Going Private

Forward - "From Done Deals to Trainwrecks."

Weblogs on private equity seem to be abortive.  They start, stagnate and then halt altogether.  Their half-finished efforts are left dangling for anyone with a search engine to wander across and wonder after.  "No updates in 6 months?  Hmmm."  This seemed odd to me.  What causes such half-failures?  Workload?  Discovery?  Boredom?  Litigation?  There must be some reason.

For a topic that seems to command so much rapt, even fanatical attention, there don't seem to be many personal diary style weblogs from practitioners.  I started off wondering why, aside from the obvious confidentiality issues and such, there weren't more that endure.  Even confidentiality hasn't stopped some other weblogs (with anonymous or public authors) from printing scandalous revelations about their work life.  Why the issue with private equity?  It could be that I am about to find out what the impediment is.

There are few fields today as well marketed to potential employees as private equity.  One discovers, as with most things, that actually practicing in the field is a much different thing than you are led to believe by the many, costly guides, consultants, recruiters, professors, lecturers, key-note speakers and associates who eagerly impart how exciting and pure the space is.  I thought I might inject a dose of "reality," if there is such a thing.

It turns out, that things are far less organized, professional or straight-forward than insiders might have you believe.  Having my eyes opened to this fact has been quite an experience.  Worth sharing?  You tell me.

It would be unfair to say that I am jaded.  A bit disillusioned maybe.  No longer blinded, perhaps, by the sparkling finish on the surface of private equity.  Irreverent?  Absolutely.  But I still enjoy what I do.  Perhaps more so after having discovered that, like all human endeavors, private equity is as full of nonsense and, inadvertent sometimes even unwitting, comic relief as any other field.  Maybe even more so.  If nothing else, that makes it fun.

I guess I don't know who my audience is.  Business school students?  Probably.  They certainly should have the most hungry ears for "the behind the scenes" story.  Bankers?  Sure.  Lawyers?  Why not?  Insiders?  Maybe.  Maybe not.  Egos run to the large side in the field.  Maybe what I have to say won't treat those with the kid gloves they have become accustomed to.  Oh well.

Of course, I am not crazy.  My name won't appear here.  If that is an issue for you, find another weblog to read.  I like my job, and my paycheck, after all.  And while some other insiders might piece together parts and end up guessing at the "real names" of some of the companies, institutions, deals and characters here, that's not my intention.

I start with Prologues I-VI.  Brief histories on how private equity got here, and how I got into private equity.  Of course, it would be nice if this gives newcomers a bit of an introduction and business students a glimmer of hope.

Following the prologues, my writings will fall into one of six categories:

"Done Deals" tracks the inner workings of deals my firm, or another firm, manages to close on.
"Getting In" revolves around recruiting and the process of getting into the business.
"Overheard" will be populated with witty (or frightening) quotes I overhear from time to time.
"Social Equity" concentrates more on the people inside private equity and their antics.
"The Business" will be filled with my blithe commentary on the world of private equity.
"Trainwrecks" will outline the flaming spirals of deals that go wrong.

Could be a fun ride.  Hop on.

-ep

Prologue III - "On Gekko."

In 1952 Harry M. Markowitz published an article entitled "Portfolio Selection."  Markowitz had studied under Milton Friedman at the University of Chicago and his work eventually spurred an interest in key relationships between the concepts (diversification, risk and return, volatility) that now form the underpinnings of financial modeling.  Additional work from James Tobin, and William Sharpe, who's 1964 article "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk," among others, eventually ended up in the body of theory we call "Modern Portfolio Theory" today.  He, along with others in the portfolio theory field, later won the Nobel Prize for their work.

This is important to our little tale here because a host of business school students, then a fast growing population and weaned on one or another early version of portfolio theory, increasingly ended up in general management positions in the largest companies in the United States.  Congress managed to fuel the fire early on back in 1950 by passing the Celler-Kefauver Act, which, among other things, made it quite difficult to acquire other firms in an industry you already had a substantial presence in.  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.

Depending on how cynical you are, you might join the voices that actually attribute the rise of the Chief Operating Officer ("COO") position to the concept that mergers and acquisitions played such an important part in the success of the large 1960s and 1970s era firms that the CEO should be freed up from the bland and routine day-to-day functions of actually operating the business in order to pursue the mergers and acquisitions strategy of the firm full time. One might imagine the various ways this played into the hands (or egos) of the CEOs.

Neil Fligstein traces the evolving strategy of corporate America in these periods to the evolving networks of "experts" that progressively dominated the management teams of large firms.  The rise of business schools during this period is, consequently, no accident.  Growth was the key motivator.  Acquisitions were the vehicle to get there.  Stock price and, to a lesser extent in this period, leverage, was the currency to fund the acquisitions.  Fligstein's 1990 work, "The Transformation of Corporate Control," is really required reading for anyone interested in the sociopolitical changes in corporate America at the time.  That population should include anyone interested in private equity.

What could be called the "core competency" model came about somewhat differently.  Instead of being the result of close cabals of insiders, from the senior executives down to the dozens of Vice Presidents who dominated the halls of public companies, and all of whom were often divided between firms along graduate school alumni lines, the rise of more external forces in finance pushed the next evolution in corporate think.

As the importance of acquisitions as a strategy rose, so too did the importance of the intermediaries who performed the mechanics of such acquisitions.  The rise of large corporate law firms with mergers and acquisition specialties as well as the large investment banks, valued primarily for their ability to identify and help fund acquisitions, proved the undoing of the conglomerate wave.

Eventually, institutional investors moved towards a preference for specialization.  The stock price of well focused firms was well rewarded in keeping with the new thinking: Firms that confined their acquisition to areas in which they had expertise, "core competencies," were more likely to be able to convert management expertise into success and therefore were rewarded on the exchanges.  Large, and what had become unwieldy, conglomerates had failed to produce efficiencies (instead the reverse).  Their stock prices sunk as their increased costs (and bloated management corps) sucked away at their profits.  With their ready acquisition currency, their own stock, now devalued, they stagnated, and, perhaps worse, became weak and slow moving targets for what became the new paradigm: The Corporate Raider.

Percentage of Firms Receiving Hostile Takeover Bids (1983-1999 3 Year Moving Average)
Source: Zorn, Dobbin, Dierkes, Man-Shan Kwok
"The New New Firm: External Control of Organizations and Corporate Prototypes"

"Core Competency Theory" was formally named with the 1990 Pralahad and Hamel Harvard Business Review article "The Core Competencies of the Firm," but it existed far before that as an informal understanding in the "Market for Corporate Control," where a slipping stock price meant Michael Douglas swooped down in a corporate jet and liquidated your sagging firm.  And that's where the bulk of our private equity story begins.  In 1985, with Gordon Gekko.  With the sudden importance of debt, rather than stock price, as an acquisition tool.  No longer did you have to be a publicly held firm with a large market cap and shares to fund your acquisitions.  Now you could be a scrappy set of smart guys with a talent for convincing bankers to lend you millions.  With the rise of the dedicated takeover firm.  With the sudden liquidity in the market for corporate control.  Here marked the early height of the buyout firm.  For good or for ill this is the birthplace of private equity.

How far we have come.

-ep

Prologue IV - "Gekko. Again."

As the raiders pulled apart the large corporate blobs that had slowly, or not so slowly, coagulated since the 1960s, they created structures that, to this day, form the underpinnings of private equity transactions.  Still, it is tempting to succumb to Oliver Stone's somewhat simple vision of the Gordon Gekkos of the world.  "Greed is bad."  He can be forgiven for the moment, as while he filmed Wall Street in hindsight, it was only two years of hindsight.  Wall Street was released in 1987 and takes place in 1985.  It is, however, hard to quibble with some of his caricatures.  After all, we had Michael Milken, Ivan Boesky, Dennis Levine, and the perhaps more colorful figures of Sir James Goldsmith and Sir Gordon White- though it is hard to get more colorful than Boesky, who actually delivered a "Greed is Good" speech at University of California at Berkeley in 1986 and, it is claimed, occasionally wore a T-Shirt labeled "He who dies with the most toys wins."

There is no doubt that the Gekko character has served as an inspiration for the many Barb and Bud Foxs haunting business school classrooms.  This is ironic, as the actor himself has quipped.  Any number of young financial professionals have, on meeting him for the first time, credited their interest in banking to the inspiration they found in his character.  "I've given up saying 'But he was the bad guy,'" Douglas says.

Denounced in the late 1980s and early 1990s, the verdict is actually still out on LBOs, "Junk Bonds," now labeled "high yield debt," and takeovers in general, but only barely.  A host of studies from the late 1980s through today seems to have, aside from the criminal acts of a precious few, vindicated the LBO and, by extension, high yield debt.  High yield debt did, after all, fund the telecom boom.

Among the earlier works, Steven Kaplan's 1989 study, "The Effects of Management Buyouts on Operating Performance and Value," sets the tone for academic study on the subject and focuses our attention on two things.  1.  The role of debt as a negative incentive to corporate waste.  (Miss those regular debt payments and the bank will take the keys).  2.  The role of management equity, either as stock or options, as a positive incentive to building shareholder value.

Joseph Schumpeter called it "creative destruction."  The shifting of resources from inefficient, but sentimentally charged endeavors to newer, more efficient ventures.  Stone called it greed, in a sense.  I leave it to you to find your own definition.  Personally, I am inclined to agree with Schumpeter.  Are we suddenly surprised that LBOs have reemerged after the tech boom and bust?  The market, if nothing else, does have ways of dealing with inefficiencies.

Our real-world characters too, have seen a resurgence.  Carl Icahn has endured and has made himself a barbed thorn in Disney's side, where his "break it into four pieces" strategy (wsj, subscription required) sounds suspiciously like a line from a shareholder meeting in 1985.  Milken has experienced such a resurgence in public as to prompt one publication to pen an article titled, "The Resurrection of Michael Milken."  How the mighty have fallen.  And risen.

"Greed clarifies, cuts through, and captures the essence of the evolutionary spirit."

Given this history, you would think that corporations would stop focusing on diffuse and unfocused merger strategies as a proxy for growth. (Ahem, Time Warner).  You would be wrong.  Very wrong.  Instead, there is a constant, bustling market for acquisitions while corporates snatch up, try on, and often quickly discard one or another divestiture, division or stand-alone like so many wardrobe experiments.  Many times these acquisitions are well thought out.  More often, in my experience, they are not.  But then, failed acquisitions make for very interesting opportunities for private equity firms.

All this is a very long way of saying that the corporate mergers and acquisitions department that I finally scraped an offer out of after my first year of business school was a relic of a nearly bygone era.  That didn't stop me from taking the position, of course.

-ep

Prologue V - "Wild Corporate Ass Guesses." (insert commas to taste)

Life on the corporate side of the mergers and acquisition world is somewhat slow paced compared to the alternatives.  Decisions within a corporate development department of a large corporation on what to buy and what to sell usually involve long-winded meetings on strategy and "positioning" with the senior executive corps.  That in itself is a cat-herding like activity.  It often takes something as dramatic as a radical management change to spur any kind of real movement and by the time that comes along, well, usually the corporate development office gets swept out along with all the other old trash.  Suffice it to say that the corporate side was a bit less engaging as a career choice and the people who gravitated to it are perceived in the more rarefied circles, wrongly in my view, as those who couldn't cut it in the more intense deal driven professions.  The hours were definitely better, however.

I had braced myself for a flurry of training and "teambuilding" exercises.  Fall back into so-and-so's arms and the like.  I, like most business school students, had read Liar's Poker and was deeply prepared for the world of finance to be fully as intense and testosterone dominated as the book portrays it.  Never mind that Liar's Poker was about sales and trading and was written in 1989.  Some things never change.

If I expected that kind of dramatic welcome in the corporate development office of my new Fortune 500 home I was to be disappointed.  I walked in, introduced myself, was ushered into a very modest and messy office of what I assumed was a co-worker, and was promptly introduced to the CFO.  I almost laughed out loud, figuring it was a joke.  It wasn't.

It is not that big offices, expensive carpeting, and wood paneled conference rooms are important to me (well not only that) it is just that the recruiting process, where these palatial edifices are prized and flaunted centerpieces for a buffet of excess, transforms the one-upmanship of "total headquarters spend" by the larger investment banks into a sort of expectation.  The interview process exposes one only to such a rarified population that after the third or fourth headquarters visit it becomes hard to imagine that any place doing mergers and acquisitions work would have carpeting that cost the owners less than $350.00 per yard.

It is hard to overstate the sometimes outright gaudiness this seems to engender. Indeed, to face the harsh, neon glare of the Kohn Pedersen Fox designed Lehman Brother's building in Times Square (it was originally built for Morgan Stanley) you'd think you were standing on The Strip in Las Vegas and that the structure housed a casino.  In a way perhaps it does.  To know what used to be the highly conservative (almost aristocratic) history of the firm it seems hard to believe this is a shell they would ever want to inhabit.  Overhead inflation is a driving force.  Part of the deal.

