The success of
secondary buy-outs
in auctions
The success of
secondary buy-outs
in auctions
René Hendrik Louis
University of Groningen, the Netherlands
Faculty of Economics
July 2007
Spuistraat 175 1012 VN Amsterdam +31 6 4634 3816 r.h.louis@student.rug.nl Student ID: 1091093 Supervisors:Dr. W. Westerman and Mr. W.W. Wijnbeek (RuG) Drs. R.S. Oudman and Drs. R.C.W. Hendriks (BNP Paribas)
The European private equity market has become an substantial and mature market. New fund raising in 2006 smashed the old time high record of 2005 with an increase of 56,4% to €112bn. The secondary buy-out is evidently underlining the maturity of the market. Even more than 50% of the major European private equity exits (€500m+ enterprise value) in 2006 have taken place through secondary buy-out transactions. But why is this way to exit that successful?
This research explains the success of secondary buy-outs in auctions by clearly presenting the perspectives of major stakeholders in auction processes of private equity held companies, focused on the advantages of a secondary buy-out. The major stakeholders in the sales process being: the selling private equity house, the buying private equity house and incumbent management.
The research comes to the conclusion that the ultimate goal of any private equity firm when selling a company is to achieve the maximum value and to return maximum cash to their funds. However, there are also 2 other key critical factors that are important which are deliverability (how quick can we do a deal and which execution risk do we run) and package for management. It are exactly those 2 where PE distinguishes itself. Price levels have to be competitive with strategic bidders, but assuming they are, it are exactly the other two factors that allow PE to win from strategics. The conditionality and additional due diligence requirements from PE are in most cases considerably less than those of strategics, which give the seller more comfort to do a deal quickly (less execution risk). Furthermore PE firms can offer a much more attractive incentive scheme to management driving a clear favourable position with management. This combination is exactly the reason why in the final stages of the process sellers are inclined to favour the SBO solution over the strategic solution as it gives them the quickest exit at the best conditions for everybody. It is only in those cases where a strategic player outbid PE significantly that the seller has a clear benefit to take the longer strategic route with more process exposure and the risk of an unhappy management team.
Provided the price is right, it is the ability of private equity firms to move quicker and to address the seller’s interests more accurately that drive the success of the secondary buy-out alternative
“The success of secondary buy-outs in auctions.” Where’s the technical part in that? Well, although there is no direct link between the research and Technology Management, a lot of graduates with a technical background - like me - are interested in economics and some of them even find their first jobs in corporate finance. As far as I am concerned, the interest was translated in a work-along internship within BNP Paribas Corporate Finance in Amsterdam for three months. During this period the opportunities have been discussed with both BNP Paribas and the University of Groningen to combine graduation with the internship at BNP Paribas. This discussion, maybe driven by my time left for graduation within the old system, was successful. Sequential to my three months work-along internship this research has been performed within five months, in order to graduate for the study Technology Management (under the old doctoral restrictions) at the faculty of Economics, University of Groningen.
Eight months as a member of the Corporate Finance team in Amsterdam, it feels like only two. Times fly when you’re having fun I think, while a 36 hour workweek isn’t that short. During this period I honestly never lost appetite to go to work. As far as this research concerns... I lost it once, I have to agree. However, after the hiccup I only felt stronger.
This foreword gives me the opportunity to thank the whole team for introducing me into the world of Corporate Finance. My first question was a genius one that’s for sure: P&L? Obviously they must have had their doubts; I really did not have a clue of any of the financial terms that would come around. I’ve experienced a period I’ll look back at with a grin. No college year brought me as much as the internship the last couple of months. It really challenged me to pick up; I have learned a lot and I am resolute to find my way in the corporate finance business.
I would like to thank all interviewees who helped me with the case studies. Wim Westerman and Wout Wijnbeek, for guiding me through the research as supervisors from the university. Special thanks goes to all members from the BNP Paribas Corporate Finance Amsterdam team with whom I had the pleasure to work with on a daily basis for 8 months. Rob Oudman, for his broad knowledge and for being not that good a golfer. Rob Hendriks, many thanks for all your support and overwhelming information; I will never buy Palmolive again. Our discussions regarding the research really helped me out a couple of times. I wish you and your wife the very best with your first daughter! Remco Haan, thanks for the valuation course and the chemicals work along. Maarten de Zeeuw for the first lessons “how to make an Eastern European women my intern”; he’s still going strong. It’s a pity you had to leave. Arne Bakker Arkema, thanks for your support and for borrowing your key in the night before the final presentation of this research. Who knows, maybe we’ll meet in Paris in a few weeks. And last but not least my special thanks and best wishes on Monday, Wednesday and Friday go to Remko Sloot. The outperformer of all of its peers with whom I have had the opportunity to work with!
Although it might sound melodramatic American, I want and just have to give my most special thanks and love to my passed away father, my mother and my sister. They created the opportunity for me to study and supported me all the way. Without their support I would never have been graduated.
