Sunday, January 29, 2012

The Rape of Persephone

Don't worry. The bruises will heal.
I never saw a wild thing
sorry for itself.
A small bird will drop frozen dead from a bough
without ever having felt sorry for itself.

— D.H. Lawrence, “Self Pity”

Now that Mitt Romney is running for the GOP nomination for President, it seems everybody and his brother is taking a whack at the private equity piñata. James Kwak recently took his turn at bat, and James Surowiecki clocked a couple swings himself. To their credit, both of them do a halfway decent job describing the private equity model, but neither one can be characterized as a fan. Kwak fears that private equity is too tempted by lax and imperfect financing markets to loot the companies they buy and leave creditors and employees in the lurch, and Surowiecki is displeased that so much of the profit in private equity is subsidized by taxpayers. Both of their criticisms hinge heavily on the financial leverage commonly used in private equity investments, so it is worth reviewing the concepts and practices in a little detail.

Private equity firms (or financial sponsors, as they are more commonly known in the trade) normally raise funds from a collection of institutional investors (“limited partners,” or LPs) like state pension funds, university endowments, sovereign wealth funds, insurance companies, and other asset managers. The sponsoring firm acts as general partner for each fund, and has a fiduciary duty to the fund’s limited partners to invest their funds prudently, profitably, and in accordance with the fund agreement. Each fund is an independent legal entity which has a limited life—normally ten years—and the goal is for the private equity firm’s professionals to invest the monies available in a discrete number of majority, minority, or other investments in particular businesses. For each such investment, the sponsor expects to hold the investment for some period of years less than the life of the fund from which the money came, and when the time comes the general partner will sell the fund’s investment on behalf of the LPs and split the profits, if any, with them.

Now most financial sponsors tend to invest in majority, or “control” stakes in discrete companies. That means they purchase a majority of the voting control (and economic value) of a standalone business, and they work closely with the management of the purchased company to realize their investment objectives. Usually, the senior management of the purchased firm holds a substantial minority equity position in the company—normally subordinated to the financial sponsor’s stake, and often in the form of common equity shares and options—which aligns their interests and incentives tightly with the financial sponsor and their limited partners. Sponsors buy these companies wherever they can find them: from private owners, family founders, publicly traded companies, the subsidiaries of larger companies, etc.

* * *

Deeply simplified,1 a typical control buyout looks something like this: Financial sponsor Big Bucks LLC negotiates the purchase of Company ABC for $200 million through its new special purpose acquisition company New ABC. ABC earns operating cash flow, or EBITDA2, of $25 million per year, which means the purchase multiple, or total enterprise value3 to EBITDA multiple, of the business is a very healthy 8 times. Prior to, simultaneous with, or after closing the transaction, Big Bucks sources debt financing to help purchase ABC from one or more lenders, which may be investment banks, commercial banks, hedge funds, or any number of institutional investors. (Some of these direct lenders are the same or similar institutions that invest as limited partners with private equity firms like Big Bucks.) Let’s assume the lenders like ABC’s business and credit profile, so they are willing to lend a generous 5 times EBITDA or $125 million to New ABC to help buy ABC. Big Bucks puts up the balance required, $75 million, in the form of equity. (Pace Mr. Kwak, this is a far more common capital structure nowadays than the 80% debt/20% equity structure he posits in his article. In large part this is due to competition among buyers of corporate assets.) Big Bucks puts a few members of its deal team on the Board of New ABC, and it’s off to the races.

In a perfect world, Big Bucks would like to exit from its investment within three to seven years, having made a hefty return on its limited partners’ money. To do that, the equity value of the company must rise. If the sponsor can realize a final equity value in excess of its initial investment of $75 million, it wins; if not, it doesn’t. It’s as simple as that. There are only three basic ways the final equity value of New ABC can get bigger than the initial investment: the multiple on sale increases, the sponsor uses the company’s cash flow to pay down debt due, and/or the company’s earnings increase. (Remember the lenders must be repaid first, so the equity value is simply the residual of the sale proceeds after debt has been repaid or refinanced. If the debt balance declines—assuming the enterprise value remains the same—equity value must by necessity increase.)

