Exit Strategies for Private Equity

In our recent post, Business Risk, Financial Risk and Attractive LBO Candidates, we discussed the importance of exit strategies and valuations.  Exit strategies refer to the way private equity sponsors hope to sell and exit from the business.  Typically their time horizons are 5-7 years.  If a deal remains on the books much longer than that, the rate of return to the sponsor declines, sometimes dramatically.

Typical exit strategies involve:

1) An initial public offering
2) Leveraged recap
3) Sale to a strategic buyer (in the same industry)
4) Sale to another private equity firm

An initial public offering or IPO can offer the highest rate of return to sponsors if market conditions are optimal.  Note that we listed these as exit mechanisms, but an IPO doesn't necessarily imply an exit.  The shares of the company become publicly traded and thus liquid.  Sponsors can cash out wholly or partially,  but until shares are sold the private equity investor bears market risk.  Depending on the level of equity held, the sponsor can also retain ownership control.

 Similarly, in a leverage recap, the sponsor is not completely exiting, but merely levering the company back up and (generally) using the proceeds to retire equity.  It may be considered a partial exit as the sponsor is able to recover some additional investment.  An advantage is that while getting a return on investment, the sponsor is keeping ownership control.  There are often tax advantages to this method as well.  The disadvantages of high leverage are the increased risk of bankruptcy and loss of financial flexibility.

Sales to a strategic buyer in the industry can provide an efficient method of exit as you are negotiating with just one buyer who is a knowledgable player in your industry.  The seller usually has greater control over the sales process in a sale to a strategic buyer.  However,  existing management may be reluctant for such a sale as there is an increased chance of a change of control (i.e management being replaced). In addition, the loss of competitive secrets is an issue as you are dealing with another firm in the industry.

Finally, the firm could be sold to a financial buyer such as another private equity firm.  By this time, the major cost savings have typically been realized.  A sale in this manner requires the new PE firm to see possibilities unrealized in the first round buyout.

We'll continue our discussion in another post and, of course, in our upcoming Acquisition Finance Course in Amsterdam.

All the best,

Ralph

Determining Buyout Capital Structures

My prior post on Capital Structure focused on how traditional corporations establish their capital structures. This entry shifts to how highly leveraged buyout capital structures are determined. Little explanation on how private equity funds set leverage levels for their portfolio companies exists despite buyouts composing an important segment of the overall M&A deal market. As previously discussed, corporation capital structures are ratings based and tend to be permanent in nature. The ratings are tied to fundamentals including size, funded debt to EBITDA and interest coverage.

Buyouts have transitory capital structures driven by factors unrelated to corporations with their more permanent capital structures. Buyouts focus more on maximizing debt capacity utilization tied to market conditions. Hence, their capital structures are highly pro cyclical and drive buyout pricing levels.  (See  Buyout Leverage.)  This is based on the limited life of private equity funds (5 year investment period and 10 year overall life) and the compensation of the general partners (GP).

The traditional GP compensation structure is known as ”2 and 20”. This means they receive a 2% management fee on the funds committed by limited partners (LP) during the investment period, and dropping to 1% for the remainder of the fund’s life. Additionally, they receive 20% of the fund’s profits (AKA the carried interest) after a guaranteed minimum return to the LP-usually 8%. The option like carry is not risk adjusted. Like all options its value is positively related to risk. This leads to a GP-LP agency (conflict of interest) problem. GP are incented to take value destroying investments that cover the preferred return requirement, but not the investment’s cost of capital, to maximize their carry. They are further incented to take as much leverage as the market will allow to enhance their carry. The “great moderation” from the mid 1980s thru 2006 (see Moderation) with its falling rates, increasing profits and high exit multiples shrouded the real effects of these facts from many LPs. The facts became evident once the financial crisis occurred and devastated many buyouts and funds.

The evidence indicates that buyout volume, leverage and purchase prices are inversely related to the spread on high yield securities less LIBOR. (see Drivers) Thus, as markets peaked in the 2006-2007 period, debt spreads fell and buyout leverage surged. Once spreads widened during the 2008-2011 crisis, leverage levels collapsed. Currently, the QE based market recovery has lowered spreads to pre crisis levels. Predictably, buyout leverage levels are approaching pre crisis levels.

The standard corporate explanations for capital structures (trade-off and pecking order) have limited ability to explain buyout leverage levels. Buyout capital structures appear to be based more on market timing and agency factors. The unique contractual organizational structure of private equity funds compared to corporations influences the way they raise capital. This is another area where capital structure theory and practice seems to have a divide that needs closing.