This did not look like a mergers and acquisitions office.  Nope.  Not one bit.

My cube was typical and typically small.  I hadn't spent but two hours in it when I was called into a smallish conference room filled with a bunch of other me-like new employees and lectured to sternly on the problems sexual harassment presented in the workplace by a immensely tall, glowering and foreboding woman, the head of Human Resources, who looked like she could break Margret Thatcher in two.  It was pretty clear she took this entire process VERY seriously.

If the lecture was dull, the film, "Sexual Harassment - A High Price to Pay," was beyond funny.  I couldn't believe it had been produced with such deadpan seriousness.  This was a major issue.  The random girl next to me whispered, "Perhaps the prostitutes in the area are overly expensive?" and that set off the girl on the other side of me who could barely stifle her laughter.  It only went downhill from there as the entire room gradually began to snicker at the outrageously implausible situations portrayed in the film.  Two guys across the table were having the most serious problem even in the face of the increasingly annoyed look on HR's face.  She looked like she was ready to engage in some serious workplace violence.

And THAT was the highlight of my career in corporate mergers and acquisitions.  It is true, the position was for three more months.  It is also true that after that first day I literally spent the next two months and 26 days working on the divestiture of a call center.  The majority of the work involved trying to predict what the place would look like financially as a stand alone company.  With no fat-cat parent to pay its bills.  This seemed silly to the non-analytical side of me since another fat-cat parent was probably going to buy the place and start paying its bills.

All of the accounting was so tied into the parent company one had to make pretty wild assumptions to get an answer.  Guesses about how much of total general and administrative expense could be attributed to the call center, and how much was the rest of the company.  Ratios of employees to expenses times headcount used to extrapolate overhead.  The amount of guesswork was pretty severe.  The analytical side of me was rather uncomfortable with this much money hanging on my entirely inexperienced swags.  Of course, when I presented some of my guesses to my superior, he frowned and asked me to rework them so that the expenses looked lower.  We wouldn't want to depress the price a buyer paid, would we?

Three days before the summer was over senior management decided to keep the call center.  I spent the remaining three days making little paperclip sculptures.  I think the one of the chair looked best.

-ep

Increasing Efficiency in the Market for Corporate Control

The Wall Street Journal is running an article (subscription required) today observing the anemic recent returns of merger arbitrage funds.  This is surprising, according to the article, because of the high number of deals tumbling in.  Last year was the most prolific since 2000.

The article quotes Mario Gabelli, manager of the scintillatingly named "Gabelli ABC Fund" thus: "Investors should think about this as an enhanced money-market return."  So much for an investment class that used to pull out 30+% annualized returns in the 1980s.  Of course, that was back when Ivan Boesky and company could boost returns by getting long on a target with huge leverage before the market was aware a deal was in the works.  I would love to see an analysis of the returns on an insider trading strategy.

So what keeps spreads (and therefore merger or risk arbitrage returns) so low?

One explanation is that we are seeing more "mergers of equals" and therefore the lack of price disparity and low spreads between such firms are more limited to begin with.  Lower spreads, lower returns.

Another explanation is that the funds investing in merger arbitrage opportunities all have effectively the same criteria and therefore invest in the same deals leaving less of a spread.  In other words, merger arbitrage is "oversubscribed."

A third explanation is that markets are getting more efficient.  They "sense" a deal before it emerges and price up targets.

A subset of this third explanation is that there is a clever and well funded insider trading network at work within the market and they are squeezing returns out of the law-abiding risk arbitrage gang.  Since this last option is the most conspiracy oriented it is also my favorite.

Of course, there is a long history of claiming that insider trading actually makes for more efficient markets.  Interested readers might start with Stephen M. Bainbridge's Florida Law Review Article, "The Insider Trading Prohibition: A Legal and Economic Enigma."  (True Gekkoists will want to ignore the fact that it was printed back in 1986).

Redemptions

Few people still think first of bootlegging money when the name "Kennedy" is mentioned, though this is still the most common explanation for the family's initial wealth.  Fewer still remember the stock pools, insider trading, and what today would be called outright securities fraud perpetrated by Joseph P. Kennedy, Sr. during the 1920s. Ironically it is the later, not the former, for which there is the most compelling evidence, and the former, not the later, that remains the most prominent figure of legend.

Bootlegging, with images of blacked out yachts quietly slipping alongside hidden east coast docks, unloading gin barrels in the dark of the night is far more romantic than insider trading.  Still, for Joe Sr. it was the insider trading stuff that got him both the first most difficult boost on his fortune, and also the Chairman of the SEC position, which he held from 1933.  Asked why someone with such a checkered past was worthy of such an appointment, President Roosevelt replied, "It takes a crook to catch a crook."

All this suggests to me that, at least in the United States, there is a certain romance associated with the rebel, the underdog.  Legitimacy is not so difficult to re-earn.  Claus von Bulow might have said it best.  "In America, it is fame that is important." I suppose this might account for the recent resurgence in takeovers, and to greater extent, greenmail as recent news from the Wall Street Journal on Carl Icahn's Disney assault suggests. (wsj article, subscription required).

I have written before about the resurgence of the likes of Michael Milken.   It would seem that greenmailers are back in vogue too, this time in the form of the old raiders and hedge funds (the new raiders).  Well, back in vogue except that now we call them "activist shareholders."

Wined and Dined

My deal was simple.  I would report directly to Armin, the Senior Partner and no one else.  I would be responsible for all of the serious M&A work.  Doing valuation and analysis.  Working the structure of a deal.  Developing post acquisition strategy and predicting what sort of gains we could expect to see by implementing our strategies.  I was to be paid more than I had ever made in salary before.  In three months we would talk about equity.  The other partners were primarily concentrated on financial due diligence and deal generation or business development.

What Armin needed, he said one of those early nights over a venison dinner, was some relief on the analysis, negotiations and mechanics of deal making.  I was nearly stunned by the level of responsibility (and by extension the workload) and I immediately felt badly under qualified.  Despite this, I kept my mouth tightly shut and spent a lot of time nodding as if the entire thing made perfect sense to me.  Of course, I would be immediately prepared to assume a level of responsibility traditionally reserved for partners.

It was a pretty lean shop from a body perspective.  Armin had his hand in both the majority of deal flow generation, where he utilized his substantial contacts both in New York and Europe to pull rabbit after rabbit out of old hats, and in structuring and negotiating the final deals.  He always seemed to be flying off somewhere to meet with one or another CEO, invariably an old friend from somewhere or another.  I was to begin accompanying him immediately to get a feel for the deal flow side of things.  To learn the practice of the schmooze, of which Armin was the master.

The rest of the time, at least in the early months, I would be spending on his estate, working through the way he liked to operate, the kinds of valuations he trusted, the verticals and industries he was interested in.  Learning the ropes, if you will.  Drinking the Kool-Aid.

Even as a small firm with only 4 partners and 3 junior people including me, we had quite a bit of help.  Armin had one of his speed dial buttons painted red.  That was the direct number to our Wall Street attorneys.  We used them liberally, given our own limited resources.  With that red button Armin probably put the kids of one or more of the senior partners in one of the top firms on the street through college all by himself.

Life on "The Estate" was strange.  I had expected to spend most of my time in the firm's Manhattan office, sitting in a cube and running spreadsheets.  I suppose I expected to be wined and dined a little bit, it being one of the rumors in b-school that such things went on for the first three months to lock in a worker bee before crushing work and total indifference to "work-life balance" was brutally applied by the firm.  Instead, I found myself living on what could have been a five star resort and quickly becoming Armin's "right hand."

I spent the first week working on a valuation for a small, privately held, environmental company we were considering purchasing.  There was no guidance.  No analysis plan.  Simply a mandate.  "Tell me how much I shouldn't pay," Armin said to me one day, laying the materials in front of me.

My "office" was actually the "English Study" (fireplace, wood paneling and all) in the main house of the estate.  In truth I was afraid to even write on the desk and instead took notes on my laptop most of the time.  I have to say, nothing seemed more foreign to me than the site of a modern laptop and an AT&T phone on that old, leather topped antique desk.

Every day, as soon as 5:30 came around, the butler would appear with a plate of smoked salmon, a fishbowl sized burgundy glass and a bottle of red wine on a silver tray and announce "Mr. Armin has asked you to join him in his office at your convenience," while he poured with great flourish what almost seemed an excessive amount of wine.  (I say "almost" because I am a big wine drinker).  I would finish up the salmon and whatever I had been working on and walk across the house, wine glass in hand, to the far wing, where Armin's office, a much larger version of the study I sat in, was.

He would stand whenever I walked in, gesture to one of the massive armchairs in front of his desk, and poll me on topics ranging from the wisdom of investing in small steel companies to the state of the German economy.  That sort of free-flowing discussion would continue until 7:30 when he would head off to the kitchen and put the finishing touches on whatever meal he had been preparing on and off since noon.

I would drift off back to my office and finish up whatever was left of my work before the butler arrived again and announced "Dinner is served," once again filling my wineglass.  It was hard to feel like I was working, though the hours were actually pretty intense.

The Hunt Part I (Chase)

For the first many weeks I didn't even meet two of the firm's partners.  I was quietly ensconced at Armin's estate, or traveling with him to management meetings.  Ah, management meetings.  But I suppose that to understand what this means one has to understand the process of hunting down deals.

The structure of "the chase" for deals is in some ways convoluted.  First you have to find the deals.  There are a variety of methods.  At our firm we had two associates calling all day, every day into the senior executives or the "corporate development" departments of large, publicly held firms.

The pitch was simple.  We are a private equity firm.  We are buying (or in "acquisition mode").  The associate had noticed an article in the (Wall Street Journal/Barron's/Economist/Investor's Business Daily/Bathroom Wall) discussing XYZ Corporation's strategy shift and if any of the divisions or units had become undesirable or "non-core" as a result we hoped they would let us know so we could relieve them of said units.

Of course, the hope was that our associate was so suave that the large corporate wouldn't even bother to call an investment banker when they had something smaller to sell.  (Having associates who put out seems to be an advantage in this business).  See, we hate investment bankers.  Investment bankers sell their services by convincing a firm's owners that their firm is worth "X" and then, right or wrong, blocking even the hint of any deal that makes their wild ass guess of "X" look silly.  It is like hiring a real estate agent who promises to sell your $900,000 house for $1,000,000 and then refuses to even inform you about the 6 buyers offering $925,000. Well, ok.  That's not really fair.  Really we dislike them because Investment bankers mean negotiations and auctions.  Negotiations and auctions mean paying fair prices for what we buy.  We hate paying fair prices for what we buy.  We love free markets.  Except auctions.  Then we want illiquid markets.

In any event, the net effect of all this calling was a seemingly never-ending series of meetings with the CEOs, CFOs and COOs of large public companies.  "Business development."  This translated t: Lunch at the Yacht Club.  Afternoon drinks at the social club.  Dinner at the Estate.  Morning meetings in Manhattan offices.  Drinks after work on Friday at the Four Seasons.  Weekends who knows where.  Then, occasionally, a CEO would call you up, or more likely, he would tell the CFO to call you up.  They had something they were thinking of getting rid of.  Could we do it quickly and quietly?

If that doesn't work then our associates spent a lot of time calling investment bankers.  Did they have anything of interest for sale to us?  Any aerospace stuff?  Fast moving goods?  (I always thought aerospace and fast moving goods must overlap).  Processed meats company?  (I'm not kidding, we almost bought one).

Ok, I know I said we hate investment bankers.  Well, sometimes we don't hate investment bankers.  "Sometimes" is when they call us trying to avoid sounding desperate because the deal they had thought was all sewn up to sell a company they were trying to dump fell through at the last minute.  Their auction broke.  Maybe we had bid on it but come in second, or third.  Or not at all.  Suddenly we love investment bankers.  Illiquid market again.

No deals yet this week?  Ok, then there is a lot of talking back and forth with accountants, consultants and lawyers.  Any deals that look like they might be a problem?  Any large acquisitions that might be threatening to close a 500 person unit somewhere after the deal is inked when the surviving company looks to consolidate operations?  Give us a call.  Slip us a note.  Whisper in our ears over drinks.  Start your sentence with, "You didn't hear this from me but..."  That's like one of those EF Hutton commercials back when.  The entire table of private equity guys and gals just clams right up.

This is, of course, a popularity contest.  It is about showing these various professionals a better time and connecting with them on a deeper level than the rest of the private equity professionals who were chasing them.  I began, I thought, to suspect why Armin found me interesting.  I sailed.  I rode horses.  I could hunt.  I skied.  I played tennis.  I was a moderately talented faker when it came to golf.  I came from a bit of a leisurely background.  Perfect to connect, charm, seduce, whathaveyou, the CEx set.  This is why you constantly see former heads of state, presidents of banks, star athletes, some of whom have no finance background at all, joining private equity firms.  They know how to schmooze.  They have contacts.  Even with this realization, the mystery to me was still how Armin credited me with such potential in this area.

