Monday, March 27, 2006

They Can Hide It in the Matress

when it rains it pours Back in April of 2004, Sealy, the mattress company, was bought out by Kohlberg Kravis Roberts & Co.  For $436.1 million in equity and after raising $1.05 billion in debt, KKR initially took 92% of the firm's common shares.  The financial structure is interesting.

The debt was made up of:

$125 million in a senior secured revolver.
$560 million in a senior secured tranche.
$100 million in a senior unsecured tranche.
$390 million in a senior subordinated notes (at 8.25%).

Transaction fees were apparently around $115.9 million on the buyout (i.e. some bankers got rich on this deal alone).

Of the remaining funds, $259 million in proceeds were used to pay off existing debt and $478 million was used to buy up the old notes Sealy had issued.  (These notes were for around 10 and 11% interest, by the way, not a bad recap for Sealy).

Sealy is due to IPO.  If they do it looks like KKR will get the following "windfalls":

An $11 million fee for the cancellation of the "management services agreement" with KKR.  Generally, buyout firms put a fee arrangement in place with the firm they buy for oversight and supervision.  This payment is likely the result of an early cancellation clause in the agreement to KKR's benefit.

Around $41.5 million from KKR shares being sold to the public.

$100 million in dividends due KKR.  KKR has probably been "accruing" dividends since the buyout.  This $100 million is KKR's share of $125 million in dividends going to all the shareholders.

KKRs remaining shares will be worth around $809 million.

If Sealy's stock does nothing, KKR will have pulled around $961 million out of the transaction after 2 years and on a $436 million investment. That's an IRR of around 121.53% 48.50% with 2.21x Cash on Cash.

Welcome to the buyout world.

(See Sealy's S-1 here)

(Note: Was asleep at the wheel on the IRR calc.  Note to self: Remember that Excel ignores empty cells when computing IRR and therefore cells representing years with no cash-flow should always be filled with "0."  Rookie mistake.  Bad Equity Private, no bone.  Thanks: KB for the catch).

Tuesday, March 28, 2006

Long Live the King

taxes to the king Burger King filed a revised S-1 today.  It gives us another peek into the mechanics of big buyout deals.  In particular, we see a re-appearance of the massive "special dividend" and the cancellation fee for the management contract with private equity holders. Burger King was bought by private equity firms led by Texas Pacific Group and including Bain and Goldman Sachs Capital Partners.  They have been drawing down rather significant management fees since.

According to the S-1:

Since 2002, we paid $27 million in quarterly management fees, which were paid as compensation to the sponsors for monitoring our business through board of director participation, executive team recruitment, interim senior management services that were provided from time-to-time and other services consistent with arrangements with private equity funds. Under the management agreement, we also paid the sponsors a separate fee of approximately $22.4 million at the time of the acquisition.

In connection with the closing of this offering, we will pay the one-time sponsor management termination fee of $30 million, which will be split equally among the three sponsors, to terminate all provisions of the management agreement, except for the indemnification provisions which will survive. The sponsor management termination fee resulted from negotiations with the sponsors to terminate the management agreement which obligated us to pay the quarterly management fee. Our board of directors 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.

We have reimbursed the sponsors for certain travel-related expenses of their employees in connection with meetings of our board of directors and other meetings related to the management and monitoring of our business by the sponsors. Since our December 13, 2002 acquisition of BKC, we have paid approximately $650,000 in total expense reimbursements to the sponsors.

In addition, we paid on behalf of the sponsors approximately $500,000 in legal fees and expenses to Cleary Gottlieb Steen & Hamilton LLP that were incurred by the sponsors in connection with their management of us and arrangements between us and the sponsors. Cleary Gottlieb Steen & Hamilton LLP is providing legal advice to the underwriters in connection with this offering.

And on the special dividend:

On February 21, 2006, we paid a cash dividend of $367 million, which we refer to as the February 2006 dividend, to holders of record of our common stock on February 9, 2006, primarily the private equity funds controlled by the sponsors which owned approximately 95% of the outstanding shares of our common stock at that date, and members of senior management.

Friday, April 07, 2006

KKR Real Time Returns

tick tock 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.

kkr to the rescue

Monday, April 17, 2006

Sleeping Sealy

wake me when something happensSo, the hype should have worn off a little.  How is Sealy doing for KKR this week?


