By Apra Sharma
Alternative investments are characterised by high leverage, more illiquid and subject to less regulation. Countering with the argument that make acquiring companies through debt illegal a valid point? Or is it that in this business, taking Sears in focus, political corruption exists? Or would one blame neither of the firms in transaction, but the ‘enablers’? Does this all boils down to flow of capital in Wall Street with such ease caused the ‘damage’ leaving big banks happy and reduced liquidity in debt markets will be a boon or bane to them?
As conceptual check, LBO managers seek to add value – from improving company operations and growing revenue and ultimately increasing profits and cash flows. The potential returns are to a large extent due to the use of leverage. If debt financing is unavailable or costly, LBOs are less likely to occur. A buyout deal may use a combination of bank loans (leveraged loans) and high yield bonds. In Leveraged Buyouts, assets of the target company serves as collateral for the debt and the cash flows of the target company are expected to be sufficient to service the debt. The debt becomes a part of the capital structure of the target company if the buyout goes through making the target company after the buyout a privately owned company.
The goal for private equity is to improve new or underperforming businesses and exit them at higher valuations, so the holding period could be from 6 months to over ten years. Although private equity funds diversify your portfolio, in short term, it may not provide returns above stocks but holding it for a longer term like shown for 20 years, private equity funds outperform. (However, PEPI isn’t a reliable measure and in absence of liquid market, investments may not be marked to market.)
American Investment Council, “Private equity continued its ability to generate the highest long-term returns, net of fees, for investors, according to the American Investment Council’s (AIC) Performance Update Report 2016 Q3, released today.
“Private equity prioritizes a long-term approach, rather than focusing on short-term gains,” said AIC President and CEO Mike Sommers. “This approach is why no other investment strategy can compete with private equity over a 10-year horizon, especially the public markets.”
The report found that annualized private equity investments over the 3- and 10-year time horizons outperformed the Russell 3000 index by 0.7 percent and 3.3 percent, respectively. Private equity also outpaced S&P 500 total returns over a 10-year time-frame, generating 10.7 percent annualized profit for investors.”
According to the Spectrem Group’s 2010 study of American investors with assets greater than $25 million, more than half have allocations to hedge funds, private equity and venture capital with 20 percent of total portfolio allocated to alternative investments. The increasing interest by institutions and high net worth individuals in alternative investments has resulted in significant growth in each category since the beginning of 2000. The Private Equity Council estimated that private equity leveraged buyout deals were approximately $720 billion in 2007 compared with $100 billion in 2000.
One of the key differences between leveraged loans and bonds is that leveraged loans are generally senior secured debt and the bonds are unsecured in case of bankruptcy. Therefore, even given covenants, because of the amount of leverage employed, the bonds issued to finance the LBO are usually high yield bonds that receive low quality ratings and must offer high coupons to attract investors.
Alternative to high yield bonds, mezzanine financing may be used. This type pays even higher coupon and in addition to interest or dividends, this also offers a potential return based on increases in the value of common equity. From 1990 – 2009, Sharpe Ratio of private equity was 0.34, global stocks 0.12, global bonds 0.50 and hedge funds with 0.62. In these two decades, private equity had -23.4% worst monthly return (VC, Real estate, commodities on more downside), hedge funds with -7.5%, global stocks at -19.8% and global bonds with -3.8%.
There are examples of successful retail private equity deal. For example Tops Market, it had a roller coaster ride. (Wikipedia)
- At 12:01 am on December 2, 2007, Morgan Stanley Private Equity became the new owner of Tops Markets. Ahold‘s subsidiary Giant Food of Carlisle provided operational and support services for up to one year after the sale. Max Henderson, Executive Vice President of Tops, resigned his position from the company, and Frank Curci, a former Tops Friendly Markets CEO, returned as CEO of the company.
- Tops Friendly Markets brought back approximately 100 corporate positions in marketing, merchandising and finance to Buffalo, New York. Recently, those positions had been based in Carlisle, Pennsylvania by Giant Food. Existing stores resumed upgrades and remodelling, and plans for new stores continue. Tim Hortons full-service restaurants or self-serve kiosks as well as Anchor Bar wings were added to all stores. A growth rate of more than 10% is expected over the next four to five years.
- In November 2013, Tops Markets announced a management buyout. The buyout, which is expected to be completed by the end of 2013 involves Morgan Stanley Private Equity selling all remaining shares to Tops management, including CEO Frank Curci. As a result, all decisions return to being locally made. In addition, it makes Tops Markets one of the largest privately owned companies in the Buffalo area.
- On February 21, 2018, Tops filed for Chapter 11 Bankruptcy. None of the stores day-to-day operations are to be affected. According to the Securities and Exchange Commission, the reason for filing is due to Tops’ $720 million debt. This opportunity is being used to restructure financially so it can grow and be more competitive.
