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

Offense and Defense - The Evolution of Takeover Strategy and Defense

One of the hot topics of today's acquisition climate is the role of activists.  While activism has been a hot topic before the situation today is a  bit different, with many boards actively listening to activists.  It is another step in the give and take of corporate acquisitions between bidders and targets.  In fact, the recent history of acquisitions reveals the continually evolving offensive and defensive strategies.   Consider just a bit of the historical give and take (not in exact order but close):

• Hostile takeovers were big in the 80's.  
• Poison Pills are invented by Marty Lipton (Enstar 1982)
• Acquiring firms started using junk bonds to finance deals.  Even large companies were vulnerable
• States enacted anti-takeover statutes to slow down hostile deals.  
• Courts strike down many of these statutes.
• States revise anti-takeover statutes to be in conformity with the law 
• Poison pills become a bit more popular
• Poison pills are challenged in the courts (Household International)
• Courts uphold poison pills (November 1985)
• Poison Pills become widespread. 
• Hostile deals decline
• Shareholder activism picks up but doesn't capture great momentum (Mid - 90's)
• Governance Scandals rock the corporate world (Enron, Worldcom)
• Sarbanes Oxley is passed
• Boards become independent in response to the law
• Shareholder advisory services gain influence (Institutional Shareholder Services)
• The financial crisis occurs
• Dodd Frank is passed
• Shareholder activism picks up speed - boards start to work with activists

Stay tuned.  It's a rapidly changing world.

All the best,

Ralph

Tragedy of the Commons in M&A

Attached is a piece on the tragedy of the commons in banking. It refers to a chain reaction (AKA herding?) in which the action of one bank triggers reactions from other banks leading to a dangerous race to the bottom in risk standards. It underlies the boom and bust cycles in many deal markets including M&A. As Ralph has noted in his anticipation article, once one competitor starts buying firms, others in the industry react. Early buyers tend to get better prices than late in the cycle buyers. Nonetheless, late in the cycle buyers are under pressure to “do something” so as not to be left behind. Hence they make over priced acquisitions. The key takeaway is firms do not operate in a vacuum and are influenced, sometimes negatively, to respond to competitor actions.

j

Managerial Indiscretions: Sex, Lies and Firm Value

Together with coauthors Brandon Cline and Adam Yore, we have completed a revision of our paper,  "Managerial Indiscretions: Sex, Lies and Firm Value".  By the time ethical problems are noticed in the boardroom, substantial shareholder wealth has been lost.  However, many executives are accused of ethical lapses in their personal lives - alleged indiscretions removed from the financial or operational aspects of business.  Are there firms impacted?  Are there signals of future corporate indiscretions?  Those are questions posed by our analysis.

From the abstract:

"Managerial indiscretions such as arrests, fabrications, and extramarital affairs are personal to the executive and separate from the business activities of the firm. We examine whether disclosure of these personal indiscretions are related to changes in firm value and subsequent malfeasance. Companies of accused executives experience significant short- and long-term wealth losses, reduced operating performance, and an increased probability of shareholder-initiated lawsuits, DOJ/SEC investigations, and managed earnings. Approximately sixty-five percent of accused CEOs retain their positions even among repeat offenders. Indiscretions are more likely in poorly governed firms where disciplinary turnover is also less likely."

The complete paper may be downloaded here.

All the best,

Ralph

P.S. Our friend Wes Gray runs a terrific blog called Alpha Architect. Wes also recently posted about our paper.  Check out his site!

Venture Capital and Sardines

Traditional VC investment has focused on firms in the rapid growth stage. These firms have passed the seed or idea stage by demonstrating an ability to generate sales-not necessarily profits. The current trend is an increasing focus on earlier stage investing known as pre-IPO investing. It is driven by the need to invest the large sums of new capital raised venture firms. In 2014 they raised over $30B which is 60% higher than 2013-albeit still substantially below the record in 2000. The investments are rationalized as part of a preemption strategy. These earlier stage investments have a host of different issues compared to more traditional VC-e.g. increased failure and liquidity risk and due diligence needs. I hope they come with higher returns as well.

VC hopes to invest in promising startups before traditional later stage competitors do so. Unfortunately, this is not much help if everyone is adopting the same early stage tactic. The newly funded startups can then exploit Network effects to achieve a First Mover advantage.  Both Ralph and I have expressed concerns with alleged first mover advantages. Its value seems as elusive as synergies in justifying M&A. The impact of all of this earlier stage investing is that VC is focusing more on momentum than the fundamentals concerning the firm, industry and the management team. As money flows in it inflates implied values - and prices. This positive feedback effect then justifies further increased investing at even higher prices.

This reminds me of studies on POW camp behavior during WWII. Prisoners used all sorts of things as money to trade among themselves and even the guards. One such medium of exchange was sardine tins obtained from Red Cross packages. Every now and then some hungry prisoner would open a can and eat the sardines. One day such a hungry soldier opened a tin only to find the sardines were rotten. He brought this fact to the attention of his superior. The wise superior calmed the soldier down by explaining there were two types of sardine tins-one for trading and one for eating. He had just opened a tin meant for trading.

