Private equity, probity, and politics
I am rushing to catch a flight, so this will be quick. But I cannot earn one more frequent flier mile without speaking on private equity, which has been treated in the press as either a sign of the devil or the highest expression of American free enterprise.
I am risking a missed flight to remind you that it is neither, and to give a little history of the idea of the leveraged buyout, which was the pimply-kid name for this type of financial engineering before the kid grew up to be Dame Private Equity.
First of all, the first leveraged buyouts were, literally, asset stripping. Buyouts of American Greetings and others in the late 1970s and early 1980s recognized that public corporations had fully depreciated assets on their books and that the market value exceeded book. Raise some bank funds to buy low and you could sell of some assets to pay off the loans to the own the company free and clear. This had the low-risk investment mindset of Graham and Dodd, the theorists who inspired early investors to buy only stocks whose asset values were greater than market capitalization.
The trouble is, the technique was easy, and the market for asset-rich companies very quickly rose to reflect the possibilities of redeployment. So the LBO artist recognized a second valuation metric: cash flow multiple. It found that buying cash flow at a low multiple could permit the effective management of the company and the increase of cash flow. One suspects also that the LBO artists knew that, with the increasing popularity of the technique, more and more institutional investors (such as pension funds) would be attracted to the potential of outsized returns. This would serve to increase the cash flow multiples at the time of sale. Many companies were bought at three, four, or five times cash flow and sold for five, six, or seven times the same cash flow. Nothing really changed except the ownership, and a previously low bank debt company having been saddled with as much debt as it could to pay for the privilege.
Change of ownership is not the most uplifting reason to lever up a company. Luckily, a Harvard professor, Michael C. Jensen, published a seminal article in the Harvard Business Review in 1989. In it, he argued that public companies had inherent conflicts between management and owners on the deployment of cash flow. Owners want dividends and management wants to invest, or so Jensen argued, and the layering on of high leverage both maximized the potential returns and reduced the potential for this boardroom conflict. Jensen’s article was a sensation, creating a number of follow-on conversations, books, and articles on the optimization of the capital structure of American companies by adding debt. It also put the booming industry of buying and selling companies in the positive light of a rational new form of corporate governance.
I must say, I have been in a number of boardrooms and have never experienced the actual throwing of brickbats between owners and managers on this point. But perhaps I wasn’t paying attention, having focused usually either on the broken projector (if I’m speaking) or on the bagels and cream cheese (if I am not).
One thing that Jensen did not focus on in his early papers was risk. Risk of the lenders requiring that cash flow go to pay down debt of a faltering company was not uttered in polite LBO society in those days. And it turns out that easy credit in good years tended to increase the prices, and the bank debt would increase proportionately. And if or when the company meets hard times, that bank still needs to be paid. If the hard times continue for more than two or three years, the very future of the enterprise can be at risk.
But the corporate discussion focused on the optimization, rather than the safety margins, of corporate financial risk. I remember thinking that optimizing financial returns by putting on debt is like optimizing your sense of balance by walking a high wire.
But skepticism on the risks inherent in buyouts does not mean that all buyouts – or all buyout artists – are bad. As a matter of fact, I can think of one or two professional friends who are buyout artists and among the people I admire most. In part, this is because I know how carefully they shepherd their investments.
Here is a short checklist of the behaviors that might distinguish the very best leveraged buyout managers from others:
- Fees. Private equity arrangers are consultants who arrange investments on behalf of the deep-pocket investors, such as pension funds. (See my previous article, “Curried Interest,” on the political shame of how these consultants are taxed). The consultants typically earn 1% to 2% of the funds committed, as well as a percentage of the gain earned on the investment. Some LBO funds add an additional fee, this one levied on the company that has been bought. It can be called a management fee or a board fee. I don’t like these fees. To me the idea of charging a company a fee for the privilege of being owned by you is not in keeping with Jensen’s articles on the best practices of corporate governance.
- Financial management. If the company has been saddled with too much debt, the company risks going under. The trouble is, many private-equity funds have limited lives of five to seven years to invest, manage, and harvest. The pressures to invest, and to do it quickly, are therefore huge. It is inevitable that in some situations, like auctions of companies, an investor would invest just a little too much in order to win the company. Unfortunately, paying a little too much is indistinguishable, at the time of acquisition, from paying altogether too much. The difference between very good acquirers from okay acquirers is risk management at the time of buying the target company. As a practical matter, that means not risking the entire company on a too-high price. It means keeping price discipline, and not getting caught up in the emotions of winning by paying – and borrowing –ÃÂ too much.
- Operating management. Virtually all private equity shops claim to provide help in operations. About half are very good at it. First, the private equity folks should have a vision for the industry that they are targeting for acquisition – they should know the players, the trends, and what makes the industry attractive. They should understand how some companies will thrive, given the strategies that are required. And they should ensure that there is enough cash either in bank lines, or in free cash flow, to permit the acquired company to make the changes required.
I suggest these criteria in case the topic of private equity continues to come up in the presidential race. I have not studied Bain Capital, so I do not know what behaviors it showed in its private equity portfolio. (And at least some of the investments made at Bain, such as Staples, appear to have been minority positions in venture-capital type investments, where Bain neither borrowed money nor controlled the company – so these criteria would not be applicable there.)
If it turns out that the private equity arranger took fees, over-levered the companies, and did not make operating improvements, I would have one opinion. If it turns out that this was not the case, I would have another. I would focus on the behaviors, rather than results – if the company went out of business or if it was sold for a big pile might be less important to me than what the private equity managers did, and when they did it.
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