INTRODUCTION
... 2
1
RESEARCH DESIGN
... 3
2
INTRODUCTION TO THE SECONDARY BUY-OUT
... 14
3
MAIN DRIVERS FOR SELLING THE PRIVATE EQUITY OWNED FIRM
... 33
4
SELLER’S INTERESTS IN THE SALE PROCESS
... 35
5
MAIN DRIVERS FOR INVESTMENT IN A SECONDARY BUY-OUT
... 40
6
DRIVERS OF THE SUCCESS OF A SBO FROM LITERATURE... 43
7
TESTING THE LITERATURE FRAMEWORK AGAINST THE CASES
... 48
CONCLUSION
... 50
APPENDIX A ... 53
INTRODUCTION
... 2
1
RESEARCH DESIGN
... 3
1.1 INTRODUCTION...3 1.2 RESEARCH BACKGROUND...3 1.3 RESEARCH APPROACH...4 1.3.1 Problem definition ...5 1.3.1.1 Objective ...5 1.3.1.2 Research question ...6 1.3.1.3 Preliminary conditions ...61.3.2 Concepts & theories ...7
1.3.2.1 Subsidiary questions ...7
1.3.2.2 Theories ...8
1.3.3 Data sources ...8
1.3.4 Measure- and observation methods ...9
1.3.5 Analysis and report ...9
1.4 RESEARCH METHOD...10
1.4.1 Case selection considerations ...11
1.4.1.1 Introduction ...11
1.4.1.2 Availability of inside information ...11
1.4.1.3 Sell-side versus buy-side ...12
1.4.1.4 Competition...12
1.4.1.5 Comparability...12
1.4.1.6 Deal size ...13
1.5 RESEARCH PLANNING...13
1.6 CHAPTER CLASSIFICATION...13
2
INTRODUCTION TO THE SECONDARY BUY-OUT
... 14
2.1 BACKGROUND TO THE PRIVATE EQUITY INDUSTRY...14
2.1.1 History ...14
2.1.2 Development and growth in Europe ...15
2.1.3 Drivers of success ...16 2.2 THE PE BUSINESS MODEL...17 2.2.1 Life cycle ...17 2.2.2 Fund raising...18 2.2.3 Fee structure...18 2.2.4 Capital structure ...19 2.2.4.1 Debt ...20 2.2.4.2 Financial leverage ...21 2.2.5 Strategy ...22 2.2.5.1 Organic growth ...23
2.3.1 The primary buy-out, secondary buy-out and beyond ...24
2.4 ENDING OR REFINANCING THE COMPANY...25
2.4.1 Exit options...25
2.4.1.1 Initial public offering ...26
2.4.1.2 Trade sale...26
2.4.1.3 Secondary buy-out ...26
2.4.1.4 Dual track exit process...27
2.5 BUY-OUT VALUATION PRINCIPLES AND TERMS...27
2.5.1 Common valuation terms ...27
2.5.2 The LBO model...29
2.5.3 Market multiples ...29
2.6 EVOLVED SHARE OF MAJOR (SECONDARY) BUY-OUTS IN EUROPEAN PE DEALS...30
3
MAIN DRIVERS FOR SELLING THE PRIVATE EQUITY OWNED FIRM
... 33
3.1 HOLDING PERIOD...33
3.2 PERFORMANCE...33
3.3 INDUSTRY DEVELOPMENT...33
3.4 FUND PRESSURE /NEW FUND RAISING...34
4
SELLER’S INTERESTS IN THE SALE PROCESS
... 35
4.1 PRIVATE EQUITY FIRM...35
4.1.1 Price...35
4.1.2 Speed ...36
4.1.3 Representations, warranties and indemnification...36
4.1.4 Privacy ...37
4.2 INCUMBENT MANAGEMENT...38
4.2.1 Proceeds/price ...38
4.2.2 Own position and independence ...38
4.2.3 New investment scheme ...38
4.3 THE COMPANY / EMPLOYEES...39
5
MAIN DRIVERS FOR INVESTMENT IN A SECONDARY BUY-OUT
... 40
5.1 STABILITY OF CASH FLOWS...40
5.2 STRONG MANAGEMENT...40
5.3 GROWTH OPPORTUNITIES...41
5.4 MARKET POTENTIAL...41
6
DRIVERS OF THE SUCCESS OF A SBO FROM LITERATURE... 43
6.1 INTRODUCTION...43
6.1.1 A willing seller ...43
6.1.2 An attractive investment case for PE and banks ...44
CONCLUSION
... 50
7.1 WRAPPING UP...51
7.2 RECOMMENDATION FOR FURTHER RESEARCH...51
7.2.1 Expand this research ...51
7.2.2 Greenfield research ...52
APPENDIX A ... 53
BIBLIOGRAPHY
... 60
2
INTRODUCTION
Whether you like it or not, M&A news is hard to avoid. You don’t have to buy the Financial Times anymore to get involved. Everyday papers are filled up with latest news about mergers and acquisitions. Since a couple of years the discussion has been ongoing about private equity investors and hedge funds as a flow of money have been coming from, and flowing to, these parties. Last years in Holland we saw KKR buying VNU and Philips semi-conductor business and Cinven buying cable businesses for example. It is expected that private equity will remain a significant involvement in the Dutch corporate environment.
Rob Oudman, managing director of BNP Paribas Corporate Finance Amsterdam described this phenomenom as follows:
With the arrival of large private equity houses and hedge funds in the Netherlands a strong “westerly wind”, i.e. Anglo-American style capitalism, has become commonplace over the last few years. Multi-billion euro leveraged buy out’s plus shareholder activism, ousted CEOs and shifts in strategy have set the scene for what is to come in the following years. For the period ahead we expect to see, apart from an active M&A market, a comeback in IPOs. However, this will probably not be able to match the number of companies being delisted. Finally, we expect a continuation of various governmental bodies selling their shares in companies operating in liberalised markets. With the arrival of large private equity houses and hedge funds in the Netherlands a strong “westerly wind”, i.e. Anglo-American style capitalism, has become commonplace over the last few years. Multi-billion euro leveraged buy out’s plus shareholder activism, ousted CEOs and shifts in strategy have set the scene for what is to come in the following years. For the period ahead we expect to see, apart from an active M&A market, a comeback in IPOs. However, this will probably not be able to match the number of companies being delisted. Finally, we expect a continuation of various governmental bodies selling their shares in companies operating in liberalised markets.
Private equity’s business model is basically: “buying low and selling high”. So within a certain time frame they want to realise their investments. How will they do this? They can sell the company or they can list the company at a stock exchange. Any other options? Of course there is one additional exit option: sell it to one of your peers, i.e. another private equity fund and there you see the secondary buy-out pops up. The last couple of years this has become more and more a common exit option. This research describes the background of this development and will address the success of secondary buy-outs in auctions.
3
1
RESEARCH DESIGN
Prior to take off with the research, the background to the research is explained to generate understanding why this research has been done. After this introduction the research is built up with the research approach which is the backbone of the research. The method to process the research is described afterwards. Finally the schedule for the research is given followed by the outline of the research.
1.1 INTRODUCTION
Former to this research, during a work-along internship of three months within BNP Paribas Corporate Finance in Amsterdam, the author has been involved in several sales processes and has captured a lot of information about other sales processes in the market. In almost all of these sales processes private equity firms played a major role. In only one sale where the author has been involved in the best offer came from a strategic company, which could be due to the fact that private equity firms were not even invited to this sales process at all. The rest of the companies all went to private equity firms. A lot of these companies were already in the hands of private equity and thus these transactions were secondary buy-outs.
1.2 RESEARCH BACKGROUND
Not only with transactions where BNP Paribas is involved but in the whole M&A market the secondary buy-out is emerging. Even more than 50% of the large European private equity exits (€500m+ enterprise value) in 2006 have taken place through secondary buy-outs.1 But why is the secondary buy-out that successful in doing transactions? Obviously, without doing research, one can imagine that the best offer wins the auction and this offer is mainly money driven. Conclusion: financial sponsors place the highest bids. Case closed? Not exactly.
Many questions pop up with observers, like: What drives financial sponsors to consider a secondary buy-out? Isn’t the company for sale already restructured as far as possible? The low hanging fruit has already been taken, so what’s left for the new guy? What interests are involved in the sale of the company? Why are financial sponsors often in the position to lay down the best offer and eventually, what is the best offer?
This research tries to explain the advantages of the secondary buy-out through describing the principles of the private equity market with its endorsing capital structure and through addressing all interests of the different stakeholders in a sales process. Obviously, BNP Paribas has a broad knowledge built upon practice to answer these questions at once. With this research the company aims to gain better insights in future transactions underlined by scientific and specialised literature. The report should be supportive for the acquisition of clients and should give input for advisement to clients in future transaction processes.
