% stake. Even assuming all these were options priced at a weighted average of $45.00 (December 2002 prices for Exxon had them around $34.50) our theoretical CEO would be looking at $2.7 billion. Let's half that, and keep his stake down to 1.1% or so. $1.3 billion. Of course, I haven't added any "compensatory make-whole payments" yet, or bonuses, or pension.

Friday, May 05, 2006

Special Dividend III: Bride of Special Dividend

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

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

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

Overhang and Exit Denial

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

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

From the Kedrosky piece:

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

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

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


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

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

Saturday, May 06, 2006

The Limitations of Divination

take the long view Louis Rukeyser: "I never make a prediction that can be proved wrong within 24 hours."

Sunday, May 07, 2006

Time to Consider Time

time is on your side "We couldn't have achieved the profitability we have if we had been a public company. No investor would have been patient enough to allow us to build a firm oriented toward long-term growth and profits.... The short-term infatuation with quarterly earnings on Wall Street restricts the earnings potential of Fortune 500 publicly traded firms. Public firms are also feeding grounds for lawyers and lawsuits."

- Charles Koch (CEO Koch Industries, largest privately held firm in the United States)

Monday, May 08, 2006

Banking on Women

as advertised Dear "Leveraged Sell-out":  Your most recent entry is highly offensive to female financial professionals.  It demeans women, particularly those in the world of investment banking, casts them as bitter and disillusioned "wilted flowers," suggests that their primary role is to service men and encourages men to use deception and manipulation to coerce these investment banking women into having sex.  Further, your parody "craigslist" advertisement is a shallow attempt to capitalize on stereotypes often leveled at such professional women.  With respect to this particular demographic, your entry is crude, misogynistic, targets a productive segment of working women and is entirely lacking any of the tenants of modern, progressive-liberal thinking.  Accordingly, please add me to your mailing list immediately or, in the alternative, forward detailed instructions on obtaining an RSS feed of your weblog.

Thank You in Advance,
Equity Private

Tuesday, May 09, 2006

Sometimes You've Just Got To Say...

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

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

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

Risk Profiles

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


Wednesday, May 10, 2006

Cannot Post Today

just plunge it in my heart already Andrew Feinberg's comments about Louis Rukeyser have so upset me that I have been unable to post today.

Thursday, May 11, 2006

The Interns Are Coming

role model or cautionary tale?Our two interns have been selected.  Offers have been sent.  One, "Alexsis," I was rooting for.  The other, Craig, well, I just don't know him well.  I am both wary and fascinated by the potential here.  I am thinking about adding an "Interns" or a "Monica" category to Going Private.  I definitely get the sense that they will take up a lot of type.  They seem young, full of energy, and maybe even fun.  How dangerous is it to go out drinking with the interns?  Fairly, I suspect.

And now, the questions have been filtering in.  "Can you suggest affordable housing alternatives in Manhattan?"  Not really, no.  "Is there a document on the dress code?  My former employer had 3 pages of guidelines but I don't see any in the orientation documents."  We have orientation documents?


The New Baroque

authority from above Readers may already be familiar with my feelings about the importance of individualism and rationality as the genesis of an authority built on individualistic, rather than centralized tenants.  Today, reading The Economist, I came across a quote in an article on Google (subscription required) that gives me pause and makes me think that we are faced with a kind of Baroque period in technology.  This is not a technology or venture capital blog, but, as a keen consumer of outsourcing services, the article exhibits a trend, today described by such phrases as "Software as a Service," and perhaps in days of yore as "The Network is the Computer," that makes me nervous.  Very nervous.  To understand why you have to go all the way back to the foundation of Apple.

First, the quote about Google:

Among Google fans, the company has come to epitomise the more mature (ie, post-bust) internet generation, which goes by the marketing cliché “Web 2.0” (see article). In this context, it is assumed to be working on absolutely everything simultaneously, and every new product announcement, no matter how trivial, is greeted as a tiny step toward an eventual world-changing transformation.

At a minimum, this hypothetical transformation would consist of moving computation and data off people's personal computers and on to the network—ie, Google's servers. Other names for this scenario are the “GDrive” or the “Google grid” that the company is allegedly working on, meaning free (but ultimately advertising-supported) copious online storage and possibly free internet access.

