DarienHacker Wrote: ------------------------------------------------------- > 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. You and I just couldn’t disagree on this more in just about every measure. Sure KKR does okay, which was my point #3 above (though their record in the last few years hasn’t been very impressive). Check out the investors in the RJR buyout a little more carefully - they didn’t do well nor did the company. Your not ‘a broad sample’ is in response to the above generalization - I get to point out that the generalization is sometimes false with an example. I could list 100 more if it would impress you more. LBO’s leading to companies run into the ground is common and mundane. Michael Milken’s place in the history of capital markets is only one of shame and dishonor.
numi Wrote: ------------------------------------------------------- > 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… LBO projects fail because they take on an enormous amount of debt that raises the probability of failure and the costs when they do. A small glitch in the cash flow and they are wrecked. Glitches in cash flow happen for billions of reasons that nobody can predict.
Okay, let’s turn to the literature. I’ll open with Andrade and Kaplan, 1997 (http://faculty.chicagogsb.edu/steven.kaplan/research/andrade_kaplan.pdf) This paper studies a sample of highly leveraged transactions (HLTs) that subsequently become financially distressed. First, we estimate the effects of financial distress on value. From pre-transaction to distress resolution, the sample firms experience a small increase in value. In other words, the net effect of the HLT and distress is to leave value slightly higher. This strongly suggests that HLTs overall – those that defaulted and those that did not – earned significantly positive market-adjusted returns.
… and I think Kaplan, 1998 (http://faculty.chicagogsb.edu/steven.kaplan/research/govern.pdf) puts to rest just about every remaining argument against LBOs. (It’s also a good review of the LBO rationale, getting back to this thread’s original question). “The LBO experience was substantially different in the latter half of the 1980s. Many LBOs defaulted, some spectacularly. As Kaplan and Stein [1993] document, roughly one-third of the LBOs completed after 1985 subsequently defaulted on their debt. This default experience led many to criticize LBOs and, in fact, the entire 1980s. But did this default experience mean that the LBO insights were wrong? The evidence, even for the late 1980s, indicates that the LBO insights hold. Kaplan and Stein [1993] find that, overall, the larger LBOs of the later 1980s also generated improvements in operating profits despite the relatively large number of defaults. Even for deals that defaulted, Andrade and Kaplan [1997] find that the LBO companies retained approximately the same value they had attained before the LBO. In other words, the net effect of the LBO and default on capital value was slightly positive. The case of Federated Department Stores (described in Kaplan [1994a]] illustrates this effect. The logical question is, if LBOs increased value, why did so many default? The answer is straightforward. The success of the LBOs of the early 1980s attracted entrants and capital to the LBO market. Those entrants understood the basic LBO insights. Because so many understood the insights, the purchase prices for the LBOs began to reflect the insights. As a result, much of the benefit of the improved discipline, incentives, and governance accrued to the selling shareholders rather than to the post-buyout LBO investors. The key point is that the combination of gains to pre- and post-buyout investors was positive overall. The LBO insights and benefits were real.”
JoeyDVivre Wrote: ------------------------------------------------------- > numi Wrote: > -------------------------------------------------- > ----- > > 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… > > > LBO projects fail because they take on an enormous > amount of debt that raises the probability of > failure and the costs when they do. A small > glitch in the cash flow and they are wrecked. > Glitches in cash flow happen for billions of > reasons that nobody can predict. inability to service debt, as i mentioned in the first sentence of that post, is a definite concern…but i wouldn’t say a small glitch in their projected cash flows will “wreck” an LBO. first, determining the pro forma capital structure involves taking into account any risks associated with the company’s sustainability and predictability of free cash flows. secondly, at least in the current credit environment, getting leverage of any kind is seen as a good thing - you certainly aren’t seeing many deals where you can get over 7-8 turns of debt financing, and initial equity injections of 35-40% for buyouts are happening more often than you might imagine. so, given the circumstances in the credit markets combined with the need to deploy capital (funds are still being raised even though deal flow is still relatively dry), sponsors are actually more concerned with being able to get debt – any kind of debt – and less so with leveraging their investments to the hilt, simply because that’s not an option for them right now.