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Because of this practical purpose, desk research is compared with four dealt cases to address the success factors of the secondary buy-out in auctions.
1.3 RESEARCH APPROACH
To generate a structured research this study takes the view of De Leeuw (2003): the classical approach of research with the complementary clip joint (“ballentent”) as expedient. The classical approach of research is built upon the following 5 steps.2
1. Problem definition
2. The broader research design 3. Data collection
4. Analysis 5. Report
The problem definition and the broader research design are elaborated in this chapter. The rest of the research copes with data collection, analysis and report. To work out the problem definition and the broader research design, the clip-joint model is brought in. The clip joint is a useful expedient for making the right choices within a research.3 Using the model helps to procure the main features of the research approach.4 In other words, the model can be seen as a guide through the research by establishing a roadmap of the research. The clip joint consists of several balls:5
Figure 1 – The clip-joint of research (De Leeuw, 2003)
Data sources Problem statement Concepts & theories Analytical methods Measure- & observation methods Data sources Problem statement Concepts & theories Problem statement Concepts & theories Analytical methods Measure- & observation methods
While the balls are related to each other, coherent decisions have to be made. The clip joint model hereby emphasizes the importance of the iterative adjustment process between the
1
Cinven, “Exit poll: 2006 – Year of the exit” February 2007
2
A.C.J. de Leeuw, “Bedrijfskundige methodologie – Management van onderzoek”, 5th ed., 2003, p.85
3 Ibid, p.87 4 Ibid, p.87 5 Ibid, p.88
5
different entities. The research approach can now be described as a couple of well-thought decisions about:6
• Problem definition;
What do we want to know and why?
• Concepts and theories;
In what concepts will we capture the phenomenon? Which apprehensions will we use?
Which expedients will we ply?
• Data sources;
Where do we get our information from?
• Measuring & observation methods;
How do we gather our data from measuring or observation?
• Analysis & report;
How do we analyse the gathered material?
How do we make the results available to the client?
The problem definition together with the concepts and theories are seen as the steering centre of the approach, the hart of the clip joint. The other three entities are summarized as: ‘gather and work with data’.7 The broader research design is worked out on the basis of the balls in the clip-joint in the following paragraphs.
1.3.1 Problem definition
The problem definition consists of a careful reproduction of the questions attempted to answer by the research, the reasons why the answer is important and the preliminary conditions.8 Therefore the problem definition is to be divided into three components:9
• Objective
• Research question
• Preliminary conditions
The problem definition is like an IANVS-head or Bifrons; a head with two faces.10 On the one hand the problem definition is the connection to the concrete problem in the field; on the other hand the problem definition faces the theory.11
1.3.1.1 Objective
The objective lays down to whom the research is performed, what the outcomes are and why it is of importance.12 The objective for this research is formulated as follows:
6
A.C.J. de Leeuw, “Bedrijfskundige methodologie – Management van onderzoek”, 5th ed., 2003, p.89
7 Ibid, p.88 8 Ibid, p.81 9 Ibid, p.81 10 Ibid, p.89 11 Ibid, p.89 12 Ibid, p.90
6
Obtain better insight for BNP Paribas in future take-overs by addressing the success of the secondary buy-out in auctions of private equity held companies
The objective stated above could raise some questions with the reader and therefore some explanation is required as given below.
First, while success is a very sensitive term it has to be specified. Let’s take a look at the part ‘success of the secondary buy-out in auctions’. What determines the success of the secondary buy-out in auctions? For instance, one could say that the secondary buy-out is successful in auctions when the overall performances of all secondary buy-out transactions over the investment period are influenced positively. A very interesting research to undertake, but given the ‘private’ nature of private equity even more difficult.
In this research success in auctions is seen as winning auctions; offering the best package and thus doing the transaction.
Second, let’s observe the part ‘addressing the success’. Addressing the best offer could be done through assigning a list of advantages to the secondary buy-out over other options. In an auction process two major parties are involved: the sellers and the bidders. Both parties have to be interested in each other; the buyer has to place the best offer else the transaction won’t take place between the two of them. However, on the buy-side the transaction option lies in the nature of the potential buyer; private, strategic or public. And thus addressing the success could be mistaken as seen from the buyers’ perspective. Therefore from the buyer’s perspective the considerations of private equity for investment in a secondary buy-out will be addressed.
1.3.1.2 Research question
To work out the objective one should ask a question of which the answer accomplishes the objective, however in an accessible formulation for research. The question composed to achieve the above stated objective is:
What are the advantages of a secondary buy-out as the exit option for private equity held companies and what are the considerations for investment in a secondary buy-out?
This question obviously is too complex to answer in a single phrase. In the following step of the classical research approach, the concepts and theories used to answer the question are worked out.
1.3.1.3 Preliminary conditions
This research is performed within a small set of restrictions. To ensure quality, the scale, scope, timeframe and disclosure are confined:
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Europe with an enterprise value of €250m or above
• Data gathered for this research are partly confidential, therefore an undisclosed version will be available to the supervisors and BNP Paribas, a disclosed version will be available to the University of Groningen.
• The timeframe for the research is 6 months within BNP Paribas, of which 5 months of doing research and an additional month for completion of the report
• This research is exclusively owned by BNP Paribas Corporate Finance 1.3.2 Concepts & theories
To generate a founded research several subsidiary questions should be composed. In some theories the research is the outcome of the subsidiary questions. Like discussed with the clip joint model it turns out to be a more iterative process between both; the subsidiary questions are continuously adjusted during the research. While performing the research, questions come up to adjust the subsidiary questions, and the adjusted questions influence the research focus.
1.3.2.1 Subsidiary questions
The answers to all of the subsidiary questions together should gather the information to generate the solution to the research question, and thereby accomplish the objective. Therefore the subsidiary questions should be, in a logical way, constructive for the report. The following subsidiary questions are defined:
1. What is the background of the private equity market and the secondary buy-out?
2. What are the main drivers for a private equity firm to sell the company? 3. What are the stakeholder’s interests in the process selling the firm?
4. What are the main drivers for a private equity firm to consider doing a secondary buy-out?
5. What are the drivers of the success of secondary buy-outs in auction processes as obtained from literature?
6. Are the drivers as obtained from literature aligned with the information in the case study?
1.3.2.1.1 Additional explanation of the subsidiary questions
The theoretical part consists of four questions. First, the secondary buy-out is explained by describing the background of the private equity industry, the private equity business model, options for ending or refinancing the fund and the evolution of the secondary buy-outs in Europe (question 1). After that, the research will take a closer look to the drivers to sell the company from the selling private equity house’s perspective (question 2). Once these drivers are clear, the sell-side stakeholders are described with a broad description of their different interests in the sale of the company (question 3). The last section of the theoretical part focuses on the reasons for considering a secondary buy-out from the buyer’s perspective (question 4). By analysis of all the gathered information from literature a list of advantage indicators of the secondary buy-out in auctions will be composed (question 5). After that four secondary buy-out cases will be studied and broadly described where BNP Paribas was the
8
advisor. By analysis of the cases the success features of these secondary buy-outs will be compiled (question 6). Finally, the combination of advantage indicators from the literature and success features from the cases will lead to the conclusions.
