Private Equity: Understanding Leveraged Buyouts Jake Cohen, Affiliate Professor of Accounting & Control and Business Law at INSEAD GLG Institute October 19th New York City
Presenter Biography • Professor Jake Cohen is an Affiliate Professor of Accounting and Control and Business Law at INSEAD and the Director of the INSEAD-PricewaterhouseCoopers Research Initiative. Professor Cohen teaches courses in Financial Accounting, Corporate Financial Reporting & Analysis, Financial Statements Analysis, Mergers & Acquisitions and Corporate Restructurings, and Business Law in both INSEAD's Singapore and Fontainebleau, campuses. Prior to teaching at INSEAD, he was a Senior Teaching Fellow in the Accounting & Management group at the Harvard Business School and Professor at the Harvard Extension School in Cambridge Massachusetts. At Harvard University, he taught courses in Business Analysis, Valuation, and Creating Value through Corporate Restructuring, Mergers and Acquisitions, and was recognized for outstanding teaching. Prior to teaching at Harvard for four years, he taught at Syracuse University as an accounting professor, where he was named 'Professor of the Year' and was selected as the graduation keynote speaker at the school's commencement ceremony. He currently sits on the Syracuse University Accounting Department's Advisory Board. • Professor Cohen worked as a tax accountant at KPMG LLP in Philadelphia and as a mergers and acquisition tax attorney for PricewaterhouseCoopers LLP in New York City. He currently consults and trains investment bankers at such firms at The Blackstone Group, Credit Suisse, Bank of America, Houlihan Lokey Howard & Zukin, and others. He has also tutored CEOs and Members of Board of Directors of Fortune 500 companies, such as Aetna, Astra Zeneca, Jones Lang LaSalle, and others.
Table of Contents • Financial buyers in mergers and acquisitions • Identifying attractive buyout targets • Understanding the drivers of private equity transactions • Capital markets regulation • Interest rates • Risks and concerns in current buyout market • Cases to discuss: Hertz, Toys R Us, Dunkin Donuts, Ducati, Coles, Serena Software
What is Private Equity? • Private equity is an asset class that has evolved substantially in the last couple of decades. • It is an alternative investment strategy that involves investing in privately held companies. • The key feature is the private nature of the securities purchased. • Investments in private equity are illiquid. • Investors in this marketplace must be prepared to invest for the long-haul; investment horizons may be as long as 5 to 10 years.
Private Equity Partnership Structure • The predominant organization form of private equity investing is the limited partnership structure. • Limited partnership consist of limited partners (LP) and general partners (GP). • The LPs of the partnership are the investors, i.e., the main providers of capital. These are typically wealthy individuals, endowments, pension funds, and other institutional investors. • The GP of the partnership are responsible for the day to day management of the partnership’s investment, as well as general liability for any lawsuit that may be brought against the fund. LPs must not be actively involved in the day-to-day operations of the funds if they are to maintain limited liability status.
Structure • An important element of limited partnerships is that the general partners also commit investment capital to the fund. This ensures that the GP and LP interests are well aligned. • Private equity partnerships are typically self-dissolving entities that have a life span of about 10 years. This limited life span highlights the point that the funds must seek exits of their investments to realize return for their investors.
General Partner Compensation • GPs of the partnership are compensated through a fixed management fee, as a percentage of committed capital, and profit sharing of investment gains known as carried interest, or simply, carry. • While the fee and carry vary across partnerships, the 2-and-20 is a standard that many funds gravitate towards. • 2-and-20 means that the annual management fee is 2% of the committed capital, and when final investment gains are realized, 20% of the profits go to the GP as their profit share.
“Money Goes, Where Money is Treated Best” • “Top quartile buyout funds have generated annual returns in excess of 40% returns in the past 20 years. The average net annual returns of the industry have been 13.3%, and the S&P 500 index has returned 12.1% per year” • Source: Blaydon and Weinwright, “The balance between debt and added value,” Financial Times, September 29, 2006
Financial Buyers in Mergers & Acquisitions • LBO percent of M&A • 2001 3%, • 2002 9% • 2003 8% • 2004 10% • 2005 11% • 2006 25%
Recent Funds Announced • Warburg Pincus $8 billion • Goldman $8.5 billion • Carlyle $10 billion • Blackstone $15.6 billion • KKR $16.5 billion (not yet closed)
Private equity firms are external change agents • Get companies to be more attentive to what their customers need and what their shareholders need. Private equity threat companies in the public markets to operate more leanly. Because if they don’t, they could be taken over. • Now with larger and larger funds as well as the growing trend of club deals, buyout shops are able to go after the larger companies, leading to those companies becoming more responsive – forced to change given more shareholders activism.
Classes within Private Equity • Venture Capital • Mezzanine Financing • Leverage Buyouts • Distressed investing
Leveraged Buyouts (LBO) • LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO. • LBOs are financed with large amounts of borrowing (leverage), hence its name. • LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company. • After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.