Alright. To address a few people who don’t understand the “magic” of how an LBO works to get the returns it does. First off leverage (duh). Leverage drives returns. Is that simple to understand? To the academics/CFAs in the crowd, firm value is not determined by cap structure (MM) - until you bring in this thing called taxes. And then as interest expense is tax deductible, you can “create” value by levering up, until the point in which your costs of financial distress are too much. The majority of public companies capital structure are not optimized. Why - because it is very hard to do this as a public company (sounds circular right?). If a typical industrial company that was publicly traded went and levered themselves up to 6 or 7x shareholders would freak out. Maybe they’d appreciate the special dividend they got initially, but the stock would trade a ridiculously low multiple going forward. Not only that, but as many public co’s trade on EPS (which is total BS), and PF EPS is destroyed with all the interest expense, you would have a twice as strong effect (lower multiple and lower EPS is stock price that is crushed). In addition, as mgt of a public co, you are incentivized by stock options to hit certain EPS targets to try and improve stock price so your options vest and you can exercise them. Unfortunately improving EPS is a totally misguided way to run a business - and can have very perverse effects. So now the confused public exec at this new leveraged company is trying everything he can to increase EPS so that hopefully his stock price will increase and his options will be in the money, while paying just enough attention to his credit stats/solvency that he can remain a going concern. Eventually economy goes into a recession and firm hasn’t paid down enough debt (b/c its been trying to improve its magical q over q EPS) to weather the storm and blows up. end of story. The simple conondrum is that firm value increases with leverage. But public companies cannot be levered as much private companies. So a perpetual arb opportunity exists - and then add generous leverage terms, low financing rates and a company that the public market does not understand or is improperly valued, or a sub that a cash strapped company needs to get rid of, or an orphan division that never received proper mgt attention/capital resources - and you can opportunities for ridiculous returns. Plus levering up instills what is often desribed as the “discipline” of debt. The 1000th project that the idiot in R&D thinks will be fantastic but everyone knows is worthless, but the company has extra cash so why not? That is gone now - never to be funded when the company has to focus on leverage. The mgt team that was held hostage to manage its EPS to make quarterly earnings targets? They are now able to focus on creating value over a 5 year time frame - their sponsor owners dont give a crap about q-o-q EPS as long as debt is getting paid down. What do you think creates more value? End goal - pay down as much debt 5 years out? or End goal - manipulate EPS long enough so your options will vest. Finally - PE guys are pros. They look at deal after deal and know very quickly how to improve margins, operations etc - or bring in people who do. It’s pretty simple - that’s how it works.
DarienHacker Wrote: ------------------------------------------------------- > … and I think Kaplan, 1998 > (http://faculty.chicagogsb.edu/steven.kaplan/resea > rch/govern.pdf) puts to rest just about every > remaining argument against LBOs. (It’s also a > good review of the LBO rationale, getting back to > this thread’s original question). > Oh my god… > “The LBO experience was substantially different in > the latter half of the 1980s. Many > LBOs defaulted, some spectacularly. As Kaplan and > Stein [1993] document, roughly one-third of > the LBOs completed after 1985 subsequently > defaulted on their debt. This default experience > led > many to criticize LBOs and, in fact, the entire > 1980s. But did this default experience mean that > the LBO insights were wrong? > The evidence, even for the late 1980s, indicates > that the LBO insights hold. Kaplan and > Stein [1993] find that, overall, the larger LBOs > of the later 1980s also generated improvements in > operating profits despite the relatively large > number of defaults. > Even for deals that defaulted, Andrade and Kaplan > [1997] find that the LBO companies > retained approximately the same value they had > attained before the LBO. In other words, the net > effect of the LBO and default on capital value was > slightly positive. The case of Federated > Department Stores (described in Kaplan [1994a]] > illustrates this effect. > > The logical question is, if LBOs increased value, > why did so many default? The answer is > straightforward. The success of the LBOs of the > early 1980s attracted entrants and capital to the > LBO market. Those entrants understood the basic > LBO insights. Because so many understood > the insights, the purchase prices for the LBOs > began to reflect the insights. As a result, much > of > the benefit of the improved discipline, > incentives, and governance accrued to the selling > shareholders rather than to the post-buyout LBO > investors. The key point is that the combination > of gains to pre- and post-buyout investors was > positive overall. The LBO insights and benefits > were real.”
So I’m paddling my canoe up river and someone decides to dynamite the dam upstream. A torrent of water comes cascading down the stream and I start paddling madly to avoid being crushed into the rocks behind me. Ultimately my canoe founders and I drown and my body is dashed against the rocks. Then some guys publish a paper about how bursting the dam was really a good idea because I was paddling so much more efficiently when fighting the torrent. There is no question that LBO’s can raise operating efficiency, cash flows, and 40 other measures of that ceteris parabis suggest a well-run company. It surely doesn’t mean that anything especially good has happened.
bankingbaby, Nice work.
