Sell Me Your Company!
from
September/October 2005
by John Curran
Remember the high-interest-rate years of the ’70s, the run of leveraged buyouts of the ’80s, the boom decade of the ’90s? Eras come, eras go. Fortunes gained, fortunes lost. The new era of the new millennium is scandal, reform—and privatization? More fortunes gained? Why not? Going private is one way directors can reward shareholders and position their company for the future.
Potential buyers abound—and they’re deep in serious cash. Over the past 10 years, more than $445 billion has flowed into private equity funds (not including venture capital funds), according to the Private Equity Analyst, a Dow Jones newsletter, and another $70 billion or so is expected to fatten that war chest by the end of the year. Among the big buyers to watch for: the Blackstone Group, Kohlberg Kravis Roberts & Co., Thomas H. Lee Partners, Silver Lake Partners, and Texas Pacific Group. And remember the power of leveraging. With the help of banks and compliant credit markets, firms like these can quintuple their effective financial might. In essence, this means that private equity funds will have raised another $350 billion of aggregate buying power in 2005, roughly equal to the combined market capitalizations of Coca-Cola, McDonald’s, Merck, Merrill Lynch, and Time Warner. Now that’s muscle.
Selling the company has got to be tempting for almost any board. Sure, there are risks. Can you sell it for a real premium? Will a new owner ruin what you and others have worked hard to build? Will there be a spot for you on the new board? And what if you open your corporate books to potential buyers and the deal falls through? It happens, and when it does, it means somebody out there now knows your secrets.
Risky or not, it’s often companies, not prospective buyers, that initiate the buyout dance. Says Stephen Schwarzman, president of the Blackstone Group:
“We have four or five deals going on right now—deals of major scale, from $5 billion to $15 billion—and most of those were not initiated by us. We get contacted by the CEO, who says, ‘This might be a good thing for us to do.’”
No matter who makes the first call, private equity firms are clearly eager to deal. If the seller is in a hurry, no worry. The biggest private equity managers brag of their ability to line up $15 billion in a week with just a handful of phone calls. And they’re buying virtually everything—public companies, and pieces of companies, of nearly any size, across any industry, from a satellite maker to a yellow-pages publisher. Recently announced deals include tech titan SunGard Data Systems, going private for $11.3 billion; retailer Toys “R” Us, for $6.6 billion; and upscale merchant Neiman Marcus Group, for $5.1 billion. “There’s almost no company beyond our reach,” says one private equity buyer. And a slew of new deals every month back his boast.
The big players these days are well-coiffed corporate types, but their immediate antecedents are the scrappy predators of the 1980s. Led by colorful financiers like Carl Icahn (who’s still in the game), Irwin L. Jacobs, and T. Boone Pickens, they exploited a new market in junk bonds to finance deals for sluggish companies with rich balance sheets. They’d gain control—typically through a hostile bid—and often strip the company’s assets for a quick payoff. Not all takeovers were unfriendly. In 1987, Kohlberg Kravis Roberts joined the battle for RJR Nabisco at the invitation of the RJR board. KKR won the company with a spectacular $25 billion leveraged buyout. Some believe the deal almost sank the firm. It certainly heralded the end of an era.
Private investors began to change their ways in the early 1990s. As stock prices rose and the junk-bond market withered, they evolved from a hostile force to more of a market-wise partner. In 1993, for example, Texas Pacific Group, one of the major players in private equity today, was instrumental in pulling Continental Airlines out of bankruptcy. Says Texas Pacific’s co-founder, Jim Coulter: “We bought about 35% of this bankrupt company, not to leverage it, but to help the board build a new management team.” A partnership was born.
These days in-depth management expertise, and not just oodles of capital, is what private equity brings to the table. As Henry Kravis told a private equity industry group late last year: “The businesses we invest in today are better-managed companies than those we invested in 10, 20, or 30 years ago. And there is more transparency in business, so it is extremely hard to find a hidden jewel. [Today] none of us make money at the time of the acquisition.” Message: KKR and other private equity firms can no longer count on a killing as hit-and-run investors; they must now earn it the hard way.
And earn it they do, offering solutions to some of the thorniest problems facing public companies. Sitting at the conference table in his New York City office, Blackstone’s Stephen Schwarzman leans back and ticks off a series of director challenges—and solutions. Want to do an acquisition, but don’t want the debt of the target company on your books?