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:


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

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.

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).

Tuesday, August 01, 2006

Getting It From The King

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, August 03, 2006

Blame The Bankers

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

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

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

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

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

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

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

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

Friday, August 04, 2006

Jeff Matthews Is Driving Through Burger King

deposing the king I admit to being a sorta-kinda fan of "Jeff Matthews Is Not Making This Up."  I don't always agree with the big JM, but his entries are generally interesting.  His tidbit on Burger King is just one such, right down to the point where I don't agree with the general conclusion he makes from the specific example of Burger King's Henryesque, public regal flogging.

Matthews ties the dual observations of the difficulty of finding good deals and the "fact" that private equity firms are "stretching" for good deals, to a prediction of the imminent death of private equity as we know it.

I'm not sure it is sound logic to use a random press quote referring to a single transaction (in this case from an anonymous lawyer for one of the losing bidders on the Phillips unit eventually won this week by Silver Lake Partners who, according to Matthews, quipped "...everyone lowered their expectations on returns...."  First, let's try to remember that for LBO firms, lowering expectations on returns is the shift from 40.0% IRR to 26.5% IRR and second, this only sounds like every auction I've ever been in...) as a general proxy for private equity deal stress industry wide.  Matthews sums this up with:

Lower margin of error + lower deal quality = recipe for disaster.

"Disaster" is, of course, not defined here.  While interesting, I think this analysis ignores some factors.

First, critical mass in Private Equity.  Second, fundamental environmental factors.

When I started the Going Private adventure I posted a quick, dirty and jaded primer on the evolution of the field.  I pointed out that the early boom in buyouts was primarily due to flaws in the "conglomerate" theory of the firm.  In particular:

Consequently, by the mid to late 1960s large corporations began to interpret the need for "diversity" to mean that they should acquire anything and everything they were able to pay for. The less relevant to their own underlying business, the better. This marked the beginning of the "conglomerate wave" where a flurry of mergers and acquisitions activity dominated thinking about how large firms should look and act. Like portfolios, it was argued. Diversified and large enough to enjoy economies of scale, of course.

It was the crash of this wave, with the slow realization that a massive corporation with no history in beverage products likely shouldn't be buying a sports drink company just "because," that fueled buyouts.  There was, around this time, an amusing commercial (and I believe it was by Pace Picante Sauce) where a monolithic boardroom filled with identically appearing directors shaped the future direction of the corporation:

Chairman: Gentlemen, shall we manufacture salsa...
(The 6 directors on the left side of the room raise their hands).
Chairman: ...or oven mitts?
(The 6 directors on the right side of the room raise their hands).

The boom of buyouts waited carefully in the wings for those sorts of decisions to blow up and then applied simple factors that proved elusive to the conglomerates of the time to suceed marvelously. Specifically, focused and incentivized management teams, brutally fast accountability and merciless cost oversight.  Of course, these factors, the actual management accumen, were slower to develop than the key tool for high returns: Leverage.

Itself a great motivater, the results leverage produced were outstanding, but then it was low-hanging fruit picking off the former subsidiary of a massive, unfocused corporate machine.  Not a lot of management expertise was really required to double productivity.

Not all firms are LBO candidates.  Some economic environments create more than others.  Low interest rates, disincentives to remain in the public market or a previous period of high P/E ratios (and therefore cheap currency [stock] for acquisitions by large corporates that should leave well enough alone) all contribute to an environment where LBOs thrive.  Money flows into LBOs, opportunities dry up, money is allocated elsewhere, the cycle continues.  That one should consider this odd or unusual is tantamount to the admission that one is not a believer in market economies.

The prefect storm story for LBOs is not the approaching demise of the field (even after Drexel fell apart the business thrived among niche players with real advantages) but the fact that the last four years have seen such a confluence of events favorable to the business that nothing other than a massive boom could have been expected.

Record low interest rates, high disincentives to remove firms from public hands, a five year prior period of insanely high P/E ratios and the huge public equities growth spurred by the tech boom all contribute to the "target rich environment" we have been seeing in the buyout world today.  But, pour enough money into it and, like any arbitrage opportunity, returns begin to slip until you have to have an awfully significant information disparity advantage to do well.