JoeyDVivre Wrote: ------------------------------------------------------- > There is no question that LBO’s can raise > operating efficiency, cash flows, and 40 other > measures of that ceteris parabis suggest a > well-run company. It surely doesn’t mean that > anything especially good has happened. I don’t think you’ve read the Andrade and Kaplan paper. It explains all the ways that good things happen. Your understanding of bankruptcy is at odds with reality. LBO’d firms are stable generators of returns, so they’re not frequently exposed to economic distress. (That’s why they were chosen for LBO.) When these firms suffer financial distress it doesn’t mean we shutter the gates and send the workers home. The assets are left in place and business continues humming along. No canoe founders. A&K explicitly examine this scenario and find, on average, firms emerge a bkrpt (or reorg) even healthier than they were going in. (Part of the reason is that bkrptcy is cheaper for a privately held firm than public.) I think you’re also ignoring Kaplan’s analysis that “we are all Henry Kravis”. Like it or not, the lessons of LBO have washed through the appropriate industries, producing the general trend toward increased leverage – importantly, among firms that have never been LBO’d. If you own equities they likely have benefited from this revolution in corporate finance whether or not the firm was taken private. Bruner (Applied Mergers & Acquisitions) gives a nicely condensed review of LBO literature if you don’t want to wade through the aforementioned sources.
Just to add to numi et al, another driver of LBO’s is the basic diversification discount within larger conglomerates. In the mid 70’s and 80’s the “conglemarate” business model was en vogue, as the market rewarded firms with steady earnings growth, international and multi-market exposure to weather an uncertain 80’s economy, and the diversified conglomerate fit this bill. Fast forward 20 years later, and now the market favors “sector leadership” and “focus” (see GOOG) as opposed to “scale”, “mediocre market positioning” and steady cash flows, thus the diversification discount for large conglomerates. You can see this in Tyco, Honeywell and to an extent the former ITT. Just do a simple sum of the parts valuation on any diversified conglomerate and 9 times out of 10, the stock trades at a discount to it’s sum-of-parts value. This is the diversification discount attributable to operating inefficienies, unjustified internal capital allocation among reporting units, and thus the case for an LBO and eventual spin-off of each reporting unit to maximize value for sponsors. This was the case behind the VMWARE/EMC and Discover/MS spin-off’s. I suspect the next LBO boom would be partially based on this fact. Private equity as an asset class is here to stay.
But the PE firms are essentially conglomerates themselves…
bankingbaby Wrote: ------------------------------------------------------- > Alright. To address a few people who don’t > understand the “magic” of how an LBO works to get > the returns it does. > > First off leverage (duh). Leverage drives returns. > Is that simple to understand? To the > academics/CFAs in the crowd, firm value is not > determined by cap structure (MM) - until you bring > in this thing called taxes. And then as interest > expense is tax deductible, you can “create” value > by levering up, until the point in which your > costs of financial distress are too much. The > majority of public companies capital structure are > not optimized. Why - because it is very hard to > do this as a public company (sounds circular > right?). If a typical industrial company that was > publicly traded went and levered themselves up to > 6 or 7x shareholders would freak out. Maybe they’d > appreciate the special dividend they got > initially, but the stock would trade a > ridiculously low multiple going forward. Not only > that, but as many public co’s trade on EPS (which > is total BS), and PF EPS is destroyed with all the > interest expense, you would have a twice as strong > effect (lower multiple and lower EPS is stock > price that is crushed). > > In addition, as mgt of a public co, you are > incentivized by stock options to hit certain EPS > targets to try and improve stock price so your > options vest and you can exercise them. > Unfortunately improving EPS is a totally misguided > way to run a business - and can have very perverse > effects. So now the confused public exec at this > new leveraged company is trying everything he can > to increase EPS so that hopefully his stock price > will increase and his options will be in the > money, while paying just enough attention to his > credit stats/solvency that he can remain a going > concern. Eventually economy goes into a recession > and firm hasn’t paid down enough debt (b/c its > been trying to improve its magical q over q EPS) > to weather the storm and blows up. end of story. > > The simple conondrum is that firm value increases > with leverage. But public companies cannot be > levered as much private companies. So a perpetual > arb opportunity exists - and then add generous > leverage terms, low financing rates and a company > that the public market does not understand or is > improperly valued, or a sub that a cash strapped > company needs to get rid of, or an orphan division > that never received proper mgt attention/capital > resources - and you can opportunities for > ridiculous returns. > > Plus levering up instills what is often desribed > as the “discipline” of debt. The 1000th project > that the idiot in R&D thinks will be fantastic but > everyone knows is worthless, but the company has > extra cash so why not? That is gone now - never to > be funded when the company has to focus on > leverage. > > The mgt team that was held hostage to manage its > EPS to make quarterly earnings targets? They are > now able to focus on creating value over a 5 year > time frame - their sponsor owners dont give a crap > about q-o-q EPS as long as debt is getting paid > down. What do you think creates more value? End > goal - pay down as much debt 5 years out? or End > goal - manipulate EPS long enough so your options > will vest. > > Finally - PE guys are pros. They look at deal > after deal and know very quickly how to improve > margins, operations etc - or bring in people who > do. > > It’s pretty simple - that’s how it works. This is such condescending BS. I highly doubt that you have the substance to be so condescending to me.
