21 January 2012

The Private Equity Enigma

Much like I do with Venture Capital investments, I've often wondered how much long-term value Private Equity firms create for their portfolio companies and society as a whole.  PE shops use a combination of financial engineering and operational savvy to generate the required above market returns that their limited partner investors seek.  But do these companies that “go private” end up as better run companies?  From an Atma perspective, do they become more sustainable as a result and create lasting value for the general public?  Or is it a case of corporate raiders manufacturing gains in the short-term while leaving portfolio companies in a weak long-term position?  
Many critics (and more recently, anti-Mitt Romney candidates) have the notion of "barbarians at the gate" in which these firms layoff employees in mass, burden the companies with unsustainable debt loads, and run the company merely for quick returns.  A recent WSJ article, which examined the performance of Bain Capital portfolio companies during Romney's tenure, might support this view.  Although creating nearly 50% return for investors,  roughly 30% of the companies went bankrupt within 8 years of investment.  Further, only 10 deals (out of 77) created the lion share of the returns (4 of which subsequently went bankrupt).  Bain Capital claims the data is skewed as it generally invests in more troubled companies than most; Either way, it surprising that a firm anchored by strategic prowess had significantly more losers than winners in its portfolio. 
The truth is that it is virtually impossible to get statistically significant data to analyze whether companies are better in the long run.  So I took a different approach.  I put together some hypothetical numbers to figure out what kind of financial improvement would be necessary to generate the required rate of returns (~20-30%) for PE investors within a typical investment period (five years).  The result of my high level experiment:  financing matters more than operational improvement. 
In the heyday, firms were able to borrow almost 80% of their purchase price.  In this scenario, a nominal 5% increase in operations (annualized EBITDA growth) would yield a whopping 29% annual internal rate of return (IRR) for investors five years later. Cutting back the debt to 50% would cut the return in half.  In the same example, doubling the improvement in performance (ie. 10% EBITDA growth), would only yield a 12% incremental IRR.   Even a slight decrease in operating performance would yield positive returns. And upon exit, the company is still left with almost four-fifths of the original debt load.  
I can send anyone who wants to see my analysis, but I would have hoped that company improvement would have mattered more.   Negotiations with suppliers, closure of underperforming locations, some minor changes in operations can readily achieve a 5% lift.  And it is clear that as debt becomes harder to come by, PE returns have significantly dropped.  It is also hard to find big successes through the PE umbrella.  Even the Bain home runs like Staples have struggled post-IPO.  And even if Staples created more jobs, what about the thousands of local office supply dealers that were forced to close its doors?
The fact that leverage matters most in these deals shows that investment performance has little to do with how the companies actually do long-term.  We are in the midst of the second PE hangover in which overleveraged companies bought up by firms at the debt market peak have yet to restructure (remember Chrysler or Hilton?).   It is clear that private equity firms will have to work harder on the operational side to generate the kinds of returns their limited partners are accustomed to.  Much like governments these days, firms have to work on both cleaning up their existing debt and investing with less borrowing capacity.  So if you are looking to invest in a PE firm, you may want to look at their ability to garner debt and sell companies much more than their track record of improving company operations.  

05 January 2012

A helping hand in a race to the bottom

Sears' holiday season was anything but as it announced sharp sales declines, shedding of locations, and reaffirmation that the Kmart acquisition was a disaster.  Sears is not alone; it is merely a recent example of  a failing company that reaches for a lifeline by partnering with another struggling one.  Why do companies repeatedly attempt this doomed strategy?  Isn't it better to try to fix your own woes instead of inheriting new ones?

It is not uncommon for large companies that lost their way to make a strong comeback.  Everyone knows the story of the resurrection of Apple and Jobs 2.0;  some, like IBM, diversified their way to higher growth businesses; others like Ford kept large cash reserves to protect itself from a market downturn.  Successful restructurings often require significant pain in terms of job losses, structural changes, and bets into new areas.  Strong management teams and sound strategy are the keys to navigating turbulent waters.

But a successful playbook never included a buyout of the weakest competitor.  No matter how cheap it is.  Companies often try it because its the easiest (or sometimes only) option.  Cut costs, raise prices, and hope things work out.  The Nextel deal put Sprint on a fast track to brinkdom.   Struggling railroaders in the 1960s were unsuccessful.  Remember Alcatel and Lucent? Even dotcoms like Lycos rolled the dice and lost. There are hundreds of examples across an array of industries that have tried and failed.

You can't fix a broken business model by adding more of the same.  Sure cost cuts can help, but surely you can do that on your own as many have done.  Ford, for example, initiated tremendous cuts (and yielded concessions from union on the heels of its struggling competitors) while revamping its focus to smaller cars. A large scale integration in a time of crisis leads to a misallocation of resources, a myopic focus on cost savings, and an opportunity for competition to steal customers and strengthen their market position.  The Japanese auto companies did so during the Daimler/Chrysler fiasco;  Southwest significantly increased share during the airline consolidation of the 1980s.  These companies had viable business models to begin with - a key ingredient that cost cutting along cannot solve.

So will Sirius and XM work ?  Given all the deal talk surrounding Yahoo these days, will a combination with AOL allow it to compete with Google ? Borders + Barnes would have been a disaster.  If history shows us anything, an announced merger of two subpar rivals might be a leading indicator to head for the exits. Generally speaking, at that point, it might already be too late.