In my view the act of "Going Private" is effectively the admission that public capital markets and the corporate governance system thereof were simply not sufficiently suitable to provide for the success of the firm in question.  At least over the last several years, the public capital markets fail because they tend to be the among the last of the "greater fools," and classic absentee owners.  I find it hard to imagine anyone could argue that, with the massive influx of the "casual investor" beginning in the dot-bomb era and that the market still sees, the average investment accumen of the market has improved in the last fifteen years.  (I fully include myself in this analysis as the only public equities I believe myself qualified to invest in- primarily because investing in public equities would never be more than a two hour a week hobby for me- are low-fee S&P 500 index funds).  I tend to think the new rise of shareholder activist funds supports my view in this.  They too have an ecosystem of deal critical mass that depends highly on the rest of the public markets being asleep at the wheel.  No signs of that abating, I think.

And so I ask two questions: What might actually be predictive of a "bust" in buyouts and what would a "bust" in buyouts look like?

If I am correct and the elements required to spur buyouts, or, in fact, a switch to any alternative capital structure, are two-fold:

1. An environment to generate targets for capital structure change:

  • Correctable inefficiencies in:
    • Management accumen.  A general lack of comparable management talent in prevailing capital structures (today public equities)- and here the differences can be quite small and subtle.  Correctable where small, focused management teams exist outside the prevailing capital structures.
    • Management compensation.  Are management incentives competitive in the prevailing capital structures (public equities)?  This, of course, requires resort to analysis I haven't seen addressed anywhere other than Going Private- i.e. risk adjusted compensation to senior management.  If risk adjusted compensation is inefficient (i.e. not comparable) in public firms, then the arbitrage opportunity is obvious.
    • Corporate governance.  Do the prevailing capital structures do a good job of culling management talent, replacing inept management quickly and installing new management?  Clearly, if not, then a capital structure change might be less costly (in all senses) than a corporate governance revolt.
    • Information disparity.  How well can the prevailing capital structure monitor its investments and apply expertise to the data it collects? Can it take calculated risks, or does it just take risks.
    • The efficient deployment of capital.  Specifically, even if it has access to good information does the prevailing capital structure make smart investment decisions?  So long as this is not the case one can not only profit by using the poorly spent capital to buy, at a discount, grade A infrastructure already paid for by the equity holders in the current system (since they likely overbought) but you can clean a firm up after the capital structure switch and re-inject it into the inefficient capital system at a premium (Ladies and Gentlemen, introducing the LIPO!).  This works best when marketing plays a major role in the sale price of equity for the firm.  Guess which capital structure suffers the worst from that state of affairs today.
  • Access to buyout capital:  This one should be self-explanatory.

Running over each of these briefly:

Management talent is being pressed out of public companies by the likes of Sarbanes Oxley and the general public sentiment that public company management are all idiots and crooks.  (Ironically, a self-fulfilling prophecy).

As a risk-adjusted figure, management compensation in publicly held firms is falling.

Ironically, even with all the "reforms," few systems are less able to police poor management than the public equities market.  The fact that special firms dedicated only to this disparity can make millions should demonstrate this well enough.

Stakeholders simply have too many filters between them and raw data to compete with, e.g., private equity shareholders.

As for the question "Are public markets 'smart money'?"  I will leave this to Going Private readers to submit to their own delicate predispositions.

Access to capital?  2005 was another record breaking fund raising year for private equity.  2006 is even pretty strong so far.  Jeff Matthews worries about rising interest rates with 3 month LIBOR at 5.50% today.  Consider that the $20 billion buyout of RJR Nabisco was agreed to in October of 1988.  Have a guess what the 3 month LIBOR was back then?


I'll try to cover the "what if" on Monday, maybe.  Until then, signs of the imminent demise of buyouts as we know them?  I think that Jeff Matthews is making those up.

Monday, August 07, 2006

Imminent Death of Private Equity Predicted

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, August 14, 2006

LIPO Suction Malpractice

slurp! Continuing Going Private's shamefully incestious link-sex with Abnormal Returns, today it points us to a slightly more masturbatory bit of link-sex in the form of a DealBook piece in which Andrew Ross Sorkin cites an Andrew Ross Sorkin article (registration required but entirely avoidable as Andrew Ross Sorkin has thoughtfully copy-pasted the Andrew Ross Sorkin article in the New York Times into Andrew Ross Sorkin's DealBook entry) on the often unrecognized long-term holding strategies by certain buyout shops in the private equity world.

