Letter number 51 of June 2010
- QUESTIONS & COMMENTS
It may seem a bit odd to be talking about creating value through LBOs at a time when, firstly, the number of LBOs has hit a low point (in the UK, 2009 saw the same number of LBOs as in 1995!) and secondly, it is estimated that around 80% of LBOs have breached covenants (even though official statistics on the basis of statements are a lot more modest), thus demonstrating that they have not got off to a good start in terms of value creation.
We have always thought and written (1) that LBOs will take off again as they present, in a certain number of cases, a form of governance that is better than that of the family-run company or of a listed company. We are now seeing the beginnings of the return, for several reasons:
• the return of IPOs (Amadeus, which belonged to BC Partners and Cinven was listed in Madrid on April), giving the LBO investors the cash they needed for a kick-start;
• the dazzling reopening of the high yield bond market (2) (Novasep raised €370m in December, Virgin Media hoped to raise £500m in January, and faced with demand, was able to raise £1,500m) which could become a major, and no longer marginal, means of financing LBOs. This dynamic behaviour recalls that of the investment grade bond market during the worst moment of the crisis, at a time when it was difficult to borrow from banks;
• a slight relaxing of restrictions at lending banks which are again keen to finance LBOs, although obviously only if conditions are attractive and leverage reasonable.
Ultimately, in response to the rather traumatising situation for many over the last two years, two new implements, which could clearly boost the market’s rebound, have been added to the Private Equity “tool box”.
But on the strength of this, can we really refer to a sustainable rebound? Over the last months of 2009, more or less everywhere in the world, volumes of new operations rose from one month to the next, the sort of growth that had not been seen for a long time. We were, however, starting out from a very very low point. Let’s wait a few months to see whether the trend is confirmed.
Finally, readers who know us will know that even in this section, entitled “News”, we try and see further than the end of our noses!
Several recently published studies(3):
• the first study analyses 241 LBOs carried out between 1999 and 2006, with 85% in Europe and equity capital investments between €1m and €4.3bn, making this one of the widest ever samples for a study;
• the second study analyses 66 LBOs in the UK between 1996 and 2004, most of which were exited between 2000 and 2007;
• the BCG and IESE study is based on the study or the performances of 218 private equity funds from 1979 to 2002;
arrive at converging results.
On average, an investment in the equity capital of a private equity fund is multiplied by 2.72 over an LBO period of 3.5 years, or an IRR on equity capital of 48%. This result is explained by the huge success of certain investements, with IRRs of over 300% (sic). The median IRR "is only” 33%. On entry, the debt / EBITDA ratio is 4.2 and on exit it is 2.7.
The authors break down this multiplying factor of the initial stake of 2.72 as follows:
• the leverage effect of the debt which increased IRRs and multiplying ratios, accounts for 0.89 points out of the 2.72, which is only one-third;
• the effect on the period studied of the increased multiples (value of capital employed / EBITDA, EV / EBITDA), accounts for another 0.47 points, or 17%;
• the rest, or half, comes from operational improvements: growth of EBITDA accounts for 29% and the effect of cash flow generation allows for deleveraging of 15%. For its part, growth in EBITDA is explained mainly (77%) by the increase in sales and 23% by the increase in the EBITDA margin/Sales ratio.
When the analysis is taken deeper, we see that over the recent period (2001-2006), leverage effects have increased compared with the previous period (1989-2000), resulting in higher rates of return, with a cost of risk that is naturally higher, although the share of EBTIDA growth is a lot smaller, showing that less value has been created.
The best IRRs are obtained on investments made during poor economic periods (1991-1993 and 2001-2003) while most of the operational improvement comes from the growth of sales. Warren Buffet couldn’t put it better!
The authors also look, over the same period, at the capital employed (i.e. by neutralising the leverage effect resulting from the debt) of an investment in the shares of listed companies in the same sectors of activity in Europe, and with the same EBITDA margins / sales at the time the LBO was put in place. They show a superperformance of companies under LBO corresponding to six additional IRR points, excluding the leverage effect, and accordingly for a comparable capital structure. The IRR of LBOs is 31% compared with 25% for comparable listed companies.
Which amounts to saying that over an average LBO period of 3.5 years, an investment of 100 becomes 100 x 1.31 ^ 35 = 257. Which makes a capital gain of 157. Managers of LBO funds take around 20% of the capital gain as carried interest, or 31, and 2% per year of the funds managed, or 7.
So, in total, the net capital gain for the investor is 157 - 31 - 7 = 119, or an IRR over 3.5 years of 25%. In other words, as much as an investment in the shares of a listed company, which means two things:
• the managers of LBO funds do create value for their shareholders, the investors in the fund;
• but, they claw, on average, all of it back and sometimes more since the calculation does not factor in the cost of the illiquidity of the investment in these LBO funds compared with the liquidity of a stock market investment.
The BCG study comes to the same conclusions.
However, investors have cottoned on to this because, except for private equity funds with a well-established track record of regular superperformances, the 20%/2% remuneration rule is a thing of the past.
It remains to be understood how the managers of LBO funds are able to improve the operational performances of companies that they have bought through LBOs.
There are reasons, linked to the corporate governance put in place, why the interests of the managers of the company under LBO are strongly aligned with those of the fund. The dual effect of the managers of the operational company getting a share in the financial performance of the LBO on its investment, and the restriction of the debt which pushes them to be more efficient in the generation of free cash flows(4) (5).
Additionally, the last two studies show that over and above the implementation and the functioning of another form of corporate governance, managers of the LBO funds are capable of outperforming when:
• the partners are specialised in a number of economic sectors that they know like the backs of their hands, which makes them more industrial than financial specialists;
• the partners are focussed because, the quicker the experience curve can be reduced, the bigger the competitive advantage that can be built;
• the partners have the ability to get involved upstream in order to detect future operations (the famous investment fund angle), enabling them to win over the managers of the target more easily and to speed up the purchasing process;
• the partners have real skills in improving the operational efficiency of firms, sometimes going as far as to get personally involved in the management of the company under LBO.
The multiplication of the number of LBO funds over the last 10 years has certainly diluted to some degree, the average skills, and finding an angle is becoming increasingly complex.
That said, given that a number of LBO funds are going out of business as a result of their poor performances, and these include the most recent arrivals on the market, the average level should improve in the near future.
(1) For example in the introduction of the 2009 edition of the Vernimmen.
(2) For more information on high yield bonds, see chapter 25 of the Vernimmen.
(3) Value Creation in Private Equity by A.K. Achleitner (Centre for Entrepreneurial and Financial Studies – Capital Dynamics ; Corporate governance and value creation : