Does Private Equity Create Wealth?

1. Does Private Equity Create Wealth? • Ron Masulis Owen Grad School of Management, Vanderbilt University • Randall Thomas Vanderbilt Law School

2. Three Themes • How private equity creates wealth • Why publicly owned firms are not managed well • How derivatives can destroy wealth (Derivatives are put & call options, futures contracts, swaps & swaptions)

3. Overall LBO Volume as a Percentage of Global M&A % Private Equity Deals LBO Volume ($ in billions) Notes: Includes announced transactions excluding withdrawn deals, share repurchases, spin-offs, and minority stake purchases. Source: Thomson

4. Basic Steps in an LBO • Buy up publicly held stock to concentrate firm ownership in a few large shareholders • Issue new debt to raise leverage and finance stock purchases • Streamline operations and sell off excess assets to pay back debt and high interest • An LBO is similar to an acquisition by a financial Bidder – Bidder with cash but no operating assets

5. Do LBOs Create Wealth? EXAMPLE – CONGOLEUM’S LBO • Conglomerate: Flooring, shipbuilding & auto parts • Pre-LBO debt level: $125 MM • Pre-LBO announcement equity value $150 MM • Buyout premium paid on stock: $460 MM • Buyout financed with $380 MM in debt and $95 MM in excess cash • 5 years later paid off debt, did 2nd LBO • 2 years later: firm liquidates - equityholders receive $850 MM

6. Stakeholder Winners & Losers • Management + • Stockholders + • Bondholders 0 • LBO investors (Private Equity) + • Employees & Pensioners - • Suppliers – • IRS – • LBO is not a zero sum game – there is large wealth creation!

7. Stakeholder Wealth Effects - Evidence • Public stockholders: 56% Buyout premium • Management: • Realizes greater gains than common stockholders • Forced to invest substantial portion of wealth in stock – bears large undiversified risk • Buyout funds: Returns have ranged from 20% to 35% • Thomas Lee had 50% + for over 10 years • Straight debt: • Bond ratings fall, but prices on average don’t change • If LBO protected, then either debt repurchased at face value or interest rate is raised – these bonds generally gain in value • If unprotected, bonds lose 7% of value on average • Employees: Often head count is rapidly reduced by substantial amount • Suppliers usually must reduce their profits from sales to LBO firm • US Government: Losses substantial taxes

8. How Do LBOs Create So Much Wealth? • Concentrates stock ownership • Shifts board control to large shareholder – LBO investor • Accepts substantially higher debt & leverage: • Small number of private debt investors • Improves management incentives • Pressures mgmt to reduce the corporate “empire”. • Forces stakeholders to make large concessions • Increases tax savings

9. LBOs Improved Corporate Governance! • What do nearly all of the changes in the prior slide have in common? • They improved corporate governance! • Create strong incentives for CEO and Board to • Work hard • Take risks • Make tough decisions to improve shareholder wealth

10. LBOs Greatly Improved Management Incentives • Raises mgmt % share ownership substantially • Substantial upside gain potential • Raises mgmt dollar investment in firm share • Substantial downside risk exposure • High leverage makes firm’s stock price highly sensitive to changes in firm value (equity multiplier effect) • Board oversight of mgmt is heightened by restructuring board of directors – these directors have strong incentives • Small board, financially sophisticated, large stockholdings • Reduction in free cash flows • Substantial risk of bankruptcy in early years

11. Empirical Evidence on LBOs:Improved Operating Efficiency • Board composition substantially changes & its size isreduced, and mgmt is often replaced within 1st 3 years • LBO firms become almost twice as profitable as industry competitors while privately held • LBO firms outperform competitors in operating income & stock returns for at least 4 years following going public again • LBO firms show improved focus, sheds excess assets • Tax payments are reduced substantially • Compared to competitors, LBO firms : • Use only half the working capital (cash) • Have largeraverage advertising budget • Overall investment level is lowered • R&D & maintenance expenses are unchanged! • Leverage is permanently higher even after a reverse LBO

12. What’s Wrong at Publicly Held Companies? • Poor corporate governance – poor management incentives to operate the firm efficiently • Major corporate governance mechanisms: • Board of directors: Has power to hire, fire and set CEO compensation • CEO compensation’s sensitivity to firm performance • CEO and Board stockholdings

13. Public Company Board Structures Need to be Strengthen • Directors of public companies are generally part time, not financial experts, have small percentage shareholdings with little incentive or expertise to effectively monitor risk exposure • Firms today are more complex and larger, making risk monitoring more difficult • Boards do a poor job of monitoring derivative risk exposure – in separate analysis we examine corporate losses from derivatives and subprime problems – strikingly large number of firms have experienced problems

14. The Rise of Derivative Contracts • Over the last 40 years, derivative contracts have emerged as a major financial instrument – heavily traded, issued and held by corporations worldwide • Ex. Swaps contracts outstanding exceeded $100 trillion • FIs in particular have been extremely active market participants • Derivatives allow investors to shift particular risks to other investors

15. Dangers of Derivatives • Derivatives allow a firm to dramatically increase risk exposure in a few minutes • Ex. Southwest Airlines buys most of its oil in the forward market – commits to a price today for delivery months into the future – • When oil prices were rising, they save $millions • When oil prices began failing substantially, they lost $millions • Metallgesellschaft lost $1.4 billion in oil futures • Sumitomo lost $2.6 billion in copper futures • Worldcom illegally reduced its costs using swap contracts by $11 billion

16. How Derivatives Make Corporate Governance Worse • Derivative contracts allow corporations to rapidly add or subtract specific risks • Financial accounting systems fail to reflect the risk exposures associated with these contracts • As derivative activity has risen, it becomes more difficult for boards of directors and investors to know what risks the firm has taken on • This allows CEOs to accept large risk exposures without board approval

17. FIs Have Serious Problems With Derivative Risk Exposure • FIs are very big buyers and sellers of derivatives • Quarterly disclosure requirements for FIs are outdated and can be evaded • Rapid changes in counterparty risk are possible in large transactions, which requires more timely disclosure • Hard to evaluate FI risk levels because of complexity of transactions, especially counter-party default risk • Moral hazard problem from government bailouts • Little shareholder oversight because of dispersed ownership of FIs generally

18. Why Private Equity Improves Corporate Governance • PE investors have large shareholdings in their firms • Hire a small group of financially sophisticated directors with substantial firm shareholdings • Enforce strong board oversight of CEOs • Implement specialized internal reports • Have high leverage, which creates an large equity wealth multiple • Require senior management to hold substantial equity positions

19. Conclusions • Extensive derivative usage confronts boards and regulators with difficult monitoring problems • Public company boards lack the incentives, time, training and information to adequately monitor firm’s derivative exposure • Private equity firms help to offset these governance problems by exercising strong control rights, decreasing board size, improving information flows, introducing improved risk management, employing financially sophisticated directors with strong incentives, and giving management greatly improved incentives