Says Sorkin, citing Sorkin:

But while private equity firms may be larding companies with debt, they aren't dumping them as quickly as you might expect.

Buyout firms often stay at the party much longer than critics acknowledge because public offerings don’t offer an immediate way for firms to generate big returns and attract new investors for future deals.

The firms typically have lockups that prevent them from dumping their shares, and it often takes them several years to sell their shares — if they do so at all. The firms that own Hertz will retain an 80 percent stake in the company after it is public.

Few people have acknowledged just how many private equity firms have ended up remaining big investors in companies after taking them public again. Little noticed — or at least little noted — is the fact that “tens of billions” of private equity dollars, according to Thomson Financial, are now floating around the public stock market.

As with most DealBook entries, this DealBook piece is not least remarkable for the reappearance of the previous butt of thinly veiled Going Private jabs, the wonderfully bitter and disillusioned comment gabster "Dr. Mark Klein" who would offend your author more if not for his inability to conceal an unending disdain for that backbone of capital markets, the investing public.  The good doctor whines:

Makes perfect sense private equity firms hang around longer. Today’s endentulous SEC allows the looting to continue until enough suckers are rounded up to buy the new common.

...before adding...

The John Q Publics are too sedated by sex, booze, gambling, and entertainments up the wazzoo to notice.

Modern version of Britain’s 19th century Opium Wars which enabled them to loot China.

I'm not sure which delusion of grandeur I prefer, comparisons of Google to Napoleonic France by The Economist (subscription required) or the metaphor, albeit soiled with a barely disguised reference to sodomy and poor understanding of the actual history of the Opium Wars, comparing private equity firms with rank extraterritorialism disguised as trade dispute.  I suppose I have to pick the Google comparison, as the private equity / illicit drug reference is old hat around here at Going Private.  (In fact, quotes from the Caryle Group's David Rubenstein referencing leveraged (read: dividend) recapitalizations as "the cocaine of private equity" tempt your author to get an even bigger head imagining the various luminaries of buyouts waiting with baited breath for the next Going Private entry, or more likely, ordering their assistants to print out the articles and leave them on the club seating in the Gulfstream V for the jaunt down to Anguilla).

Sorkin has managed, however, to hit an important point.  Certainly, leveraged recapitalizations used to pay large dividends to private equity shareholders, particularly when followed by Going Private's favorite new term of art, the "Leveraged Initial Public Offering" (LIPO), are viewed as opportunistic transactions by large buyout firms.  The resulting payments often, and likely this is not coincidence, look very similar in size to the initial equity outlay made by the buyout group, or (in more sophisticated cases) the initial equity outlay with the firm's targeted IRR tacked on top (see e.g., Blackstone).  I've been calling these large self-payments followed by a LIPO "LIPO Suction," after the giant sucking sound employees hear if they are near the CFO's office.

Sometimes, however, what appears to be shameless profiteering is the order of the day.  Sun Capital quietly leveraged daughter firm Hub Distributing Inc. and took a $71 million dollar dividend after only 16 months and on an initial equity investment of $2.3 million.  On its face this is offensive, until you realize that Sun Capital managed to increase Hub's EBITDA by 300% or so.  And even in the absence of such improvements to EBITDA, I believe it difficult to make logical criticisms of the practice.  And, as Sorkin indicates, critics often ignore the long term interest private equity firms have in the continuing operation of the business.  As if buyout firms were disinterested enough in hitting their IRR that a dividend recapitalization move that merely limits their downside without providing the targeted return would remove their incentives to attempt to grow (or salvage) the business.

Expecting private equity firms to look out for lenders or anyone else is a silly expectation.  In the case of closely held LBOs, as results from most buyouts, the people with standing to complain (i.e. the shareholders) are making the dividend recap decision in the first place.  I often hear the argument "yes, but the business is already on shaky ground, why would you lever it up?"  I can't imagine why you wouldn't.  Given the opportunity to pull risk off the table for the shareholders, i.e. return the initial investment- or even more, in the face of potentially deteriorating business, why would you ever leave the money at risk when you could protect the downside to a break-even (or better) level and still maintain upside in the continuing operation of the business?  To do less would be to sacrifice the interests of the shareholders in favor of the lenders who might be harmed in a bankruptcy.  This requires the assumption that these lenders need to be protected from themselves.  That is, in my view, dangerously paternalistic.

