Letter number 25 of June 2007


News : Managing a company under LBO

In 2002 CEP Communications group, one of the divisions of Havas, the French media conglomerate, was taken over by Cinven, Carlyle and Apax three high profile LBO funds.  It was renamed Aprovia.  The LBO appointed Mr. Philippe Santini chief executive of the new entity.  Mr. Santini was Chief Executive of Havas at a time when Havas was the first European media group and he also held the function of CEO of the cable division of French utility Générale des Eaux. In addition, he was an independent consultant.  Hereafter he gives us his thoughts on management of a company under LBO.

The establishing shot

I got my first glance of the situation when the funds that hired me asked me to present Aprovia’s activities to their investors. I therefore had to fly to Washington for Carlyle, to London for Cinven and present in France for Apax. I understood that there were four layers of anxiety that I had to soothe. This was a learning experience for me as I found out that the fund managers that I faced in turn had to mollify their own investors and make the case that their funds were wisely invested. Apprehensive LBO fund managers had to overcome uncertainties about the future as they came to face their own fidgety investors. Fourthly I had to confront the trepidation of the banks who funded the deal, fearful that the loans would not be paid back in due time or simply that they may fail.

Understanding these stratifications of stress sheds a light on the particularities of LBO management.  I discovered the level of pressure that my new shareholders were up against as they faced their own shareholders and their banks, I discovered a number of rules that set company management under LBO apart from traditional management.

The first principle of company management under LBO is the time factor. The time frame and its limits really bears heavily on the way that you set about defining company strategy or solving problems. When you manage a business, you are seldom given a time constraint in your mandate and told that the goal is to sell the business within five years. Most of the time, it is implicitly, at least, an open-ended contract.  You stick your neck out because you are in there for the long haul.

You project where you want to take the company on a ten year time horizon, not how much financial value you can add with a five year deadline. In fact, when I headed Havas, I could never have predicted how the company would end. That’s a debate in itself and now is not the time to take it up.  But to give you an idea of how I felt at the time, I could never have imagined that the company would be sold five years later.  Imagine getting hired to run a company and straight out of the gates being told that the deadline to sell business is just five years away with the implication that you’re not going to be around after five years!

So setting a limited time frame, really underscores the importance of setting a rhythm to implement the strategy. In turn, the urgency of temporal developments must be stepped up compared to pre- LBO times and not least, some measures must be put in place to sustain the pace throughout the holding period even as the story has moved off the front page. I had been exposed to formative situations in my previous jobs:  if management upstairs is asleep, there’s little hope for subordinates to be awake and alert!  And that realization really hit home when the company I ran became an LBO takeover target and was subsequently taken over. It became critical to lay out a clear strategy for all of management to understand, to stipulate rules governing all aspects of the competition, and to set goals that increase the pressure at every level of operations. Moreover this pressure has to be constant, and the employees must keep pace with the management. Once again, understanding the temporal urgency is essential, and in practical terms it translates into getting a firm grasp on the business model and the valuation of the company assets within the first four months. It requires evaluating the company assets and identifying the growth areas and setting them apart from the ones that are a drag; basically, getting ready to restructure or unload those unworthy of being carried and building up those that offer development potential.

You sense right away if a manager has a clear understanding that he is operating under a new set of rules: the LBO rules. You detect if he is willing to get on board, to get the strategy under his skin; if he is willing to forgo instant gratification to embrace the prospects of greater returns, if he is willing to put in the extra work for the extra return. If he is willing to play by the rules, a manager will instantaneously switch habits, reduce his expenses, forgo the luxury car, get to work earlier than usual and stay in late. He becomes an interested party in the optimal course of action for the company and his attitude and behavior speak to the rules of engagement.  In sum, you are racing against time and cash!

The second fundamental LBO principle is that you go from virtual cash to real cash.  When you are at the helm of a large group, your financial directors come to you and inform you: “I’m putting this amount in provisions, that much in this account, etc…” The very notion of provisions under an LBO does not exist. Cash is the only game in town and you have to screw down the rules of how to use it. 