J

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Acquisition Finance - Training in Amsterdam!

We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.   I thought I'd show last year's program to give an idea of our coverage.  This year's program will change to reflect current market conditions.  (One of the principal concepts we address in the program is the need to understand current market conditions.)  The basic content will remain the same, however, as will our approach: a highly interactive program combining theory and practice taught by an active researcher and an active practitioner.  We hope to see you there.

Joe and Ralph

Acquisition Finance - Overview of the Program

Day 1

Introduction to M&A Deal Design and Acquisition Finance

• M&A strategy
• Components of an M&A deal – where finance fits in optimizing M&A deal design
• Current conditions and trends in acquisition finance

Valuing the Highly Levered Transaction

• Techniques of valuing the target firm
• How financing creates – or destroys – value

Non-investment Grade Leveraged Financing

Private Equity Requirements

Framework for Analysis: the "Whole Deal" Approach

Case Analyses: Participants analyze and structure deals to better understand the interplay of capital structure, cost of capital, market products and deal design

Day 2

Designing the Capital Structure

• Identifying the range of financing alternatives
• Choosing the right mix of financing
• How lenders and investors look at the mix of debt and equity

Structuring the Financing

• Designing the terms of financing instruments
• Pricing the instruments
• The syndicated loan market
  -  Covenant late
  -  Second lien

• Developing the term sheet
• Risk analysis

Fixing the Broken Deal

• Decreasing senior debt
• Adding a back ended T/L C held by the originating bank
• Additional covenants
• Increased pricing

Additional Case Analyses of the Dynamics of Acquisition Finance

Day 3

Acquisition Financing in the Context of Negotiations and Auctions

• Acquisitions as bargaining outcomes; Behavioral finance
• Varieties of auctions and the incentives they create
• Hostile takeovers as settings for negotiations and auctions

How Financing Can Influence Outcomes in Negotiations and Auctions

Negotiating the Deal

• Understanding the needs of the other party
• The inter-related elements of deal design
• Bargaining on many fronts
• The ‘whole deal’ approach

Dealing with Risk in Acquisition Finance

• Earnouts – a great technique for closing the deal
• Toeholds
• Collars
• Termination Fees

Additional Case Analyses

Concluding Case in Deal Design

Setting a Capital Structure: The Great Divide

There is a great divide between academics and practioners on how to set a capital structure. Modigliani and Miller (MM) proved capital structure is irrelevant under a set of restrictive assumptions. Once those restrictions are relaxed, especially taxes, capital structure can have a major value impact. Academics have focused on the tax benefits of debt, thru the interest tax shield, to emphasize tax considerations in the setting of optimal firm capital structures Trade-Off Theory . An alternative information asymmetry based Pecking Order Theory also exists.

In practice, taxes have a much lower impact on capital structure decisions than theory would suggest-except for extreme cases (e.g. firms with little or no debt like Apple). In fact, while there is little opportunity to create value thru capital structure, there is the likelihood of destroying value given wrong capital structure decisions-especially having too much debt. Both of the main theories are unfortunately silent on how to determine precise capital structures.

Chief financial officers (CFO) are concerned with effective, not optimal capital structures. This means one which supports the firm’s financial strategy (e.g. dividends, flexibility and control). They are uninterested in minimizing their weighted average cost of capital (WACC).  Rather, they seek to preserve financial flexibility to fund their business plan under a variety of market conditions. This is expressed in their target debt rating from the major agencies including Moodys, S&P and Fitch Survey. Ratings are the language of capital structure just like the price-earnings ratio is the summary statistic for valuation. Ratings incorporate cost (debt spreads), availability (the non-investment grade market is smaller than the investment grade market) and terms (covenants) considerations that dominates other explanations of capital structure.

The ratings based capital structure approach used by most corporate (non Private Equity excluded and the subject of a subsequent post) involves the following:

1)     Ratings Factors: major considerations include firm size, industry and financial characteristics including fixed charge coverage (EBITDA/Interest) and funded debt ratio (FD/EBITDA).

2)     Target Rating: most nonfinancial firms chose a moderate investment grade rating between BBB+ and A-.This provides a balance between flexibility and cost. The target should be based on thru the cycle not just point in time considerations. The final decision is usually one for the board and should be periodically reviewed.

3)     Comparative Peer Credit Analysis: spread peers based on their existing ratings and financial characteristics. Focus on peers with your desired rating to determine your required financial ratios. For example, currently, A rated firms have interest coverage ratios of 3X or above and FD ratios below 3X.

