You may have already noted that the major deals announced in recent years are far greater in value than the total value of a typical private equity fund. Welcome to the world of private equity financing, which puts the “leverage” back in leveraged buyout.
It’s rare that a private equity firm will simply buy a company outright with its own money. For one, even the biggest private equity fund could only manage to buy a company on the small end of the large-cap scale. And as any fund manager will tell you, it’s never wise to put all your money into a single investment. So instead, the money that private equity firms raise is, essentially, seed money. To get the rest, private equity firms enlist banks and hedge funds.
There are plenty of different ways to raise leverage. The first is a simple bank loan—simple, of course, if you consider $10 billion a simple sum of money. But, in essence, the private equity firm promises to repay the bank the money borrowed with a certain amount of interest. This is generally backed by either the private equity firm’s own resources or, more likely, the value of the enterprise to be purchased. In theory, if the firm defaults on the loan, the bank can go after the purchased company and/or the firm itself. In reality, this rarely happens; if there’s a problem, the two sides iron out a solution that, sometimes, can even involve the bank pouring more money into the target company or private equity firm to affect a greater turnaround.
Sometimes these loans are simply that: loans from a bank. In many other cases, the private equity firm will float a corporate bond, based on the perceived value of the enterprise to be purchased. In fact, over the past few years, private equity firms have sought to lever up their new companies as much as possible. That’s not simply because they want as much capital as they can get to expand the companies. At least some of that leverage goes back to the private equity fund as a “special dividend” for the people who just bought the company. Much of that new debt stays on the target company’s books throughout the private takeover period and on through the exit strategy.
Here’s an example, admittedly somewhat extreme, of how financing works. The Ford Motor Co. sold car rental chain Hertz Inc. to Clayton, Dubilier & Rice, The Carlyle Group, and Merrill Lynch Global Private Equity for $5.6 billion in September 2005. The three private equity funds put up $2.3 billion—the rest came from debt that ended up on Hertz’ balance sheet. Indeed, shortly after the sale, the private equity firms got $1 billion back in dividends. Ten months later, Hertz Global Holdings was re-introduced to the marketplace in an initial public offering that raised roughly $5 billion. The three private equity firms logged a $4 billion paper profit on the deal through more special dividends and, it should be noted, about $100 million in fees charged by the private equity firms!
Over the past decade, private equity firms have increasingly paired up with hedge funds, essentially coming together with pools of private capital to buy out a company. The hedge fund, instead of getting a fixed amount for its investment, will often go along for the ride, hoping for the same outsized returns the private equity investors will get.
Some companies may not need to be “fixed,” per se, but the whole reason they were brought private was because the private equity investors saw ways to unlock increased value within the company that wasn’t being used. In the next one to five years, the private equity investors go to work on leaving the company, ideally, in a better state than they found it.
A company bought out by a private equity firm won’t notice what happened the day after the deal closes, but within a year, the firm will have left an indelible mark on the company. Inefficient processes are tossed out without a second thought, activities and supply chains are streamlined, the company’s workforce is often cut back (at least through attrition if not outright layoffs), and new initiatives and, in some cases, new products are introduced.
The firm’s role in this stage of the process is to set definitive goals for improvement and lead the company to make those goals a reality. Targets are set—often during the deal-making process—and are reached through the leadership of the private equity firm’s consultants and hand-picked managers. There are often those within the newly private company who will bemoan the changes; they’re generally the ones who will be shown the exits first. Private equity firms have neither the time nor the inclination to be sentimental about their new purchases, and thus the changes that take place can be jarring and drastic. A good private equity firm, however, will take the time to get the employees to buy into the new program, which helps everyone—the employees keep their jobs and feel good about change, while the private equity firm gets a quicker and more efficient outcome.
There are, of course, an infinite number of ways to unlock value in a given company. Retail chains have traditionally been popular targets of private equity firms because underperforming outlets can be closed and the real estate sold.
But after years of success, private equity firms have had less success lately. A Financial Times analysis reports that “more than half of the largest leveraged retail buyouts completed since 2007 have either defaulted, gone bankrupt, or are in distress.”
Private equity firms also have their sights set on manufacturing companies. Industrial companies can be improved with new machinery and tighter supply chains. Payrolls can be reduced, debt can be restructured, and a variety of expenses can be cut through using different vendors or items. New customers and contracts are pursued.
Alternatively, the “fix” may involve disbanding the company, either in part or altogether. Smaller conglomerates tend to be unwieldy—so why not focus on the core business and sell off the other divisions? Perhaps there just aren’t enough synergies within the company, so the divisions can be sold off to rivals. So long as it generates capital or the potential of higher profit down the road, the private equity firm will do whatever it takes.
Private equity firms aren’t in the business of actually owning companies. They buy and sell companies like one would buy an old house, fix it up, and resell it for a handsome profit. At some point, the private equity firm will want to close out the investment and reap the returns. In general, it has plenty of options.
The most common way to reap the benefits is to reintroduce the company to the public market via an “initial” public offering—a somewhat misleading name since this is likely the second time the company has floated stock. Nonetheless, the company is new in the eyes of regulators, and thus is a new offering.
The IPO route is quite similar to that of any other company seeking to go public. The private equity firm hires an investment bank (or walks across the hall, in the case of a private equity division of an investment bank) to underwrite the offering. The investment bank does an assessment of what it thinks the enterprise is now worth; ideally, the private equity firm has brought enough value to the company to make it worth more than the initial
purchase price. The private equity owners and investment bank come to a consensus of value, and then the company goes on a junket with the investment bank, giving institutional investors and Wall Street analysts a “road show” to discuss how much the company has improved and what it’s worth now—and, of course, what it will be worth in the years to come.
Ultimately, the company sets an offering price and a date, and stock is floated. Generally, the private equity firms will retain large chunks of equity in the company, floating anywhere from 20 to 90 percent of the stock on the open market. The proceeds of the IPO generally go to the private equity firms. Sometimes, the firms will float only a minority of the outstanding shares, leaving them with effective control of the company. The private equity firm may unwind its position in time, of course. Other times, the firm is simply interested in getting out with as much money as possible. It may hold on to a stake to see how much it appreciates, however, building even more value for its own stakeholders.
Private equity firms are partial to IPOs because they bring about returns in several stages. When the firm releases
stock to the public, it receives the returns. It then gets to see its remaining stake appreciate, and can participate in dividend and stock buyback programs as well. And, as we saw from the Hertz example previously, it can find whatever additional fees it wants to end the relationship between it and the newly public company.
The other exit strategies are fairly straightforward—outright sale and disbanding the company. In an outright sale, the “fixed-up” company is sold to someone else, generally a larger public or private company. This can be somewhat less lucrative, but the company also doesn’t have to be in pristine shape, either. If a private equity firm has come across some recalcitrant problems within its target company, selling to another company effectively passes off the problem while still generating returns for the firm’s investors.
Alternatively, the private equity firm may opt for a sum-of-its-parts strategy, selling off the company piecemeal. This is particularly popular when a private equity firm purchases a distressed or even bankrupt company that has more than one operating unit. The units can be broken apart and sold to rivals, who are likely to pay a premium to buy up market share at the expense of a one-time rival. Some private equity firms will even purchase a company solely for the purpose of merging part of it with another portfolio company to strengthen the latter, and then sell off the rest of the former company.
This is, of course, a necessarily broad overview of how private equity deals work. There are many private equity funds that specialize in distressed debt, early-stage venture capital investing, and other wrinkles. But ultimately, the roles and the process are generally the same.