In this article, we’re going to talk about private equity buyout strategies.
It’s the 21st century. Everyone in private equity and probably their relatives know about the trick behind using leverage. What else is new?
While LBO was an innovation during the 1980s, it’s practically common sense in today’s day & age.
Now if you’re a private equity investor and everyone is doing the same thing, it’s obviously hard to differentiate yourself, right? So how do you achieve superior returns vs. the rest of the industry?
Truth be told, not all LBO deals are created equal.
There are different buyout strategies and some are fundamentally more attractive than others before even taking into account what the business does, how much leverage you can use or the valuation.
These buyout strategies take advantage of the inherent inefficiencies in businesses. Some private equity firms have caught on to this and began developing an expertise in these niche buyout strategies.
To set the scene, let’s understand why these niche private equity deals have become a necessity.
Back in its heyday, private equity investors were able to achieve vastly superior returns than investors in the stock market.
There were little capital available competing for deals. Selling shareholders don’t have that many potential buyers to turn to. So those who had capital were able to negotiate sweet terms and purchase companies at a low multiple.
That was a great time for those in the industry. There wasn’t much competition for deals and returns were amazing.
Time has changed.
Lots of Competition
There are now thousands of private equity firms around the globe competing for buyout deals.
Limited Partners (i.e. pension funds) started to allocate a greater portion of their assets to private equity funds. Adding on top of that, there’s a “denominator effect” at work with the LPs. The overall value of the pension funds’ total assets increases over time due to general stock market appreciation. This forces pension funds to diversify their portfolios so they move the money to private equity.
If you think about this on a supply & demand basis, the supply of capital has increased significantly. But the demand side – the availability of companies looking for sale, hasn’t increased at the rate of capital availability.
The implication from this is that there’s a lot of dry powder sitting with the private equity firms. Dry powder is basically the money that the private equity funds have raised but haven’t invested yet. Said differently, it’s the amount of cash that PE firms can still deploy.
It doesn’t look good for the private equity firms to charge the LPs their exorbitant fees if the cash is just sitting in the bank. So private equity firms are pressured to invest the funds they’ve raised.
Companies are becoming much more sophisticated as well. Whereas before sellers might negotiate directly with a PE firm on a bilateral basis, now they’d hire investment banks to run a broad-auction process. The banks would contact a ton of potential buyers and whoever wants the company would have to outbid everyone else.
So the PE firm that ultimately wins the deal ends up paying a higher price than everyone else. All the high returns are competed away by paying the high price because of all the bidding.
Low teens IRR is becoming the new normal.
Buyout Strategies – Striving for Superior Returns
In light of this intensified competition, private equity firms have to find other alternatives to differentiate themselves and achieve superior returns.
In the following sections, we’ll go over how investors can achieve superior returns by pursuing specific buyout strategies.
Take-Private: Buyout of a publicly-listed company. The company then becomes privately held.
Corporate Carve-Outs: Buyout of a segment of a larger company. You’re “carving out” a piece of a larger company. The carve-out segment becomes a standalone business.
Buy & Build: Buyout of a company as a platform to acquire competitors in order to create a much larger business.
Distressed-for-Control: Obtaining equity control of a company in or near financial distress (i.e. companies near bankruptcy).
Sector Specialization: Some PE firms try to become an expert of a particular sector to develop differentiated views
that will give them an edge.
Portfolio Operations: This is where PE firms’ in-house portfolio operations team add value to investments by making operational improvements to companies.
There are a few reasons why Take-Privates can offer superior returns.
First, many publicly-listed companies are mispriced. The stock market may be efficient in the long-term but it is certainly inefficient in the short-term.
This gives rise to opportunities for PE buyers to acquire companies that are undervalued by the market.
PE shops will often take a “toe-hold”. That is they’ll buy up a small portion of the company in the public stock market. That way, even if someone else ends up acquiring the business, they would have earned a return on their investment.
Second, many of these same companies are also mismanaged. As a public company, management teams are greatly limited in their ability to execute long-term plans that will maximize shareholder value.
Counterintuitive, I know.
A company might want to enter a new market or launch a new project that will deliver long-term value. But they might hesitate because their short-term earnings and cash-flow will get hit.
Public equity investors tend to be very short-term oriented and focus intensely on quarterly earnings.