When you first "officially" hear about a deal you get a "teaser."  A one page document describing in general terms, and without any names, the nature of the business and the most basic of financials.  Well, that's not always true.  Sometimes there was no teaser.  You liked those deals.  That meant that there was no one who had the time to actually write a teaser.  That meant no banker.  That meant no resources to the transaction.  That meant "cheap."  If you get a teaser, and if you are interested, you sign a confidentiality agreement and a more detailed document, sometimes running into the hundreds of pages, is forwarded to you.  This is "the book."  Of course, some small or last minute deals had no "book."  Then you had a lot of guesswork to do and a lot of questions to ask.

From the book you are supposed to decide you are interested in bidding, forward a "letter of intent" outlining the fact that you are interested and schedule a management meeting (or several).  This is where you (duh) meet the managers, ask questions about the business and start deciding if you want to buy this sagging firm or if it is just too much trouble and too expensive.

Now, I pretty much glazed over the "sign a confidentiality agreement" step as if it were simple, but this process itself can take weeks as one haggles over terms and conditions.  Alternatively, sometimes neither party even reads the damn things before signing them.  This last point prompted me to put in some cute language in the middle of one of our standard NDAs just to test the waters:

Section 2: Information.

“Information” shall mean all data (whether provided orally, in writing or on computer disk), reports, plans, interpretations, designs, software, drawings, models, forecasts and records containing or otherwise reflecting any information not generally known to the public.  Information shall include, but not be limited to, any information supplied to either party prior to the proper execution of this Agreement and any additional information provided subsequent to the date of this Agreement; provided, however, that this term shall not include any portion of the Information which (A) is or becomes generally available to the public other than as a result of a disclosure by the Receiving Party or its representatives, (B) is a part of the Originating Party's ever growing collection of printed, online or multimedia pornography and/or other erotic materials, (C) becomes available to the Receiving Party on a non-confidential basis from a source other than the Originating Party or its representatives which has been represented to the Receiving Party (and which the Receiving Party has no reason to disbelieve after due inquiry) that it is entitled to disclose it or (D) was known to the Receiving Party on a non-confidential basis prior to the disclosure thereof to the Receiving Party by the Originating Party or its representatives.

A dangerous game, I know, but I managed to get signatures on that 4 page document from 5 parties, including one CFO at a household name type public company, before one of our associates, instead of printing off a new copy from the Microsoft Word template on our server, and in a fit of apathy that nearly cost him his job, made a Xerox of an executed copy of my version, whited out the names of the original parties wrote in new ones and faxed it out to a firm fairly famous for being nitpicky with such documents.  That was the end of my little "joke," though to this day no one knows where the "new" version came from.

We never got a deal from that firm again.

On Tech, Debt, Bets

The Economist this week carries an article (subscription required) on Private Equity firms, buyout firms specifically, and their renewed interest in tech and telecom.  Most importantly, in my view, the article points out the new depths within target balance sheets that buyout firms have been able to bury their equity investments.

It wasn't so long ago that debt was limited to around 3 times EBITDA for deals like this.  Today 7 times is not unheard of and one notable deal for Serena Software peaked at 11 times EBITDA, with Silver Lake Partners paying $24.00 a share to scoop up the firm.

At 11 times PE firms are banking on massive growth to pay off the debt the deal takes on in a reasonable time.

It's not surprising that Silver Lake, and co-Founder David Roux, would be so optimistic.  An investment of $874 million by Silver lake in combination with Texas Pacific Group and others in Seagate in 2000 is worth nearly $6.8 billion presently.  Silver Lake retained around 20% of the new firm.

Just to name one interested party, Silver Lake's 1999 fund had given CalPERS a 66% IRR on its $64 million investment as of August 2005.

But buyout firms have been burned on tech before.  Names like Prime Computers, Rhythm NetConnections, XO Communications are the reason no one wanted to lend on weak balance sheets.  Until recently.

One thing is certain, there are a lot of nervous private equity associates tracking the telecom and tech sectors.

Inverted

I love economic phenomenology.  Finding abnormal states and making predictive guesses based on them seems like a blast to me.

So, of course, like a good little b-school grad, I've been watching the interest rate inversion carefully.  More for the reactions of the many experts in the financial world than any real expectation that it will tell me what's about to happen.

For the uninitiated, short term interest rates (the return you'd get on say a 3 month term) are usually lower than long term rates.  This is because your money is tied up for less time and therefore there is less risk of something adverse happening.

Intuitively this should be fairly easy to follow.  There is a greater chance of some large upheaval causing problems with money you have "at risk" for 30 years than money you have "at risk" for 30 days.  Therefore, the return (interest rate) should be higher to compensate you for the risk.  The more risk I want you to take the more return you will want in compensation.  Finance 101, really.

The various returns versus time of maturity for debt make up the interest rate curve.  Presently the shape of that curve is "inverted."  That is, short term rates are actually higher than long term rates.  This is an unusual circumstance, and one that many have argued predicts a recession.

Of course, not everyone thinks so.  No less than former Fed Chairman Alan Greenspan has pooh-poohed the ability of the yield curve to do any signaling.  According to him the economy is too complex now for it to be of any use.

If you're still interested, there's more than you could ever want to know about interest curves out there.  Start with Potters, Bouchad, Cont, et. al. "Phenomenology of the Interest Rate Curve."  From the abstract:

This paper contains a phenomenological description of the whole U.S. forward rate curve (FRC), based on an data in the period 1990-1996. We find that the average FRC (measured from the spot rate) grows as the square-root of the maturity, with a prefactor which is comparable to the spot rate volatility. This suggests that forward rate market prices include a risk premium, comparable to the probable changes of the spot rate between now and maturity, which can be understood as a `Value-at-Risk' type of pricing. The instantaneous FRC however departs form a simple square-root law. The distortion is maximum around one year, and reflects the market anticipation of a local trend on the spot rate. This anticipated trend is shown to be calibrated on the past behaviour of the spot itself. We show that this is consistent with the volatility `hump' around one year found by several authors (and which we confirm). Finally, the number of independent components needed to interpret most of the FRC fluctuations is found to be small. We rationalize this by showing that the dynamical evolution of the FRC contains a stabilizing second derivative (line tension) term, which tends to suppress short scale distortions of the FRC. This shape dependent term could lead, in principle, to arbitrage. However, this arbitrage cannot be implemented in practice because of transaction costs. We suggest that the presence of transaction costs (or other market `imperfections') is crucial for model building, for a much wider class of models becomes eligible to represent reality.

If you are still hungering for more after that work you are a true bond lover.  Meanwhile, hemlines, the world series, and cardboard box sales are still probably better prediction tools.

Inverted Again

An outstanding review of inverted rate curves (complete with very sexy animation of the curve going back to March 1977).  You have to like a financial website that has an entry prone to remind one of a flipbook.

Not sure I agree with this sentiment, however:

Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown — or outright recession — as well as lower interest rates across the board.

And I have Alan Greenspan and Wharton on my side.

The Hunt Part II (Seduction)

Somewhere in here, someone like me makes a 50 page spreadsheet that "models" the company based on the financial information I have or am able to find.  "Models."  That is, predicts the revenues, costs and profitability the firm will experience in the years to come.  Usually as many as 5-7 years to come.  Of course, this is a bit silly since if I could predict the performance of a company in the 5-7 years to come I'd just make millions in technical analysis by analyzing publicly held firms.  Still, we have to start somewhere.  We have to be able to impose our will in an educated way on the company.

Modeling is an art and a science.  A good model allows you to quickly answer questions like: "Will we be able to reduce 10% of the General and Administrative costs starting in year 2 by eliminating that Florida office and moving the people to Bufu, Indiana?"  "What if interest rates shoot up 3% in year 4?  Will the company melt down?"  Or "What happens if Hillary Clinton wins in 2008 and the economy tanks to the tune of 15% and takes our revenues along with it?"  "How much will the debt each year cost?"  "How many licks does it take to get to the tootsie roll center of a tootsie pop?"

With a model the most attention goes to something called "EBITDA."  "Earnings Before Interest Taxes Depreciation and Amortization."  This is really a complex way of saying "profits."  We ignore taxes, interest, depreciation and amortization because we want to see what the "earnings potential" of the firm is independent of these factors, all of which are in turn dependent on the structure of the firms capital and operations, which we may well change.  In other words, "all structural factors being equal, how much does this firm make compared to other firms with different capital structures, more or less debt and more or less machinery?"  EBITDA, for all its faults, is the lifeblood of the model and arguments over $500,000 in EBITDA can ruin a deal or reduce the amount of debt you can put in to the point where you lose an auction.

Based on the model we come up with a basic idea of what we think the company is worth by predicting its "free cash flow" (calculated from EBITDA) and using a "discounted cash flow" or "comparables" model to come up with a value range for the company.

Of course, since we are an LBO shop, eventually we have to find the "L" in LBO.  The debt.  That means talking to leveraged finance desks.  That means schmoozing the leveraged finance desks of a few (or many) firms in order to win their trust and (in theory) improve the interest rates you get on debt since the risk of us screwing them is lower.  I highly recommend martinis as a means to reduce "reputation risk" in this way.  Three martinis, ($60.00) can buy you 0.05% in interest which, over 7 years, is more than $1,750,000 in interest on a $500 million dollar deal.  I don't have any figures yet on what sleeping with the debt people will get you.

"L" also means, nowadays, talking to hedge funds, which are trying actively to muscle in on the leveraged finance groups in investment banks.  Dealing with the "debt guys" and occasionally "debt gals" was a job that increasingly fell to me, invariably entailing a number of "after-work" outings in Manhattan with free-flowing vodka as a central attraction.

Having fought over how much debt was a good idea (since it means less money out of our pocket, we want more, bankers and hedge funds want less) we then fight over the interest rates.

Then we fight over prepayment penalties (what we get charged if we pay it off early, which we want to do any time we can since we are probably paying interest rates near 13-15% on some of the debt and the faster we get rid of it the more money we make).

Then we fight over "covenants" (what conditions can trigger nasty letters and eventually lawsuits from our lender, like missing payments, falling short of revenue targets, selling all the furniture in the building on eBay over a quiet weekend, etc).

When all that is done we get a term sheet.  Then, if we are feeling ornery, we quietly go to another bank and ask them to beat the terms we just hammered out with the first bank.  I know.  We are big ole' meanies.  Hey, you drive around looking for a few cents off on a gallon of gas, right?

Having figured out what we think our debt will cost and how much of it we can get, we then fill the rest of our proposed purchase price with "equity."  In our context equity is short for: "Armin, you need to write a big fucking check.  Now."  Debt to Equity usually looks like around 2.5:1 to 4:1 (rarely) today.  (It was nearly 14:1 in 1987).  The higher this ratio is, the more money the buyout fund (us) makes.  So on a $500 million dollar deal we might have to kick in a check for $150 million and borrow $350 million.  Our first quarterly interest payment might be as high as $9,500,000.  That's before we even touch the principal, which we are probably mandated to do each quarter.

The sum of our debt and equity (usually we calculate this back according to what we think the company can actually pay in quarterly debt and principal or the "debt service") becomes our bid for the company.  As you will quickly see, if there is an auction, success usually goes to the party who can put the most leverage on the deal.  Of course, like a submarine you only get to see how deeply into debt you can go once.  Miss a few payments (or one if the lender is nervous enough) and it is good night.  Your $150 million check is gone and the company is in the hands of the lender.  Picking the right debt levels is a delicate balancing act between fear of losing the auction and fear of the lender foreclosing.

All through this process we query the company.  We ask for assurances that the revenue figures are correct.  We ask how much customer concentration there is.  (Would the bankruptcy of a single customer destroy 15% of revenue?  What if Hillary Clinton got into office the month after that happened?  Ouch).  We ask about lawsuits.  We ask for the color of the CEOs underwear.  Boxers or briefs?  We want to know everything and we are convinced all along that management is lying through their tightly clenched teeth to us, seeking to keep the nasty stuff hidden and pump the good stuff up to great stuff.  As to this assumption, usually, we are right.

Finally, the day comes and we submit our "bid."  A long agonizing process of review begins by the selling firm until they either announce a winner or try to convince us that "you are very close, but we'd like everyone to sharpen their pencils a bit more" and we squeeze what is probably now a mildly imprudent amount of additional debt and equity into the transaction.

Then we agonize again and then, maybe, a winner is announced.  God forbid we actually win because then we have to go into "exclusive due diligence," where we descend on the place like as many paratroopers and REALLY go through the books.  We look under every rug until we are satisfied everything is (near as we can tell) as it appears and then we work towards the closing.  The day of the closing we spray champagne around but then reality sinks in.  Now we have to run the damn thing.  Now all the little things we missed crawl out of the woodwork to haunt us.

Then we have to make that merciless quarterly debt payment every quarter.  Not a penny short.  It is like being on an episode of the Sopranos.  If you have to dip into the college fund, you dip.  Sell the factory?  Done.  Fire 25% of the workforce?  Bye!