There are already tools to deal with leveraged recapitalizations that "shock the senses."  After Bain Capital took a $84.5 million dividend payment from KB Toys using a leveraged recapitalization for more than a 350% return on their equity investment and then tossed the firm into bankruptcy protection, lenders sued, recently got the go-ahead to make fraudulent conveyance claims against Bain and are now demanding the return of the payment.  I will watch that case with interest.

Shifting the analysis to public or about to be public firms, many critics of LIPO suction complain that companies are badly weakened before they IPO.  These critics strike me as even more insulting to the investing public than Going Private's occasional barbs, or the even curmudgeon "Dr. Mark Klein" (who appears ready to label Jim Cramer fans as evil drugged-out sodomites- though I suspect this suggestion means Dr. Klein owes an apology to evil drugged-out sodomites).  Are we at the point where we believe the investing public unable to understand debt ratios and credit ratings?  For they seem to flock to LIPOs regardless of these statistics.  Are we confusing an appetite for risk with stupidity?  Headlines that read "flippers leave Burger King IPO investors holding the bag" confuse me for this reason.  Either the investing public is smart and some fraud involving non-disclosure of debt obligations has been committed, or they are dense and who do we blame for that?  (The baby boomers and sex education, according to Dr. Mark Klein).

Comments from the likes of Standard & Poor's Steven Bavaria to the effect that "...we are trying to shine a light on an area of the market that was previously opaque," make me wonder what sort of investors S&P thinks are out there.

So are we surprised when private equity firms employ complex but entirely legal structures (say, a recapitalization with holding company preferred stock as collateral) to assure riskless profit to their limiteds (to which they owe a duty) and themselves?  Are we to blame sophisticated lenders for the loose state of the credit markets?  Were they unable to price the loan properly?  As if they are equally inept as llamas when it comes to assessing and hedging risk?  Should we point at collateralized loan obligation instruments as an evil?  Surely they must be opaque and illiquid instruments that befuddle and victimize the horribly financially naive victims like Stanford University of Chicago MBAs who studied under Eugine Fama and who hold a concentration in debt instruments.

Wednesday, August 23, 2006

Positive Suction?

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

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

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

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

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

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

Monday, November 27, 2006

Self Serving

lipos make the street The tasty Abnormal Returns points us today to a piece by Matthew Goldstein over at on LIPOs.  It is notable both for its numbers and for its use of the term "LIPO" coined here on Going Private.  Goldstein's short-term analysis (he only looks year to date) is a flaw however, in his article.  It would be interesting to me to see if longer-term returns on IPOs are as dismal, particularly in light of other work I've done on the subject, or if they compare favorably to unlevered IPOs.

Tuesday, December 12, 2006

Bourgeois Pigs

we may yet have use for joseph-ignace guillotin Always yummy Abnormal Returns calls our attention to a reaction from Michael Lewis, of all people, which throws enough heat off of his Bloomberg piece yesterday to fuse income inequality (lately a fashionable armchair socialism yarn for would be populists) with private equity returns and create a dense and opaque argument decrying what I can only brand "return inequality," a structural plague Lewis sees afflicting the market.

Why, wonders Lewis, isn't the "proletariat of Wall Street," the middle class, the "proles" permitted to participate in the private equity boom?  (Amusing to call those with wherewithal enough to invest in stock at all "the proletariat," given that even Marx's definition of bourgeoisie is those who earn their income off of ownership or trade in capital assets).  Lewis tell-tales his answer early on in his piece:

The job of the private-equity investor is -- again, speaking loosely -- to exploit the idiocy of the ordinary investor, and the corporate executives and mutual-fund managers who purport to serve him.