While executing a growth plan might maximize the company’s value in the long-run, the company’s stock price might get killed in the short-run. Worse, they might even become the target of some scathing activist investors.
Third, many publicly-listed companies are able to achieve significant cost reductions after they’ve been taken private.
For starters, they will save on the costs of being a public company (i.e. paying for annual reports, hosting annual shareholder meetings, filing with the SEC, etc).
Many public companies also lack a rigorous approach towards cost control. More often than not, these publicly-listed companies have large amount of costs that can be reduced without affecting revenue.
So their status quo financials don’t accurately reflect the true underlying earnings power of the business.
Over the past decade, corporate carve-outs have become a favorite for sophisticated private equity firms.
The formula to 25% IRR usually goes like this. Search for a slightly forgotten segment in a large company. Buy segment at a low price. Expand customer base. Enhance margins. Sell for tremendous profit.
In the recent years, there’s a growing number of corporate carve-out opportunities. This is driven by the rise of shareholder activism, who often agitate for breakups to unlock shareholder value.
As a result, there’s a greater emphasis for public companies to show an inclination towards fewer business lines and a streamlined focus.
The segments that are often divested are usually considered “non-core”. Non-core segments usually represent a very small portion of the parent company’s total earnings. Because of their insignificance to the overall company’s performance, they’re usually neglected & underinvested.
Similar to the dynamics in take-private transactions, the segments’ status quo financials don’t represent their true earnings power.
As a standalone business with its own dedicated management, these businesses become more focused. Their sales force begin generating more leads and management start to reduce unnecessary spending.
Next thing you know, a 10% EBITDA margin business just expanded to 20%. That’s very powerful.
As profitable as they can be, corporate carve-outs are not without their downside.
Think about a merger. You know how a lot of companies run into trouble with merger integration?
Same thing goes for carve-outs. It’s effectively a de-merger where one company separates into two. This separation process is very tedious and expensive.
It needs to be carefully managed and there’s huge amount of execution risk. But if done successfully, the benefits PE firms can reap from corporate carve-outs can be tremendous.
Do it wrong and just the separation process alone will kill the returns.
Buy & Build
Buy & Build is an industry consolidation play and it can be very profitable.
The idea is to acquire a leading company in a fragmented industry. The acquired company becomes a “platform” company, on which the PE firms will do add-on acquisitions to form an even-bigger business.
These add-on acquisitions can drive significant LBO returns by boosting operating performance as well as valuation.
First, the add-on company could have a superior growth profile or complementary product-lines that provides an up-lift to the platform company’s earnings.
An add-on company that has a higher growth than the platform company effectively “averages up” the pro forma company’s growth.
Having higher growth means the PE firm can sell the business for a higher multiple when it exits.
Another frequent reason for a platform company to acquire a bunch of add-on companies is to develop an end-to-end solutions. Offering end-to-end solutions makes the company a one-stop shop for all the customers’ needs. You see this more often among service businesses.
Second, it allows the platform company to reap benefits of having a larger scale.
There are a lot of benefits that come with having economies of scale. For one, fixed-cost driven businesses can effectively reduce their marginal cost. Larger companies often have stronger pricing power so they can increase prices.
It also gives them stronger bargaining power against suppliers so they can negotiate lower costs. The platform company can also achieve cost-synergies by removing redundant operating expenses.
Finally, add-ons are often acquired at a lower EBITDA multiple than the platform company’s valuation.
So once it becomes part of the platform company, the add-on’s EBITDA immediately gets valued at a higher multiple. So they buy the EBITDA low, and sell it high.
This is known as multiple arbitrage and can be very lucrative.
It may seem unusual that there are great returns to be found among companies nearing bankruptcy. Perhaps the stigma attached to it scares away competition, allowing the investors who stay to reap all the rewards.
PE firms that specialize in this area include Apollo, Centerbridge and Oaktree.
Companies in financial distress aren’t necessarily bad businesses or bad investments. In fact, some may be great businesses but became financially distressed because of poor management choices.
Let’s understand what financial distress means first and why companies become distressed.
Simply put, a company is in financial distress if it doesn’t have enough cash for its operations and/or repay debt.
In general, companies fall into financial distress because of three reasons: severe legal penalties, poor capitalization, and/or deteriorating operating performance.