Get yourself a private equity partner. Envisioning major changes in your company to make it more competitive, but reluctant to take those ugly write-offs while on the public stage? Go private for a few years, do your write-offs, then reemerge stronger. Want to make a strategic acquisition, but can’t afford it? Partner with private equity and tack on an agreement to buy it out in a few years, when you’re more flush. He goes on and on. “We lay out all the options,” he says.
There are still the occasional financial nasties between big investors and CEOs, but those usually come from hedge funds or mavericks like Carl Icahn, who this year fought his way onto Blockbuster’s board. A more representative example of private equity’s dealings is that recent $11.3 billion acquisition of SunGard Data Systems in Wayne, Pennsylvania, by a consortium of seven firms, including Blackstone, KKR, and Silver Lake Partners.
SunGard had faced a perplexing problem. Its three disparate businesses—software, data processing, and data backup systems—were not well understood by the equity marketplace; a haze hung over the stock. The board struggled with ways to catch Wall Street’s attention. Late last year the company announced its intention to spin off its data backup business, declaring that this was the start of a long transformation that would help it attain better growth and a higher stock-market valuation. Private equity firms heard that announcement as a mating call. Within a short time, a consortium of would-be buyers was talking to SunGard about an alternative plan, namely to take the whole company private. Says one investment banker involved in the deal: “The more the board thought about it, the more they thought it might be better this way. If the private equity firms will pay for the value of this transformation up front, and the public market won’t, then why not do it in the private environment?”
In late March, SunGard and the consortium of seven buyers had a deal. The price they agreed on was $36 per share, 40% more than the stock had been selling for the previous day. That premium is significant, because the sale wasn’t an auction but a negotiation. “SunGard’s board did a very good job,” notes Edward Gilhuly, a KKR partner. Adds SunGard chairman James Mann: “We said no two or three times, until they [the private equity consortium] reached a price we believed reflected the fair value of the company.”
Private equity firms are demonstrating long-term interest in their acquisitions—a dramatic change from the quick asset-stripping of 20 years ago. Case in point: Texas Pacific, which had sought to buy IBM’s personal computer business. The firm lost out to the Chinese computer maker Lenovo Group. But when the Chinese then invited Texas Pacific to join two other private equity firms and invest in the Big Blue spin-off, it jumped at the chance and put in $200 million. In exchange, the U.S. firms have two representatives on the board. Says Texas Pacific’s Jim Coulter: “We were not the cheapest source of capital that would have been available to them, but we brought additional expertise to the party—especially in helping management to change strategy and integrate the companies.”
Deals rarely go sour—there’s too much at stake—but when they do, as one did recently between retailer Woolworths Group PLC of Britain and Apax Partners, a heavyweight in European buyouts, things can get ugly fast. Apax made a preliminary offer for Woolworths in March. But the deal fell apart during the due-diligence phase when Apax withdrew its offer. Woolworths issued bitter statements, and the CEO had to embark on a road show to reassure investors that the company was financially stable. Apax Partners has remained relatively quiet on the matter, saying only that it was “unable to confirm certain cash items” on the Woolworths books. That’s the kind of image damage that can take years, and countless road trips, to repair.
To engage private equity successfully, you have to make thorough preparations. Kees Cools, a senior adviser to the Boston Consulting Group, recommends that companies approach divestitures as a process. First, when you’re deciding what, if anything, to sell, “don’t focus so much on profitability as on the bigger question—do all of your businesses fit with the evolving strategic direction of the company?” When you’re selling the whole outfit, Cools’s second point is more relevant: Know what the value possibilities are. “It’s not enough just to know profitability,” he says. “You want to know what’s driving value creation, and what its potential is.” Also, can current management maximize value, or can somebody else do it better?
That last question is a key to negotiating the best price. Understanding what new value could be created if a business were in different—private—hands helps you understand what the company might be worth to a private equity buyer. Says Phil Wisler, managing director of fairness-opinion services at Standard & Poor’s: “In a sale negotiation, success is getting some of that potential value creation in the price the buyer pays today. So it pays to know what that potential value is up front.” Not only does Wisler’s team render straightforward fairness opinions for company transactions, it also runs the value equation under different ownership scenarios. Wisler says, “This helps educate the board on the synergies a new owner may bring.”
