Thursday, 4 March 2010

How to make money from leveraged buyouts 101

I was writing a post on David Gill's interview when up he popped on the TV talking about the Glazers "are not sellers" so I thought I'd break off to write a quick post about  how people who buy companies through leveraged buyouts ("LBOs") are always sellers because that's how you make money from an LBO.  It is intended as a quick description for people who know nothing about the subject.

An LBO is the acquisition of a company using a large amount of debt (secured on the company you are buying) and relatively little cash ("equity").  Because LBOs gear companies up and impose higher interest payments on them, they are risky for both the buyer and the company.  Readers Digest was acquired by Ripplewood, a private equity firm, in 2007 using $2.2bn of debt and $275m of equity.  In less than two and half years, poor management and recession made the excessive debt unaffordable and the company went into "Chapter 11" administration.  Ripplewood's investors lost every penny of their $275m and the lender now own the company.

There are two standard means of getting a return from an LBO (and a little "extra" sweetener). The two main ways of making money are "dividend recaps" or selling the business.  Ideally you do both.

A dividend recap (recapitalisation) is where you drive up the profits to a level where more debt can be taken on and you pay yourself a dividend using all or some of the debt you've raised.  Example: you buy a company with EBITDA of £100m using £500m cash and £500m debt.  Through great management and ruthless cost cutting you drive the EBITDA to £130m.  Assuming you can still borrow 5x EBITDA as you did when you bought the business, you can now borrow another £150m (five times the extra £30m of profits).  You pay the £150m to yourself.

A sale speaks for itself, but its worth pointing out that leverage exists to boost the return.  Take the same company as above.  You paid £1bn which is 10x EBITDA.  When the profits hit £130m (assuming valuations haven't changed) its now worth £1.3bn (10x the £130m profits).  You sell that to somebody else and pocket £800m (they keep or refinance the £500m debt).  So you've made a profit of £300m on the £500m cash you invested  or 60% and all because you added a mere £30m (or 30%) to the profits.

Dividend recaps are comparatively rare, because they increase the risk for the debt holders relative to equity holders and increase the risk for the company itself (which the owner wants to sell looking all shiny and attractive at some point).  Lenders don't like to see the equity owners reducing their financial stake in the business whilst the debt holders are stuck in a riskier venture.  Dividend recaps were very "pre-credit crunch".  For an example of recaps followed by a swift sale, the sad tale of Debenhams being floated back on the market with over £900m of acquisition and recap debt just as the economy began to sank is a good place to start.

The point is, you strip out dividends or sell, that's how you get a return.  There are no other ways to make proper money from LBOs.  All LBO buyers are sellers by definition.  The only uncertainty is when you sell and how much you get.

Finally, the "sweetener".  Most leverage buyouts are done by private equity funds (companies make acquisitions using debt too but we are looking at single company deals by self declared experts in the industry, not mergers).  The Private Equity manager gets a cut (usually 20% above a certain hurdle) of the profits from the deals he does, but deals can take years so in the meantime the private equity manager charges his investors fees (often 2% of the committed value of the fund each year), in addition the manager can charge various expenses and fees to the companies owned by the fund.  The big money is in the manager's share of the profits (the "carry" or "carried interest") but the 2% pa and expenses at least pays for the golf club membership and the second home in the meantime.  As we know, the Glazer family have put in place their own sweeteners to the tune of £23m in the last five years and are entitled to £9m in fees and expenses every year under the bond agreement.

There is no evidence that the Glazers (like Hicks and Gillet) are anything other than financial buyers.  And no financial buyers can honestly say they "aren't sellers", its purely a case of when.