Now the first value creation method—increase in the selling multiple—is almost entirely outside the control of the financial sponsor. It depends on market conditions at the time of sale, many years distant, and demand among buyers for New ABC. Sometimes the sponsor can tilt the field in its favor by buying the asset particularly cheaply, but the growth in the private equity industry itself and the increased competition among rival sponsors has made this opportunity increasingly scarce. In addition, sell-side advisors and investment bankers like Yours Truly do everything in our power to prevent any buyer, financial sponsor included, from buying companies cheaply. Much to private equity’s chagrin, we have gotten pretty good at it.

The second method requires the sponsor to use excess cash flow generated by the business (after it pays suppliers, employees, interest expense, and the like and invests required money in maintaining or improving capital assets and financing the company’s working capital needs) to repay the debt used to buy it. But given that financial sponsors typically try to minimize the amount of equity they put up in the first place (remember: their return on investment depends on having as small a denominator as possible), they usually load the business up with as much debt as prudently possible at the outset. This means, after accounting for cash operating expenses and required capital and working capital expenditures, the typical private equity investment has very little free cash flow to direct toward debt. Unless the company’s earnings and free cash flow increase, the only way to direct more cash toward debt repayment would be to starve capital expenditures, cut operations to the bone, and generally milk the property dry. This is the caricature of private equity as “vulture capitalism” which so many commenters condemn.

But this rarely happens, and almost never intentionally. Because remember: the private equity firm and its investors only make money if they take more money out than they put in. And starving a company of resources it needs to sustain and grow future earnings destroys value. Think about it: the next buyer of the company is almost certain to be a sophisticated buyer itself, and they will figure out pretty quickly if Big Bucks has permanently weakened New ABC’s earnings power. If so, it will pay less, and the reduced debt balance will likely be more than offset by the lower value it offers for the entire business. Levering up businesses with huge amounts of debt and making your equity returns primarily from the paydown of debt with excess cash flow was the old model of the leveraged buyouts of the 1980s. It only worked then because private equity firms could get businesses cheaper than they can now. Fierce competition has shut this sort of financial engineering down.

So the only reliable model for private equity to make the returns it promises to its LPs is to increase the earnings of its portfolio companies. And that is what they all try to do. Sure, a lot of this involves cutting costs, and labor costs are often one of the biggest line items in company income statements which can be trimmed. But private equity also looks to improve the sales and margins of its companies, and this often entails increased investment in productive assets, company infrastructure, and, yes, employees. Many financial sponsors invest additional cash in their portfolio companies over the life of their investment, in order to support increasing sales, improved productivity and margins, and occasionally add-on acquisitions. Their objective is to make the company stronger and healthier than it was when they first bought it, and hence more valuable. Financial sponsors frankly don’t care whether increasing EBITDA and free cash flow comes from cost-cutting or revenue and margin increases—a dollar is a dollar is a dollar, after all—but most of them are fully aware that the latter is normally sustainable in a way the former is not.

* * *

One more wrinkle is worth discussing. This is the relatively recent phenomenon of financial sponsors borrowing additional debt through their portfolio companies during the life of their investment, and using the proceeds to pay equity dividends to themselves and their limited partners. These are known as dividend recapitalizations, or “dividend recaps.” Often, financial sponsors can use such recaps to withdraw money equal to or even in excess of their initial equity investment. This leaves the portfolio company with an increased debt burden and the financial sponsor playing with house money. Many people outside the industry, including our friends Messrs. Kwak and Surowiecki, don’t like dividend recaps, because it loads up the portfolio companies with risky debt while appearing to reduce private equity’s skin in the game. This is very true.

However, having participated in or observed a number of such deals, I must strenuously disagree with Mr. Kwak’s contention that the lenders which participate in such transactions are unsophisticated dupes. They lend with eyes wide open, after having done an impressive amount of company-specific due diligence. Normally, a company is able to take on a bigger debt load because the financial sponsor and company management prove to new lenders that they have improved the company’s earnings power and free cash flow enough to sustain it. In our example, if Big Bucks had sustainably boosted New ABC’s EBITDA from $25 million in year one to $50 million in year three, the same lenders who lent at 5 times EBITDA at the beginning should be more than happy to lend another $125 million to New ABC. Big Bucks could dividend the entire amount to its limited partners and itself, and still have a company with a pro forma value (at 8 times EBITDA) of $400 million, a pro forma debt load of $250 million, and a pro forma equity value of $150 million after the $125 million dividend. Big Bucks’ initial investment of $75 million would have turned into $275 million: $125 million of dividended cash and $150 million of unrealized equity value. This would be an enormous home run, and it still gives Big Bucks and its limited partners an opportunity to ride the value creation curve of New ABC even higher into the future. Leveraged finance lenders are very comfortable with such transactions, and they base their comfort on the visibility and sustainability of company results, and the credibility of the financial sponsor and portfolio company management to sustain and build earnings and cash flow.