That, with a dozen shortcuts and skipped explanations is a transaction.  Let me tell you: In practice, it is much less straightforward.  The soap-operaesque, insane drama that unfolds in one way or another in every transaction is pure madness.  And the reason I will never want to do anything else for a single day of my life.  I think.

The Power of Small

After reading the old, wonderfully offensive and quite true article on The Leveraged Sellout I couldn't help but notice that an article in Today's Wall Street Journal makes a point of pointing out the major ground "boutique" banks have covered in the last 5 years.  (I wonder what Mr. Jonathan A. Knee had to do to get a puff piece like that in the Journal?) 

Compelled to Submit to Privations

M. Olivier de ---- was a dissipated young gentleman.  His family was one of the oldest and most respectable of the country, and deservedly enjoyed the highest consideration.  M. Olivier de ----, his father, was not rich, and therefore could not do much for his son; the consequence was that owing to his outrageous prodigality the son was sorely pinched for means to keep up his position; he exhausted his credit, and was soon overwhelmed with debt.  Among the companions of his dissipation was a young man whose abundant means filled him with admiration and envy; he lived like a prince and had not a single creditor.  One day he asked his friend to explain the mystery of the fact that, without possessing any fortune, he could gratify all his tastes and fancies, whilst he himself, with certain resources, was compelled to submit to privations, still getting into debt.

Chauvignac--such was the name of the friend thus addressed--was a card-sharper, and he instantly seized the opportunity to make something out of the happy disposition of this modern prodigal son, this scion of gentility.  With the utmost frankness he explained to the young man his wonderful method of keeping his pockets full of money, and showed that nothing could be easier than for Olivier to go and do likewise in his terrible condition;--in short, on one hand there were within his grasp, riches, pleasure, all manner of enjoyment; on the other, pitiless creditors, ruin, misery, and contempt.  The tempter, moreover, offered to initiate his listener in his infallible method of getting rich.  In his frame of mind Olivier yielded to the temptation, with the full determination, if not to get money by cheating at cards, at any rate to learn the method which might serve as a means of self-defense should he not think proper to use it for attack--such was the final argument suggested by the human Mephistopheles to his pupil.

Taking Olivier to his house, he showed him a pack of cards.  'Now here is a pack of cards,' he said; 'there seems to be nothing remarkable about it, does there?'  Olivier examined the pack and declared that the cards did not appear to differ in the least from all others.  'Well,' said Chauvignac, 'nevertheless they have been subjected to a preparation called biseautage, or having one end of the cards made narrower than the other.  This disposition enables us to remove from the pack such and such cards and then to class them in the necessary order so that they may get into the hand of the operator.'  Chauvignac then proceeded to apply his precepts by an example, and although the young man had no particular qualification for the art of legerdemain, he succeeded at once to admiration in a game at Ecarte, for he had already mastered the first process of cheating.  Having thus, as he thought, sufficiently compromised his victim, Chauvignac left him to his temptations, and took leave of him.

Two days afterwards the professor returned to his pupil and invited him to accompany him on a pleasure trip.  Olivier excused himself on account of his desperate condition--one of his creditors being in pursuit of him for a debt of one thousand francs.  'Is that all?' said Chauvignac; and pulling out his pocket-book he added,--'Here's a bank-note; you can repay me to- morrow.'  'Why, man, you are mad!' exclaimed Olivier.  'Be it so,' said Chauvignac; 'and in my madness I give you credit for another thousand-franc bank-note to go and get thirty thousand francs which are waiting for you.'  'Now, do explain yourself, for you are driving ME mad.'  'Nothing more easy.  Here is the fact,' said Chauvignac.  'M. le Comte de Vandermool, a wealthy Belgian capitalist, a desperate gamester if ever there was one, and who can lose a hundred thousand francs without much inconvenience, is now at Boulogne, where he will remain a week.  This millionnaire must be thinned a little.  Nothing is easier.  One of my friends and confreres, named Chaffard, is already with the count to prepare the way.  We have only now to set to work.  You are one of us--that's agreed--and in a few days you will return, to satisfy your creditors and buy your mistress a shawl.'

'Stop a bit.  You are going too fast.  Wait a little.  I haven't as yet said Yes,' replied Olivier.  'I don't want your Yes now; you will say it at Boulogne.  For the present go and pay your bill.  We set out in two hours; the post-horses are already ordered; we shall start from my house: be punctual.'

The party reached Boulogne and put up at the Hotel de l'Univers.  On their arrival they were informed that no time was to be lost, as the count talked of leaving next day.  The two travelers took a hasty dinner, and at once proceeded to the apartment of the Belgian millionaire.  Chaffard, who had preceded them, introduced them as two of his friends, whose property was situated in the vicinity of Boulogne.

M. le Comte de Vandermool was a man about fifty years of age, with an open, candid countenance.  He wore several foreign decorations.  He received the two gentlemen with charming affability; he did more; he invited them to spend the evening with him.  Of course the invitation was accepted.  When the conversation began to flag, the count proposed a game--which was also, of course, very readily agreed to by the three comperes.

While the table was prepared, Chauvignac gave his young friend two packs of cards, to be substituted for those which should be furnished by the count.  Ecarte was to be the game, and Olivier was to play, the two other associates having pretended to know nothing about the game, and saying that they would content themselves by betting with each other.  Of course Olivier was rather surprised at this declaration, but he soon understood by certain signs from Chauvignac that this reservation was intended to do away with the count's suspicions, in case of their success.

The count, enormously rich as he was, would only play for bank-notes.  'Metal smells bad in a room,' he said.  The novice, at first confused at being a party to the intended roguery, followed the dictates of his conscience and, neglecting the advantages of his hands, trusted merely to chance.  The result was that the only thousand-franc bank-note he had was speedily transferred to the count.  At that moment Chauvignac gave him a significant look, and this, together with the desire to retrieve his loss, induced him to put into execution the culpable manoeuvres which his friend had taught him.  His work was of the easiest; the count was so short-sighted that he had to keep his nose almost upon the cards to see them.  Chance now turned, as might be expected, and thousand-franc bank-notes soon accumulated in the hands of Olivier, who, intoxicated by this possession, worked away with incredible ardour.  Moreover, the count was not in the least out of humour at losing so immensely; on the contrary, he was quite jovial; indeed, from his looks he might have been supposed to be the winner.  At length, however, he said with a smile, taking a pinch from his golden snuff-box--'I am evidently not in vein.  I have lost eighty thousand francs.  I see that I shall soon be in for one hundred thousand.  But it is proper, my dear sir, that I should say I don't make a habit of losing more than this sum at a sitting; and if it must be so, I propose to sup before losing my last twenty thousand francs.  Perhaps this will change my vein.  I think you will grant me this indulgence.'  The proposal was agreed to.

Olivier, almost out of his senses at the possession of eighty thousand francs, could not resist the desire of expressing his gratitude to Chauvignac, which he did, grasping his hand with emotion and leading him into a corner of the room.

Alas! the whole thing was only an infamous conspiracy to ruin the young man.  The Belgian capitalist, this count apparently so respectable, was only an expert card-sharper whom Chauvignac had brought from Paris to play out the vile tragi-comedy, the denouement of which would be the ruin of the unfortunate Olivier.

At the moment when the latter left the card-table to go to Chauvignac, the pretended millionnaire changed the pack of cards they had been using for two other packs.

Supper went off very pleasantly.  They drank very moderately, for the head had to be kept cool for what had to follow.  They soon sat down again at the card-table.  'Now,' said the Parisian card- shaper, on resuming his seat, 'I should like to end the matter quickly:  I will stake the twenty thousand francs in a lump.'

Olivier, confident of success after his previous achievement, readily assented; but, alas, the twenty thousand francs of which he made sure was won by his adversary.

Forty thousand francs went in like manner.  Olivier, breathless, utterly prostrate, knew not what to do.  All his manoeuvres were practised in vain; he could give himself none but small cards.  His opponent had his hands full of trumps, and HE dealt them to him!  In his despair he consulted Chauvignac by a look, and the latter made a sign to him to go on.  The wretched young man went on, and lost again.  Bewildered, beside himself, he staked fabulous sums to try and make up for his losses, and very soon found, in his turn, that he owed his adversary one hundred thousand francs!

At this point the horrible denouement commenced.  The pretended count stopped, and crossing his arms on his breast, said sternly--'Monsieur Olivier de ----, you must be very rich to stake so glibly such enormous sums.  Of course you know your fortune and can square yourself with it; but, however rich you may be, you ought to know that it is not sufficient to lose a hundred thousand francs, but that you must pay it.  Besides, I have given you the example.  Begin, therefore, by putting down the sum I have won from you; after which we can go on.' . . .

'Nothing can be more proper, sir,' stammered out young Olivier, 'I am ready to satisfy you; but, after all, you know that . . . . gaming debts . . . . my word . . . .'

'The d--l! sir,' said the pretended count, giving the table a violent blow with his fist--'Why do you talk to me about your WORD.  Gad!  You are well entitled to appeal to the engagements of honour!  Well!  We have now to play another game on this table, and we must speak out plainly.  Monsieur Olivier de ----, you are a rogue . . .  Yes, a rogue!  The cards we have been using are biseautees and YOU brought them hither.'

'Sir! . .  You insult me!' said Olivier.

'Indeed?  Well, sir, that astonishes me!' replied the false Belgian ironically.

'That is too much, sir.  I demand satisfaction, and that on the very instant.  Do you understand me?  Let us go out at once.'

'No! no!  We must end this quarrel here, sir.  Look here--your two friends shall be your "seconds;" I am now going to send for MINE.'

The card-sharper, who had risen at these words, rang the bell violently.  His own servant entered.  'Go,' said he, 'to the Procureur de Roi, and request him to come here on a very important matter.  Be as quick as you can.'

'Oh, sir, be merciful!  Don't ruin me!' exclaimed the wretched Olivier; 'I will do what you like.'  At these words, the sharper told his servant to wait behind the door, and to execute his order if he should hear nothing to the contrary in ten minutes.

'And now, sir,' continued the sharper, turning to Olivier, 'and now, sir, for the business between you and me.  These cards have been substituted by you in the place of those which I supplied . . .  You must do them up, write your name upon the cover, and seal it with the coat of arms on your ring.'

Olivier looked first at Chauvignac and then at Chaffard, but both the fellows only made signs to him to resign himself to the circumstances.  He did what was ordered.

'That is not all, sir,' added the false Belgian; 'I have fairly won money from you and have a right to demand a guarantee for payment.  You must draw me short bills for the sum of one hundred thousand francs.'

As the wretched young man hesitated to comply with this demand, his pitiless creditor rose to ring the bell.

'Don't ring, sir, don't ring,' said Olivier, 'I'll sign.'

He signed, and the villany was consummated.  Olivier returned to his family and made an humble avowal of his fault and his engagements.  His venerable father received the terrible blow with resignation, and paid the 100,000 francs, estimating his honour far above that amount of money.

An old tale by Robert-Hondin, Tricherics des Grecs devoilees, retold by Andrew Steinmetz, Esq. (c. 1860).  Steinmetz was an interesting character and among other things was the Officer Instructor of Musketry for the Queen's Own Light Infantry Militia.  This tale struck me because if we replaced Olivier with "Seller," Chauvignac with "Banker," and the Belgian Capitalist with "Private Equity Partner," it could have taken place in 2005.

-ep

PE Titles

"Vice President of Dust Collection" (also: "VP of DC," "VPDC," "Voice Mail VP") Refers to the token position in a portfolio company afforded a favored employee of a Private Equity firm whereby she may enjoy a myriad of corporate benefits, expense account privileges and salary from the portfolio firm for doing essentially nothing.  Derived from the dust collecting action of the empty chair and empty desk in the empty office where the "employee" is not sitting or the fact that only the voice mail system ever answers the employee's phone.

Example:
Senior Partner: "Ok, we've closed the SillyCorp deal.  Sally, good work.  You are promoted VP of DC for SillyCorp.  Talk to HR about getting a corporate credit card and signing up for payroll there.  Oh, and see if they have any decent laptops we can use over here.  It's about time we upgraded."

Related Terms:
"Chief Strategy Officer":  The direct superior of a VP of DC.

The Fit

I have been struggling for a while to define what this business is.  Where I fit in it.  How it plays against and with my quirks.  At some point half a dozen loose pieces slip together with a loud "click."  Like some kind of complex, three dimensional, mechanical puzzle.  Clicking from configuration to configuration with a muted, soft -thack- -thack- until all the pieces align with a tight, metallic snap of perfection.  -click-

Buyouts are hard.

Obtaining "superior returns" is a tough business.  Everyone in the market is out to beat you to it.  Everyone has an idea how to do it.  Almost all of these ideas are premised on doing it at the expense of someone else.  Because they are unable, unwilling or unaware of the value you, uniquely, can extract.  It is a dog eat dog world out there.  No one is, after all, in the market for inferior returns.  Well, almost no one.