1.3.2.2 Theories
The theory used for this research is partly scientific. The background of the private equity market with its underlying endorsing capital structure is for instance based on books and scientific articles. Examples are the oration of dr. Han (2007) about private equity as well as the trade-off theory from Modigliani and Miller (1958). Due to the lack of scientific research on secondary buy-outs specifically, most of the theoretical part is subtracted from professional literature. A lot of research is done by e.g. financial advisors, legal advisors or private equity houses it selves. These articles could be positively coloured due to the fact that these parties fare well with the business. Nevertheless, due to the nature of private equity information from insiders is very valuable. Furthermore, the literature is a diverse selection of sources like research institutes, private equity investors and law firms.
Like already mentioned, the subsidiary questions gasp for literature. Opposite, the subsidiary questions are partly built upon the literature. The iterative adjustments led to a classification of articles and books needed for the first four subsidiary questions. The aspects that have been found led roughly to the chapter classification of the chapters 3, 4, 5 and 6; being the theoretical part.
1.3.3 Data sources
Six different data sources can be distinguished in business administration practice research: documents, media, reality (‘the field’), imitation of reality, experience of researchers.13 For this research 4 different data sources are used:
• Documents
o Primary sources
Library (books, magazines) Archives (BNPP internal) o Secondary sources Theses, articles • Media o Press-releases • Reality o Interviews • Databases o Internet
These sources are used in a combination of desk-research and field research which will be explained in the research method (1.4). For the desk research, the primary document sources
13
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books and magazines are used as well as media and databases. Furthermore, theses and articles have been used as secondary document sources. For the field research four different cases have been studied by the primary document source: archives. Additionally, interviews with actors are used within the field research as a reality source.
1.3.4 Measure- and observation methods
The actors concerned with the cases are also interviewed as a measurement tool. These actors are people concerned with the cases from BNP Paribas. The interviews are performed to test whether the information found in desk research and case-study is complete or not. Although this measurement tool won’t bring any figures, it is very useful to test the correctness of the information found. Furthermore, the interviews will give new insights and could even bring totally new advantages to light. Therefore the interviews are a data source as well as a measurement tool.
1.3.5 Analysis and report
Analysis has been a continuous element within this research to extract the relevant information out of the raw material. There are several expedients for practical management administrative research, of which the most common are statistical expedients, simulation, schematizing and attentive study and consideration.14 Schematizing already has its ground in a previous paragraph by the conceptual model. In the rest of this report several schemes and models have been used or have been created to gain better insight in relations of different entities. Further analysis is done in three steps by attentive study and consideration:
• Composing a list of secondary buy-out advantage indicators from literature
• Projecting the drivers from the literature on the cases whether to check if the information is right
• Combining these two lists into the success of secondary buy-outs in auctions
To report, four different ways can be distinguished: written reports, oral presentations, teaching and perform research together.15 The report of this study is a written document and an oral presentation. The research is generated under supervision of BNP Paribas and the RuG. The involved supervisors guided the research and have been updated continuously during the research. Therefore also reporting in the way: ‘perform research together’ is done.
14
A.C.J. de Leeuw, “Bedrijfskundige methodologie – Management van onderzoek”, 5th ed., 2003, p.112
15
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1.4 RESEARCH METHOD
The applied research method is twofold: desk research and field research. The two types of research will be combined by analysis. The desk research answers the subsidiary questions 1-4 from a theoretical perspective; ‘theoretical’ is hereby seen as information gathered from documents, media and databases, referred as literature.
The field research provides information from the real world and is performed by a case study. The case study contains four different cases of secondary buy-outs BNP Paribas has dealt with. As such, many internal archive documents have been studied. This information has been complemented with interviews with people that have been concerned with the transactions.
As mentioned above, the desk research and the case study are combined by analysis to link the theoretical part with the real world. First a list of indicators is composed from the desk research. Secondly a list of common features is built upon the case study. Finally these two are combined to answer the research question.
The desk research and the case study are performed separately as far as possible. Obviously the desk research gains a lot of input for the case-study. The idea is though, to gather new information from case study. The indicators composed by the desk-research therefore will be used as a handle for the case study and will be tested in by the cases to gain further insights. The next figure will clarify the methodology used to answer the research question by the subsidiary questions: 5. Literature drivers 6. Case projection Σ:Success factors Nucleus (sell-side) i n p u t 4. Investment consideration 3. Seller’s interests 4. Investment consideration 3. Seller’s interests 2. PE drivers to sell What are the backgrounds of the private equity
market and the secondary buy-out? 1 What are the backgrounds of the private equity
market and the secondary buy-out? 1
What are the drivers for a PE firm to consider doing a secondary buy-out?
4 What are the drivers for a PE firm to consider doing a secondary buy-out?
4
What are the drivers for a PE firm to sell the company?
2 What are the drivers for a PE firm to sell the company?
2
What are the drivers of the success of secondary buy-outs in auction processes as obtained from literature?
5
What are the drivers of the success of secondary buy-outs in auction processes as obtained from literature?
5
What are the stakeholder’s interests in the process selling the firm?
3 What are the stakeholder’s interests in the process selling the firm?
3
Are the drivers as obtained from literature aligned with the information in the case study? 6 Are the drivers as obtained from literature
aligned with the information in the case study? 6
What are the success factors of the secondary buyout in auctions
Σ What are the success factors of the secondary buyout in auctions Σ ---1. Intro to the SBO Wizard (buy-side) Atlas (sell-side) Wilhelmina (sell-side)
11 1.4.1 Case selection considerations 1.4.1.1 Introduction
As with any study, the quality and level of detail and accurateness of the available information is the critical factor in the quality of the outcome of the analysis and the ultimate conclusions. Due to the nature of the M&A business, insight deal information is not publicly available and hard to access. As such, only M&A deals in which BNP Paribas acted as advisor have been considered for inclusion in this case study.