Ignoring, for a moment, that the job of every participant in the market is to "exploit the idiocy" of anyone else in the market dumb enough to display that idiocy in a public forum like the market, Lewis attempts to use Hertz to make the implicit case that an open auction on the most liquid market on the planet somehow perpetuated a massive fraud on the investing public and badly cheated the "ordinary investor," who willingly (even if not enthusiastically) scooped up the debt laden Hertz in one of the most successful LIPOs (from an IRR perspective) on record.  Comments Lewis on the topic:

But it's hard to see how Hertz is a riskier investment simply because it is owned by the Carlyle Group and not by Ford.

I can't speak to the risk effectively, but Lewis, in my view, over-hypes the importance here of "risk" and under-appreciates the "conglomerate discount" imposed on Hertz by Ford, a corporate owner that doesn't exactly represent the shining platinum standard of management acumen in the United States.  All it takes is a quick look to understand why private equity made out well here and, to summarize, that case includes "right place," "right time," "right checkbook balance."

A bit of history, though it has been badly neglected by Mr. Lewis, is probably useful.  Amazingly, Steven Pearlstein over at the Washington Post recently gave a much stronger summary of the Hertz case then anything I've seen in Bloomberg, marking the first time, in a dramatic role reversal, that the Post has slipped to the right of Bloomberg on matters financial.  (Then again, Bloomberg has of late been slipping badly).

Hertz found Ford as a major holder in 1987 back before Ford was rumored to be something other than a total charity case.  (I cannot confirm this rumor as I am too young to remember a time when Ford was something other than a total charity case).  Ford took the company over entirely by 1994, mostly under the thinking that if they didn't Chrysler or GM would.  (GM had, itself, owned Hertz once).  Not the best reason, perhaps, but it could have been a strong showing, handled properly.  It was not.  Partly because of the purpose that had been slated for rental car companies in the United States at this point in history.

Ford, as most of the big three had for decades, treated Hertz as a captive revenue machine (by selling, albeit for not much revenue, cars that couldn't compete in the consumer markets straight to Hertz).  Because of the nuances of "total fleet fuel efficiency laws," this also helped Ford meet fuel standards, dumping fuel efficient but undesirable sedans into Hertz while still selling guzzlers to the lucrative consumer truck and SUV market.  Decades of selling second-rate Tauruses to a captive customer who didn't much care what they looked or drove like didn't exactly prepare Ford to offer a decent car to the mainstream consumer market if something ugly were to happen to consumer tastes or (god forbid) gas prices.

While they couldn't sell well in the consumer markets, as former rental cars the sedans poured by the thousands into the used car market which meant those models had no resale value (a key metric for increasingly value oriented car buyers) compared to e.g., the Toyotas of the world.  Once on the used car market they also canibalized the higher margin new cars the big three were trying to hock.

Two and a half years after slurping it up, Ford IPOd a Hertz minority interest off and bought that interest right back (urgently and without much reason) three years after that.

The initial IPO valued Hertz at nearly 17 times earnings.  Read that last sentence again.  Go ahead.  Absorb it.  Here.  I'll give you a bit of white space.

That was the time of "irrational exuberance."  Travel businesses were on fire at the time.  All those New York investors going to board meetings for their VC interests on the Left Coast, I suppose.  The stock, which IPO'd at $24.00, hit $64.00 inside of 4 years.  Ford used a good bit of the proceeds to buy back Ford shares and attempt to buoy their flagging stock, it worked a bit, but not forever.  The party didn't last and not four years later Hertz was back to $24 and Ford wanted it back  Why, no one seems to know.  They got it by paying something like a 46% premium over the stock price before the Ford offer.  Read that sentence again too.

Moving forward, Hertz saw a 130% increase in net income from 2003-2004 (never mind that these figures were gains against the devastating travel years of 2002 and 2003, they looked sexy in offering documents) and coming off that Ford would be hard pressed not to want to divest the unit again (especially considering its own developing management issues and lackluster performance- due, not unsubstantially, to decades of short-term thinking in the form of piss-poor negotiations over what were eventually to become crushing pension and retirement benefits surrendered year after year to the UAW).

On top of this, Ford, along with the other big three, had no incentive to develop decent, fuel efficient automobiles.  Why bother?  No one cares much if a rental car is a keeper, or if it is particularly fuel efficient.  As long as it is just efficient enough to keep the fleet efficiency rating under the federal requirement by two tenths of a MPG or so.

