Monday, January 19, 2015

How Private Equity Creates Value: A Look Back


Carlyle purchased the industrial fastening and packaging firm Signode from ITW in 1H14. The purchase price was 9X EBITDA. They contributed $885 mln in equity representing around 25% of the transaction. The leverage multiple was 4.5X FLD (loans) and 6.5X total with a B/B2 rating. So how did it workout for Carlyle?

There are four levers PE can use to create value:

1)     Buy Right (i.e. cheap): this is increasingly difficult in the competitive domestic PE market. Here, Carlyle appeared to pay about market as it was competing against other PE firms for Signode. Signode was attractive given its established customer base and low cyclicality. Result-neutral.

2)     Financial Engineering (i.e. leverage): Carlyle capitalized on aggressive debt market conditions to obtain a relatively full leverage level with loose loan terms (i.e. covenant lite). Carlyle’s reputation and large dollar amount of equity contribution probably helped creditors get comfortable with financing. The large leverage level illustrates that PE firms really do not care about risk adjusted returns. All that counts for them is nominal returns, which of course are amplified by leverage. Result-positive.

3)     Improved Operations: an initial move was to improve working capital efficiency by increasing accounts payable to 60+ days, which freed up millions. Remember free cash flow= EBIT X (1-t) + D&A- (CAPEX + Working Capital Increases). Additional efficiency improvements and cost cuts were also planned. These were possible as Signode was no longer a division of ITW, but now a motivated highly indebted LBO. Result-positive.

4)     Sell High (i.e. multiple expansion): Carlyle signaled that they planned a liquidity event in 2016/2017. So far they are benefiting from an increase in PPX from the 9X paid last year to the current 10.5X. This combined with improved operations should provide multiple exit opportunities including a trade sale, dividend recap or IPO. Of course Carlyle cannot control market developments, but they can capitalize on them. Things can change before their planned value monetarization, but right now things look promising. Result-positive.

Bottom line, the transaction looks very promising despite Carlyle having paid a then full price. 
Most of the gains come from an old fashion carry trade (borrow and pay interest to acquire an asset with a higher cash yield) which appears to have worked out. Investors could have replicated the results by employing similar leverage to acquire stock in a comparable firm that would have also benefited from a rising stock market. Market timing is everything as other deals, richly priced at the wrong point of the cycle, like TXU and Caesars, have experienced trouble.

J



1 comment:

  1. s a staunch believer of the theory that a company's decision to fund revenue-gathering via its own balance-sheet (i.e. Tesco owning its stores) or on somebody else's (i.e. H&M leasing its stores) should not in any way impact a company's true cash flow returns, I find the part about correcting accounting measures into a true gross investment base especially rewarding and providing immense value to users. Behind the convenient summary-charts of real cash flow based returns lies a painstaking effort not performed by other market participants. The answer to the question "Why does HOLT perform so many adjustments to numbers" should actually be turned on its heed. The first questions to companies ought to be "why do you adjust your numbers so much"?
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