Successful LBO Strategies • Finding cheap assets – buying low and selling high (value arbitrage or multiple expansion) • Unlocking value through restructuring: • Financial restructuring of balance sheet – improved combination of debt and equity • Operational restructuring – improving operations to increase cash flows
Value Creation • Management incentives and agency cost effects • Increased ownership stake may provide increased incentives for improved performance • Better aligns manager / shareholder interests • Lower agency costs of free cash flows: debt from LBO commits cash flows to debt • Debt puts pressure on managers to improve firm performance to avoid bankruptcy
Value Creation • Wealth transfer • Wealth transfer from current employees to new investors – low management turnover (but sometimes new mgmt. team), slower growth in number of employees • Tax benefits in LBO constitute subsidy from public and loss of revenue to government – LBO premiums positively related to tax benefit • Net effect of LBO on government tax revenues may be positive due to gains to shareholders and increased profitability • Many of tax benefits could be realized without LBOs
Value Creation • Asymmetric information and underpricing • Managers, investor groups have better information on value of firm than shareholders • Large premium signals that future operating income will be larger than expectations – investor group believes new company is worth more than purchase price • Other efficiency considerations • More efficient decision process as private firm • Influence of favorable economic environment
Leverage Amplifier – the double edge sword • Return on investment > cost of debt • Cost of debt > Return on investment
Apax Partners • “Funds advised by Apax Partners look for companies that have strong, established market positions and the potential to expand into new markets. Our global presence and reach allows us to support such initiatives effectively.” • Source: Apax Partners website, http://www.apax.com/en/aboutus/index.html
Bear Stearns Merchant Bank • “BSMB focuses on designing capital structures for its investments which minimize risk and prudently take advantage of leverage. In addition, BSMB will customize transaction structures in order to help address circumstances unique to specific situations. Following the investment, BSMB provides value to the portfolio company in numerous ways including: active board participation, helping establish best practices, providing assistance in recruiting and including the company in its portfolio-wide purchasing program among other activities.” • Source: Bear Stearns Merchant Bank website, www.bsmb.com
Carlyle • http://www.thecarlylegroup.com/eng/company/l3-company735.html
Disadvantages of Public Equity Financing • Costs of compliance with rules and regulations • Disclosure of competitive information • Management's time spent on meeting statutory demands and investor relations • Greater scrutiny from the public and authorities
Capital Markets Regulation • Securities and Exchange Commission (SEC) • Department of Justice (DOJ) • State Securities Commissions • State Attorneys General • Self-Regulatory Organizations (SROs)
Sarbanes Oxley Act - Sec. 404 – Management Assessment of Internal Controls • (a) RULES REQUIRED.—The Commission shall prescribe rules requiring each annual report required by section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)) to contain an internal control report, which shall— (1) state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. • (b) INTERNAL CONTROL EVALUATION AND REPORTING.—With respect to the internal control assessment required by subsection (a), each registered public accounting firm that prepares or issues the audit report for the issuer shall attest to, and report on, the assessment made by the management of the issuer. An attestation made under this subsection shall be made in accordance with standards for attestation engagements issued or adopted by the Board. Any such attestation shall not be the subject of a separate engagement.
Regulation • “Sarbanes Oxley makes companies act much more risk averse. RegFD significantly restrained or constrained information that gets out to the market.”
Dunkin Donuts • Dunkin' brands has been sold to a group of private equity firms for $2.43 billion, Bain capital, the Carlyle Group and Thomas H. Lee Partners. What was the reason to buy?
Serena Software • Acquired by Silver Lake Partners. Silver Lake focuses exclusively on large, technology companies that it feels are, underappreciated but also have substantial unrecognized growth potential. • “We felt that Serena was, underappreciated by the equity markets. Really misunderstood.” • “By taking the company private we can take a bit of a longer term view on how to grow and run the company and invest a bit more aggressively in areas we think will help us build a stronger, more successful company and not have to focus on making earnings every 90 days.” • Source: CNBC Interview of Serena Software CEO
Beat by a Penny, Miss by a Penny • “I think that, both on the sell side and the buy side analysts tend to focus just on earnings and earnings is how the measuring stick for the success, health or failure of a company. • You make earnings or beat by a penny or two, obviously you know what you're doing and your business is great. You miss by a penny, there is something horribly wrong. It's just not that way. I think that, truly understanding the value that certain technology provides to companies, sometimes is just difficult to understand. Therefore, the metric becomes just earnings.” • Source: CNBC Interview of Serena Software CEO
Investing in Technology • Traditionally not an area of private equity investment • Recently, private equity has entered this space
Coles Myer • “KKR, unable to engage the CML directors unless they are prepared to offer more than $14.50. If KKR was prepared to offer that price (and that would have depended on the outcome of its due diligence) it suggests that it shares CML's view that there is potentially much more value in the group, and believes that it is capable of unlocking it - where, to date, CML hasn't succeeded. • But any increase in the bid price would reduce the bidder's IRR (internal rate of return) and mean a transfer of some of that value away from the bidder and to CML shareholders.” • Bryan Frith, “Hostility Looms as Coles and KKR bicker over the price,” The Australian, September 27, 2006
Risks and Concerns in the Buyout Market • Rising interest rates • Higher asset valuation - overpayment • Political backlash • More regulation of Industry • “US private equity shaken by revelation of price collusion probe” October 11, 2006 • Economic slowdown • Failure of exit strategy
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