DarienHacker Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > > There is no question that LBO’s can raise > > operating efficiency, cash flows, and 40 other > > measures of that ceteris parabis suggest a > > well-run company. It surely doesn’t mean that > > anything especially good has happened. > > I don’t think you’ve read the Andrade and Kaplan > paper. It explains all the ways that good things > happen. > I have read it before and I re-read it this morning. I think it’s highly misguided. > > Your understanding of bankruptcy is at odds with > reality. LBO’d firms are stable generators of > returns, so they’re not frequently exposed to > economic distress. (That’s why they were chosen > for LBO.) When these firms suffer financial > distress it doesn’t mean we shutter the gates and > send the workers home. The assets are left in > place and business continues humming along. > I think working in distressed debt for a few years suggests I understand the realities of bankruptcy. There is nothing good about bankruptcy for a company except that it’s better than their alternatives at the time. > >No > canoe founders. A&K explicitly examine this > scenario and find, on average, firms emerge a > bkrpt (or reorg) even healthier than they were > going in. (Part of the reason is that bkrptcy is > cheaper for a privately held firm than public.) > No doubt. All companies emerge from bankruptcy healthier than they went in. That’s the point of bankruptcy. > I think you’re also ignoring Kaplan’s analysis > that “we are all Henry Kravis”. Like it or not, > the lessons of LBO have washed through the > appropriate industries, producing the general > trend toward increased leverage – importantly, > among firms that have never been LBO’d. If you > own equities they likely have benefited from this > revolution in corporate finance whether or not the > firm was taken private. > I am absolutely not Henry Kravis (although we share the same feelings about art). > > Bruner (Applied Mergers & Acquisitions) gives a > nicely condensed review of LBO literature if you > don’t want to wade through the aforementioned > sources.
bankingbaby - great post. wessun - thanks for elaborating…good points too. i think the stuff you’ve mentioned flows well into the topic of multiple expansion, which you and i have discussed before. diversified conglomerates could still make for good acquisition targets if there is an opportunity to spin off or divest underperforming businesses, or restructure the company so as to minimize costs and improve operatoinal efficiencies. in general, i think of the PE value creation process as driven by (1) EBITDA growth, (2) debt paydown, and/or (3) multiple expansion, and i see the multiple expansion portion of things either driven by increasing the value of the industry as a whole or the “perception” of the particular firm’s value (either through repositioning the company with respect to comps, restructuring, or strategic acquisitions/divestitures).
I am absolutely not a LBO expert but as a value investor I sure like them when they buy one of my investments for a big premium and take it somewhere else. What happens next is not my problem ;-). Love them.
JoeyDVivre - I’m not sure why my post is condescending? And I am sure I have the substance. JoeyDVivre Wrote: ------------------------------------------------------- > This is such condescending BS. I highly doubt > that you have the substance to be so condescending > to me.
I agree with Joey that everything posted here is a total BS. The only theoretical reason in efficient markets why PE firms can be successful is that gradient optimization can lead firm rather to a local optimum than a global one (market vision vs. PE vision). But most of PE investors don’t have a strategic vision. So, fundamentally what PE firms are doing is exploiting the market inefficiencies. Period.
mcpass Wrote: ------------------------------------------------------- > I am absolutely not a LBO expert but as a value > investor I sure like them when they buy one of my > investments for a big premium and take it > somewhere else. > > What happens next is not my problem ;-). Love > them. This presents a much more interesting question - what is a “high enough” premium to take a company private? There are certain companies in our portfolio that I would be pissed if they tried to take private for less than a 100% premium to today’s price. One one hand, the shares are trading freely in the market at today’s price, so the consensus is that’s the fair price for a non-control stake in the company. On the other hand, everyone who owns the stock thinks it’s undervalued, by definition, so they might not be so anxious to let it go for a 15% premium.
torontosimpleguy Wrote: ------------------------------------------------------- > I agree with Joey that everything posted here is a > total BS. > > The only theoretical reason in efficient markets > why PE firms can be successful is that gradient > optimization can lead firm rather to a local > optimum than a global one (market vision vs. PE > vision). But most of PE investors don’t have a > strategic vision. So, fundamentally what PE firms > are doing is exploiting the market inefficiencies. > Period. What are you talking about, guy? Your use of “gradient optimization” in that context doesn’t make any sense (though I suppose it’s fashionable these days to throw out random applied math terminology when you have little else of substance to say). And while I can somewhat appreciate your broad-based theoretical view of the markets, you haven’t worked in private equity (and I am not even sure whether you work in finance), so to say that PE investors don’t have a strategic vision is rather absurd and generally incredible.