I am not sure I would say that obtaining superior returns via buyouts is "harder" than via equity hedge funds, mezzanine or venture capital. But within private equity buyouts are a particular kind of hard.  There is that particular thrill of the chase.  Finding the deal.  Chasing the deal.  Losing the deal.  Or catching the deal.  For every 20 opportunities we look at perhaps one actually grabs our attention and earns out real sprinting effort.

The jockeying for position starts.  Our angling for an advantage. Deciding if we should pull out all the stops, or hold back, quietly trailing the pack and spring at the last moment.  There is the crafty temptation to coax intelligence about the other bidders.  The long run up to the auction itself.

Then there are those last minutes of panic.  The moments before the call comes.  Won.  Lost.  The unsealing of the bids.  How can I explain that feeling?  The last moments of an eBay auction that lasts for 4 months and costs thousands even hundreds of thousands of dollars even to the loser?  The culmination or final frustration of expectations? Knowing you must not "get emotional about stock," but failing miserably as your investment in time, diligence, even love, vests.  I'm not sure there is a parallel feeling outside of the deal world.

The loss.  It is difficult, but critical to shake and move on.  Or the win.  It is precious and sweet.

But it only begins there, the hard part.  A slow, grinding agony hard. After the close the lawyers are off the hook for the most part.  The investment bankers pack up and go on to the next deal.  The leverage folks, they check their mailbox every quarter for the seven figure check we send them.  The accountants... do whatever accountants do in their off hours.  The seller takes the cash and (one hopes) deploys it to more efficient ends.  We... we are now stuck with a wounded animal. Poked and prodded and backed into a corner.  Run around frantically, unsure of its fate.  Its leaders defecting.  Its employees struggling with new benefits forms.  Its morale low.  Its cash strapped.  Its balance sheet burdened now with debt.  A sword over its head should a payment be late.

Our capital is frozen.  Illiquid.  We will be the very first to lose if things go more than a just little awry.  Our ongoing participation is expensive.  In every way.

This is where the challenge is.  Not in finding the deals.  Not in chasing the deals.  Not even in winning the deals.  Well, not only that.  But seeing the deals on which you can execute after the victory.  Buy nothing you cannot run better than it is already being run.

Making money elsewhere is a different story.

I don't think I would be suited for a life in the trading world of hedge funds.  Too intense too often.  Too much volatility compressed into too little time.  But in a way it might be easier emotionally.  Or not.

The market has no face.  You cannot look the market in the eye.  You do not have to look the party on the other end of your trade in the eye. There is no body language in crowds theory.  There are no intentions to read.  No tone of voice to hear.  A trade is an idea, a position is taken, and closed and it is done.  3 months is a long position for most hedge funds.  3 years is a short run for an LBO.  With the market there are no interpersonal politics.  Traders read impersonal markets.  True, they live, they breathe, they grow, they die.  They do all these things impersonally.  "A stock doesn't know you own it."  A company does.

There is a lot of talk about hedge funds getting into the buyout world.  Or the reverse.  I don't think hedge funds would make good buyout investors. That could be my ego talking.  I certainly wouldn't be the first to make the argument.  The short attention spans.  The rapid fire decisions.  All you have to do is read Barton Biggs' "Hedgehogging," which is less a book than a collection of anecdotes that all seem to follow the same plot:  Investor has different style.  Style is compared to investor's personality.  Path of investor to gather great riches is outlined.  Investor embarks on the hedge fund journey.  Investor succeeds spectacularly in the face of crippling near-failures.  Or investor fails spectacularly in the face of enlightening near-victories.  Return percentages are tossed about.  The word "billion" is overused.  In 15 paragraphs it is all over.  But then, this is the book we expect from a hedge fund manager.  A 7 year position?  Learn to manage cash flow, distribution networks?  How could they cope?

Venture capital is closer, perhaps.  But at least the venture gods can remake their world from near-scratch.  The downside is they have no platform to work from.  The upside is they have no platform to work from.  They thrive on the new.  Though their time frame, their horizon is similar, they themselves are much different animals.  There is not bank waiting to take the keys if a startup has three bad months.  In fact, a startup is expected to have 48 bad months from the very beginning.  Controlled failure (from a cash flow perspective) is planned.  We cannot afford it.

Buyouts don't have the advantages of these others.  We buy a closet after being afforded only a 10 second flash with the door open, guessing as best we can at the contents.  Then we laboriously comb through the closet, sell the old rusted bicycle we cannot use, if anyone will buy it, and try to cobble together what we can from the drawer of old, naked Barbies, socks and shoe stretchers.  Sometimes you find a gold pen.  Maybe it dropped, forgotten, behind the shoe rack. Other times you find a dead rat.  So that's why the socks smelled so badly.  Whatever is in there, you own it.  And if you want to keep owning it you better make a pretty spiffy looking closet out of it pretty quickly.

Politics are the essence of the first part of an LBO.  The Chase.  And this, I finally discovered, is why I was brought on board so quickly, elevated with such speed and saddled with such responsibility without, from what I could see, even a second thought.

My mentor, Ron, had sold me pretty hard to Armin.  I found this out only later.  Perhaps, I think now, to keep me from pestering him for the many months after our dinner.  Maybe because my father would have pestered him for not, after all my years of expensive education, finding me somewhere to land.  When he sold me, however, he sold me on a political platform.  As the answer to the political element in an LBO.  And, without indulging too freely in immodesty, I have to say that this was a good guess on his part.

I enjoy nothing more than reading the "other side."  Having grown up amongst bankers, lawyers and CEOs anyhow they all seemed transparent to me.  I am gawked at, yes, but if I remain quiet, I seem invisible to them once the discussions begin.  Perhaps because I am slight of build, too pale, or that my demographic is rare in the deal world.  If I am really noticed, perhaps I am taken for a plaything of the senior partners.  I don't know exactly what it is that makes me nearly invisible, but being underestimated is a very VERY valuable thing in the LBO world.  Unfortunately, most practitioners have egos too substantial to exploit this advantage.  I, on the other hand, quite enjoy engaging without warning in a fencing match with an opponent who, Princess Bride like, intends to fight the match with me left handed. The best way to fight an unarmed opponent is to disarm them first.

Before this I had never thought after my ability to size up a room, decipher the relationships of the parties and understand the interlocking of competing interests.  It had been a casual annoyance before.  Now it was gold.  Exploitable.  Monetized.  Ron saw this. Armin uses it.  For my part, I am content to be used in this way.  It is my nickname now.  "The Empath."

I am teased in the typical team-building way.  Victim of crass (but mostly mild) jokes.  Babied a little perhaps.  But whereas I started off being resented, a pair of big wins, the credit of which was laid (rightly or wrongly) at my feet, made me instead valued.  Paraphrasing a favorite film of mine, "No one is more prized than who brings victory in battle."  I acquired a pack of big brothers, all protective of me. All eager for my attention.  All wanting my view on everything from their girlfriends to their portfolios.  I, who know nothing about trading public equities, try to demure, but they are insistent.  I am at the point where I just say "Short Google," knowing none of them have the courage to short anything.

But then, and it happens in every deal we are serious about, the option on me is exercised.  "What the fuck is that guy thinking," Armin might rave after some inexplicable behavior by a target company's CEO.  It takes only one of these before he is intercomming his assistant.  "Get The Empath in here.  I need my crystal ball."  Time for me to go to work.

Fears

With such long horizons as one finds in the LBO world, it is quite easy to get very nervous about the economy.  One is almost certain to meet at least a slowdown in any seven year period.  Add to this the sudden bubble in private equity, and buyouts are no exception, and it is even easier to be even more nervous.

Someone once told me that the time to dump a sector is when you first hear someone who never traded a share of stock in their life tell you they were going long on it.  Drop it like a hot rock.  Today, everyone and their brother is pouring into private equity.  It feels a little like venture capital in 1999.

Now add another wrinkle.  Debt is plentiful and cheap.  The Wall Street Journal's always interesting (sometimes scary) "Heard on the Street" is posting articles with titles like "Din of Roaring Corporate-Debt Market Drowns Out Growing Talk of a Bubble" (Wall Street Journal subscription required).

Says the Journal's Henny Sender:

But these blissful conditions are prompting rising concern among some veteran analysts about a possible bubble, fueled by a still-easy monetary policy, despite 14 consecutive short-term interest-rate increases by the Federal Reserve since June 2004. "The Fed hasn't done much," says William Dudley, an advisory economist for Goldman Sachs Group. "Overall financial conditions are much easier than in 2002."

The clearest understanding I had of the tech bubble boiled down to this: The thing you least want to be in a bubble is the greatest fool. The last guy (gal) to buy before there is no one more foolish left to pass the bag to.  When you start creeping into people who have neither bought stock before, nor know anything about it, you are clearly running out of greater fools.  Time to be worried.

In the tech bubble days the "greater fool" was the public markets. Armed with less information on what they were buying and more distant in terms of the number of intermediaries between them and the source of information to begin with, each intermediary, by the way, with an interest in passing it forward and taking a cut along the way so the stock gets more and more expensive with each jump, it is pretty easy to see how things get overpriced and overhyped.

The angels funded looking to dump to the seed gang.  The seed gang funded looking to exit via the venture gang.  The early stage venture gang funded looking to dump to the late stage gang.  The late stage gang funded looking to pass it off to the investment banks via an IPO.  The investment banks scraped the top off and tossed it to the rest of the market.  The rest of the market looked to pawn it to... uh, the rest of the rest of the market.

None of the players early in the chain were all that worried. The deals they were cutting and the stability of the firms they were underwriting were quickly to become "someone else's problem."  After they collected their fat checks.  That sound you hear is the strained surface tension on the bubble.

Unfortunately, debt in buyouts has taken on similar tones.  "Covenants" are eroding in an effort for groups to place more debt ahead of the competitors.  The Journal article mentions Neiman Marcus and AMC as "covenant lite" deals done not long ago, with few if any serious restrictions by lenders.  Why would lenders forgo their customary protections that reduce their risk over the lifetime of the loan?  They have no intention of holding the loan for long, that's why.  It's all about to become "someone else's problem."

An old tool, recently dusted off, called "Collateral Loan Obligations" packages a series of loans and boxes them up for sale in large chunks to other investors (who are quite a bit removed from the sources of information about the quality of these loans).  Worse than that, CLOs are themselves bought by loans.  Whole funds use 4:1 leverage to buy 4:1 leverage.  That sound you hear is strained surface tension.

How do you know when you're running out of fools?  Your investment of choice ends up on the cover of a major "McNews" publication like Time, Newsweek or such.

Thank god that's not happened yet.  It's not like someone stole the name of my blog and put it on a McCover about private equity.  -cough-

Cracked Crackberry

Maybe it's just me, but doesn't it seem like Research in Motion is ripe for a hostile takeover?  Expensive?  Sure.  But what shareholder could possibly be happy with management for giving away one whole year's EBITDA because they forgot to file the right fricking form many years ago and have been hard nosed idiots in settling with the, admittedly opportunistic, NTP?  Not to mention that the competition hasn't exactly been standing still and new subscriptions are way down.  Death to the Crackberry?

Deporting Private Equity

Yesterday Victor Fleischer, professor at the UCLA School of Law presented, "'Two and Twenty' Partnership Profits in Hedge Funds, Venture Capital Funds, and Private Equity."  Fascinated by this subject, and immediately alarmed at Professor Fleischer's proposal to impose reform to more aggressively tax these gains, I sought out a copy.  Professor Fleischer replied to other requests on the always thought provoking Conglomerate thus:

"It's not quite ready for prime time, but I will post it to SSRN in a couple of weeks."

I guess he shouldn't have left a Google searchable copy of the draft in the open then.

-giggle-

Ok, ok.  I know. Sorry.  I didn't want to wait.  Bad Equityprivate.  No bone.

It is most certainly worth the read, and contains some very good analysis.  I think, however, the professor has missed some things.

First, the central issue with respect to character of compensation centers around the premise that:

...while the carried interest can give rise to capital gains (depending on the character of the underlying partnership income), management fees give rise to ordinary income.  Some GPs, recognizing the tax play, opt to reduce the management fee in exchange for an enhanced allocation of fund profits.

The argument goes that since these reduced management fees are exchanged for higher carries, there is a structural wrong being perpetrated.

The professor eventually concludes that:

The granting of a profits interest in a partnership should not be treated as a taxable event.  When those allocations of profits eventually arrive, however, they should be treated as compensation, not investment income, and taxed as ordinary income and not capital gain.

I believe this fails to account for several issues.

1.  Capital calls often are allocated proportionally to a partner's carry in the fund.  Accordingly, if management fees are exchanged for carry, these fees are "at risk" in a more substantial way than I think the professor accounts for.  Since when is ordinary income treated compensation for service subject to the foibles of interest rates (other than in hyper inflationary situations)?  If a GP puts these at capital gains risk levels he should be compensated via capital gains rates.  The professor ducks this by hinting that "risks are not as large as they seem" but I don't think he has studied hedge funds carefully enough.  The reality is that management fees in most funds barely even pay the bills.  Only the supermassive funds can hope to promise more.  2% of $200,000,000, for example, makes for a very lean fund in Manhattan.  The source of those fees, and most compensation, eventually comes from capital gains.  We might as well make the argument that none of the gains obtained purely due to structuring (i.e. leverage and deleveraging) should be afforded capital gains treatment either.

