Going Private

Project Spy

Somehow or another Armin hears about the potential divestiture of a small ($55 million) unit within a Fortune 500 firm.  As is not infrequently typical, no one else knows about it and there is no banker.  The unit isn't performing poorly exactly, but it is dragging down the otherwise very hot division it is in and running it requires a great deal of managerial attention.  This particular Fortune 500 has the managerial attention of an 8th grade boy in a co-ed gym class.  Since SarOx the fact that the Fortune 500 is forced to consolidate these financials irks them to no end.  Bright lights hurt the eyes of little captive units who are below par for the division.

Our quest to secure this unit I have labeled "Project Spy."

Spy has its main operations in Europe divided up seemingly haphazardly in six different locations in the United Kingdom.  It was acquired in a corporate shopping spree about 5 years before along with two other similar businesses, which explains the fact that it has more locations than it does products.  We like this, actually, because we will, in theory, immediately be able to consolidate the locations and enjoy the gains.  The parent hasn't had the will to make these changes so far, even though they have drawn up a "consolidation plan."  I understand also that some relatives of the CFO work in the unit.  Always a sign that tough but important decisions that should have been made have been deferred.

I know nothing about Spy when Armin takes me to the meeting with the COO.  We meet at a private club in Manhattan and I don't get a chance to ask Armin many questions on the drive over as he spends most of his time on the phone.  Two minutes before we arrive he chimes in, "I want to you be a little tough with this guy.  Wait until the main course, when he has food in his mouth and pepper him with some tough questions, you know the kind I mean."  So it's "bad cop" for me.  I shouldn't have played that part well in the past, now I'm getting typecast.  If I'm not careful I'll be as pigeon holed as Macaulay Culkin.

I feel out of place usually in the conservative establishments that are private New York clubs.  I think that I hide it well though.  We sit and Armin makes introductions.  He calls me his "Deal Veep."  I almost squirm with pleasure at the public compliment, but instead I manage just a shy smile.

Spy's COO is a measured and quiet guy.  He spends a lot of time listening and his pace of speech is almost slow enough neutralize any attempt to rattle him with question peppering.  Someone once told me that New Yorkers talk fast and think slow and southerners think fast and talk slow.  Spy's COO must have been from Florida.

Armin and the COO spend some time exchanging war stories.  It's during this back and forth that I discover the connection between them.  The COO actually reported to Armin "back in the day" at a large conglomerate, though his position was two levels below Armin's at the time.

The progress of the private club business lunch, at least in this particular private club, is decidedly Not-New-York.  Two hours could easily pass at the rate the meeting is going.  The break and chance of pace is actually quite refreshing, though it plays to the COO a bit too much for my taste.  Things could stretch to three hours without much effort.  The salad course finally draws to a close (I had the most magnificent cold salmon salad in recent memory) and I have hopes that the lunch entrée is at least cooking by now.  There seems to be some unwritten understanding between Armin and the COO that no new business can be discussed before the entrée.

They are in the middle of a conversation about what ever happened to the upstart Director at the firm they once shared when the dishes finally arrive.  The COO has a massive steak in front of him but begins so delicately that I wonder if ever I am going to get a chance to catch him with food in his mouth.

As if literally on cue, Armin inaugurates the business discussion when the COO's fork first pierces his steak.

"So, tell us how we can help you with your little... difficulty."

The COO begins by reminding us that this is all very, very confidential and that news that the unit is being sold should be considered highly sensitive.  As is typical in such situations, none of the management at the unit itself knows that a sale is even being considered.  At the moment it is just the COO, CFO and CEO of the firm who have any idea that a sale might be in the works and, if it is all the same to us, he'd appreciate it if we kept it that way for the time being.  Armin gives placating reassurances and I nod in agreement.  He describes the unit in more detail, pointing out that there are a series of sacred cows there and that even the senior management at the Fortune 500 parent is having a hard time cutting the cords that need to be severed.  The business is cash flow positive, but they spent far more than they should have when they picked up the businesses, and they haven't written down much of the costs yet.  The value on the books is somewhat high and they are looking at taking a punishing write-down if they can't extract some value in a transaction.  The CEO himself has directed that this unit is history, one way or another, even if it has to be closed down, yesterday.  Closing the unit would also be quite a pity as several net operating loss carry forwards (NOLs) which could be applied to reduce taxes on future profits will be lost.  As they are already on the books as assets, these too would have to be written off.  The picture is ugly, but mostly for accounting reasons.  This is, of course, all music to our ears.

Armin doesn't react positively.  "Look, we are just not going to get into a situation where we do the heavy lifting and give you an idea of what it is worth to us if you are just going to shop it around later and drop us into an auction.  We can put together an initial LOI in 48 hours or less, but I need a long exclusive on the due diligence.  I need to know this is our deal, otherwise, it's just not worth our time."  I almost come out of my chair when he says this.  Not worth our time?  The unit is perfect for us in about nine different ways.  I'd happily sit in an auction for it.