I'm not a rabid Apple fan, nor do I have the qualifications to be much of a nerd, but I do share the afterglow associated with the introduction of the "personal computer."  Apparently, I say this because I was far too young to know, long ago there were these things called mainframes.  Mainframes were massive pieces of iron that provided a central source for computing power.  Since they were centralized, and sufficiently complex to defy individual intrepretation, little empires developed centered around the computing resources in large corporates.  They controlled access to computing.  They had power.  That this empire would ever be challenged by smaller, autonomous computing was unthinkable.  So interwoven was this belief that Ken Olsen, founder and CEO of Digital Equipment Corporation famously told the World Future Society "There is no reason for any individual to have a computer in his home," in 1977.

It seems obvious now that the personal computer was destined for ubiquity and centralized resources for obsolescence.  Haven't we had this argument a few times already?  Isn't this the point of capitalism, individuality and free markets that individual market actors have importance?  What better example than the personal computer?  It deconstructed centralized control over computing resources.  (There's nothing more annoying than IT people with the power to nix a merger).  In short, it introduced individualism into the computing world.  So why is Google, along with Microsoft and others, working hard to reverse this trend?  This question is even more puzzling when you look at the many failed attempts to go back to a mainframe model over the last 20 years.

With my data on my hard drive in my computer running on my software, I don't really have to worry about their data backups, their storage provisions, their network connection or their disgruntled employees.  Why would I want to give up my data and my processing to a third party, ever, unless I couldn't get done what I wanted to do on my own, increasingly cheap hardware?  Why introduce dozens of people into the potential failure chain?

I think the answer lies not in what consumers want, for anyone who has lost a long blog entry or a seven page email due to a web-based front end crashing, the wireless network at the airport dying for 30 seconds, some piece of heavy equipment digging up a fiber cable, or a session timing out, has exactly zero interest in using those applications via the network unless it is mandatory, but in what software companies want.  They want to control how data, content effectively, gets processed.

If you follow digital rights management (DRM) at all (I do because of one of our portfolio firms) you know that software makers and content providers have long been trying to control what you process and how you process it on hardware that you already own.  "Piracy" is the usual boogieman used to justify these restrictions.  They started with selling you a "license to use" software rather than actual title to the software itself.  Certain uses could be restricted this way.  That didn't really give them active control so they moved to technological restrictions on use, DRM and burdensome and capricious legal structures (like the Digital Millennium Copyright Act) to protect their poorly designed DRM.

DRM isn't working well.  Primarily because it is an impossible problem to solve while I have, as one SubRosa partner says quoting a security expert who's name some might recognize, "their security in my pocket."  This is as it should be.  My data and my hardware should not be held in trust for me by content providers, the principal of which they generate revenue with in the interim.  But they need this structure to preserve their middle-man revenue model.  Arbiters of content, as it were.  Many of them have lost their distribution monopolies.  Accordingly, they have to move the processing, the repository for software or the data itself into their own hardware.  How can that be done?  Software as a service.  GDrive.  GMail.  Now all your data and all your processing are subject to terms of use and they can enforce these directly.  Scary.  Now my data is a source of revenue.  I have to pay to get at it.  They can use it to develop more sophisticated ways to force me to view, and others to buy, advertising.

Contrast this against the stated benefits of "software as a service," all of which strike me as as much steaming dung.  And what happens when Microsoft.net Word 2.0 eats my offering memorandum?  Well, I'll call the help line and utilize the "customer service as a service" India outsourced support rep, of course.

Time for the Second Enlightenment.  With any luck there will be some bloodshed.

Monday, May 15, 2006

Punishing Talent for Fun and Profit IV

duck duck duck goose No less formidable pair than The University of Chicago's Gary Becker and Richard Posner chime in via their excellent blog on CEO pay and, to some extent, take to task the many measures used by the clamoring masses to whine that CEOs are overpaid in the United States.  The two make some interesting observations.

U.S. CEO compensation has increased 6 fold in the last 25 years, a point often made large in the argument that CEOs are fat cats.  Interestingly, and deflating the sting of this argument some, this is almost exactly the increase in size of the average, large publicly held firm in the United States. 

U.S. CEOs make about twice what their foreign counterparts do, but salaries are a much smaller portion of CEO compensation in the U.S. (less than half) than, say, in Europe.  Posner points out that foreign CEO compensation is actually catching up with U.S. compensation, which is an interesting point if you think the foreigners have it right.

