Mini-Course Series - Alternative Investments (Part 4) by Institute of Business & Finance

MINI-COURSE SERIES ALTERNATIVE INVESTMENTS Part IV

ALTERNATIVE INVESTMENTS

PRIVATE EQUITY The perception about private equity firms ranges from vultures, barbarians, and flippers to job creators and increasing a company’s net worth. Private equity firms typically invest in U.S. companies that are underperforming their industry peers. Investors in private equity make money if they improve the performance of the companies invested in; private equity tends to use more incentive-based pay than other firms and is last in line to be paid in case of insolvency. Private equity specializes in leveraged buyouts or deals funded by debt that is loaded onto the target company’s balance sheet. The acquired companies are often restructured to reduce costs, improve efficiency, and repay the debt before being sold or listed on the public markets. The preferred “exit strategy” of a private equity firm is to take the company it has acquired public, thereby raising even more money that may help the company become even stronger. By law, a company cannot pay a dividend unless it is solvent. It is illegal for a director to authorize a dividend that would render the company insolvent. Board members can be personally liable for agreeing to a dividend of an insolvent corporation.

Private Equity Firms The Good

The Bad

6.6% annualized returns over five years vs. -0.9% annual returns for stocks held by pension plans (September 2011)

2% annual fees + 20% of any profits

Industry employs 8.1 million worldwide

Borrowed money = 49% of buyout value

In 2010, Apollo Global invested $1.5 billion in LyondellBassell; Apollo was worth $6.6 billion in early 2012

Annualized rates have fallen to single digits

At the height of the 2008 financial crisis, the GAO’s private equity report wrote “academic research suggests recent equity LBOs have had a positive impact on the financial performance of the acquired companies.” The same reported noted that in the 2004–2008 period it studied, none of the 500 complaints received by the SEC’s Division of Investment Management involved private equity fund investors.

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The 2008 GAO report shows companies that private equity firms invested in had low growth relative to their peers and that employment growth grew after they were acquired by a private equity firm. In 2009, Ford sold Hertz to a private equity firm for $14 billion. A year later, the private equity firm took Hertz public at a $17 billion valuation.

Bain Capital In a January 2012 article, The Wall Street Journal reported their assessment of 77 businesses Bain invested in, while Mitt Romney led the firm from its 1984 start until early 1999. Among the findings: [a] 22% filed for bankruptcy reorganization or went out of business by the end of eight years after Bain first invested. Another 8% resulted in Bain losing its entire investment money (note: figure drops down to 12% if the period is five years). [b] A different study, covering the 1985–1999 period found bankruptcy rates among target companies globally was 5–8%. [c] The stellar returns for its investors were largely concentrated in a small number of deals; 10 deals produced more than 70% of the dollar gains. Of these 10 companies, four later landed in bankruptcy. [d] Many of the Bain acquisitions that went into bankruptcy emerged far healthier after the reorganization (similar to GM a few years ago). [e] Bain generally invested in smaller companies that carried greater risk. [f] A 1995 Bain investment of $6.4 million in eyewear company, Wesley Jessen VisionCare, resulted in a gain of more than $300 million, a 46-fold return. [g] Research shows buyout companies, on average, add value to their targets. Romney and his colleagues raised $37 million for their first fund in 1984. At the start of 2012, Bain Capital was managing $66 billion. One Bain investment during Romney’s tenure was backing an entrepreneur who was convinced that he could provide savings for small business owners. The start-up was called Staples, which currently employs 90,000 people. Unlike other investments that trade in debt and derivatives, private equity firms make money by investing in businesses making things and providing services.

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Bain Capital: 10 Largest Profit Deals [1984–1998] Company, Date, and Bain Investment [in millions]