Desperate for cash, and fending off the bond ratings folk, Ford started the IPO process for Hertz again in 2005, hoping, in typical front-running fashion, that the filing would flush out deep pocketed strategic buyers.  None appeared.  The other big three were up to their eyeballs as well.  Private equity came to "the rescue," but even from this sector there was limited interest.  Only two clubs bid.  The Clayton gang and a group including Bain, Blackstone, Texas Pacific Group and Thomas H. Lee.

Ford sold to Clayton's private equity gang for a net of $5.6 billion.  5.1 or so times earnings.  Read that last sentence again.

Ford could have held onto Hertz and collateralized the automobiles for cheap debt, but instead they sold outright.  The private equity guys and gals, seeing the demand for collateralized debt, collateralized, in turn using those assets to pick up $6 billion in very cheap debt to partially fund the transaction.  Not bad.

Holding out the disparity between the latest IPO price and Ford's selling price as some evidence of injustice ignores the role of the cash crunch Ford was in (owing to their own mismanagement and cannibalistic short-sightedness) and the outstanding timing of the private equity folks, picking up an asset from a motivated seller on the cheap just when the seller needed it gone the most, few questions asked.

There is no better example, in my view, of the absurdity of large conglomerate ownership in recent memory than the fire sales we see- the last vocalizations, as they were, the death rattles of the big three.  Their idiotic forays into the likes of consumer finance (GMAC) are coming to roost.  I, unlike Lewis, am entirely unsympathetic to their plight.

So much for the evil of private equity.  Ford's other option was a cheap IPO or to liquidate Hertz.  Private equity just happened to be the best cash available for the asset given the market's assessment of it.  I'm not crying for the market.  Nor should you.

There seems, of late, to be a revival of a kind of social justice theory based not on risk return, or the value of liquidity, smarts and timing, but the "inequality" some see as implicit whenever a clever group creates and captures value.  Green with envy, these fairness vigilantes target anyone who is written a large enough check, forgetting, time after time, that these transactions are as between willing buyers and sellers in a highly liquid and transparent market.  Ford shareholders barely made a whimper when Ford announced the sale.  Desperate, perhaps, to cash out right after the deal closed to save themselves from their own poor judgment in buying shares of Ford in the first place.

Lewis continues to lament the plight of the casual investor:

One day the private-equity markets may expand to the point where even proles are offered a little piece of the action. That will be the day the action is no longer worth having. Trust me. The ordinary investor is now and forever cast in the role of the peasant at the king's banquet. He's so happy to have any food at all that he fails to notice that bone between his teeth isn't the meal. It's the scraps.

Mr. Lewis should direct his ire towards the SEC, suggesting, perhaps, a repeal of the "accredited investor" requirement for participation in private placements.  Maybe we should let anyone who can scrape up $9.95 put it all in LBO funds.  And if they lose it there?  Lewis, in my view, must decide which evil he is prepared to endure.  Personally, I don't believe his course wise for two reasons.

First, the general public already participates in the private equity boom through the many institutions and pension funds that invest heavily in private equity, but, one hopes, with mostly prudent diversity.  CalPERS certainly has enjoyed it, and so, therefore, have the "poor" California public employees.  Unless, therefore, Lewis wants to suggest that the hopelessly poor household with joint income in the $300,000 range should be dumping all its retirement savings into Texas Pacific Group VII, L.P., he might have to admit that a good 401k or state pension plan is a better option.  Looking to improve the return of the "everyman" through that kind of concentration in LBOs seems absurd to me.  Moreover, I suspect a more measured investment by professionals who, smart or not, spend all their time investing rather than those who treat it as a pastime with financial benefits is the better option.

Second, let us not forget that the public is bathing in the bath they have themselves drawn.  Ford, trying desperately to satisfy a quarterly-report driven public market culture, and a misguided (but very trendy) focus on "all the stakeholders" rather than the owners of the company, increasingly resorted to complex revenue structuring, internal product dumping, short-sighted developmental programs, ruinous pension concessions and market cannibalizing tactics to give the public shareholders and pressure groups what they wanted: quarterlies, now.  Running factories, now.  Jobs, now.  Damn the costs tomorrow.