The COO is compliant.  "That's fine.  We aren't going to play around with this.  It has to be handled.  Fast.  If you can commit to a quick closing, we have no problem with an exclusive diligence period."

Agreement seems close.  Armin leans back a little in his chair and addresses his food.  Then, he glances at me.  Just a split second of a look.  My turn.  I wait for a few rounds of entrée slicing before I catch the COO with a moderate piece of steak.  I watch out of the corner of my eye for him to chew at least once so he doesn't just put it back on his plate or something and then I strike.

"If the business has been profitable all these years, where are the NOLs from?"  I ask this almost innocently.  Like a junior executive who just needs a simple mistake explained.  My timing is near perfect. Suddenly the steak seems as rubber and the chewing gets slower and more measured as the COO gesticulates in a manner that is supposed to indicate he is getting ready to say something witty.  Finally, something emerges, in-between the last few chomps and two swallows.

"I'm not exactly sure.  I will have to talk to the CFO but I think we obtained them during the acquisition."  This sounds fishy to me, so I press a little.

"How old are the NOLs?  When do they expire?"  I almost add "Do you know?" on the end to be polite, but I don't want to make the "I don't know" answer too easy.

"Well, I think they are only 3 years old, but I will have to check."  I follow this up with another quick and hopefully annoying question.

"Do you plan to keep using the services of the unit?  Will we have some guaranteed stream of revenue after the transaction?  If the unit has always been an internal staff like resource it's hard to justify anything other than a negative sale price unless there is a steady and secure revenue stream.  And if the parent no longer wants the product, well, then I get worried about trying to sell it to the rest of the world."  This time the COO, furiously sawing to get a large piece of meat in his mouth to buy time before he has to answer, is caught a little off guard.  Armin takes up the cause, leaning forward and interested again.

"You know, Equity has a point.  We are going to have to make a very careful analysis of the costs required to make this a stand alone business again."  After a long bit of chewing and far less gesticulation, the COO has little comment.

"Of course."

The rest of the lunch was quite subdued.

Negative Sale Price

I had intended to go to the office after the lunch with Spy's COO, but Armin cuts those plans short.  "I would like you to come out to the estate for dinner."  It was not phrased like a request.

We are driven back and discuss the Spy meeting on the way.  Armin asks me for my view.  It is a simple one this time.

"He has a political problem.  They know they are going to have to write down.  The question is how much.  We can use this, I think.  That is if you are confident he won't just go to another firm willing to actually pay him a stack of money to take it off his hands."

"No," Armin answered immediately. "He doesn't trust private equity people.  This was a friend to a friend sort of thing.  He's probably already represented to the CEO that he will take care of this problem and figured that I was the best one to solve it for him.  Now he's in a corner.  We'll lend him a hand, but it will cost him, of course.  Your job is going to be to figure out what his closing costs are, and if we can make any money with this thing.  A negative sale price isn't out of the realm of possibility here.  What do you make of the fact that it was just him, the COO, and not the CFO or both of them at this meeting?"

"I didn't think of it.  I thought you two were friends and that's why we were meeting with the COO.  If there was another reason I suspect that maybe the CFO isn't perfectly in line with the decision?  Or he is mouthy and prone to say too much, but that's not something you see in the CFO of a publicly held often."  To this, Armin just nodded.

An odd thing about being driven around with Armin.  Sometimes he can go an hour or more without saying anything.  He doesn't take notes, or read or talk on the phone.  He just... contemplates.  What I wouldn't give to hear a snippet of his inner monologue (or perhaps it's a dialogue?)

I spent the rest of the drive back thinking to myself that the term "negative sale price" is somewhat comic.  It means that the asset is such a pain in the ass that a private equity firm has to be compensated in cash at the close for taking possession of it.  It is like finding an add in the classifieds reading: "1990 BMW 3 series.  Runs fine. Needs oil.  Will pay buyer $5,000 to take possession."  Sounds silly, yes?  Well, it makes sense for the seller when it would cost $6,000 to have it towed and scrapped and they just don't want the car anymore. When you have substantial severance and golden parachute clauses for employees, it quickly becomes easy to see why a disgruntled owner would want to pay someone to make short work of the firm.  Of course, we almost never actually spend the cash given to us to take a property on cleaning it up, like we claim we will have to during negotiations. There are few certainties in life, but one of them is that a private equity firm already thinks it has found the "hidden value" once they make a bid.  Project Spy had substantial hidden value even before we starting talking about negative sale prices.

Passive Theft

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

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

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

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

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

Cash is King (for Some)

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

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

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

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

Loose Lips

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

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

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

Quickly, to the Chopper

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

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

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

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

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

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.