You have your EBITDA and you have to transform it into cash flows. You dig into all corners of the company, you turn every stone, open every drawer.  You know that ultimately you have to square up and repay the debt. Debtors cannot wait!  You know that you cannot accept the usual routine: “Well, this year my division is earning 110 and I am going to set aside 10 for next year.  We are going to provision this amount somewhere and this will generally pad the accounts for next year's operating result. With LBOs, the aim is to drain cash from all levels of the organization and reroute it towards settling the debt.

The free cash flow is the overriding accounting measurement.  You have to live by it.  You get to the real root of economics.  It is with cash that you reimburse the debt and following on, it is debt that creates IRR for equity. Believe it or not, this is a concept most people have a problem grasping…  Therefore, you need to have the best financial director on hand.

The third concept is to establish a trust relationship with your restless LBO investors. This has to click in almost immediately and a compact will be established between you and your investors in the understanding that everybody has got to profit from this.

It is impossible to succeed at LBOs if you do not build trust with your bosses, the LBO funds. “First impressions are always the best” and you don’t get a second chance at making a good first impression. The key here is that trust is a long-term proposition that builds slowly as people use your expertise, get good results, and do not feel disappointed or cheated. In other words, true trust develops from a manager's actual behavior towards his investors experienced over an extended set of encounters. Trust is difficult to build and easy to lose.  A single violation of trust can destroy years of slowly accumulated credibility.

After the small talk, the first informal introductions, the usual civilities and superficial bonding you are led to the upstairs meeting room where the excitement is replaced by the   reality of the hard core negotiations for your own pay package and for your lieutenants’.  You’re fighting your corner.  Next comes the first board meetings which will turn your world around!  This is where you cut into the meat of the LBO drama and you realize that actual people have vast sums invested.  This is your chance to step up to the plate and enter into a special relationship of trust, confidence, or responsibility with your investors.  You are reminded that the engine that drives the markets is not money but integrity.  It takes a roomful of committed, principled, and vigilant participants to make the LBO project successful.

You must demonstrate your ability to think on your feet, and show that you process information quickly, that you are on top of the strategy, that you know the company inside out, that you know where you want to take the company and that you share professional excellence and thought-leadership. You also must be open to any questions, be willing to disclose any information or discuss any issues. You must be very transparent when you are only dealing with these shareholders.

The people you have in front of you are of the highest caliber and deeply engaged.  I have been remarkably impressed by the quality of my counterparts at the fund where they offered their insights, reflections, hopes and doubts.  I came from a world where I witnessed many a grandstanding board meetings where a roomful of supine board directors could be taken in by the managers’ posturing, duplicity and double talk.

Here, the shareholders are highly professional. As you would expect from activist investors, they are highly knowledgeable, master the operational know-how, are well versed in dealmaking and possess a strong entrepreneurial spirit. The carried interest system subjects each LBO fund manager to put part of their salary in each of the deals.

The quality and focus of the board meetings is fundamental. The degree of excellence of the participants is enhanced by the fact that their own money is at stake. The debates are highly focused and intensely axed around some very pressing issues. In previous circumstances, I had known board meetings to go off on tangents that have absolutely no bearing on the main subject. Political and psychological digressions where participant end up in an irrelevant debate about the state of the world leave much to be desired. The focus here is the end of the month bottom line:  How do you extract cash?  What’s the cash flow? What’s the better strategy? Who can we hire to carry it out?

This is a whole new set of work rules. No philosophical digressions here, yet, it is all the more enriching. On a personal level, it was a life altering experience and I could never return to the less driven environment of the routine shareholder meetings.

