I feel a little silly for not understanding this, but… What is the logic of doing an LBO? Obviously, someone thinks they can make lots of money by doing it, but what’s the advantage of taking a company private that one can’t do as a public company. Here are some things I’ve thought of: a) If you have a private company, you can make and enforce management decisions… but couldn’t you do this by having a controlling portion of public stock, or maybe even all of public stock? b) Maybe there are reporting requirements for public companies that reduce the ability to keep trade secrets? c) Maybe the imperative to keep the stock price high in a public company interferes with some necessary strategy for increasing cash flows? I know that it somehow boils down to using massive leverage to maximize the cash flows to equity. Doesn’t one need to take the company public again to exit? Or at least find another private equity guy or company to buy you out? What makes one company a better LBO candidate than another, aside from high free cash flows to the firm? How does an LBO firm choose its targets? (numi, I think this Q was made for you )
- there are many reasons for LBOs. look at the reasons for M&As, divestitures, mgmt insight that adds value…etc. look at the measure of return in lbos. IRR = (fv/ pv)^1/n the lower the equity injection, the higher the debt required. debt is tax deductible so the return is higher. http://www.lbo-advisers.com/LBO.asp
The fundamental logic behind an LBO is two fold. First is to reduce the target companies cost of capital by applying as much debt as possible(financial enginering). Second is to restructure/retool/renovate the business to increase profits (or cash flow as the case may be) so that it can be re-sold for a premium(business enginering). The argument for private is that these operations work better when the owner/manager can take a longer term view and not have to worry about how the stock price will fair if they miss eps by .01 this quarter to pursue a stratedgy that will increase eps by .5 in one year and $2 in three years.
Does anybody believe that? This “investors are stupid” view of LBO’s is antithetic to just about everything that we believe about equity valuation, efficient markets, etc… Isn’t it much more likely that things like self-aggrandizement is more important than the exceptional prescience of the owner/manager to see the long-term better than capital markets?
^I would assume so. Isn’t that why many of us entered the industry to begin with - although many of us would be hard pressed to admit it.
for a lot of these, wasn’t it kind of “can’t lose” to the pe firms? they put up a small amount of equity and borrow the rest. the banks, at the time, were falling all over themselves to loan them the money. a couple years, or sometimes months, the pe firms would again go to the banks for an additional loan to pay themselves a dividend that took all their money off the table plus some. again, the banks can’t wait to make the loan. now the company is near 100% leveraged and the pe firm has its money back with a pretty nice return for a short period of time. my guess the reason they could do this was 1) public markets weren’t comfortable with that much debt and 2) the banks needed the relationships with the firms so they gave tremendous terms. i can’t remember who it was (maybe rubenstein) but he basically said that it would be ludicrous for the pe firms to not take advantage of such terms on the loans. bear in mind, though, that i don’t work in the industry. this is just conjecture from what i’ve read/heard.
LBO (which often includes mgr housecleaning; take-private; equity incentives for mgmt) improves efficiency in a number of ways: + reduced WACC + eliminate entrenched&ineffective management + align managers’ and shareholders’ incentives more closely + through higher debt service costs force management efficiency improvement + if take-private, improve operating flexibility As has been documented empirically (and in a variety of academic studies) it’s clearly a formula that frequently works.