In consultation with the supervisors and based on a combination of a set of careful selection considerations being (a) availability of inside information, (b) sell-side versus buy-side, (c) competition, (d) comparability and (e) deal size, four deals have been selected for this case study:
• Project Alpha (completed sell side):
• Project Beta (completed sell side):
• Project Gamma (completed sell side):
• Project Delta (buy side, last 3 bidders):
The order of the case studies has - in consultation with the supervisors - been chosen deliberately. The first determining factor in choosing the order of analysing the cases is sell side versus buy-side. As for sell-side mandates more detailed information is available these deals have been analysed first, providing a clear and detailed insight in the drivers of the SBO and determining a framework of key factors to be tested from a buy-side perspective. The three sell side deals have been analysed in chronological order, which also has been deliberately done. Alpha was one of the first deals in the industry where Private Equity outpaced strategic bidders on all aspects and showed the strength of aggressive PE bidders. As such, this deal can be regarded as one of the earmark transactions of a trend that continues until today – the strength of the SBO as exit alternative. Beta and Gamma are deals that occurred in the same industry (both companies are peers) and the successful Beta deal has been one of the triggers for initiating the Gamma transaction. Therefore Beta has been analysed before Gamma.
1.4.1.2 Availability of inside information
First of all it is essential for this study to gather information on the complete sales process. In general, there is only one sell side party involved in an auction process while many bidders are competing with each other. Typically sell-side advisors play a role during the whole process, whereas advisors on the buy-side only manifest in the latter stage when their client is invited to the formal process. As such, information concerning SBO advantages from the whole process and insight on stakeholder intentions, exit considerations, key events during the process, bidder selection criteria etc is only available in cases where the seller has been advised by BNP Paribas. They have discussed the pre-marketing and the exit strategy with both the private equity firm and management. Moreover, during the process they gained knowledge on all the details from non-binding offers, the proposed Sale Purchase Agreements (SPA) and Management Investment Term Sheets (MITS) from potential buyers. As such, much more information about the process is available to them, which has been a key driver for
12
selection of these deals. Project Delta is an exception in this respect, as BNP Paribas acted as a buy-side advisor on this deal. This deal, however has still been included in the analysis, driven by on the one hand the rationale set-out in paragraph 1.1.1.3 and on the other hand the fact that BNP Paribas advised the management of Delta in their initial buy-out in 2003. Due to the strong relationship with the management team of Delta that has been built up during the original buy-out, BNP Paribas had very detailed knowledge on the process which is almost comparable to sell-side knowledge.
1.4.1.3 Sell-side versus buy-side
Since much more data is available, sell-side deals seem to be more valuable for this research than buy-sides. Nevertheless, when only studying sell-sides some blindness could arise. A lot of information made available to buyers in these processes is composed by BNP Paribas and this could create a coloured perspective. Also, incumbent management has a conflict of interests with the selling private equity house and the buying private equity house and thus both sides have to be examined. Furthermore, a complete view on investment considerations of the potential buyer can only be correctly obtained from parties advising on their side. As such, taking a closer look to a buy-side could reveal other advantages of a secondary buy-out in auctions.
The considerations above led to the selection of three sell-sides and one buy-side as a counterpart. The selected sell-sides are projects Alpha, Beta and Gamma. The selected buy-side being project Delta.
1.4.1.4 Competition
Obviously enough interest in the company at the time of the sales process is essential to gather valuable information for this research. Cases with competing financial sponsors and strategic players seem to be most suitable for addressing the success of secondary buy-outs in auctions at first. However, their differences could distinguish them in the beginning or even prior to the process, e.g. views on the company for sale, seller’s interests and market conditions. Some of these aspects could well be in the advantage of a secondary buy-out. According to the considerations above, the cases have been selected on the amount of interest from the market, regardless of the competition level between strategic players and financial sponsors in the process. All four cases attracted interest of both strategic and PE players, albeit that the drivers of the inability of strategic players to compete and the timing and drivers of their drop out from the process differ.
1.4.1.5 Comparability
Within this research dissimilarity as well as comparability of cases could reveal valuable information. Dissimilarity of the cases, like sell-side versus buy-side and deal size, creates a broader view and thus could gather divergent information. Comparability creates a way to narrow the view to discover links or discrepancies.
While no company is the same, dissimilar cases are easier to find. However, BNP Paribas has been the adviser in two highly comparable sell-side cases. These two cases are therefore included in the case study, being project Beta and project Gamma.
13 1.4.1.6 Deal size
It could well be that the price level of a company influences the amount of interest from either the private equity part or the strategic part. As such, widely spread deal sizes could gather information on this element. With this consideration in mind the buy-side project Delta is inserted in the case study.
1.5 RESEARCH PLANNING
Due to the limited time that’s left for graduation in the old style, this research is performed within a very tight schedule as presented next:
Figure 3 – Research schedule
4 11 18 25 1 8 15 22 29 5 12 19 26 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 24
Date DecDecDecDec Jan Jan Jan Jan FebFebFeb FebMarMarMarMarApr Apr Apr AprApr May May May MayJun Jun Jun Jun Jul Jul Jul Jul Jul Aug Aug Aug AugAug
10 17 24 31 7 14 21 28 4 11 18 25 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 30
Weeknr 49 50 51 52 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35
Work-along / exploration
Gather docs & data
Planning Research method Research question Subsidiary questions Chapter classification Literature study
Write theoretical part
Case studies
Combine theory/analysis
Draft completion
Revision
Completion
1st meeting, draft problem definition Theory (draft) Draft version
Questions & Chapters final Theory (final) Final version July 31, 2007
Colloquiem August 30, 2007 Graduate version August 31, 2007
1.6 CHAPTER CLASSIFICATION
This last paragraph of the chapter provides the research outline. After this chapter part 1 of the research will take off containing the desk-research chapters 3-6. The desk research will be followed by the first step of the analysis in chapter 7. Then the case study is worked out in part 2, consisting of the four case chapters 8-11. The case study is followed by the step 2 of the analysis in chapters 12. Eventually, conclusions and recommendations are given in chapter 13.
14
2
INTRODUCTION TO THE SECONDARY BUY-OUT
This chapter describes the different aspects and the terminology of the private equity (PE) market as an introduction to the secondary buy-out (SBO). These aspects will return in the light of a secondary buy-out in later chapters. The chapter has a descriptive nature and is essential for a good understanding of the report.
The first paragraph tells the background of the PE industry. It goes back to the American pioneering history of the market, followed by the development and growth in Europe and the rationale for private equity.
The second paragraph describes the PE business model. The paragraph includes elements like the life cycle of funds, fund raising, fee structure, leverage and strategy.
The third paragraph contains possibilities and motives to end or refinance the fund. Three exit options are briefly mentioned: initial public offering, trade sale and the secondary buy-out. The last section will explain the motives for refinancing an investment
2.1 BACKGROUND TO THE PRIVATE EQUITY INDUSTRY
2.1.1 History
The private equity industry gained prominence in the early 1980s as firms like Kohlberg Kravis Roberts & Co. (KKR) and Forstman Little & Co. started closing big, public leveraged buy-outs16 (LBO, 2.3) in America. The economy declined in that time and the conglomeration trend from the 60s and 70s turned around. Big conglomerates began to divest less efficient departments in a back-to-the-core-business wave, which together with the availability of cheap loans opened the way for private equity. 17 The private equity business mostly consisted of restructuring mature businesses. The highly leveraged investments (2.2.4.2) could be redeemed by the stable free cash flows.