- On August 30, 2018, Tops announced they would be closing ten underperforming locations by November, including two in Syracuse, one on West Genesee Street (NY 5) at Westvale Plaza, and another on South Salina Street (US 11) at Valley Plaza, two in Rochester, one on Lake Avenue and another on North Winton Road, and one each in Perinton, Lyons, Geneva, Fulton, Elmira (the South Main Street location) and Saranac Lake (at the Lake Flower Plaza).
- Tops Markets announced they emerged from bankruptcy on November 19, 2018.
However, not many retailers are likely to end up with the same fate as this grocery retailer. Debtwire tells us that about 40 percent of all US retail bankruptcies in last three years were private equity backed. Retail businesses under any circumstances is a difficult business to sustain and threats are from various domains.
“One example, Debenhams, a 200 year old British department store ended its operations last week. It was purchased by Texas Pacific Group in 2003, they a while later, promptly began selling assets, dramatically cutting costs and awarded themselves large dividends. Threats come from e-commerce, oversupply of retail, rising rents, tighter margins and OVER GEARED BAANCE SHEETS. Payless Shoes, Toys ‘R’ Us, Gymboree, Sears holding, Mattress Firm and Radio shack – all companies at some point were owned and controlled by private equity firms have filed for Chapter 11”, writes John McNellis on Wolf Street.
Toys ‘R’ Us story: Wolf Richter on Wolf Street writes, “On June 29, its remaining stores in the US will close. And then it’s over of the iconic retailer — one more victory for PE firms that have ploughed into retail during the leveraged buyout boom before the Financial Crisis, loaded them up with debt, and watched them collapse in what I have come to call the brick-and-mortar meltdown. Toys ‘R’ Us is just one of them.
PE firms Kohlberg Kravis Roberts (KKR), Vornado Realty Trust, and Bain Capital Partners acquired the publicly traded shares of Toys ‘R’ Us via a $6.6 billion LBO in 2005. They funded the acquisition in large part by loading up the acquired company with debt — hence “leveraged buyout.” In other words, the PE firm had little skin in the game, and over the years extracted $400 million in fees even as the retailer died.
The 33,000 employees, when it is all said and done in a few days, will be out of a job.
In a sense, the end came very rapidly, after 13 years of building up to it under the PE-firms’ iron cost-cutting fist. The meltdown started in early September when rumors emerged that Toys ‘R’ Us had hired a bankruptcy law firm. Its bonds collapsed on the spot. On September 18, the company buckled and filed for bankruptcy, assuring everyone that it would go on as a going concern. In early March, it became apparent that liquidation would be next. On March 15, the company announced it would liquidate all its operations in the US and Puerto Rico. And it began “final liquidation sales” at all its remaining Toys“R”Us and Babies“R”Us stores.
Among the biggest investors in PE firms are public pension funds. They provide about 20% of the $3 trillion in assets managed by PE firms. Public pension funds like the accounting of investing in PE firms: These investments are considered illiquid and long-term and don’t get marked-to-market. This gives pension funds the illusion of stability during times of market turmoil, and they don’t mind the sky-high fees. And PE firms love public pension funds because that’s where the money is – and the sky-high fees. It’s a symbiotic relationship.
But the Toys ‘R’ Us demise under the auspices of KKR, Bain Capital and Vornado Realty Trust has rattled some nerves, including at the $129-billion Washington State Investment Board (WSIB), which has been investing in KKR for over 30 years, making it one of the earliest backers. According to the Wall Street Journal, it invested in at least 23 KKR funds, including $1.5 billion in the fund that contained the Toys ‘R’ Us investment.
The WSIB held a meeting last Thursday discussing its investment in KKR and KKR’s account of the Toys ‘R’ Us debacle. A recording of the meeting was heard by Bloomberg News:
“Did anyone at KKR lose their job over the failure of Toys ‘R’ Us?” asked WSIB member Stephen Miller. “Did anyone have their bonuses cut? Did anyone have their compensation cut significantly? Because that’s one of the consequences of free-market capitalism.”
This is another retailer that was bought out by a PE firm, saddled with $8 billion in debt, and now grapples with its fate.”
Matt Levine writes on Bloomberg Opinion, “And in fact the financial press is absolutely full of stories of creditors complaining about private equity firms putting one past them, finding clever ways to get paid themselves while stiffing the creditors.
But that’s just the typical conflict. There are other possibilities. For instance here is the story of a time that Apollo Global Management LLC acquired a company and got its executives to pay Apollo to work there.
The dust-up involves CEVA Logistics AG, a Swiss company that Apollo acquired more than a decade ago.