bchadwick Wrote: ------------------------------------------------------- > I feel a little silly for not understanding this, > but… > > What is the logic of doing an LBO? Obviously, > someone thinks they can make lots of money by > doing it, but what’s the advantage of taking a > company private that one can’t do as a public > company. Hi bchadwick, thank you for your kind words last week on the PE thread posted on Level III. Nice to see you around as well. A key reason for doing an LBO is that taking a company out of the public spectrum into the private space enables the equity sponsor and management teams to focus on developing and growing the underlying business without having to worry about reporting financials or catering to outside shareholders. Importantly, when you (the private equity firm) owns a company, it is far easier to influence decisions on operations, strategy and capital structure; you don’t have this type of say as a minority investor obviously, and even in the case of an influential ownership (such as growth equity), it is much harder to help influence the direction of a company as compared to a controlling interest position. > Here are some things I’ve thought of: > > a) If you have a private company, you can make > and enforce management decisions… but couldn’t > you do this by having a controlling portion of > public stock, or maybe even all of public stock? You could, but you would still have to concern yourself with reporting quarterly results and disclosing material events, and on the day-to-day you’re allowing yourself to be judged by the public equity markets. Not so in the private setting. > b) Maybe there are reporting requirements for > public companies that reduce the ability to keep > trade secrets? Yes. And also remember that even as a control investor, public securities laws mandates fair and full disclosure of material events. Not so if you are a private company! > c) Maybe the imperative to keep the stock price > high in a public company interferes with some > necessary strategy for increasing cash flows? Exactly. This is a key argument that private equity investors put forward – oftentimes management teams are too concerned with creating short-term opportunities for investors and themselves (since the public stock markets are fairly myopic), while overlooking the opportunity to create long-term value. > I know that it somehow boils down to using massive > leverage to maximize the cash flows to equity. Actually, massive leverage creates pressure on the company because more of the free cash flows generated by the firm will have to be dedicated towards the servicing and paydown of debt. Rather, value is created for the financial sponsors at the liquidity event, where the company is generally sold at a multiple of EBITDA during the exit year. The important thing is that higher debt actually constrains FCFE (note the key difference between FCFF and FCFE!), but the whole point of a leveraged buyout is that by minimizing your initial equity commitment and hopefully piling on as much debt as possible so long as you can meet the covenants and terms of the loans, you will be able to maximize your IRR at the time of exit. > Doesn’t one need to take the company public again > to exit? Or at least find another private equity > guy or company to buy you out? You can sell it to another private company, public company, or financial sponsor as well – you can also sell your equity stake back to management who may decide to still keep it private. There are a variety of ways to exit a private equity investment. > What makes one company a better LBO candidate than > another, aside from high free cash flows to the > firm? How does an LBO firm choose its targets? This varies depending on the PE shop. There are a number of different types of investment strategies - firms may focus on different things like industry, market capitalization, special situations, and so forth. But there are certain traits that you look for in a cogent private equity investment, which include but are not limited to the following: - Experienced and committed management team (it’s much easier to find and develop a company with a good management team in place, rather than having to go out and replace them, although there are some strategies that operate in this fashion) - Low capital expenditures and working capital commitments (recall that this leads to higher free cash flow, which could increase your debt capacity) - Low seasonality/cyclicality and high recurrence of revenue streams (sustainability of cash flows are important, but so is predictability, which is why these factors are considerations) - Favorable industry dynamics, such as high barriers to entry or market fragmentation (you want high barriers to entry because you want the company you invest in to be able to protect and grow its share, though market fragmentation is also a positive trait because it creates the opportunity for add-on acquisitions thus leading to potential multiple expansion) - Differentiated products and defensible market position - High operating margins and low operating leverage (high EBITDA margins are a good proxy for the company’s ability to pay debt, while low operating leverage means that the company is less exposed to fluctuations in top-line, which is another important trait because PE investors, again, are concerned about stability of cash flows) Bottom line is, private equity investors are principally concerned with (1) free cash flow generation and (2) ability to pay debt. > (numi, I think this Q was made for you ) Thank you, I didn’t even see this until I typed out the rest of this post! I hope you find it informative. And I have to give some credit to VOBA, wessun, and others who have helped educate me as well on this topic. I hope this post answers your questions about LBO, PE investing, and so forth.
Darien… you nailed it. Read Darien’s answer straight from the CFA curriculum.
This is great, numi, very clear and helpful! Thanks.
Numi, did/do you work in IBD and PE?
I think it’s all BS straight from a KKR PowerPoint presentation. 1) The business about equity markets being myopic is a nice story, but not true and not even really testable. Certainly equity markets have capitalized very distant earning possibilities in growth companies in ways that, if anything, overestimate their future revenues. Further, the whole business about massive leverage puts pressure on a company stomps this idea pretty well. A firm saddled with huge debt needs to be much more short-sighted than one with equity financing because equity investors can wait for dividends but the debt needs to be paid. To suggest that a company saddled with massive debt can take a more long-term perspective than one financed with equity is just weird. 2) The stuff about replacing poor management with good management is certainly sometimes true but whether it is true in general is not clear. I have a friend who was once a big mucky-muck at Revlon before Ron Perlman and company got a hold of it. That assertion would cause him to start sputtering and shaking violently. 3) If you could borrow massive amounts of money to buy any random public company, be free from reporting requirements, and have lots of bankruptcy protection if the whole deal went belly-up, would you do it? The business is certainly very profitable for lawyers, bankers, principals of the firms, etc. but as a whole I think LBO’s destroy value. BTW - Whatever happened to RJR Nabisco anyway? Did that turn out well? And in that case, they really did have incompetent management running the place. 4) "Bottom line is, private equity investors are principally concerned with (1) free cash flow generation and (2) ability to pay debt. "
sternwolf Wrote: ------------------------------------------------------- > Numi, did/do you work in IBD and PE? no – i’m actually in equity research. however, the better question might be, “will i be working in IBD or PE?”