Equally important to the foregoing is that you do not manage the company as though it is under LBO. LBO funds have been criticised for taking over companies with lacklustre growth but healthy balance sheets. The argument goes that they skimp on the overheads, spin off divisions, and re-launch the company on the stock market laden with debt and stripped of some of its business divisions. It becomes clear that setting an industrial strategy and production goals are key to the success of the LBO venture. Thankfully, I was lucky enough grasp this corollary risk of LBOs very quickly. I had to explain to my shareholders that if you do not create industrial value, you cannot create financial value. You absolutely need an industrial strategy and a financial policy that are adequate and allow strong business development and set more tangible goals for the staff.

If you go into the business throwing your weight around saying: “I’m the sole new owner of this company, and to fund my acquisition I’ve taken up debt equivalent to seven times EBITDA.” and with the first 100 dollars that comes in being funneled out again towards debt repayment, with nothing left for investments and to fund growth, you’ll find it hard to rally your troops!

It’s true that for someone unfamiliar with the business, there is a most peculiar side to LBOs. Companies take on the aspect of railroad switching terminals for cash. Say you have a debt that is 300 million, cash comes in through one end and goes out the other end. Usually, the banks have sucked it up. You barely see it coming and it’s already gone to the banks! You could just as well be at “Grand Central Station” and have missed the express to Wallawalla /get away! All this because you didn’t state your claim in due time!

You have to adopt a firm stance with the LBO fund managers. You have to set some rules and state that you won’t have 100% of EBITDA going towards debt reimbursements. You’ll try and keep 20 to 25% for investments. It’s your company. Nothing will change the fact that it needs be perceived as more than a cash cow to repay the bankers. It’s a going concern or it will not work!

So here are four rules that are in my opinion quite powerful and I think every manager operating under an LBO has to deal with these variables. In sum, a clear time frame, management as though it’s an ongoing business venture, absolute transparency, and the cash obsession!

(1)  For more on LBO’s, see chapter 44 of the Vernimmen.

Statistics : Free cash flow generation in Europe

According to computations from Lehman Brothers, free cash flow (1) generated by non financial European listed groups will reach $ 500bn in 2007, i.e., five times higher than in 2002 :

This is due to the good current economic climate, to the operational leverage effect, the vigorous restructurations carried out during 2001 – 2004, and improved efficiency in capex. This explain why external growth paid in cash, dividends and share buy-backs have never been so large without a noticeable deterioration in the credit quality of listed groups.

(1)  For more on free cash flow, see chapter 2 of the Vernimmen.

Research : Corporate financial policy and the value of cash

Research into the capital structure of firms has led to a number of studies on how the financial markets value the level of indebtedness of a company.  There are far fewer articles that seek to measure the value that a firm’s cash has for its shareholders. Theory does, however, suggest that there is a compromise to be found between two opposing effects:

• A lot of cash or cash equivalents (including marketable securities) enables the firm to seize investment opportunities without going outside for additional financing.  This helps to avoid information asymmetries and transaction costs on external financing.

• Too much cash or cash equivalents implies an opportunity cost:  better to pay dividends to shareholders, especially if this will prevent this cash from being siphoned off by management

Two researchers at the University of Washington (Saint Louis) have made an original contribution to this topic (1). Their empirical study, which covers unlisted, non-financial US firms between 1971 and 2001, provides figures that confirm the theoretical assumptions. The authors measure the value that each extra dollar of cash brings to shareholders.

For the whole of their sample, the arrive at a valuation of $0.96 for $1 of liquidity.  But their main conclusions result from the very sharp differences in valuation, depending on the situation of each firm:

1. The more cash a company has, the lower the value of every extra dollar of cash on its books.  This is explained by the fact that the likelihood of this cash being used in productive investment decreases as the proportion of cash on the firm’s balance sheet increases. The excess cash effect becomes dominant.

2. This valuation is lower for heavily geared firms.  In the sample analysed by the researchers, one dollar of cash is valued at $0.15 more in a company with no debt than in a company that has a gearing level of 10%, a very substantial difference.  In a heavily geared company, any improvement in cash reserves usually goes straight to creditors, not shareholders, since the probability of bankruptcy is more likely. On the other hand, if gearing is reduced, the probability of bankruptcy becomes lower, and the extra cash has more of a chance of falling into the hands of shareholders.