Both are quick to give the competition for CEO spots, the "market for management talent" as it were, a nod.  Both are also quick to point out that the increasingly reliance on stock options as a long-term compensation structure accounts for some of the change, but Posner points out that stock price is not necessarily correlated to CEO effectiveness or contribution.  Of course, that is a difficult argument to make without a good control sample, but the point remains.  So what are we to use if not stock options?  Phantom options perhaps?  Tied to metrics we believe are more closely correlated to CEO performance?  What would those be?  Net Profit?  Market Cap?  Revenue?  (Surely not). 

Mystery Science Theater 2006

it's not a state secret Key hint that there might be a issue in the marketing department of a firm: You can't tell, on reading the first three paragraphs of the firm's description of itself, what the hell it does.  Case in point, this missive from a large publically held firm (can you figure out what they do without Googling the text?):

Be sure you're getting the most value from your information—and your IT resources. From proven systems and open software to world-class services and solutions, Firm X provides tight integration and advanced networked solutions for full compatibility with your existing infrastructure. So you can manage your information across its entire lifecycle—while you manage your budget.

Answer below.  (No peeking).

EMC Corporation.

Tuesday, May 16, 2006

Dumber Than Dumber

dumber than dumber Some time ago I pointed out that the Wall Street Journal had subtle ways of making predictions without smacking readers in the face with their bias.  One method, which is sneaky but kind of amusing, is to pick a rather questionable figure as the representative for a questionable trend.  The Journal had this particular tactic in full force back in April when they picked (subscription required) former dot-bomber Ryan Kavanaugh as their feature for hedge and "private equity funds" that invest in Hollywood movie productions.

The Journal didn't make too much more than a paragraph of the fact that Hollywood has sucked in "dumb money" from outsiders for decades without even a Christmas card to the dozens of bankrupt shells of investors they left behind.  And with respect to Ryan Kavanaugh, they might have done better if they picked Benjamin Waisbren.  An astute attorney reader forwarded me an article in the LA Times (who else?) describing the fallout from the Poseidon debacle.  Now, maybe it's just me, and maybe it's hindsight but I think Poseidon might have been near the top of my list for bomb predictions had I been paying attention.  Says the LA Times:

One person who worked on "Poseidon" is already out of a job. Just days before the film opened Friday with audience surveys showing scant interest, Benjamin Waisbren lost his position running Virtual. Waisbren, who also served as a "Poseidon" executive producer, did not return telephone messages Monday seeking comment. Stark Investments, the primary hedge fund behind Virtual, declined to comment on the film's performance but said Waisbren's leaving had nothing to do with the film.

Under Waisbren, Virtual signed a deal to invest $528 million in six Warners films. Returns so far have been unimpressive. The first co-production, March's "V for Vendetta," collected good reviews and grossed $85.6 million domestically but less than that in overseas theaters. "Vendetta" cost more than $50 million to produce.

As I mentioned back in April, one of the major issues cutting against outside investors is the preference order on these deals.  The LA Times doesn't miss a beat here:

In the case of "Poseidon," Warners and Virtual split production and marketing costs. But Warners will recoup prints and advertising costs, collect interest and pocket a distribution fee of 12.5% before it shares any revenue with Virtual, according to people familiar with the deal. The film's gross-profit participants are also paid first.

As a result, Virtual covered about $125 million, or half of the $250 million it should cost to make and market "Poseidon" around the world. At the current rate of ticket sales, Virtual could end up with $75 million or so from "Poseidon" — meaning it could lose more than $50 million on the movie, said two people familiar with the film's finances. A Stark executive disputed that worst-case scenario and also said its Hollywood investments should not be judged on the domestic box office of one movie.

And who comes to the rescue for Dumb and Dumber Money?

The "Poseidon" premiere should not be seen as a referendum on private equity investing, said one prominent person in the field. Ryan Kavanaugh, chief executive of Relativity Media, among the biggest suppliers of private equity film financing, said that "while no one is jumping for joy over the domestic performance of this one film, its future is yet untold as the international markets have yet to open. There are also other ancillary platforms where revenues will be made that will help to define this picture's outcome."

Wednesday, May 17, 2006

Aristotelian Debt

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

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

Indeed.  Find some balance.

