Private Equity & ‘War Machine’-like activity: the cases of LFC & Focus DIY

1. Private Equity & ‘War Machine’-like activity: the cases of LFC & Focus DIY Adam LeaverCentre for Research in Socio-Cultural Change (CRESC)University of Manchester

2. “Private equity (is) a new and very powerful model of general management. It takes companies out of the capital markets, out of this highly counterproductive game in which managers are lying to the capital markets and the analysts are lying to the managers and both are manipulating each other -- in short, a game that destroys value…It's not just arithmetic. It's a new model of corporate governance…” Prof. Michael Jensen, Harvard Business School

3. “(Private equity) is just a way to get more juice out of a lemon… It ain't complicated… We tend to mystify simple math. It's kind of like sex, there's nothing new about it…. I'm all for the private equity guy. People who invest in them, no one's putting a gun to their head. They're doing it to make a quick buck.” Kenneth Langone, Vantis Capital Management LLC and Invemed Associates

4. Contrasting frames • The two quotes illustrate strikingly different accounts of PE: • Business school account: superior contracting & better governance to solve agency problems; the ‘means’ through which ‘ends’ (higher returns) are achieved. • Industry account: emphasises importance of ‘ends’ and is ambivalent about ‘means’: getting more ‘juice out of the lemon’, the principle that motivates action. • How does PE get ‘more juice out of the lemon’, and what are the implications for the firm and investors?

5. Changing the frame • At one level extraction is acknowledged by supporters & critics: asset stripping for the fund vs ‘disgorging free cash flow’ of the firm. • Need a more sophisticated understanding for post-2000 practice: financialization, bricolage & conjuncture • PE often thought of as an operating model. But in a financialized world, extraction takes increasingly creative forms, which centre on financial sources, where the firm is treated as a conduit. • Conjuncture (Braudel, 1982) facilitates or constrains PE strategies (eg credit conditions, movement in corporate asset prices); but becomes the input for the next stage of bricolage • Bricolage (Levi-Strauss, 1964) isthe motor; structures from events = innovation around holding co’s and financing; & incl. new opportunities via spreads and recaps.

6. Why this matters • Outcomes of PE are difficult to generalise because strategy is reactive; not one general model across PE funds, or even within the same fund over time • Potential for ‘War Machine-like’ activity: involving pressure, force, (often erratic) legal action etc to defend position or lever advantage; using tools as weapons to exert pressure and ‘make the position work’. • Illustrate this with 2 case studies, introduced by two questions before reflecting on financialization, bricolage & conjuncture; and the problem of War Machine like activity:

7. Two Tricky Questions: • Question 1: how it is possible to invest £340m into a business, sell it for £1 and return a gain of £369.2m to investors? • Question 2: how is it possible to buy a business for £220m, sell it for £300m and lose £144m?

8. 1. Focus DIY • Founded by Bill Archer in 1987: • acquired ‘Choice DIY’ in 1987 & ‘DIY’ stores in 1988. • firm then grew organically, taking advantage of growing DIY market • 1996, Duke Street Capital bought 45% of the business for XXXX: • acquisitive strategy: Do It All £68m, 1998; Wickes £290m, 2000; Great Mills £285m, 2001. • Acquisitions made Focus DIY the 2nd largest DIY gp in UK w/430 stores • Expansion largely funded by debt, put on the balance sheet of the operating co.: Wickes, part funded by £250m loan; Great Mills, funded through 170m high-yield bond, w/main tranche of coupons worth £125m priced at an 11% return • By November 2002 the combined company held £650m debt on its balance sheet

9. Cashing in on the conjuncture • Context of conjuncture, opportunism & timing: • Rising corporate asset prices & booming housing market = buoyant HI mkt & many willing investors. • plentiful credit as PE loans were often securitized = opportunities to cash out through part sales & dividend recaps. • Facilitated financial innovation: recapitalisations to quickly recover equity stakes…and more. • Sold 28.9% of business to Apax for £340m, November 2002 = special dividend to recover equity stake. • Sold Wickes for £950m, 2003 = extraction of £369.2m after leveraged recapitalisation. • Recovering returns, leaving firm with the liability

10. Slow motion collapse • Refinancing and buyout debt left the company vulnerable to modest downturn • Declining DIY sales in October 2005 = Moody’s downgrade in February 2005, followed by others in August, September, October 2005 • By March 2007, it was rated Caa3 - unlikely to generate the earnings to cover interest • Breached its loan covenants & defaulted on bonds June 2007. • Sold to US HF/PE firm Cerberus for just £1 to avoid bankruptcy, July 2007. • Rationalisation & repayment of bondholders • But…entered administration again 5 May 2011.