2.  Enforcing the distinction between "carry for service" and "carry for non-service" necessarily requires a document somewhere demonstrating that that tradeoff has actually been made.  It also seems to suggest that some "standard" in the industry would serve as a benchmark to determine if "gamesmanship" is being played. General partners typically have their own funds at risk.  (1% of a typical buyout fund comes from GPs).  How we can distinguish the carry we give GPs between service or non-service carry is somewhat beyond me.

3.  These thoughts are not new.  Similar hintings have caused quite the uproar in the UK. Funds would likely flee to jurisdictions without burdensome tax schema designed particularly to impact investment funds if the current status quo were tinkered with.  And there are plenty of places to go. Luxembourg, for instance.  Many funds already take clear advantage of these jurisdictions.  Soros is famous for it.  (His Quantum fund is domiciled in Curacao though it is managed in Manhattan).  See how a sudden exodus would impact tax revenues.  (The professor does acknowledge this at least).

Nothing is more sacred than the 2 and 20 we PE types lust after for our sweat and tears.  I don't recommend toying with them if you want funds to stick around.  I think we do want funds to stick around also. Drawing any more attention to the benefits they would gain from offshore domiciles is not a good bit of policy.

I suppose I'm not surprised that he's from California.  What does surprise me is that he's not a Stanford grad.

(Do examine the professor's other work, of note: "The Missing Preferred Return.")

-ep

Fear II (The Sequel)

The well filtered stuff at Abnormal Returns yesterday turns up a bit more scary news on the buyout front.  This time by reference to a Forbes article titled "Private Inequity." (Subtitled: "The mad rush into private equity-is your retirement at risk?" Catchy, no?)  It is a parade of horribles about all that is bad about "private equity" (though the article seems to fail to realize that buyouts are only one class of private equity investments).

Among other things, the article notes:

“There’s a group of new private equity guys chasing deals for the sake of putting money to work,” says Darrell Butler of Billow Butler & Co., an investment bank in Chicago. “They’re affectionately known as ‘dumb money.’ They’re going to have a hard time when the economy turns, profits go south and covenants get blown and banks come calling. And it will happen.”

No doubt.  Well, except those smart enough to do "covenant lite" deals.

Over here we too have been feeling a lot like the tanks of money being poured around have been elevating prices beyond all reasonability.  Still, seems people believe they can make money at those kinds of valuations.  Everyone seems to be dumping money into the mega funds.  Greater fool theory in large fund private equity?  Uh oh.

The most interesting point the article makes, in my view, is with respect to pension funds.  If you are an underfunded pension fund then alternative investments (like private equity) and those high returns are a tempting way to get yourself into three digit percentages of obligation coverage.  The weaker the coverage the more allocation you will be tempted to put in private equity.  A deadly race to the bottom?  Maybe.  Perhaps we'll see the weakest pension funds take the biggest hits if the private equity crunch is around the corner.

Then we have Warren Buffet berating the "hyper-helpers" for their high fees. (He means private equity and hedge funds).  Of course, there are still investors lining up around the block to pay these "high fees."  With returns to the top buyout houses upwards of 50% IRR why not?  After fees they are still superior.  Of course, the rest of the class doesn't command those kinds of returns.  And here, as everywhere in the market, fees might bring total returns below even the S&P 500.

Certainly, there are some shifty practices in the buyout world.  Don't even get me started on dividend recapitalization.  But much of this recent language sounds to me like the national paranoia that hit in the 1980s in response to the buyout craze then.  The Forbes article even dusted off the old "locusts" comment from Germany's Social Democrats.  Ugh.  I expected more than petty fear mongering from Forbes.  Ok, nevermind, no I didn't.

Pretenders may jump on the private equity band wagon, and they may crash spectacularly, but solid professionals will always find ways to improve efficiency and add value though the incentives of debt. Buyouts are as American as apple pie.

The problems arise when funds get to big and unwieldy (-cough- Blackstone V -cough-) to manage well, and the law of large numbers starts eating into returns.   Add to that the level of pain SarOx has mandated public companies now endure and then who could act surprised when they jump off the exchanges by the dozen?

No doubt there is a bubble.  No doubt it will burst.  Soon.  But, as in the 1990s, buyouts will go on. Thank god I work in a smaller fund. I'm looking forward to seeing the riff-raff cleaned out.

-ep

PatArb: Leveraging Law

In economics, arbitrage is the practice of taking advantage of a state of imbalance between two or more markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices.

When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state. A person who engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives and currencies.

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium. An arbitrage equilibrium is a precondition for a general economic equilibrium.

                            - Wikipedia

It is hard to dislike the Wall Street Journal's Law Blog.  Today a posting by Peter Lattman quotes a Washington Post story with background on the Research In Motion/NTP case.  I think it illustrates an interesting market trend.  The trend towards exotic arbitrage.

There was never any dispute that Research in Motion Ltd., the Canadian firm that introduced the world to the BlackBerry in 1999, came up with its own technology to power the wireless e-mail device.

But Thomas Campana Jr., co-founder of a small McLean firm called NTP Inc., noticed an uncanny resemblance between the BlackBerry technology and a technology he had developed years earlier.

When he and business partner Donald Stout contacted RIM in 2000 about obtaining a license for the NTP technology, however, they didn’t get a response. (emphasis added)

Six years later, the dispute has been settled, with RIM agreeing to pay $612.5 million to NTP to resolve the patent dispute.  I keep hearing the words "nuisance suit" used to describe NTP's action, but for some reason the authors of that sort of text never mention that RIM had an offer of $450 million on the table.  Hardly the kind of price one would expect a firm to voluntarily offer to dispose of a mere "nuisance." These authors also seem to forget that a jury found against RIM on 5 patents.  They also found that the infringement was "willful."  Ouch.

Also remember that RIM was hardly underrepresented.  Jones Day and Howrey Simon Arnold & White, RIM's attorneys, are about as big as those guns can get.  I wonder what their bill was.  NTP spent at least $7 million.  The return to NTP after legal fees?  Assuming we amoritize the legal expenses equally over the timeframe of the lawsuit, with about a 20% boost to the first year for "start up legal expenses" and minus the 33% cut the patent firm will take, I show IRR returns to equity for NTP of around 1,090%.  Wow.  Rim, by contrast, took a $294.2 million "litigation charge" back in April of last year.  That number seems large to me.  I wonder what it is composed of.

How did things get so far?  Said U.S. district court judge James Spencer: "It seems to me that some of the folk took it personally, and that's how it got this far."  NTP started talking settlement immediately.  According to NTP's Donald Stout: "We were always surprised that RIM didn't want to explore settlement. We had a very preliminary discussion after the suit started. They offered us nothing, so we said, 'Here we go.'" Arrogance on the part of RIM?  Imagine that.

Of course, the case has stirred up a lot of loud squawking about reforming the patent system in the United States.  To some degree I believe these calls are warranted.  In other ways, I think this "egregious" case isn't all that egregious.  Recall from the text above that RIM had a chance to deal directly with NTP and come to an arrangement (back when the valuations were small and a fairly harmless deal could have been struck).  RIM decided instead to stonewall.  In this, I think it is quite easy to underestimate the importance of the date.  2000.  The high-flying, invincible tech attitude that drove the markets to the outer reaches of the atmosphere also made it easy to blow off a small McLean, Virgina firm writing with patent concerns. (They aren't even in California, for christsakes!  How can they be a serious tech company?)

There is an issue in patent law in the United States that is somewhat obscure, but also important.  In short, the critical element is that the patent holder has a lighter legal burden to meet than the potential infringer.  This is where the arbitrage part comes in.

I define arbitrage a bit differently.  I define an arbitrage opportunity as any case where costs, returns or price differs between two choices in an amount in excess of the switching costs.  Using cashflow as a criteria, which the Wikipedia definition does, seems wrong to me.

A patent with its potential for injunctive relief, is really an option on an injunction.  In fact, options theory is often used to put values on patents via Black-Scholes.  One author, Alan C. Marco, goes so far as to develop a real options theory for patent litigation.

All this is a long way of getting to the point that because there is a perceived "mispricing" between patent holders and accused infringers, (the cost of an option on an injunction and therefore some finite level of expected value) is far below the cost to the accused infringer to dispose of the matter.  Arbitrage theory would suggest that money will quickly pour into patents with litigation potential.  Of course, this is already happening and firms that do nothing but hold patents and litigate them have cropped up.  To the extent they have investors to cover the litigation costs for a percentage of the carry (NTP had 20 stockholders in addition to the founders and the founders gave away only about 50% of the ownership in NTP to 20 other shareholders) they already look like a hedge fund.

As conventional arbitrage opportunities begin to thin (that's what happens when you pour money into an arbitrage opportunity; it approaches equilibrium) hedge funds in particular, beset by hyper-expectations they have managed poorly over the last several years, will be forced to look for more creative opportunities.  Enron's trading desk took advantage of these sorts of imbalances in the California energy market, which cannot have been designed by anything other than Stanford grads.  You cannot have your cake and eat it too in a near-liquid market.  Arbitrageurs will eat your lunch, and then happily snack on the cake you were counting on for dessert.

So, what areas might we see big growth in?  Anyplace where there are regulatory or other mispricing issues.  Patent Litigation Arbitrage is clearly on the rise.  (We had one firm recently pitch us on funding a bankrupcy filing for a residual in the assets, not that this is a new thing).  And, of course, NTP just woke up the sleeping bears by nabbing an entire year of EBITDA from RIM.  Minority Shareholder (Shareholder Activism) Arbitrage (read: Greenmail Arbitrage) is nothing new, but the focus on shareholder rights and the increasing levels of suspicion afforded management in the wake of Enron, SarOx and the like are the incentives here.  Hello Carl Icahn. And, of course, SarOx arbitrage (i.e. "Going Private").

Ten Years. That's Half Our Lives.

The Wall Street Journal is out today with an article on the 10 year Treasury note.  This is important to us LBO types, and anyone who does DCF valuations, because the 10 year note is what we use to determine the "riskless rate."  (It's not really "riskless" but it's close enough for the moment).

It bothers me, of course, because it is a hint of higher interest rates to come.  (That means higher payments on all that debt we have out there).

I like it because the yield curve is flattening out.  Yum!

Arbitrage Blood in the Water

I have to think that, cool as it looks, the folks at Intrade are in way over their head in the futures markets.  They currently have trading in daily closing price futures for indexes like the S&P 500.  Though they bill their service as "prediction markets," in fact, they aren't totally.  Instead, they are acting as a new financial futures market.  I cannot imagine that the market there is sophisticated enough or liquid enough to be efficient yet.  Some aspiring young trader type, or even just a good script programmer with some finance theory under their belt, could clean house, I suspect, by taking advantage of the exchange (owned by what is effectively a sports betting company) and the naiveté of its traders.  One could easily arbitrage their entire S&P contract set against CME's E-Mini S&P 500 futures.

Just looking at the market briefly today I spotted a quick arb play between the "S&P 500 to close DOWN by 2.5 points or more at 1pm EST" and "S&P 500 to close DOWN by 5 points or more at 1pm EST" futures pricing.  There looks to be about $750,000 at risk in Intrade's top 5 contracts.  Pulling even a 2% per day return would be a nice catch.

I'm not sure what Intrade thinks they are adding to the equation.  These kinds of futures in exchange indexes are already VERY well covered and the people who play with them at the smaller capital levels Intrade is permitting are unlikely to have the needed sophistication to compete with the real sharks in the futures world.

Then again, it is interesting to see that the "market" thinks there's an 18.5% chance that "Abu Musab al-Zarqawi to be captured/neutralised by 31 Dec 2006" will pay off.  (The British spelling is ubersexy enough to make even a hardened finance girl moist too).  Still, they don't seem to be capitalizing on the real opportunities in prediction markets that the DoD bungled.  Where's the "major terrorist event by January 2007" contract, for example?

Well, even if the DoD missed the boat, there are a series of these upstarts.  Perhaps someone will get serious about them eventually.  As with any new market, the early period of inefficency is a huge opportunity for a seasoned player.

On Excess

Behold the very definition of excess.

Arrogance

Some stereotypes get to be stereotypes because they are primarily true.  That finance professionals, particularly those from certain firms or certain schools, are arrogant is, at least in my experience, true. I swore to myself when I took this job that I wouldn't go down the road of superiority in this way.  I promised that I would try to maintain perspective.  Dedicated myself to keep an open mind.  That lofty ideal lasted about 4 months.

This job breeds contempt.  Oh I love it so.

The thing about buyouts, as in sales and trading, is that your value is extracted at the expense of someone else.  Every time we buy a company we are in effect saying, "we paid less for this then we can get for it, and we can run this better than you ever could."  The difference is that in sales in trading you are saying this to some anonymous other trader with a thick skin and the protection of an anonymous terminal screen between you.