Estimated Bain Gain

Later Status

Chap. 11 B/K

Steel Dynamics [1994] $18m

$85m

Public in 1996

American Paper & Pad [1992] $5m

$102m

Public in 1996

2003

DDi Corp. [1996] $41m

$117m

Public in 2000

2003

Experian Corp. [1996] $88m

$164m

Sold in 1996

Physio Control [1994] $10m

$168m

Public in 1995

2000

Stage Stores [1988] $10m

$175m

Public in 1996

Waters [1994] $27m

$178m

Public in 1995

Dade [1994] $30m

$186m

Dividend

2002

Wesley Jessen [1995] $6m

$302m

Public in 1997

Italian Yellow Pages [1997] $17m

$373m

Sold in 2000

Back to the Basics The term private equity refers to a type of transaction. It is about finding investments such as family-owned companies, buyouts, sweetheart deals with public companies, and joint ventures in foreign lands. Private equity’s selling point is that because their investments are not publicly traded, it is possible to invest for the long term outside of the craziness of Wall Street. Investments made by private equity companies are “marked” or valued by the private equity fund or a third party brought in. When a company is no longer on the public market, it can be “marked” closer to what people will call its true value. The challenge of running a private equity investment is that the private equity fund is literally running the company once it takes on the investment. Most companies acquired are run down and in turmoil. The process begins when a company is approached by a private equity firm who presents them with an offer: the opportunity to no longer have to worry trading on the public market. If the company accepts the offer, the private equity firm makes an offer to the public—a tender offer to buy all the outstanding stock from every shareholder. The private equity firm typically has the company issue collateralized bonds. Once the buyout closes, the company disappears out of the public spotlight and goes into the private equity group’s portfolio. Operational or strategic changes to the company are made to improve its performance. After many years, the private firm sells the company privately or goes public with an IPO.

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The most famous example of such a deal was between private equity firm Kohlberg Kravis Roberts (KKR) and the management of conglomerate RJR Nabisco (as detailed in the book, Barbarians at the Gate). Today, virtually every leveraged buyout is a friendly one. Wall Street loves an LBO. Everybody gets paid. A billion dollars went out the door in fees during the RJR-KKR auction. Investment banks get to make and sell securities, lawyers get to write up complex agreements, and consultants get paid for opinions on the company’s value. In 2011 and 2012, private equity firms were doing fewer and fewer deals. The price for acquisitions has gone up, debt is less available and recently acquired companies are harder to sell. As a result, “private equity is focusing on midsize deals, growing existing businesses and expanding into real estate” (source: WSJ). Still, over $220 billion of deals took place in 2011. Borrowed money (leverage) made up 49% of buyouts in 2011 (vs. 57% in 2010). According to The Wall Street Journal, investors in private equity funds netted 5–11% a year for funds launched between 2004 and 2008. For the previous five years, these funds netted investors 15–30% annually. In 2011, private equity firms paid acquisition prices averaging nine times earnings before interest, taxes, depreciation, and amortization (EBITA) of target companies (vs. 7x in the early 2000s). During 2011, the Carlyle Group, considered the biggest private equity fund manager, sold 43 companies and took 10 companies public. Investors in private equity funds range from pension plans and charities to global insurance companies and university endowments. Public and private pension fund represent 43% of the money invested with leveraged buyout firms in 2010; foundations represented another 12% (source: Private Equity Growth Capital Council). As of September 2011, median private equity returns for large public pension funds over the previous five years was 6.6% vs. -0.9% per year for their stock market returns (source: Wilshire Associates). Cambridge Associates tracks the returns of over 4,500 private equity firms.

The Process To own a company, you need to buy up all of its outstanding shares. However, the people holding those shares are not going to sell them unless they can make a good profit doing so. As a result, the private equity firm needs to offer a price at a premium (typically 30%) to the current stock price. The first wave of debt comes from banks. They are bank loans very similar to that one would get for a home mortgage. Like mortgages, it is backed by specific assets held by the company (e.g., building, machinery, etc.). Because these assets have value, a bank can seize that asset and sell it. There are certain covenants the borrower has to abide by. PART IV