11. The winners and losers • Employees: • numbers employed fell from 6,232 in 2001 to 5,091 in 2007, before collapsing to 3,250 in 2010 • wages as % of t/o fall from 79.9% to 65.9% in 2007 to 40.7% by 2010. • In 2007 Focus pension funds left with a deficit, which were later topped up after intervention by pensions regulator. • Pre-2007 bondholders: senior holders paid in full; mezzanine note holders repaid just 40p in the pound for their debt. • CVA deal with landlords, who cut (or waved) rents in exchange for a special dividend. • What about the PE investors?

12. Focus DIYInitial investment in 1998. In 2007 Cerberus acquired the company

13. 2. Liverpool FC & AG • A different kind of story: • Not a fund buyout (no LPs) • Limited possibility for inorganic expansion via the operating entity (LFC&AG) • Hicks & Gillett bought LFC+AG Feb 2007 for £220 (incl. £45m debt repayment), from 51% shareholder David Moores • Both had experience in sports, which played well with the LFC Board: • Hicks Sports Group: Texas Rangers (b/ball) & Dallas Stars (IH) • Gillett: Montreal Canadiens (IH)

14. LFC: a classic b/out opportunity • LFC arguably a company that needed a takeover: poorly run with big brand & loyal ‘customer’ base • Weak matchday revenues relative to rivals; dilapidated stadium; neglected commercial revenue streams. • Appealed to H&G: • An easy ‘build & sell’ exit opportunity, which could be achieved with someone else’s money; strong cashflows which could be clipped & secure ‘outs’ if the strategy failed. • But problems post August 2007: • a) crisis in credit markets = difficulty financing stadium plus rising LIBOR; b) reliance on s/t debt made refinancing tricky c) downturn in corporate asset prices = no easy ‘outs’

15. Confusion built into the model • Confusion through tiering and refinancing: • Tiered holding company structure across (at least) three domicilities • Companies connected through fragile chains with falling domino effects • Complicate liability (which insulates claims) and confuses observers • Shifting financial arrangements within the structure, • Obscure who owns what, where the funding comes from. • In the event of a default, lots of blur about owner liability; relevant jurisdictions; can the creditors claim, and if so, what assets? • Ended in a legal debacle: suits and counter-suits about who was allowed to do what (the RBS-imposed board at K Holdings vs Owners of K. Cayman, who sacked board.

16. 50% owned by Hicks, 50% owned Gillett 2007-8

17. Key problem: S/T Debt • Reliance on s/t debt just as credit crisis begins = more expensive refinancing • Little negotiating power with the banks: • Feb 07: Refinance 1: £296.5m facility offered by RBS to KF(H) - £202.6m drawn down at LIBOR + 1.5% (finances buyout) • Jan 08: Refinance 2: £350.5m facility offered by RBS to KFL at LIBOR +3.5%; Fac A: KFL £245, £105.5 Fac. B LFC&AG, Fac. C LFC&AG (stadium); Kop Cayman starts to lend at high rates • July 09: Refinance 3: £297m to KFL (£200m + £97m); Owner guarantees + promise to raise £100m finance; Cayman extend loans.

18. Feb 2007 Refinance 1 £296.5m @ LIBOR + 1.5%; £202.6m drawn RBS

19. Jan 2008 Refinance 2a Repays KF(H) £202.6m loan £245m £350.5m @ LIBOR + 3.5%; £245m drawn by KFL, LFC&AG draw £14.4m RBS £105.5m

20. Jan 2008 Refinance 2b £43.5m @ 10% ? Master Swap RBS Wachovia ? Financing costs charged to club Fwd Start Swaption Collar

21. July 2009 Refinance 3a £144.4m @ 10% ? £200m £297m @ LIBOR + 5%, secured by £110m Owners’ personal guarantees RBS £97m ?

23. LFC&AG interest payments

24. (How) did they get the money out? • Aim = clip the cashflows if can’t sell club: • Spread profits on the Cayman loan? • Forced clientalism: use of favoured suppliers for stadium work (Hicks Real Estate Partners) • Expenses: amounting to approx £6-7m + emoluments. • But ultimately undone by events outside LFC: • Kop Investment were – and then weren’t – part of HSG; problems with Texas Rangers & Dallas Stars (no accounts filed). • Forced restructuring of loans used by Gillett to invest in Kop Investments (Mill International HF, loan £75m at 19%!). One asset/multiple loans. • Sale left Kop Football (Holdings) with £144 debt, and no assets. Debts to other counterparties, but no assets to back them.

25. Not just a financial disaster… • Poor news & expectations management • ‘We have purchased the club with no debt on the club’; ‘spade in the ground by March 2007’, made publically and easily refuted. • Acrimony and fall-out: • Between H&G and manager; between H&G/family on the board & fans; between H&G themselves. • Riddled with undisclosed power games between owners • Right of veto and first option, with Gillett the weaker party - significantly in debt with other ventures.

