Private Equity Firms

9/10/08

To All Fixed Income/ Interest Rates Students:

I would like today to discuss the activities of private equity firms.

A pretty good summary of the activities in which these firms engage may be found in Wikipedia (http://en.wikipedia.org/wiki/Private_equity), namely: Leveraged buyout (LBO-remember this acronym!!!), venture capital and growth capital. I would like to briefly concentrate on the LBO issue that is not illustrated very well by the Wikipedia page (http://en.wikipedia.org/wiki/Leveraged_buyout). The following description of the LBO process is a general scheme and may have other variations. In essence the process entails finding other people to pay for the deal while keeping all the upside potential from equity ownership of the Company.

Step 1: The private equity firm (“the Firm”), identifies a target with (preferably) the characteristics described by Wikipedia. The Firm thinks that it is a good idea to take over the Firm because of the following potential advantages:

a. The Firm judges the Company's management lacking.

b. The Firm owns other companies with potential synergies with the Company under consideration

c. The Firm judges the Company as underleveraged. The more the leverage the more the tax advantage (Modigliani-Miller)

d. The Firm hopes it can find a lot of suckers that will help it take all the risk while accepting low returns.

Step 2: The Firm identifies a bank (or a syndicate) that will be willing to provide it a bridge loan. This loan is intended to help the Firm to pay for the purchase of ALL the Company shares until new suckers are found.

Step 3: Approach the Company’s management (and board) and convince them to approve of the takeover at a premium over current market price.

Step 4: Once agreement is reached, the Firm purchases all shares in the Company with money provided by the banks in Step 2.

Step 5: Once the Company is fully owned by the Firm, it issues a large amount of new debt. Because this debt comes on top of older, pre-LBO, debt it usually offer high interest and fall into the junk bond (=high yield bond = below-investment-grade bond) category.

Step 5: The Firm makes the Company pay most of the proceeds from the new bond issue in dividends to itself (the Firm)

Step 6: The Firm repays the bridge loan from the dividend money. In many cases the dividend amount exceeds the bridge loan amount. After paying the bridge loan, the private equity Firm already has some “free” money in its coffers.

Step 7: If the Company does well, the Firm can re-sell it (to another private buyer or even back to the public (reverse LBO!) and pocket the selling price (it doesn’t owe anything to the bondholder, the Company does).

If the Company does not do well, it can go bankrupt and taken over by the bondholders or even be liquidated. Although this may deprive the Firm from additional profits, it doesn’t suffer any out of pocket cash losses if this happens.

A few asides:

1. When the Company is made by the Firm issue additional debt, the situation of the original bondholders is worsened (say the interest coverage ratio of the firm goes down from 2 to 1). These original bonds lose value. Since this is all a zero-sum game, who is gaining this value? Answer: the Firm.

2. Issuing additional bonds is not the only way in which the deal can be financed. In recent years, leveraged loans (high-interest loans granted by banks) became popular. Not surprisingly, more than a few such loans became virtually worthless in recent months. The lending banks had to take a bath on this account as well.

Read the following article from yesterday’s WSJ (http://online.wsj.com/article/SB122091910239912651-email.html)

Think about the following: At what Step did this deal go wrong?