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

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

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

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

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

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

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

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

sleepy stock

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

Thursday, May 18, 2006

Yes, Oh, Yes Your Majesty!

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

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

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

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

Never Surrender

never surrender Project Spy has deteriorated to the point where it doesn't look like there is a deal left to do.  Management now has it in their head that it would be cheaper, in the end, to restructure the unit themselves with their present divisional managers in place.  How this math works, frankly, quite baffles me.  Not only that, but the weeks and weeks of delay they have heaped on the group since we started talking to them has bled out three more senior salespeople.  It had gotten to the point where there was serious talk within Sub Rosa about dropping our interest in the deal entirely since the deterioration was continual and severe.

Armin and the CEO had a letter writing exchange that slipped into the double digits over the last 48 hours but even Armin's formidable sorcery doesn't seem to have moved management any closer to numbers we can live with.  I feel like the deal is entirely dead and I am ready to move on.  My youth was showing, I think.  Nothing doing, says Armin.  "Half of the deals we've done we've been thrown out of twice before closing."  Never say die, I suppose.

CNBC: Financial News You Can Lose

the best condition the cnbc set can be in, empty My favorite Bain Capital reader laughingly points out an exchange on CNBC today that pretty much sums up the state (absence) of that offering's financial intelligence.  He cites Bob O'Brien, of Dow Jones, as explaining that while Chipotle's IPO closed at day's end up 22%, the Burger King IPO is only up 7% (intraday) because: "The difference is in the burger... Burger King is stuck in a low growth industry."

Can no one on that program have realized that in the absence of major market moving news the daily gain on an IPO the same day of its initial issue has only to do with how well priced the deal was by the underwriters?  Someone pays these people?  Ugh.

Monday, May 22, 2006

Cable Complexity?

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

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

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

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

I've [...]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

KKR Amsterdam

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

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

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

A First

Special Executive for Counter-intelligence, Terrorism, Revenge and Extortion Going Private's readers are generally in the top quartile of people I "meet" on a daily basis.  Not a hard standard to exceed though, since I spend most of my time with bankers and lawyers.  By no means are they some kind of fawning groupie base.  Many of the emails I get are critical or at least in disagreement with my posts.  They have, however, been, almost to a letter, respectful.  So imagine my surprise today when I recieved an email from a reader claiming to have discovered my identity and threatening to "out" me.  Imagine my further surprise when the email went on to demand some kind of payment for this reader's continued discression.  Rather bold, no?

"...how bad do you not want me to disclose who you are?" he/she writesIt is sort of like being in a bad horror film plot.  I keep picturing a dark room with a badly scarred, bald guy with a big signet pinkie ring methodically stroking a long-haired, white Persian with a diamond collar.  "Put zee private equity blackmail plan inzoo effect."  How thrilling!  And how criminal.  It is all fun and games until someone commits a felony.

Extortion and blackmail are federal offenses and carry federal prison terms varying from 1 to 20 years.  The interstate transmission of threats of this kind is itself a crime, even without any other action.  To wit, 18 U.S.C. 875(d) "Interstate communications" provides in part:

Whoever, with intent to extort from any person, firm, association, or corporation, any money or other thing of value, transmits in interstate or foreign commerce any communication containing any threat to injure the property or reputation of the addressee or of another or the reputation of a deceased person or any threat to accuse the addressee or any other person of a crime, shall be fined under this title or imprisoned not more than two years, or both.

Since the threat was made over email and probably crossed state lines there's probably a federal wire fraud charge for an eager prosecutor to dig up as well.

Sounds like my reader has already made him or herself a three count felon with about 20 seconds of effort.  Woops.  I'm sure badly scarred, bald guys with pinkie rings and Persian cats wearing diamond collars generally have a good legal defense fund socked away though.

This, of course, is before we even get to New York state law or the laws of the state in which my faithful reader is resident.

Of course, pressed to disclose what it was he or she knew about me, where I work or any other details the reader could not provide any answers of substance.  But, 18 U.S.C. 875 doesn't require the threat to be plausible, and there is no capacity requirement, only that the threat was made.  Still a felony.  Woops #2.  I'm sort of assuming it was a careless game.  Still, a dangerous one.