An unusually severe legal penalty, as in the case of Gawker, can cripple a business. But that doesn’t necessarily mean the business is bad. In fact, it can be a great business just dragged down by an unfortunate one-time extraordinary expense.
More often than not though, companies enter distress because of over-leverage and deteriorating operating performance.
In the case of former, management or private equity owners put way too much debt on the company. It’s not that the business is poor. Just that the owners / management were too greedy. So it’s entirely possible that with an optimal capital structure, the business will take off and be a great investment.
In the case of latter, earnings deteriorate to the point where the company is no longer compliant with debt covenants or able to repay its obligations.
Distressed investors often obtain equity control of the company through the purchase of debt. They’d pay pennies on the dollar to buy the business and once the business is turned around, they’ll sell for a tidy profit.
Take-private, corporate carve-out, buy & build, and distressed-for-control are great buyout strategies. While they offer superior returns, there are plenty of deals that just don’t fall into these categories.
Another way for private equity firms to achieve superior returns is to specialize in a particular sector.
There’s a trend in the industry where new private equity firms are becoming specialized in a particular area.
In the technology space, you have Silver Lake, Vista Equity and Thoma Bravo. For media & telecom, there’s Providence Equity. For natural resources, you have First Reserve and Riverstone. Financials, there’s Stone Point. For consumer retails, there’s L Catterton.
There are also PE firms that choose to specialize in a particular region or country. You see that more with European and Asia PE firms than in North America.
Specializing in a specific sector or geography certainly has its advantages. There’s a direct correlation between how much you know about a topic and how much time you spend on it.
These specialized PE firms will know more about the industry and business model than general PE firms. They keep closer tabs on what assets are coming to market so they can preempt others. They’re constantly developing relationships with key players (i.e. business executives, regulators) in the space so they have a stronger network.
All of these things will help them develop differentiated views during their due diligence. And if their view is proven correct, they’ll make millions.
Increasingly, private equity firms are developing in-house portfolio operations capability. This team is distinct from the investment team and usually come from an industry or consulting background.
These groups provide additional expertise to company managements by defining strategic priorities and implementing operational changes. When done well, they can add significant value to private equity investments.
This has also become a major differentiating factor when it comes to fundraising. LPs love the story of a PE firm that adds operational value to portfolio companies.
Impress them enough and the LPs might just give you an extra billion to manage.
With industry’s standard 2% management fee, that’s an extra $20 million a year going into the PE guys’ pockets.
So What’s the Least Profitable Type of LBO Transaction?
Buying a company from another PE firm has the least favorable dynamics in place for good returns.
PE firms are immensely focused on returns. They’ll do everything needed to maximize the returns on their investments. So what does that mean for their portfolio companies?
It means that they’ve probably already done everything that can be done to maximize the operating performance of the business.
The incompetent CEO that mismanaged the business has already been replaced. New markets have already been entered to boost growth. Corporate excess have already been eliminated to improve profitability. CapEx has already been optimized to maximize cash flow to the PE firm’s pockets.
Why wouldn’t they? For people whose mission is to make millions, do you think it’s in their nature to leave millions on the table for the buyer to take?
In fact, some selling PE firms often pressure the portfolio companies the year before sale to optimize operating performance. So the most recent year’s numbers can sometimes be artificially boosted and might not be truly sustainable.
You have to be very careful if the sell-side banks or consultants tell you that there’re cost reduction opportunities.
And the selling private equity firm almost always want to run a broad auction sell-side process rather than negotiating bilaterally with a specific buyer.
They do that to encourage competitive bidding to get the highest price. Remember, the PE Partners behind the investment is getting a cut of the gains so they’re highly motivated to maximize returns.
Now that’s not to say that secondary investments are never profitable. Plenty are.
Case in point. Bain Capital acquired Blue Coat from Thoma Bravo for $2.4 billion in 2015. A year later, they sold it at double the price.
You just have to be able to separate BS from truth.
Picking the Cream of the Crop
It’s great to look for great businesses at a great bargain as Buffett would say, but that’s not enough in today’s PE world. You also have to look for the right transaction types where the underlying transaction characteristics are in your favor.
If you go with a buyout strategy that puts you ahead of the returns game, the most important work is already done.
You’ll still have to diligence the business closely. But if you’re picking from a pool of transaction structures with favorable dynamics for the best business, you’re more likely to hit a home-run.
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