The due diligence process supports this turn of the psyche.  Due diligence primarily orbits around the concept that there is something wrong and that the current management is either unaware of it (in which case our business acumen is superior) or actively concealing it (in which case we are ethically superior).  Often, however, our suspicions are correct.  That's not to say we don't create our own problems or make different mistakes in the company once we get our hands on it.

As for investigation?  We spend our diligence time finding faults, highlighting them and exaggerating their impact and effect.  We are the arbiters of failure.  Soon it becomes easy to find fault in everything.

So much gamesmanship surrounds the process, in fact, that you grow used to thinking of other parties in the transaction as the dupes and victims of the "negotiating strategy" and "diligence tactics" you deploy.

You develop similar ideas about the employees in your portfolio firms.  (At least the ones still left after the firings you oversaw).

God forbid you went to an ivy league.  -cough-  Then you start to think the same thing about your peers in other PE firms.

Really, I think this kind of bitching is just a response to the pressures of the job.  It is a lot of really hard work.  Small things, like dry-cleaning- which drives me batty- get under your skin.  Near perfection is your metric for everything.  You are hyper-sensitive to any, even slight, waste of time.  (That's just a consequence of living in New York City).

You start to use phrases like "We can put a man on the fucking moon but no one in your marketing department can do a price elasticity regression?" with the portfolio companies.  You respond to the growing loathing the employees have for you with "I am here to get this business back on track, not to win a popularity contest."  Of course, these things are true.  You aren't in a popularity contest.  (Or you are losing it very badly).  We can put a man on the moon.  No one in the marketing department can do any kind of regression at all.  The new associate who just joined is lazy and can't be counted on to put the firm first and, goddamnit, there is just no place to get my best suit dry-cleaned.

Imperialist Democracy?

Martin Lipton's objections aside, the Economist seems to think little of the new "Imperialist Shareholder," and in fact argues quite strongly in an article this week (Economist subscription required) that shareholders are quite a bit less powerful than they might seem. Lipton's primary argument was one of focus. Permit shareholders to go wild, he argues, and management will be so focused on short term gains that long term planning will fall by the wayside.  Similar arguments are made to support the notion that firms shouldn't give quarterly earnings guidance, or seek to maximize quarterly earnings.

Funny that it would be Time Warner now, and Carl Icahn's siege of that firm, that prompted Mr. Lipton's outrage.  Back in 1989 a Delaware court backed Time against a hostile bid by Paramount.  (The famous "Just Say No" case resulting in the "Nancy Reagan Defense").  The case resulted in the adoption of "Poison Pills" by management all over the country and a series of takeover defense mechanisms with names like "Bankmail," "Flip-out," "Flip-in," the "Pension Parachute," the "Pac Man Defense," "White Squire," "Jonestown Defense" and the dreaded "Goodbye Kiss," all shifting the balance of power to management and from shareholders.  Poison pills had been around since 1982 (in fact there is a strong argument that Lipton actually invented them) but their sudden widespread adoption was a dramatic shift.

Of course, hedge funds are getting in on the gig and, as I've mentioned before, they look quite like the new greenmailers.

But then what does this mean for the smaller shareholder?  According to the Economist, not very much.

As Bob Monks, a shareholder activist, puts it, “the American shareholder cannot nominate directors, he cannot remove them, he cannot—except at the arbitrary pleasure of the SEC—communicate advice to them. Democracy is a cruelly misleading word to describe the situation of the American shareholder in 2006.”

Personally, the increasing heat on the management of public companies convinces me that private equity, even with the bubble like signs it has begun to show, has a long and valued place in the microcosm of Corporate America.

Unintended Globalism Consequences

The Wall Street Journal ran a piece this weekend on Carl Icahn's latest shareholder activism (read: hostile takeover) efforts at KT&G, the Korean tobacco concern.  Icahn is pressing for control of the firm which means, of course, that he believes he can extract significant value through superior management (or be annoying enough to be bought out at a premium).  He just won a board seat for an ally of his.  A nice victory (but just a single step forward) given his recent back-down from Time Warner.

KT&G's history is an interesting one.  State owned and a monopoly until 2002 when privatization (read: taking money from foreign institutions) took them public.  They have benefited greatly from foreign capital and for the longest time haven't carried any debt at all.  I will leave it to the students of finance to comment on the wisdom of that particular fiscal strategy.

As is becoming typical of such endeavors, Icahn has an ally in other activist firms overflowing with cash.  In this case, Warren Lichtenstein, who leads the hedge fund "Steel Partners II, LP."  There is a side of me that wonders if Icahn, when he sits down with the likes of Lichtenstein and plots a takeover, isn't revealing material non-public information in the process.  Certainly, that Icahn is plotting a takeover would be material, no?  Why should Lichtenstein benefit before the rest of the market?  Ah, well.

Korea is particularly closed as a capital market jurisdiction.  It is also very isolationist.  That is changing, clearly, given that the activism at KT&G is the first foreign led hostile "takeover" (I use quotes because so far they haven't committed totally to a pure takeover) in the country ever.

I found it comic that the unions picketed Icahn and that the move is spawning a great deal of hatred for foreign capital under the thin guise of nationalistic pride.  Take heed, foreign firms: You cannot have your cake and eat it too.  If you take foreign capital, enjoy the advantages thereof and then try to lock out foreign shareholders (KT&G earnings releases are in two versions, Korean and English.  Guess which is the more extensive.) then don't expect them to roll over and play dead.

Exeunt omnes

The always excellent "The Big Picture" today leads with a column tagged "Lots of jawboning out of the Fed these days."  I find this both interesting, and alarming.  The issue of central bank transparency is not even remotely new, of course.  The trend in the last decade has been to more openness which, in the context of a free economy, seems the course most aligned with market philosophies.  (It is maybe no accident that Alan Greenspan is an Ayn Rand disciple and used to be a jazz saxophonist).  That pronouncements by any Fed Chairman can move markets is not new.  But caution is the better part of valor in this context, I think.

The grip with which the markets held the collective armrests of the movie theater chairs when Greenspan assumed the podium, however, is a more recent phenomenon.  So much so, in fact, that one can find substantial research measuring the impact of the former Chairman's pronouncements (and even the anticipation thereof) on the market.  My favorite recent work in this field is Chirinko, Curran, "Greenspan Shrugs.  Formal Pronouncements, Bond Market Volatility, and Central Bank Communication," January 2006 (183k .pdf) which, in summary, notes "the possibility that one or more aspects of [the Chairman's scheduled public statements] may be counterproductive."

What worries me, however, is that on the heels of a highly respected (even worshiped) Chairman, the incoming "younger brother" might be subject to overcompensation.  Bernanke has already fallen into the deadly trap of taking sides on spending and tax cuts when asked.

Part of Greenspan's charm was his inscrutability.  His pronouncements were delivered with such measure and pace that even a hint of bias was seized upon by the market.  Fed watchers once spent untold hours examining photos of Greenspan's briefcase as he walked into Open Market Committee meetings, the idea being that a full briefcase meant he had brought substantial supporting materials to support a target hike. CNN's Eyes on the Fed even used to run pictures of Greenspan and the case on his way into and out of the meetings.  I heard a rumor that it was a clever "Fed Watcher" who put together this little correlation and that once Greenspan found out about it he would deliberately load his case with the same quantity of irrelevant papers before entering the building.  As with everything Greenspan, the truth is probably unknowable (until the Memoirs are published- I can't wait).

All this is a way of saying that I think a Fed Chairman needs to be a bit of a showman.  Flirtatious.  Hard to get.  Coy.  Would we have the words "irrational exuberance" if Alan "If you think you understood me, it's because I misspoke" Greenspan was constantly holding court?  Would Greenspan's memoirs fetch something like $9 million if he hadn't been an inscrutable enigma for so long?  I don't know.  (He never returns my calls anymore).

Race to the Top (Bottom)

I enjoy Conglomerate Blog.  Particularly when entries like today's "Private Equity, Illinois Pensioners and Sudan?" make the page.  New contributor Bobby Bartlett pens an interesting yarn about Illinois' attempts to prevent funds of all kinds from investing in the Sudan.  The mechanism is to require from all pension funds over which Illinois has jurisdiction documentation that they have not invested in any vehicle (including hedge funds and private equity) that in turn invests in the Sudan.  The pension funds are expected to obtain this certification from the vehicles themselves.  The result is predictable and Bartlett summarizes it thus:

...private equity funds are already concerned with the additional disclosure burden of having public pension fund investors, and the Illinois legislation seems to be viewed by many private equity investors as simply one more reason to stay clear of “public” money.

Forgetting for a moment that such embargoes are probably most properly left to the Federal Government to enforce, and that Illinois means well, the entire situation is an interesting demonstration of the powerlessness of governments to influence large (or even medium sized) investment vehicles.  Switching costs have become quite low and many funds have already fled the United States to avoid regulation. Soros is a famous and prolific user of offshore jurisdictions.

Financial disclosure is, of course, key.  But I think the pendulum has swung too far.  The United States risks being marginalized when it comes to alternative assets classes by jurisdictions like Luxembourg or the Islands.  The United States is going to have to come to grips with the fact that burdensome disclosure will, first, press talent into private ventures, then if, as I suspect it will, the United States attempts to clamp down on those vehicles, those too will flee, taking with them their profits and tax revenue therefrom.  Of course, I am a fan of private equity.  There is a reason that it has become a highly preferred vehicle for high-risk, high-reward investment.  There is a reason that the balance for talent and capital has tilted in the direction of firms like the one I work for.

It would be interesting to see what a survey of entering MBA students list as their primary motivation from coming to business school is.  Then again, insofar as "interesting" means "surprising" it might be quite bland.  Hedge funds and private equity would, I strongly suspect, feature highly.  With all the whining about American educational competitiveness you'd think anything fostering the huge suction into United States' advanced degree programs would be a good thing.

We are actively shopping for our next vehicle.  The United States isn't even in the cards, even though we plan to invest here (and perhaps even manage the fund out of Manhattan offices).  And, of course, we don't touch "public money" either.  With a track record you don't have to.  There is enough sloshing around for everyone in the top quartile.

All of this might actually have an unintended effect.  If the big "private equity bubble" exists and is about to pop, Illinois might weather it well.  I doubt it, but we'll see.

Debt Bitch

Right after I joined the firm I spent several weeks meeting with people from the leveraged finance desks of a series of investment banks.  The point, of course, is to develop a strong relationship with a few key players who dole out leverage for buyouts and inspire enough trust to buy yourself concessions when it matters.  Initially, I thought this a fool's errand.  Why, after all, would hardened bankers give up even a touch of advantage because you bought them a few drinks?  This was the hardened, hyper-capitalist realm of Wall Street, wasn't it?  What had happened to "if you want a friend, get a dog?"

While I didn't think it particularly useful for the reasons suggested by, among others, Armin, I went along.  It would, certainly, be useful to know the players in any event.

Of course, what I didn't properly account for was that the debt gang at banks are trying just as hard to schmooze the private equity folks for deal flow.  They are as anxious to take us for drinks as we are to take them for dinner.

At the crack of dawn, Armin's driver took me down to the Midtown offices where I picked up Laura, our "Debt Associate," affectionately the firm's "Debt Chick."  Sometimes, owing to her tough-as-nails reputation on interest rate negotiation, our "Debt Bitch."  Laura was a tallish brunette who wore a lot of Hermes scarves.  They became a sort of trademark for her.

The Debt Bitch and I had arranged for a whirlwind tour around Manhattan.  We scheduled 5 meetings starting at 9am and going in a sort of radiating pattern emanating from the nucleus of our offices.

Most of our little jaunts were only 30 minutes or so.  Sure, we had a pair of deals, here's the initial materials.  Are you interested?  Oh, this is Equity Private, by the way.  Equity will be around more and more as our newest Vice President.  Well, give me a sense of where you think we are on this.  We'd love to see your term sheet.  Drinks?  Later tonight?  Could be.  Excellent.  Ciao.

Sometimes we'd meet a Managing Director, but typically it was at the Vice President level.  Oddly, a private equity Associate seems to start off life at the Investment Banking Vice President level.  And as a Vice President, I seem to spend a lot of time being introduced to Managing Directors at Investment Banks.  At least, that's how it seems to work with us.  Title inflation, perhaps?

Our fourth meeting was with Morgan Stanley.  Apparently the Morgan Guy, let's call him "Nicholas," prefers to meet outside the office.  Later it was explained to me that Morgan can be a pretty oppressive environment and that therefore their younger people took any excuse to get out of the office that afforded itself.  A date with the Debt Bitch, I figured, had a reputation for being a good gig.

I was puzzled because though we planned to meet for a late-lunch "drink," Nicholas insisted we come up to the office before heading out.  Nicholas turned out to be a five foot five, blonde haired and blue eyed workaholic type.  At first I figured he just wanted to talk some shop before we went anywhere and that he preferred a more professional environment for that sort of thing, but when we were shown to his office his reaction was strange.  He and Debt Bitch locked eyes silently for a solid and wordless twenty seconds and after that the first thing he did was grab his coat and lead us out.