The LBO funds outperformed the stock market by getting higher returns. Therefore more money was flowing into private equity hands to raise new funds, implying polarized available cash in market. In 1988 financial buyers dominated the acquisition world, representing 34% of all acquisitions in the US.18 But deals were closed against too high prices with own investment stakes of less than 10%. As a result the junk-bond market collapsed, all credit tightened and the private equity market dried up in the late 80s.
In 1992 money started to flow back to private equity funds. In only two years, at the end of 1994, private equity crunched the old-time raised funds record of 1987. However, the banks were more conservative. Leverages between 3 and 4 were the norm (against leverages of over 10 times in 1988!) and strategic buyers were dominating the acquisition world again;
16
R.F. Bruner, “Case studies in finance – Managing in corporate value creation”, 3rd edition 1999, p.603
17
J.T.J. Han, “Waarde en ontwikkeling van buy-outs”, MAB, 2004, p.33
18
15
financial buyers accounted in 1994 for only 6.9% of all acquisitions.19 Buy-out specialists were creating innovative approaches pointing value creation and growth, like the buy-and-build strategy. The still growing trend ended in 2001, when the economy collapsed.
After a short period, the American government as well as many European governments responded by giving out cheap loans to escape from a recession. America and Europe gave out obligations against only one and two percent interest respectively to gain back the trust of investors.20 Financial sponsors saw the opportunities again and a new revival of private equity investments was born. This revival is still going strong. All records are broken for 3 years in a row and 2007 is expected to do the same for the fourth time.
2.1.2 Development and growth in Europe
As described above, the private equity market gained it’s prominence in the late 80s in America. With some delay, investors saw their opportunities in Europe. Therefore roughly the same trend flowed to the European market, although with some delay and a bit more conservative. Nevertheless, the European private equity market has become a mature one. The next figure shows the strong developed European private equity market as a percentage of Gross Domestic Product (GDP), especially in Northern and Western Europe:21
Figure 4 - Private equity investment as % of 2005 GDP
In June this year, the European private equity & Venture Capital Association (EVCA) reported last year’s record fundraising: European private equity firms raised a new record €112 billion in 2006 (up 56.4% on 2005). 22 The evolution of the private equity market over the last ten
19
R.F. Bruner, “Case studies in finance – Managing in corporate value creation”, 3rd edition 1999, p.603
20
“De tikkende kredietbom: hedgefondsen. Scenario in 7 stappen als het misgaat.”, Elsevier Magazine, nr. 13, March 2007, p. 57-60
21
Oudman, R.S., Hendriks, R.C.W., Zeeuw, M.J., “Dutch M&A Landscape: Strong Westerly Wind”, BNP Paribas, 06, p.5
22
“EVCA Final Performance and Activity Figures 2006”, EVCA, 2007, p.1
0.3% 0.9% 1.2% 0.0% 0.6% Poland Slovak Ireland Austria Czech Republic Belgium Hungary Portugal Italy Greece Norway Germany Switzerland France Finland Spain Netherlands UK Sweden Denmark
16
years is presented in the next figure, showing raised funds and invested equity per annum:23
Figure 5 – Raised funds & invested equity per annum
0 20 40 60 80 100 120 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 V o lu m e ( € b n )
Funds raised Investments
Source: EVCA
2.1.3 Drivers of success
What is the rationale behind the private equity market? Common stock shares are more liquid than shares in a privately held company. Furthermore economic principles are very clear about the fact that the way a firm is financed has no influence on its outcomes.24 So what drives the success of private equity?
Private equity financing is in place where bottlenecks exists in the financial markets, therefore private equity’s reasons for existence are:25
1. Information problems in financial markets 2. Lack of discipline
Information problems in financial markets refer to the differences between the ideal financial market theory and the real world. Theories about ideal financial markets state that stakeholders of a company will have all relevant information at the same time, while practice teaches us that capital markets could never fulfil this requirement.
Lack of discipline refers to the agency theory. Jensen and Meckling (1976) described the problems that arise when principals and agents both try to maximize their benefits:26
If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal.
The private equity market then exists by the reduction of above mentioned bottlenecks: 1. Obtaining ownership of a company reduces information chain problems
2. Extremely high commitment from PE investors as well as top-management together
23
“EVCA Final Performance and Activity Figures”, combined 2002, 2005, 2006
24
Modigliani, F., Miller, M. “The cost of capital - corporation finance and the theory of investment”, The American Economic Review, June 1958
25
J.T.J. Han, “The economics of private equity” – oration, Erasmus University Rotterdam, 2002, p.2-4
26
C. Jensen, W.H. Meckling, “Theory of the firm: managerial behaviour, agency costs and ownership structure”, Journal of Financial Economics, 1976, V.3, No.4, p.305-360
17
with the large amounts of debt creates discipline
2.2 THE PE BUSINESS MODEL
Private equity funds are typically structured as finite-life, limited partnerships in which a private equity firm, made up from General Partners (GPs), raises funds from a group of investors, known as Limited Partners (LPs).27
As illustrated in the figure above, management buy-outs and buy-ins are only part of the business of private equity. Funds could be raised for different kinds of portfolio company investments. In example, a buy-out fund could be raised to take public companies private and to take-over family businesses. In line with the evolving buy-out market more and more dedicated buy-out funds are raised although. Investment banks and private equity houses are even raising funds with dedication to secondary buy-outs nowadays, e.g. Goldman Sachs and Pomona.