Wednesday, May 24, 2006

Punishing Talent for Fun and Profit V

time is on my side Just after an outstanding article (subscription required) on the real brains behind Voltaire (his lover, Emilie du Châtelet), the Economist chimes in (subscription required) on executive pay.  The article outlines the perils of stock option based pay (stock prices badly correlated with executive performance and the evil this does, e.g., rewarding poor bosses who happen to preside over the firm during a general stock market boom) and notes some of the various performance based packages that seem to be all the rage.  Pay "inflation," seems now to be in full effect, in Britain at least, with the Economist noting the impact of some of the typical scapegoats:

But pay moderation among British executives may now be coming to an end. Hedge funds and private-equity deals are proliferating, bringing with them rewards that make the offerings from public companies look stingy. So remuneration committees are approving more generous schemes to retain their best executives.

I've touched on CEO compensation before, more than once actually.  So have the Economist (subscription required), Gary Becker, Richard Posner, and Financial Rounds.  This most recent Economist article makes three interesting points, one implicitly and two directly.

First and implicitly, the article suggests there is an active market for managerial talent, at least in Britain, with the passage I cite above.  That senior management pay floats with supply and demand is, and please do forgive me for being a capitalist, a good thing.  I expect that enumerating the arguments for such a system would be beneath the notice of Going Private readers.

Second, the Economist points out that there has been a move to "absolute" metrics to trigger incentive pay (bonuses, etc.) and away from "relative" metrics, based, for example, on the firm's performance relative to the competition.  The Economist notes that payouts under relative systems that could, for example, require the firm to beat the average for the industry in, say, earnings growth, have a particular effect.  Quoth the Economist: "Indeed, if all companies used them, only half of all bosses would get a payout in any given year."  That great sucking sound you hear is the slurping draw of managerial expertise to the far higher pay packages offered by private equity and hedge funds.  Absolute metrics, that might even be set quite arbitrarily low or split into two severable targets, tend to increase the frequency of payouts and keep public firms competitive in an inflationary compensation environment.

Finally, the Economist comments:

Transplanting pay plans from private-equity firms to public companies is dangerous, not least because doing so confuses two quite separate issues: how much executives ought to be paid and what their incentives should be. Managers involved in buy-outs are usually expected to put some of their own money at risk. And it is far easier to fire an executive in a private company than in a public one. Big rewards in private-equity firms are in part supposed to compensate for bigger risk. But more important, private-equity investors typically have direct control of the companies they manage and are able to set targets and structure incentives that align managers' interests with their own.

I have some issues with this analysis.  First, insofar as executive compensation is being moved from salary to incentive based pay, executives do have their own money at risk.  Second, I'm not sure how one can argue that the compensation committee of the board of directors of a public firm doesn't have similarly "direct control of the companies they manage..." with respect to "[setting targets and structure incentives that align managers' interests with [the shareholders]."

Of course, this silliness about executive pay has caused all sorts of regulation and calls for regulation on the issue.  Section 162(m) of the internal revenue code limits deductions for executive pay to $1,000,000- unless it is "incentive based."  At least one article I caught the other day wondered in print if options backdating, the latest scandal, isn't just a means to avoid these deduction issues by giving an option grant with a built in cash certainty.  Looks just like a bonus, when you think about it.

Thursday, May 25, 2006

The Time To Make Money is When...

the bary place Sub Rosa Vice President: "Wow, I expected some convictions, but... wow."  Any wagers on the effect this has on private equity?

They're KKRrrreat! (Part I)

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

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

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

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

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

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

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

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

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

initial investment and policy

And what about these "opportunistic investments?"

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

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

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

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

Friday, May 26, 2006

Some Taxing Options

taxing I mentioned in a pervious entry the notion that regulatory overzealousness may have actually have caused the backdating scandal to some degree.  I couldn't remember at the time the article I had seen referencing this.  I found it again on the University of Chicago Law School's faculty blog.

They're KKRrrreat! (Part II)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Welcome to private equity.

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

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

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

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

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

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

Good luck.

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

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

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

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

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

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

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

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

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

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

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

Wednesday, May 31, 2006

It Takes More Than One

collective violence Sub Rosa VP: "The incompetence displayed here is far too insidious, too pervasive to be the work of one person.  This is clearly the work of a committee of the Board of Directors."

KKR Luxembourgeoise

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

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

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

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

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

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

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

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

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