26. 3a) Frame: financialization • So how do we begin to theorise these developments? Frame, Bricolage, Conjuncture. • Financialization = the broad, long run frame which is the context for these outcomes; different definitions: • Fligstein (199x): shift in conceptions of control around the firm: the firm as a bundle of assets. • Krippner (200x): changing source of profits from productive to financial activities. • Froud et al (2006): the growing influence of financial actors, measures and imperatives; but NOT anchored in some behavioural fundamental - produces a set of open dynamics and variable results distinguished by instability, unpredictability & reversibility. • Relevance of agency, firm, industry and conjuncture…

27. 3b) Conjunctural opportunities • Conjuncture (Braudel 1984) = unstable confign of 4-7 years ex (a) asset prices and flows of funds (b) new business models and intermediary opportunities (c) grand narratives, reinforced by performance: • Egnew economy 1995-2000: a) dotcom start-ups & new economy stocks b) new venture capital funds and growth in NASDAQ investment c) reinforced by narratives about falling costs of information and end of bricks & mortar • Eg excess liquidity & real estate 2002-07: (a) credit boom drove up asset prices, linked to securitization (corporate assets to MB CDOs); feeds rising house prices, buy-to-let etc (b) new banking business models: originate to hold, repo spread profits c) narrative about marketisation of risk

28. PE returns reflect conjunctural conditions… Post 2000 easy fund gains from borrowing to hold for profit: • Excess liquidity and cheap debt after Greenspan cut interest rates to 1% + low BoE base rate = huge opportunity to open more funds & buyout more companies, which push up prices. • Post-2002 rising asset prices as FTSE 250 doubles, guarantees high returns without much intervention in operations. Low interest rates cap returns to bondholders: • 70% debt at 3.75% above LIBOR means all the upside is held by the equity owners…where some are more equal than others 2 and 20 structures proliferated under the boom…

29. Some owners are more equal than others… Two classes of owners: • General Partners (GP) ie PE fund invest 2% of equity and take 2% man. fee of funds invested, and “carry” 20% of profits • Limited Partners (LP) ie outside investors eg pensions funds hold 98% equity and get profits minus GP charges • flat 2% can make more than 20% profit share: eg Yasuda and Mettrick (2007) find US buyout fund GPs make twice as much from flat fees….without performance conditions • If the fund makes a profit (over an IRR hurdle of 8-10%) then GPs get a jackpot carry 20% of the profits for investing just 2% of the equity Financier GP get a much higher multiplicand than investor LP (US pension fund or endowment)

30. 5 years of GP fees: ex fund management accounts

31. 3c) Agency & ‘Bricolage’ • Lévi-Strauss (1966): distinction between the plan w/formal/scientific knowledge & ‘bricolage: ‘build(ing) up structures by fitting together events, or rather the remains of events, while science, “in operation” simply by virtue of coming into being, creates its means and results in the form of events, thanks to the structures which it is constantly elaborating and which are its hypotheses and theories’ (Lévi-Strauss, 1966, p.22). • Bricolage, in PE, is conjunctural opportunism: • Frame and conjuncture open out possibilities, which agents navigate & build upon – it was not planned. • Shifting/moving strategies as events change.

32. 4. War Machine-like Activity • Focus DIY & LFC are examples of ‘War Machine’-like activity (Deleuze & Guattari 1984): (a) not independence & opposition, but “coexistence and competition in a perpetual field of interaction”; a pair - “antithetical and complementary, necessary to one another” (b) nature of instruments depends on the assemblage ie “work machine” or “war machine”: tools or weapons? (c) securing mobility of routes and objectives; ‘extending the desert’ & drifting from striated spaces; altering space to facilitate the journey

33. Extending the desert: Arbitraging corp. law & LLC • Dividend recaps: • The payment of a special dividend, often after new debt issue, to equity providers which allow funds to recoup a portion, or all, initial investment • This in effect inverts the normal seniority of claims: i) debt issue represents a claim on future value creation at firm ii) cash extraction via dividend brings forward returns to equity & leaves other claimants scrabbling for what’s left. • S&P Leveraged Commentary Data: $71bn div recaps in N America alone between 2003-6, c/w $10bn 1997-2003; default rates much higher even in boom (6% c/w 3.7% on other leveraged loans) • PWC (2007) 1/3 of funds received a recap in 2006 & 94% of respondents intended to use div recaps as part of exit strategy

34. Arbitraging corporate law and the LLC • Hostile takeover via the debt markets: • Hostile takeovers via equity markets have disclosure obligations • Not so in 2ndry debt markets: purchase distressed senior debt, force bankruptcy – wipe out junior bondholders & equity holders • Congratulations! – you are the senior creditor and you own the company!

35. What the war machine analogy helps us to see: Not meant in pejorative sense, but as a means to understand action: (1) The buyout is a battle, which is about making positions work; PE’s use of leverage + novel corporate structures/financing as a way of exerting power, confusing the opposition etc – not one fixed model (2) The outcomes of the war reflect the changing topography of the battles; risk of overextension and retreat from positions of fortitude as the terrain changes. (3) This is a long way from PE as an operating model, which solves agency problems.