2.2.1 Life cycle
Private equity funds are raised in general for a predefined time period. This period is simplified divided into 3 parts:28
• Fund raising (this can take between nine months and two years)
• Investment period (usually here to five years)
• Divestment period (a fund is usually wound up after ten years)
The limited life cycle of the fund means private equity fund managers might typically invest the capital committed to the fund during the first five years of the fund’s life, allowing enough
27
“Private equity: visionaries or locusts?” McQueen, November 2006, p.7
28
P. Sanderson, “ Secondary buy-outs – moving on” , Practical Law Company (PLC), 2004, reprinted p.3 Private equity firm Fund I Fund II Fund III Management buy-outs / buy-ins Development / growth capital Public-to-private Seed / venture capital Pension funds
High net worth individuals Institutions, insurers and banks Corporates / government
Limited partners (LPs) General partners (GPs) Funds Portfolio companies
Private equity firm Fund I Fund II Fund III Fund I Fund II Fund III Management buy-outs / buy-ins Development / growth capital Public-to-private Seed / venture capital Management buy-outs / buy-ins Development / growth capital Public-to-private Seed / venture capital Pension funds
High net worth individuals Institutions, insurers and banks Corporates / government
Limited partners (LPs) General partners (GPs) Funds Portfolio companies
18
time to improve the performance of each of the companies invested in and arrange their divestments before the end of the fund’s normal life span.29 The latest exit poll from Cinven showed that the average holding period of the large LBO exits over the last 5 years was 3.2 years.30
2.2.2 Fund raising
Funds are typically raised with an expected life of around ten years, with the possibility of a further pre-determined extension (to be used only in exceptional circumstances and only with the agreement of investors).31 The life span of the fund is established in the Limited Partnership agreement. During the initial period of the fund, the fund raising, the GP’s (fund manager’s) focus is on adequate commitments of capital to close the funds. Commitment is done typically by completing an application form for a number of LPs interests, where each of these interests has a pre-determined value. 32
2.2.3 Fee structure
The fee structure of a private equity fund is divided in several different components and is often complex. Typical fees that can be derived are: 33
• Priority profit shares / management fee (EVCA response)
• Transaction fees
• Monitoring fees
• Carried interest
Priority profit shares are the remuneration for GPs through a combination of management fees and a share in the profits over the lifetime of the fund. Management fees are typically between 1% and 2% of committed funds for the first 5 years of the standard 10 year life of a fund, and are then calculated on the basis of residual funds (i.e. committed funds less any capital returned through realised investments) for the remaining years of the fund’s existence.34 GP’s can only start charging management fees once a fund has reached its first closing. The European private equity and Venture Capital Association (EVCA) remarked on this description: after funding the private equity fund, the management (or advisory) fee shall not be regarded as a “priority profit share to the general partner” but as a management fee, paid to the fund’s management team who invest accordingly to a pre-agreed strategy with the LPs, on behalf of them, to produce a diversified portfolio to its investors.35
Transaction fees could be found in funds run by strong track record managers and explain why private equity firms face little difficulty in employing talented human capital. These fees
29
“Private equity: a discussion of risk and regulatory engagement”, FSA, Nov 2006, p.21
30
Cinven, “Exit poll: 2006 – Year of the exit” February 2007
31
“Private equity: a discussion of risk and regulatory engagement”, FSA, Nov 2006, p.21
32
Ibid, p.21
33
Ibid, p.23
34
“Private equity: visionaries or locusts?” McQueen, November 2006, p.8
35
19
can amount to 1% of a deal enterprise value, essentially representing a success fee for identifying and completing a transaction.33
Monitoring fees could be charged to ensure continued monitoring of companies invested in. These fees are less common and when included only account for a relative small part.
Carried interest, last but not least, could be a real bite for the GPs. This kind of fee is similar to performance fees. The carry vests only when LPs are paid off for the risks they took, which commonly implies the full return of committed capital plus the ‘hurdle rate’;36 a predetermined Internal Rate of Return (IRR) of circa 8%. When it comes to carried interests, it carries a lot; usually in the order of 15- 20% of the surplus returns.37
2.2.4 Capital structure
The implication of rising debt levels is falling levels of equity funding, as reflected in Figure 6, which also reflects the increasing complexity of capital structures in private equity-led vehicles.38 Pay-in-kind loans/ not es 1% Bridge loans 12% High-yield 6% M ezzanine 2% Second-lien 2% Ot her senior 10% Tranche C 15% Tranche B 17% Tranche A 15% Equit y 21% Debt 79%
In decreasing seniority, the typical LBO debt structure as illustrated above is thus divided into: 39 1. Senior debt a. Tranche A b. Tranche B c. Tranche C d. Other senior 2. Junior or subordinated debt
a. Second-lien debt
36
Bartel, J.C.K.W., Frederikslust van, R.A.I., Oudman, R.S., Schenk, H., “Fusies & acquisities”, Elsevier Business Intelligence, 4th ed., 2007
37
Ibid
38
“Private equity: visionaries or locusts?” McQueen, November 2006, p.8
39
Ibid, p.8
Figure 7 - Average LBO capital structure
20 b. Mezzanine debt
c. High-yield (or junk) bonds d. Bridge loans
e. Pay-in-kind loans / notes
LBO financing spreads the risk of the project among several types of instruments, from the least risky (senior debt) to the most risky (equity).40 Senior loans are the dominant and, from the debtor’s point of view, the cheapest source of finance for LBO transactions, being secured against the target company’s assets and shares. Each of the different tranches features different risk profiles and repayment conditions. Evidently, reflecting the higher risk involved, lower-rated senior debt tranches also carry higher interest margins.41
Recently, there are signs that the B and C tranches of the senior debt have gained importance in EU LBO deals at the cost of the more senior A tranche. The current market conditions even allow for capital structures where senior debt tranche A does not exists anymore. Besides the interest being paid in terms over the year, the B and C tranches are repaid mostly in non-amortising “bullet" form after the full maturity of eight to ten years, while the more senior A tranche is typically repaid linear over the maturity of seven years. The bullet-types of debt allow target companies to take on higher leverage multiples as the backended amortisation schemes relieve cash-flow pressures by avoiding debt servicing during the first years of investment.42
During the last couple of years, capital structures of leveraged buy-out showed an increased level of junior and subordinated debt. Subordinated debt e.g. high-yield debt and mezzanine debt are, additional components of the typical LBO capital structure.43 The subordinated debts allow for lift gearing (leverage as described below) beyond the level acceptable for bank lending.44 The higher risk profiles of these loans, as being subordinated to senior debt, are aligned with the higher interest margins. These interest margins are often approaching up to 15% per annum.45
Equity is typically injected by management and the private equity fund as common shareholders. Obviously, equity is subordinated to all kinds of loans, and thus the most risky investment.
2.2.4.1 Debt
PE backed companies commonly have, as seen in the previous paragraph, complex debt structures to attract the highest amount of debt possible. But what is the gain of a high amount of debt? While interest tax shield is certainly a key parameter in absolute terms, it is unlikely to be the determinant of capital structure.46 In fact, Modigliani and Miller (1958)
40
Vernimmen, P. et al., “Corporate finance – theory and practice”, 6th edition, 2005, p.918
41
“Large banks and private equity-sponsored leveraged buyouts in the EU”, European Central Bank, April 2007, p.11
42
Ibid, p. 11
43
Ibid, p. 11
44
Vernimmen, P. et al., “Corporate finance – theory and practice”, 6th edition, 2005, p.918
45
Ibid, p.918
46
21
stated that the improved financial situation by tax deduction is abolished by decreasing dividends.47 The study was refuted afterwards by the fact that still low tax savings could be gained. Miller (1977) later on revised the study and factored both corporate and personal tax, stating again that there should be no optimal capital structure.48 According to this study it is still generally assumed that the value of a firm remains the same, regardless of the type of financing used. So what is the effect of high amounts of debt? The answer is again in the agency theory. The theory demonstrates that in the absence of heavy debt, the executives of such companies will be strongly tempted to use the substantial free cash flow to grow to the detriment of profits by over-investing or diversifying into other businesses, two strategies that destroy value.49 Combining both theories comes to the conclusion that the only value created by debt is discipline; it forces managers to improve enterprise value. While debt does not create value in absolute terms itself, it does create financial leverage as explained next. 2.2.4.2 Financial leverage
One of the key ways in which private equity sponsors achieve above normal returns is through harnessing the power of financial leverage.50 Financial leverage is created when a company is financed with minimum equity and a large amount of debt. The large amount of debt is redeemed and interest is paid by the free cash flows that the company generates. The surplus in these free cash flows is allocated to the shareholder’s equity.