3. Financial constraints that a company is facing also impact on the value of its cash.  It would be better for a firm that has difficulties in obtaining financing to have more cash for coping with unexpected events or for making investments. The authors check this assumption by using three financial constraint criteria: the pay out ratio (2) (generally lower for financially constrained companies), the size of the firm (bigger companies are in a better position to tap the financial markets, and the debt rating of the firm. According to these three criteria, the value of a dollar in cash is higher in financially constrained firms.  For example, a dollar of cash is worth $0.71 in the largest firms and $1.18 in smaller firms.

On the basis of these empirical elements, it can be assumed that there is an optimal level of liquidity for a listed company. 
(1)  Faulkender M. and Wang R., 2006, Corporate Financial Policy and the Value of Cash, Journal of Finance, vol.61 n°4.
(2)  Ratio for a financial year between total dividends paid and profits, see chapter 38 of the Vernimmen.

Q&A : A few insurance terms

The world of insurance, like that of finance, has its own jargon, which is sometimes difficult for the uninitiated to understand.  This month we provide you with a few definitions of commonly used insurance terms.

Adjusted Net Asset Value (ANAV)
The insurance company’s equity capital plus unrealised capital gains that will go to shareholders (not policyholders), less policyholder acquisition costs that have not yet been amortised.  It is the net asset value.

Annual Premium Equivalent (APE)
For most insurance policies, premiums are paid on an annual basis.  There are, however, some policies on which a single premium is paid at the start of the policy, especially in the life insurance sector.  This makes it difficult to compare volumes of new business from one insurer to the next solely on the basis of premium income on new policies, because the proportion of single premium policies varies from one insurer to the next.

The APE makes this type of comparison possible because, by agreement, 10% of the amount of single premiums are factored into the calculation of premiums generated by new business.

For an acquisition to be covered by the Hart Scott Rodino Act:

Combined ratio
The sum of claims and operating expenses as a percentage of total premiums collected by the insurance company.  If the percentage exceeds 100%, the insurance company will be unable to make a profit, except if its financial products (dividends, interest, rent and capital gains) set off the shortfall between premium income and the sum of claims and operating expenses.  It is a way of measuring the efficiency of the insurance company's management.

Differed Acquisition Costs (DAC)
Amortisation of policyholder acquisition costs (essentially commissions paid to agents or external insurance sales representatives who brought in the policy) over the duration of the insurance policy.

Embedded Value (EV)
EV corresponds to the intrinsic value of a life insurance company, without taking goodwill into account.  It is calculated as the sum of Adjusted Net Asset Value (ANAV) and the discounted value of expected future profits on active insurance policies less the cost of capital.

Gross Written Premium (GWP)
Total premiums that the company will collect over the duration of a policy.

Loss Ratio
The ratio of the cost of claims to premium income.

Net Book Value (NBV)
The net value of the asset recorded in the accounts.  Corresponds to the acquisition cost less any amortisation and impairment charges.
Net Written Premium (NWP)
Total premiums that the company will collect over the duration of a policy less the cost of reinsurance taken out.

Solvency II
Based on the Basle Agreement applicable to banks, the EU has drawn up a new regulatory code for managing the risks of insurance companies.  The final version of Solvency II should be approved in 2007, for application in 2010.

Compared with the Solvency I Directive, currently in force, Solvency II generalises the measuring of operational risk introduced by the Solvency Capital Requirement and will lead to increased control by the regulator.

Value of Business in Force (VBI)
Business in force corresponds to all of the insurance policies for which premiums are being paid or have been paid.  It amounts to the portfolio of active policies.  In life insurance, the VBI corresponds to the discounted value of expected future profits.  No goodwill or value of newly acquired business is taken into account.

(1) For more information on the multiples method, see chapter 40 of the Vernimmen.