Moreover, there was far more than the tacit acquiescence of the public shareholders at work here.  This evil was quite active and persistent in its menace.  No manager who proposed a hard line with the UAW at the expense of a brief plant shut-down or four quarters of strong R&D expenditures would have lasted for more than a shareholder meeting cycle or two at Ford, or indeed any major public firm.  Ford's stockholders got their returns when they wanted them.  Back then.  To what extent did they enjoy them because the basic illness of the company was masked by these schemes?  Well, that's for you to decide.  One thing is sure: today the piper is collecting.  Damn that piper.  He's a right nasty bourgeois pig, he is.

(Art Credit: "Liberty Leading the People" Eugène Delacroix, 1830)

Wednesday, February 21, 2007

Neiman Marcus or Needless Markup?

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


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

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

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

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

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

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

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

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

Wednesday, April 09, 2008

God of Truth and Prophecy

at what price, truth I have to admit to having a bit of a soft spot for Apollo.  At the very least, they seem to have a grip on the cyclic nature of economies, and how a private equity firm can, and should, use the ups and downs that naturally accompany such shifts to make money.  They also seem to have been one of the few firms to hold on to the notion that private equity is a contrarian sport.  But there are a few new features among large LBO firms that, I suppose, they couldn't resist adopting.  For example:

On April 20, 2007, Apollo Management Holdings, L.P., one of the entities in the Apollo Operating Group, entered into the AMH credit facility, under which AMH borrowed a $1.0 billion variable-rate term loan. We used these borrowings to make a $986.6 million distribution to our managing partners and to pay related fees and expenses. The Apollo Management Holdings, L.P. credit facility is guaranteed by Apollo Management, L.P.; Apollo Capital Management, L.P.; Apollo International Management, L.P.; Apollo Principal Holdings II, L.P.; Apollo Principal Holdings IV, L.P.; and AAA Holdings, L.P. and matures on April 20, 2014. The pro forma adjustment in the column labeled Borrowing Under AMH Credit Facility gives effect to the increase in interest expense, without consideration of any hedging, resulting from our entering into the AMH credit facility, as if the transaction occurred on January 1, 2007.

Well, who can blame them really.  And they got, well, a pretty decent deal.  Elsewhere we find:

Our April 20, 2007, $1.0 billion borrowing under the AMH credit facility bears interest at three-month LIBOR, plus 1.50%

Private equity loves 3-Month LIBOR.  Quarterly payments on their bonus advances, you know.

On July 31, 2007, certain management companies within Apollo Management Holdings, L.P. transferred their indirect interests in a corporate aircraft, a G-IV, to a group of Apollo Non-Controlling Interest holders, which was treated as a distribution to such Non-Controlling Interest holders. Simultaneously with the transfer, such management companies were released from their obligations as guarantors of the loan used to finance the purchase of the G-IV. The transfer of the indirect interests and release as guarantors resulted in deconsolidation of the trust that owns the corporate aircraft. The pro forma adjustments in the column labeled Reorganization and Other Adjustments include the deconsolidation of Wilmington Trust, which holds the G-IV Aircraft.

I know, but now, really, who can begrudge them their airplane?  It is not even a VI, so cool it.  I suppose one could say that the name "Wilmington Trust" is an awfully boring moniker for an aircraft holding company, but then, the subtlety is somewhat crafty, no?  "Trump Aircraft Holdings," does sound just as crude as "Trump," after all, so perhaps Apollo gets points here too.

Cranky as that may make you, there is, however, really a wonderful chart of their cyclic investment strategy worth taking a look at.


And, why is it, exactly, that private equity firms always make the best orgcharts?


Posting will be slow through April as I am on "vacation," and also acting as Guest Editor over on

(Art credit: Lycia Apollo.  Musée du Louvre, Paris, France, seized during the French Revolution).

My Photo

Offering Memorandum

- New? Start Here -
(Updated 03/13/08)

Earnings Calendar for: February 2009

Sun Mon Tue Wed Thu Fri Sat
1 2 3 4 5 6 7
8 9 10 11 12 13 14
15 16 17 18 19 20 21
22 23 24 25 26 27 28

Wall Street Journal: Market Headlines

Investor Relations


powered by typepadListed on BlogSharesthe world's leading business publicationthe deal

rss 1.0rss 2.0

Link to going private:
going private

© 2006, 2007
Rights to other works/marks are
reserved by their respective creators.