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A covenant is a requirement imposed by the bank, so the bank knows the company is staying healthy enough to pay off the loan. For example, one common covenant is that the portfolio company has to keep its EBITDA to Interest coverage ratio above some number. If it fails to do that, then the covenant is breached, and the entire loan amount becomes due immediately. It is more than likely that bank loans alone are not enough. The answer is high-yield debt. This includes junk bonds and mezzanine debt. In order to accept that amount of risk, the bond market is going to demand a handsome reward (sometimes as high as 16%+). Eventually, it gets to the point that the necessary interest rate is so high the company will bankrupt itself paying such interest (usually, the highest interest rate they can accept is ~ 20%, lower than most credit card rates). This causes the private equity firm to use mezzanine debt, high-yield debt with stock options attached to it. It is hoped that adding a stock option “gimmick” can woo debt buyers into charging a lower rate. The rest of the money has to come from the private equity fund’s own pocket, which may come from “road shows” for institutional investors. A few private equity firms have hedge fund subsidiaries that also invest in the debt. Private equity refers to a type of transaction, a classification. A private equity fund is just a fund made up of private equity investments. A private equity transaction can be called as such if it involves the purchase or sale of securities not publicly traded on the market. These securities have little, if any, marketability. The investor should be prepared to own this type of investment for 10–15 years. There is a large risk of a substantial or complete loss but the rewards can be huge. There are four parts to the private equity sector: venture capital, leverage buyouts, mezzanine financing, and distressed debt. An investment in a private equity fund means access to privately held companies that would not normally be available to a traditional portfolio. This type of investment refers to a range of strategies with different risk profiles and return expectations. Venture capital (VC), buyouts (including LBOs), and mezzanine funds are the three most popular private equity strategies. From 1990 through 2008, $1,000 invested in the S&P 500 grew to $4,000; the same $1,000 invested in an LBO grew to ~$13,000. Issuers of private equity are typically companies unable to raise money publicly. Issuing stock or bonds is not an option, either due to the nature of the business or the lack of capital used to fund such an undertaking. Private equity investing can be divided into two categories: venture capital and leveraged buyouts. Some very bright portfolio managers, such as Yale’s David Swensen, invest ~ 17% into private equity. The advisor should be leery of this category for a number of reasons:

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[1] Swensen has unique access to investments and information - Such as Yale students, graduates, and alumni who do start-ups - Everyone wants Yale and Harvard to invest in their venture - Yale gets first dibs on the best stuff; everyone else fights for scraps

[2] Returns for these assets are extreme; average returns are unlikely - For every Google there are dozens of losers

[3] The story behind almost every venture capital program sounds enticing - “This application will change the way you buy groceries…”

[4] Leveraged buyouts typically claim an undervalued stock - It seems highly unlikely, so much gross undervaluation exists

Frequently, leveraged buyouts have the same (secret) agenda: “rip, strip and flip.” The fund buys the company, issues huge amounts of junk debt to pay for the deal, while fund managers pay themselves hefty dividends and fees from the bond sale proceeds. This allows the leveraged buyout fund managers to largely cash out before any reorganization—resulting in less incentive moving forward. If the advisor wishes to include private equity in the portfolio, opt for one of the best, Warren Buffett. He is the most successful capital allocator in history and makes a salary of $100,000 a year (the vast bulk of his compensation is based on Berkshire’s stock performance). Some private equity funds have opened hedge funds of their own, trying to leverage the brand. Some funds make private equity type investments. As funds get larger, they start finding that it is getting harder to find opportunities that give them high returns. They cannot buy the stocks of smaller companies because their purchases send the prices skyrocketing. They are not satisfied with just purchasing the stocks of large cap companies because everyone owns those already. A private equity type investment is most often done as a direct arrangement between a hedge fund and a company. Suppose a hedge fund meets a telecommunications company in Vietnam. The company wants to continue its expansion by setting up a series of cell phone towers across the country but cannot find the money to do so. The hedge fund offers to start a joint venture—the fund provides the cash, and the company brings the expertise. The company does well, goes public, and makes billions for both sides. Or it fails, losing millions of dollars. In making a private arrangement between two parties, the investor forgoes two things taken for granted by holders of public stock: liquidity and counterparty risk.

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Counterparty risk is whether or not the other party stays solvent enough to uphold its half of the deal. The hedge fund needs to consider the counterparty’s credit, the nature of the deal, and methods of grievance settlement. In some foreign countries, where the courts are not always an ideal pathway to an agreeable compromise, the fund might have to modify the deal. Counterparty risk is forever present, but it is more of an issue with more complicated financial deals.

THINGS TO DO  Your Practice Contact a high-end or respected clothing store (e.g., Neiman Marcus, Nordstrom’s, etc.) and ask about putting on a private showing of new clothes with your clients. You can introduce the showing by talking briefly about your practice or a few of your favorite investment strategies. In the alternative, you can postpone any discussion until during a luncheon you may want to schedule after the private showing.  Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

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