Suppose a company generates profit through the use of the funds. These funds, as seen in the capital structure, are inserted trough debt and equity. The profit the company generates is apportioned between returns paid to debt holders (interest) and to shareholders (sweet equity). So when the company generates more operating profit after tax than the cost of capital, this surplus is attributed to shareholder’s and is added to shareholder’s equity; thus lifts return on equity.51 The next figure will clarify this description.
Figure 8 – How wealth created is apportioned (Vernimmen (2005)
Shareholders’ equity
(Management & PE)
Net Debt
(senior & junior debt)
Capital employed
(total capital structure)
Operating profit after tax Interest expense after tax Net income Financing Allocation Wealth generation (return on capital employed after tax)
Returns paid to debt holders (cost of debt after tax)
Returns paid on shareholders’ equity (return on equity after tax) Shareholders’ equity
(Management & PE)
Net Debt
(senior & junior debt)
Shareholders’ equity
(Management & PE)
Net Debt
(senior & junior debt)
Capital employed
(total capital structure)
Operating profit after tax Interest expense after tax Net income Interest expense after tax Net income Financing Allocation Wealth generation (return on capital employed after tax)
Returns paid to debt holders (cost of debt after tax)
Returns paid on shareholders’ equity (return on equity after tax)
47
Modigliani, F., Miller, M.H. “The cost of capital - corporation finance and the theory of investment”, The American Economic Review, June 1958
48
Miller, M.H. “Debt and taxes”, The journal of finance, may 1977
49
Vernimmen, P. et al., “Corporate finance – theory and practice”, 6th edition, 2005, p.681
50
“Private equity: visionaries or locusts?” McQueen, November 2006, p.9
51
22
The next figure illustrates this flowchart in a typical leveraged buy-out (LBO) capital structure. A case description with explanation of the leverage effect is given afterwards.
Figure 9 – Typical LBO leverage effect
65.0 55.8 50.0 10.0 10.0 10.0 23.0 46.3 46.3 26.2 1.5 3.0 0.5 1.0 8.7 -20.0 40.0 60.0 80.0 100.0 120.0 140.0 160.0
Entry Exit - 2.0x cash Exit - 3.0x cash
E n te rp ri s e v a lu e ( € m )
Senior debt Mezzanine PE loan note PE equity stake Management equity stake
Source: McQueen analysis
Over time, senior debt is retired out of operational cash-flow. Even without a multiple re-rating on exit, assuming modest growth in the underlying business, the equity returns can be very attractive. The private equity loan note grows due to the interest that rolls up over time; the sweet equity (i.e. the “real” equity) contributed by management and the financial sponsors increases through the value growth in the business. The return comes from a combination of the sweet equity and the loan notes, while management receives a generous incentive through the thin strip of equity they contribute. The power of financial leverage is illustrated through the difference between the two cases. The above scenario assumes EBITDA (Earnings Before Interest, Tax, Depreciation And Amortization) growth of 3% per annum to achieve 2x cash multiple. In the latter case, a 6% EBITDA growth rate yields significantly higher returns for both management and the private equity firm.52
But, before getting too carried away, readers should note that the leverage effect works both ways. Although it can lift a company’s return on equity above return on capital employed, it can also depress it, turning the dream into a nightmare.53
2.2.5 Strategy
A company on the PE watch strives to gain capital as much as possible. As mentioned before several strategies evolved in the PE market. Financial sponsors were often referred as raiders; invading big conglomerates, dividing them by divestments or split-offs and walking away with a big load of money within a few years. Typical in the private equity market is the shift from
52
Private equity: visionaries or locusts?” McQueen, November 2006, p.10
53
23
the efficiency perspective to the growth perspective, although divestments and split-offs are still common in optimization processes. There are as many different strategies as ideas, well-known being the back-to-the-core strategy and the buy-and-build strategy mentioned in chapter 2. It’s useless to describe only a couple of them. Therefore only the two clear ways of growth are described below. A blended growth strategy is often part of future plans. Even divestments could be mixed in the strategy for the future.
2.2.5.1 Organic growth
Organic growth is growth that comes from a company's existing businesses, as opposed to growth that comes from buying new businesses. It may be negative. Organic growth is possible in many ways like launching new product lines, deploying derivatives or opening branches. According Rothenbuecher e.a. (2007), the following are three quick wins – fast-to-implement – initiatives that can lead to significant benefits: pursue attractive customer segments, deploy the existing portfolio and expand the geographic footprint.54 Although there are many ways to realize organic growth, it is not always possible. Barriers to growth are everywhere. When a company wants to establish itself in a new market it could be a problem due to the entering barriers for instance. A lack of preconditions for growth means that many actions the company undertakes will fail.55 Furthermore, it could be very difficult to establish a network in a new market. For many reasons it could be better to realize sales growth through acquisitions.
2.2.5.2 Acquisitive growth
Acquisitive growth is growth realized through take-overs. These could be minor acquisitions which are often referred to as bolt-on or add-on acquisitions, but could be take-overs of companies even larger than the company itself.
An aggressive acquisition strategy can be an extremely effective way to build large, efficient companies more rapidly than can otherwise be obtained through organic growth. Acquisitive growth is because of this swift growth opportunity often a key-strategy within the private equity market. However, scepticism that M&A transactions fail to create significant shareholder value may prevent executives and managers from conducting attractive and profitable M&A transactions.
2.3 BUY-OUT & BUY-IN TERMINOLOGY AND THEIR DIFFERENCIES
While studying the private equity market one will find several terms in takeover transactions of which the most common ones will be mentioned briefly. As private equity firms use a lot of debt to finance an acquisition, the term leveraged buy-out (LBO) is often used for the transaction. When the incumbent management team takes over the firm (frequently backed by private equity investors), the LBO is called a management buy-out or MBO.56 When an
54
Rothenbuecher, J. e.a., “”The inside story on organic growth”, Atkearney, 2007
55
Ibid
56
Renneboog, L., Simons, Th. “Public-to-Private transactions: LBOs, MBOs, MBIs and IBOs”, Tilburg University and ECGI, 2005, p.3