Former executives today say Apollo double-crossed them. In a $34 million class-action lawsuit against Apollo and CEVA, they say the buyout firm looked out for its own interest and used a deft stroke of financial engineering that ended up wiping out their equity. Apollo denies wrongdoing. …
Interviews with 35 current and former CEVA managers, as well as presentations made to prospective executives, reveal how Apollo and CEVA persuaded, pressured or required managers to put their money in. Over the years, Apollo and CEVA told executives they could make as much as 15 times their investment when Apollo eventually took CEVA public.
“It didn’t even enter my mind that I could lose this money,’’ said Smit, who signed a document promising she wouldn’t sue over the investment. “It feels like they robbed hundreds of people by legal means.’’
Apollo bought most of the equity of CEVA in a buyout, and let (or required) executives buy some equity too “since it would give them ‘skin in the game.’” When CEVA ran into trouble you might have expected Apollo to maximize the value of the equity even at the expense of its creditors. But instead Apollo bought a bunch of CEVA debt cheap, became a creditor, and then wiped out the equity:
Apollo started buying CEVA debt at a discount in 2007, according to the lawsuit and an Apollo document. That made it possible for Apollo and other big creditors in 2013 to swap debt for equity in a new company that would own CEVA. The lawsuit says the move erased the shareholders’ stake and let Apollo maintain control with minority ownership of a going concern with less debt.
This wiped out Apollo’s equity (but then Apollo got new equity in the recapitalization), and it also wiped out the executives’ equity (and they got nothing).
In response to the lawsuit, Apollo and CEVA said they had no fiduciary duty to CEVA executives, and that even if they did, it wasn’t breached. Apollo said it lost its equity stake, too, and that a recapitalization was needed because CEVA was close to defaulting on some interest payments.
Huh. Look, this is fine. Executives ought to be compensated in part through equity ownership of their company, and when a company can’t pay its debts, that’s supposed to wipe out the equity, including the equity owned by the executives. Their equity is supposed to be at risk, to pay off if the company works and not if it doesn’t. “It didn’t even enter my mind that I could lose this money” is a terrible thing to say about paying cash to buy illiquid unlisted stock in your own highly levered employer, come on.
There is one general lesson here, which is that when a portfolio company runs into trouble, a smart aggressive private equity firm will tend to do a good job of maximizing the value of its own stake in that company rather than the total return to all stakeholders. (Also it will do that openly and proudly, saying things like “what, we had no fiduciary duty to anyone else”: Every unsympathetic story like this makes Apollo look great to its actual investors, who are pleased to see it working hard and smart on their behalf.) There is also a more specific lesson, which is don’t pay Apollo to work at one of their companies. Honestly, when you write a check to Apollo to work at their portfolio company, and then you sign a document saying you won’t sue about it, what do you think is going to happen?” Looking back a year, in 2018, alternative investment firms have more than $1.8 trillion in ‘dry powder’ reserve with more than half with private equity funds.
Nicholas Rabener writes on Enterprising Investor, “Exposure to small caps likely explains private equity returns. Liquid alternatives to private equity can be created simply by buying small, cheap, and levered stocks.
Some have reached similar conclusions and proposed that the nature of locked-up capital is what makes private equity so advantageous. It keeps investors from redeeming their funds at market lows and helps private equity firms weather storms like the global financial crisis. But the same fund structure can be replicated through public equities at a fraction of private equity fees.
Furthermore, with $1.8 trillion sitting on the side-lines, too much money may end up chasing too few deals, creating high acquisition multiples that don’t augur well for expected returns.
Of course, high valuations are now the rule in both private and public markets. And corporate debt levels are at all-time highs.
Neither of these developments bode well for expected returns. So investors might be wise to reconsider direct private equity allocations and their liquid alternatives altogether.”
Barbarians at the Gate a docudrama and a comedy is based on a book about leveraged buyout of food giant RJR Nabisco. It is a story of greed, egos, and lust for luxury, high stakes, and treachery. After the expensive failure of a smokeless cigarette, the CEO of RJR Nabisco draws up plans to buy the company outright. But an influential LBO guru, who initially gave the CEO the idea for the LBO, is unhappy that the CEO is using his idea without involving him, and they end up in a bidding war. As the LBO guru puts it, “It’s not the company. It’s the credibility. My credibility. I can’t just sit on the bench and let other people play the game. Not my game. Not with their rules.” Among other things, the movie also shows that a CEO may have little to do with the success of his company — and much to do with its failings. The movie features many humorous but telling lines, such as: “You know the three rules of Wall Street? Never play by the rules, never tell the truth, and never pay in cash.”
https://wolfstreet.com/2019/04/19/retails-existential-threat-is-private-equity/
https://blogs.cfainstitute.org/investor/2018/12/03/private-equity-the-emperor-has-no-clothes/