4)     Testing: test against projections to ensure debt servicing ability.

This approach is equally applicable for smaller and private firms which do not plan on obtaining a public rating. Such firms should keep in mind that larger syndicated bank loans will be rated.

I am not criticizing the academic approach. Rather, I am pointing out a disconnect between theory and practice.

More to follow.

J

(Don't forget the upcoming Acquisition Finance Course in Amsterdam.)

Warren Buffett's Criteria for Acquisitions - Thoughts for Selling Firms

In last week's post, I commented on Business Risk, Financial Risk and Attractive LBO Candidates.  Today, I just want to note the correspondance of many  of these items with those stated by Berkshire Hathaway.  The items noted on their website are quite similar (with the exception of concentrating on large companies).  From their website:

"BERKSHIRE HATHAWAY INC.

ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

1. Large purchases (at least $50 million of before-tax earnings),
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations), 
3. Businesses earning good returns on equity while employing little or no debt, 
4. Management in place (we can't supply it),
5. Simple businesses (if there's lots of technology, we won't understand it),
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)."

These criteria tie in very nicely with what we noted in last week's post: Strong stable companies with good management and predictable cash flows make excellent targets for leveraged finance.  

Buffett concludes with his typical humor:

"Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me."

See our previous post on Buffett's advice to acquiring firms as well!

(Don't forget the upcoming Acquisition Finance Course in Amsterdam.)

All the best,

Ralph

Return on Equity: How Much Is Enough?

Linked to this post is my recent American Banker article on the dangers of using an incomplete performance measure-return on equity (ROE) Performance.  ROE is incomplete because it ignores risk. Thus, when used as a performance measure it encourages management to assume more risk in pursuit of their ROE objectives. This can produce problematic growth initiatives including high risk M&A.The article also provides a back of the envelope approach to calculate the cost of equity, and how it can be used to set performance objectives.

J

PS (Don't forget the upcoming Acquisition Finance Course in Amsterdam.)

Business Risk, Financial Risk and Attractive LBO Candidates

As the time grows closer to our Acquisition Finance course in Amsterdam, I find myself thinking of the relation between business risk and financial risk.  Business risk, of course, is the volatility in a firms pretax cash flows. Simply put, some firms have more stable business environments over time - without even considering how the firm is financed. Business risk is often measured as the variability of EBIT or EBITDA, although I've also seen the variability of sales used as a measure.  A utility like Trans Canada Corporate (TRP), for example, has much lower business risk than say, Dunkin Donuts (DNKN).

One of the basic concepts of capital structure is that business risk and financial risk should be inversely related.  A company with less business risk can afford (tolerate) more financial risk.  This concept for business should not surprise us - the same holds for individuals.  Imagine you and I are otherwise identical, making the same average income, etc  The only difference is that I earn my income by commission while yours is fixed.  It is not hard to see who can tolerate the most debt.

All of this relates nicely to LBOs.  When considering candidates we look for strong, stable companies with predictable cash flows to cover the increased leverage we will add to the capital structure.  In more detail, we would consider the balance sheet, the income statement, the company itself, the business cycle of the industry and any synergies.  For an LBO, it is also important to consider the exit strategy.

Let's consider these in just a bit more detail.  First, the balance sheet.  Good LBO candidates are those with low debt but high debt capacity and possibly non-essential assets or divisions than be divested to free up cash.

Now - the income statement.  Steady, predictable cash flows are important (i.e., the low business risk).   In addition, investors in LBOs such as KKR are interested in strong management teams.  This is important since private equity investors typically don't want to run the company's themselves.   They do want a strong managerial team that they can motivate with a carrot (high personal equity) and stick (high personal debt to buy the equity) approach.  Companies with low capital requirements and strong strategic positions in their industry are also desirable.

Possibilities for synergies are always desirable.  In an LBO this typically this includes paring expenses, or combining various firms (i.e., rollups) to create economies of scale.

The exit strategy is also important. A typical time horizon is 5-7 years.  Without a good exit plan, a relatively short term and lucrative investment can quickly turn into a less desirable or even disastrous investment.

A concept related to many of these items is the stage of business cycle for the industry.  One problem to avoid is the 'catch a falling knife' syndrome which occurs when investors purchase a company with declining cash flows.

Other considerations are important as well, but these are top of the line (or should I say bottom line) items.  We'll have more to say in Amsterdam and in future posts.

All the best,

Ralph