"What's the story on the useless office visit?" I whispered to Laura while Nicholas ducked into an Associate's half-office and gave some instructions.

"Well, he needs some people to see that he's going out with 'clients,' and not just 'going out.'  The 'face time' thing is big here."

"That sucks.  Does Nicholas pull this often?"

"I've never met this guy," she told me.  This surprised me.

"The way he asked us out for drinks and the way he looked at you, I assumed that you knew him well."

"Never met him," came her reply.  It was short and abrupt.  Laura, though I barely knew her, was prone to long, expressive discussions.  I was sure she was hiding something from me.  I wanted to pry, but Nicholas emerged from the Associate cell and led us to the elevator banks.  On his way out he announced loudly, "Headed out with the folks from Sub Rosa," here he jabbed a thumb back through the air indicating us to the admin.  "Be back in a couple hours."  Laura gave me a knowing look.  That was for the benefit of any Managing Directors who might later ask.

Constructive Debate

The Corporate Tool has an interesting comment today about the negative impact hierarchies have on frank and open discussions in organizations.  Emphasized is the chilling effect strong personalities are likely to have on the willingness of subordinates to speak their own minds.  The paradox, of course, is that excatly the strong, outspoken superiors that are needed to get new views into the organization tend to stifle the rest of the group.

This is a very particular dynamic in private equity firms and The Corporate Tool has gotten me thinking about the merits of these systems.

The alarming thing about private equity firms is that structurally, they often have huge centrifugal forces (specialization and conflict) matched only by the equally substantial centripetal forces (outlandish compensation and the golden handcuffs in text of the partnership agreement).  In this case the centrifugal force is really the inertia of a given partner's specialization.

Private equity firms, both VC and buyout, generally select and retain partners for specialized roles.  Often these are along industry vertical lines.  Larger firms also might have a "big name" or two who act as the rainmakers and have the connections, or are the generalists with access to capital and debt.  Usually, these are the "managing partners" but it varies from firm to firm.

This is the typical structure in buyout and VC firms.  It is also highly destructive.

All partners are expected to bring in potential deal flow in smaller firms.  Naturally, this means that partners bring in deal flow from their particular area of expertise.  It also fosters a "champion" model of deal review.  The "aviation" expert, for example, will find a hot aviation deal because those are the personal connections she has.  She knows the ins and outs of the deal and has a good grip on what is required to make it work.  She likes the deal.  She knows a few of the players in management.  She immediately becomes the deal's Champion.  This, unfortunately, forces her to press the deal to the other partners who, by definition, know less about the deal's merits and don't particularly care to expend the resources required to understand them.  Aviation is a dead industry, they might believe.  Look at all the airline bankruptcies.  Let's invest in automotive instead.  There are a lot of good values now that that industry is being shaken out.  (I actually heard this incredibly ironic exchange among members of another firm).  Complicating things, often a rather droll process for approving investments requires input from all the partners before a deal is consummated.  It becomes obvious quickly the kinds of conflicts that can arise.

The consequence of big partner egos is that everyone needs a say.  The deal approval process is therefore burdensome and to the extent each partner has their own favored deals and there are, by definition, somewhat limited financial resources to do deals, something has to give for a given partner to get a given pet project "through committee."  The resulting debates often look remarkably like jockeying for a finite amount pork in Congress.  Tempers can flare and coalitions and enemies emerge.  Soon you have 7 people working together that don't actually like each other very much.  They all wish they could go their own way.  They are held together for another 5 years by a 7 year life span of the fund and illiquid stakes. Ugh.

The Corporate Tool Suggests:

So what can leaders do to encourage openness? Roberto suggests actively seeking dissent by soliciting it directly, having staff role-play adversaries, or even appointing someone as devil’s advocate on a proposal

Sub Rosa has done this from the beginning.

When a deal comes in the closest thing we have to an industry expert does a little briefing on the industry for two "advocates."  The advocates are assigned randomly but since Sub Rosa is small, it is generally two of the same four people.  The idea is to keep people who already know an industry out of these roles.  This has two purposes.  First, to get the junior members of the firm to learn the industry (I cannot emphasize enough how important this is to the life-cycle of the firm and how rare it is to find in private equity).  Second, to avoid undue bias by the deal advocates.  The concept is somewhat similar to the American jury system in this respect.  One advocate is randomly "pro" the deal and the other advocate is the "risk" advocate.  They get some prep time and then present their arguments to the investment committee.

It is less adversarial than it sounds.  The "risk" advocate is tasked more with identifying and describing ways to mitigate risk than shooting down the deal.  The "pro" advocate is tasked with making the "do the deal" case, including returns analysis, a read on the politics of the capital structure and stakeholders and developing a financing structure.  The presentation is formal for the first half and then is passed into a constructive discussion phase.  Is there enough return? How can we be creative about the risks we have identified?  Can we get comfortable enough with them to do a deal?  How?

By assigning specific roles that require advocacy from junior members of the firm we avoid the "Champion" structure and continually build both generalist and specialist knowledge in the junior members of the firm, who eventually are slated to run the place so that the existing partners can have a sort of pension from their carried interests without spending 90 hours in the office when they are 60 years old.

As a system it is not without its problems.  There is the risk of it turning into a Soviet style Aerospace program if the two advocates are not constructive in their discussions, but, let me tell you, it is a hell of a lot of fun.

Debt Bitch Part II

We ended up walking into Joseph's without a reservation or so much as a "by your leave" and plopping down at an upstairs table next to three older women, classic New Yorker widows I suspect in their 60s or even 70s who looked to be well on their way to being seriously sauced.  The annual meeting of the spinster society.

By contrast, our "meeting" immediately turned weird.  Very weird.  Laura and Nicholas were constantly locking eyes and having this strange exchange which excluded me entirely.  By the third time they connected like this, and all the while debt-speak was pouring out of Nicholas' mouth, I was beyond unnerved.  I was certain they knew each other and that there was some deep secret event or happening they needed to discuss without cluing me in.  If their goal was to keep me from noticing, their efforts were a total failure.

If I was in shock before, I slipped into near heart failure when first Nicholas and then Laura, without hesitation, ordered vodka martinis like they were club sodas.  Suddenly, it felt like the 80s again.

It was just as my frustration and curiosity was at its peak when something clued me in.  The formerly constant chatter from the spinster table, which was behind me, had fallen silent.  I hadn't seen them pass by, and since our table was between them and the door I figured something unusual had passed.  Over the course of 4 minutes I engineered to drop a piece of silverware behind me so I could turn around and determine what had stifled them.  They were all staring, rapt, at our table.  Or more directly, at Laura and Nicholas.  It hit me.

Who better to detect lust vicariously than these three?  Nicholas and Laura weren't hiding some critical business deal from me, afraid I would take the credit or something.  Laura was just trying to avoid being labeled a slut on her first full day with the New Vice President.  When I looked at her again I could see it.  Lightening had struck her.  She was screwed.  Or rather, about to be.  They just wanted me to leave so they could go somewhere and fuck.  I almost laughed out loud on the spot.

The best excuse I could come up with was that I had forgotten I had to finish up a model and could Laura handle the next meeting and meet me back at the office?  Of course she could.

Somehow I suspect Nicholas has never been so eager to see a potential client leave in his entire life.

What has happened to my psyche that such blatant sexual tension is totally lost on me even when it's slapping me in the face for 45 minutes?

Laura didn't make it back to the office that afternoon.  Nor the next day.

Project Velocity

At some point as discussions with a prospective target advance, us buyout firms want to lock the seller into advanced discussions that exclude other competing firms.  After a certain point this only makes sense.  We, the buyout firm, are about to spend a pile of money on lawyers, consultants and our own time and travel to assess the business more completely.  We're not going to spend that sort of money so some other firm can come and snatch it up at the last minute.  Typically this is after the seller has gotten an offer from us (that is contingent on our doing due diligence) and likes it better than what they already have on the table.

Shifting into "exclusive due diligence" is usually the next step.  For some period (60 days perhaps) the seller is prohibited from talking to other potential buyers.  The buyer feels safe, therefore, that the deal is their's to lose and they can commence more intense (and expensive) due diligence.  This can lead to abuse, as we run into occasionally including just this week on "Project Velocity."

If a seller is foolish enough to be obvious about the time pressure attached to a deal it is pretty easy for a private equity firm to construct an exclusive diligence schedule that makes it impossible for the seller to keep a firm timetable if negotiations break down.  Of course, many firms abuse this by putting high bids in their letters of intent and then working down the price aggressively on the excuse that substantial "problems" or "risks" were discovered during the diligence process.

By the time these revelations are uncovered, the opportunity for a competitive auction is limited at best.  The seller is stuck.  Some sellers are wary of this nuance.  Others are not.

Project Velocity involves a wholly owned subsidiary of a massive high tech firm (Velocity) you would surely recognize the name of.  It used to produce a key product for the market which was, within 2 years of being the singularly most revolutionary development in its category, another runner in a large pack.  In the last 3 years it has become entirely obsolete.  Fairly typical for tech firms with steep research and development curves that don't know how to manage their development properly.  More on this later.

Velocity, however, is bound to several long-term support contracts to maintain the product.  They need to continue to produce it and provide replacements.  Of course, back "in the day" it was common for large tech firms to sign up massive multi-year maintenance contracts (and book much of the revenue up front in some instances) figuring, in their arrogance, that they were certain to be the chief supplier for 7 years.  So now Velocity has a problem.  They have to honor these contracts, but they have long since left the manufacturing business and, instead, have "transformed ourselves into a service company."  Or so their latest public filings say.  Did I mention yet that Velocity pissed in excess of $500 million in IPO money away in under 5 years?

From my perspective, Velocity's problems started with their product being too good.  Yes, too good.  Riddle me this:  If you developed and patented an aircraft and air transportation system infrastructure system that reduced the price per mile of flying, price per pound of lifting goods and increased the lifetime between service of aircraft all by an order of magnitude, would you immediately set up transportation to all corners of the globe with this new system?  I would suggest that the answer here is "no."  Particularly if you were in the business of selling and operating such systems.

Rather than blowing away the market, you would improve things in increments, each time beating your competition's latest cost structure by about 10%.  Constantly one-upping them every time they improve and meanwhile causing them to tear out their hair in clumps wondering how the hell you were doing it and waiting for you to bankrupt yourself in a price war of their making (which you can never lose).  You would avoid the "single blip" approach because you would destroy all competition (and have the Justice Department all over you).  Also because you would leave significant revenue on the table.  You'd also destroy your own market.  The fleet you put in the field today would not need replacing for 200 years.  You'd never sell another aircraft.  This is a crude and heavily disguised example of what Velocity did to itself.  They commoditized their own market.  So severely, in fact, that being in the business has become a chore.  Innovation that went too fast.  Too much Velocity.  Sound Machiavellian?  Well, that's my job.

So now they want someone to take over the business.  It's "non-core."  We were the only ones talking to them until a pair of other firms got involved.  One firm, we happen to know from experience, is notorious for using the due diligence gambit to squeeze firms. Velocity wants to get something done before they have an earnings call for the first half.  They are playing right into the hands of our little diligence predator who is promising them the world, but requiring 90 days of exclusive diligence.  What can we do but warn them that their near-term and unintellectual greed (which ironically got them in trouble in the first place) is about to end poorly for them?  Nothing.

To paraphrase Gekko: Intelligent greed works.  Blind greed (ahem, quarterly earnings guidance) is counterproductive.  That is, of course, unless you are a consumer.  But why should we care about consumers?  No one else does.  Consumers were commoditized long ago.

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.

They Can Hide It in the Matress

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).

Long Live 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.

NYSE Buyout in the Works

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

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

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

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

Stay tuned.  More details below.

Calm Before the Storm

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

Project Sinister is, happily, mostly off my plate.

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

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

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

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

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

For Whom the Bell Tolls

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

The Wall Street Journal sounds the covenant alarm.

KKR Real Time Returns

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

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

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

SarOxidized

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

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

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

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

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

Bears Eat Blackberries, Don't They?

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

Ouch

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

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

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

Senior debt interest per year: around $10 million.

Junior debt interest per year: around $8 million.

Total interest payments?  $18 million per year.

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

Total debt service: $36 million or so.

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

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

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

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

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

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

Publicly Private

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

Quoth the Journal:

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

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

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

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

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

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

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

Slowly SarOxidized

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

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

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

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

Multiples Multiply
Source: Securities Data Corporation

Bartlett continues:

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

[...]

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

[...]

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

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

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

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

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

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

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

What Spaceward Ho! Taught Me

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

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

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

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

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

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

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

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

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

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

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

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

New, Now With 40% Less Covenants

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

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

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

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

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

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

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

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

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

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

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

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

Locusts No More

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

Dealbook, on Germany, locusts, private equity.

High Potential Energy

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

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