Sometimes, of course, the future performance of a private equity company falters unexpectedly, and the debt load craters it. But this happens as often with the initial capitalization of a private equity investment as with one that has had a dividend recap. Sophisticated financial sponsors are not infallible, and neither are sophisticated institutional lenders. Mistakes are made, market and company conditions change, and sometimes earnings can’t keep pace with debt service. Bankruptcy happens, lenders lose money, and employees are laid off. This is a bad outcome, and one which hurts financial sponsors and their investors too. Fortunately, it is relatively rare; rare enough that lenders continue to make such loans and limited partners continue to invest their money with financial sponsors.4 It is also worth keeping in mind that this happens in Corporate America, as well. Financial risk and bankruptcy from excess leverage is not exclusive to the private equity industry.

* * *

Private equity, as I have said many times before, is a valuable part of the financial ecosystem. It is particularly suited to helping businesses which require some sort of transformation, in structure, methods, and/or capital, in order to improve their value. All of these transformations are very difficult if not impossible to accomplish in a publicly owned company which answers to multiple, often conflicting constituencies in the full glare of public attention. For that reason alone, financial sponsors are a useful subset of capital providers, because they work their magic in private. As Mr. Surowiecki points out, they are not net job creators (or destroyers) of any magnitude. But they are not asset strippers, “vultures,” or liquidators, either. Think of them instead as boot camp drill instructors, whipping out of shape or underperforming laggards into top-flight athletes. Sure, they have their failures, but on the whole they do a pretty good job for a bunch of undersocialized ex-investment bankers.

Like every other corporation in America, private equity does benefit from the tax deductibility of corporate debt interest, but, pace Mr. Surowiecki, this loophole is not the secret sauce in private equity’s formula.5 As for the unconscionable and indefensible carried interest tax break private equity gets treating its earned income as capital gains for tax purposes, well, the less said about that the better.

I am trying to keep this a friendly blog post.

Related reading:
James Kwak, What Is Private Equity? (The Baseline Scenario, January 27, 2012)
James Surowiecki, Private Inequity (The New Yorker, January 30, 2012)

1 This example would count as a small, or small “middle market” buyout. While lots of these actually get done, I am using this scale to keep the numerical intuitions simple. In outline, the big buyouts you read about in the financial media look just the same.
2 Earnings Before Interest, Taxes, Depreciation, and Amortization. Don’t ask.
3 Total enterprise value, or TEV, is what the entire business is worth, prior to carving up the resulting cash flows to various stakeholders like lenders and equity owners. It is independent of capital structure.
4 It is worth noting, as I alluded to above, that many of the institutions which lend directly or indirectly to private equity-owned companies also invest as limited partners alongside sponsors. On top of that, many of these institutions happen to be funds managed for the benefit of public and private pensioneers, government employees, teachers and firemen, and other universally regarded good causes. It is a funny fact of private equity bankruptcies that the end result can be value transfer among these different groups.
5 Supplementing my simple example above with a few unremarkable assumptions about earnings growth and free cash flow efficiency, I ran a simple buyout model for New ABC over a five year horizon to test the magnitude of value created by the tax shield generated by debt. Allowing the tax shield, as current tax law does, created an final equity value of $223 million, or 2.97 times Big Bucks’ initial investment, and an internal rate of return of 24.3%. Stripping the tax shield from the same model generated figures of $199 million, 2.66 times, and 21.6%, respectively. While the free cash flow of $23 million over five years generated by the tax shield is nothing to sneeze at, it is dwarfed by the returns generated by growth of the business, and a 2.7% difference in IRR is unremarkable. Similar scaling applies to most private equity investments. The tax shield of corporate debt, while real, is not critical or even a major factor in private equity’s business model.

© 2012 The Epicurean Dealmaker. All rights reserved.