My Investment banking professor is with the argument that LBOs destroy value more often than create it. He was a harvard econ Ph.D and Economist at Goldman/Morgan before he made MD in Morgan IBD, but never worked in PE. Why do you want to leave ER, numi?
JoeyDVivre Wrote: ------------------------------------------------------- > I think it’s all BS straight from a KKR PowerPoint > presentation. They’ve done all right for themselves. (as have most people who invent and dominate a market for a couple of decades) > A firm saddled with huge debt needs to be > much more short-sighted than one with equity > financing because equity investors can wait for The argument for debt is not the vision thing, rather it diminishes the likelihood of investment in subpar projects (rather than returning capital to investors). For mature, stable businesses (typical LBO candidate) it’s hard to argue against this. > 2) I have a friend Not a very broad sample. > 3) BTW - Whatever > happened to RJR Nabisco anyway? Did that turn out > well? All the investors did very well. KKR itself did okay, but not great. > Michael Milken used to walk into groups of > investors and charm the pants off of everyone with > stories like above. Tons of people believed them. Milken also invented and dominated a market. He had a character flaw, but that doesn’t diminish his leadership role and place in the history of capital markets.
I was thinking that Joey might have a beef with the myopia part. My sense is that the LBO guys have a distinct idea of how to restructure a company and use the private aspect of an LBO to ram it down managements throats instead of having to negotiate with other shareholders. Shareholders might not be myopic after all, but if management just thinks they are, maybe it will be a lot harder to get the restructuring done quickly. When do LBO projects fail, and why? Obviously failure to generate cash flows that can cover the debt is a main reason, but how does that come about? And are there other things to look out for?
DarienHacker - good points. +1 bchadwick - as for why LBO projects fail, there are some factors that may be specific to a particular LBO investment, such as inability to service debt, sponsors being at odds with the management teams). and then there are macro and industry issues such as a decline in the high yield market (most important for companies that use PIK notes but this is essentially a non-issue in the current credit market), as well as any other factor that can potentially affect ANY company irrespective of ownership such as changes in competitive landscape, regulatory issues, poor operating performance, inability to grow revenues or expand/maintain margins, etc…
i don’t buy the better management argument as a general rule. i’m sure its the case at time, but if the bod is doing its job, it shouldn’t be. (of course, its not like the bod and management are always 100% independent of each other.) as an example, when bob nardelli is the choice to run chrysler, i have to be skeptical that management is the reason. i know that’s only one example but its the first one to cross my mind.
I suppose value is created if the LBO guys can access debt at a rate lower than the earnings yield of the public stock, or if management changes make a real change in operational performance, EBITDA or something. As for things going wrong, it usually has to do with mistaken assumptions, so i was tryin to think of what the most common mistaken assumptions are. Thanks!
mlh97 Wrote: ------------------------------------------------------- > i don’t buy the better management argument as a > general rule. i’m sure its the case at time, but > if the bod is doing its job, it shouldn’t be. (of > course, its not like the bod and management are > always 100% independent of each other.) as an > example, when bob nardelli is the choice to run > chrysler, i have to be skeptical that management > is the reason. i know that’s only one example but > its the first one to cross my mind. it is by far the norm rather than the exception that PE funds search for management teams with a proven track record and whose long term interests are aligned with the company. private equity investors only help to “run” the company from a very high level; as an investor you normally want to find a management team who already has the relationships, understands the market and knows how to run a business. it is very difficult to go out and find competent senior management – it can take months and sometimes years to find the right fit. as for your example about nardelli, this is little to do with leveraged buyouts and much more to do with whether or not you personally think nardelli would be a good CEO.