There’s a separate list of considerations when it comes to evaluating would-be buyers. Edward Gilhuly of KKR, who has worked on dozens of deals, points to several critical issues. The board should know how well the acquirer understands the business it’s buying, for example, lest it face last-minute jitters. “You don’t want the buyer discovering the true nature of the business after the due-diligence process,” he says. Directors also need to know everything about how the deal is going to be financed. “It’s not just the debt financing but the equity component as well,” says Gilhuly. “How leveraged will the acquired company be, and how stretched will the sponsor be? If there’s going to be a complication in a deal, it’s probably going to trace back to one of these issues.”
Private equity firms are different creatures from public companies, and they bid differently than their public counterparts at auction. While they typically seek a higher return than, say, a publicly traded industrial company would, they are also inclined to bid more for their prey. One reason for that is the shortened time horizon of private equity investors. A recent M&A report by Paul Gibbs, head of research for JPMorgan’s investment bank, notes the paradox: “Private equity firms usually [outbid] industrial firms in take-private bids for public companies. At the same time, private equity firms seek significant returns—of 15% or more—and have earned a reputation for delivering such returns. These contradictions prompt unsuccessful industrial bidders to ask, ‘How can a private equity firm bid more than we can?’”
The answer, allegorically, is the reverse of the tortoise and the hare. While the tortoise may win in the fable, in real life the hare wins most races because it’s faster and—at least in the case of private equity—it doesn’t nap. Typically, private equity firms are looking to cash in, either by selling the business to another private buyer or by taking it public again in three to five years, whereas strategic (that is, industrial) buyers ordinarily have a long timeline. This difference leads to different ways of valuing an acquisition. In most cases, an industrial buyer will use a discounted cash-flow analysis to value a company and bid slightly less. A private equity bidder, on the other hand, doesn’t need to discount distant cash flow, because it’s likely to exit the deal through a sale or an IPO within a few years. Thus the private equity firm estimates cash flows over the short period, figures on an “exit price” that the company might fetch in an IPO, and then, as the JPMorgan report says, “adjusts the contemplated capital structure to achieve a particular equity return.” In other words, it can tweak the financing in any number of ways to reach the desired objective.
There is also that little thing called leverage, and recently it’s been a tremendous boon to private equity bidders. Deals are often capitalized at a debt-to-equity ratio of 4 or 5 to 1, far more than a public company might use (some private equity buyers go even higher). Right there, with interest rates low, the cheap cost of the debt produces a big difference in expected return for the two buyers.
The Blackstone Group’s Stephen Schwarzman is almost philosophical about return prospects: “What we find is that the ultimate rate of return you make is never what it is when you first analyze it. There are always things in the external environment that change the outcome. Say you hit a much better economic environment, or a much better credit cycle, where rates are much lower than you thought they’d be over the first year or two of the investment. In that case, you can continually get more leverage once you own something. You can refinance it within six months and take out huge dividends that were never contemplated at the outset.” He also acknowledges that cycles can turn against private equity: “Then some of the deals that happened at the end of the cycle, at high leverage, will create the new opportunities.” In the spring Blackstone was reportedly raising money for a new equity buyout fund, to be the world’s largest at $11 billion.
The latest twist in private equity isn’t necessarily to the seller’s advantage. It’s the emergence of the consortium, in which a group of private equity firms can combine resources to make a bid for a large company, as happened with SunGard. While this puts many new companies on the list of potential acquisitions, it also changes the dynamics of bidding. Explains Jim Coulter of Texas Pacific, a frequent member of consortia: “When different private equity firms are competing against each other as bidders, the winner ends up paying the price that no one else was willing to pay.
With a consortium, the final price is the price that all members of the group agree to.” SunGard’s successful sale notwithstanding, a company seeking the highest possible price for its shares will probably do better in a heated bidding war among competing outfits than at a sit-down with a consortium of firms.
For directors, private equity’s buying binge has one important personal implication—your place in the boardroom may be at risk. Yet while an acquisition of your company almost certainly implies changes in board membership, the extent of those changes is by no means certain. Notes Andrea Redmond, co-head of the board services practice at Russell Reynolds: “A private equity purchase creates an event whereby the new owner does an assessment of the existing board, but that doesn’t necessarily mean the end of the board.”
If the private equity firm is mounting a major change in strategy, she says, an entirely new board is in the cards. But if the existing strategy is just being tweaked, a director with special experience is likely to be kept around. Indeed, as private equity shops expand their holdings, their own bench of board members is stretched, so the odds for you improve. If you do find yourself privatized out of a board seat, take heart in your suddenly much-more-valuable stock options, and include private companies as you search for new board openings.