Some day someone eventually opens a sardine tin and discovers they are rotten. Then investors start raising embarrassing questions about the nature of these seed firms such as who is going to buy their app and at what price for how long, their cash burn rate and can they raise additional cash if needed-especially if market conditions tighten. Then the market will re price and the price of sardine tins like seed companies will collapse. This is plight of most momentum based investing strategies. So just like the Wizard of Oz told Dorothy-don’t look behind the curtain or inside the tin.

J

The Venture Capital Lottery

Venture capital investing has never been for the faint of heart. It seems to be getting even less so with a new type of deal risk entering the market. The current VC environment is characterized as follows:

1)     Profitable exits 2012-2014 and LP distributions have increased the demand for VC investments.

2)     VC industry has responded to LP’s forgetting that past success does not guarantee future success by raising new VC funds to satisfy LP demand.

3)     VC funds are having trouble investing the funds raised in high quality investments and are engaging in higher risk transactions.

4)     The number of hyper risk lottery ticket investments is increasing i.e. investments in pioneer-idea only type firms (no sales) at high valuations.

Usually in such investments founders remain fully invested until later financing rounds i.e. they have skin-in-the-game and are committed. Now, VC are allowing founders to withdraw liquidity in the first financing round. This should send a negative signal to investors. If founders, usually an optimistic lot, are willing to share their upside, it suggests they are unsure about that upside. If founders have questions, then so should investors. Founder liquidity should depend on the firm’s success not the VC fund raising cycle. Remember, these firms must at least pass the revenue test, and hopefully the cash flow positive test before the end of the current up cycle in VC fund raising; otherwise they will fail.

This newest development is being rationalized as removing financial distractions from founders. May be I am cruel, but I want the founders to be paranoid committed to their firm’s success. If they want me to take the plunge, then I want them jumping alongside me for the entire journey. This development is another froth indicator in the VC industry along with nose bled valuations.

VC is moving into the lottery phase. In lotteries, the size of the prize, regardless of its likelihood increases the demand to participate. Everyone becomes fixated on the multibillion payouts of firms like Whatsapp. They are focusing on the greatest maximum return or variance, while ignoring the negative expected return. This is not investing-it is gambling.

I hope everyone had a Great Holiday Season.  I wish all a Happy New Year!

J

The Siren Song of Public-to-Private (PTP) Buyouts

A BC Partners consortium announced an $8.7B PTP buyout of PetSmart out bidding Apollo and KKR. The deal is the largest buyout of 2014 and one of the rare PTP transactions since the Great Recession. The purchase price is 9.1X railing EBITDA and represents a 40% premium to the pre bidding price. Its capitalization includes 20% equity and 7.2X trailing EBITDA in debt facilities underwritten by Citi, Jefferies, Nomura, Barclays, and Deutsche. The aggressive capitalization runs afoul of U.S. regulatory guidance. Perhaps that is why the bank group includes 2 non banks, Nomura and Jefferies, and 2 foreign banks, Barclays and Deutsche. PetSmart had been under activist pressure to improve its lagging stock price, which had only increased by 3% in the past year. The activist identified pricing, ecommerce and cost issues as factors underlying PetSmart’s performance problems.

More interesting than the deal is the possible return of higher risk-lower quality PTP transactions. PTP deals involve a PE firm taking a public firm private. The grand daddy of PTP was the disastrous RJR deal lead by KKR in the 1980s. PTP transactions are the poster boys of boom period deals. They reached almost 50% of the dollar amount of all LBOs before the financial crisis. The performance of PTP deals like TXU and Caesars, among others, caused PE firms and their investors to swear off PTP. Through 3Q14 the volume of PTP fell to less than 15% of LBOs-the lowest level in a decade. 

The issues with PTP include the following:

1)   Size: they involve large companies which entailed significant capital commitments.

2)   Fully Priced: public firms usually involve auctions which increases the risk of the winner’s curse. While PetSmart’s PPX seemed modest in the current market with PPX exceeding 10X-it still is over 15% higher than the median retail PPX over the past 5 years.

3)   Aggressive Financed: needed to offset the rich price.

4)   Limited Improvement Potential: most public firms have picked the low hanging fruit. Thus, the ability to achieve improvements needed to offset a 40% premium plus achieve a 20% IRR is questionable.

So why might PTP deals like PetSmart be returning? The answer is PE needs to deploy its substantial dry powder. LBO volume remains depressed at 2009 levels. A rising stock market and strategic buyers have simply out priced PE firms. Many recent LBOs have been Sponsor-to-Sponsor (STS) or pass the parcel deals. These involve one PE firm buying another PE firm’s portfolio company. Trouble is STS deals tend to smaller in size, and most the upside has been squeezed out by the original LBO buyer. As boilerplate PE documents highlights-GP carried interest depends on performance which means GP’s are motivated to approve more speculative investments than would ordinarily be the case. Yes, GPs are pirates, but at least they are honest pirates and state upfront what they are going to do to LPs.

PE restraint lasts only so long. When pressured by the need to invest GPs can no longer resist. PTP deals represent another sign, along with high leverage, that the LBO market is entering into a more speculative state. 

j

MergerProf will not publish this Thursday due to the Holiday.  Best wishes of the season to all our readers.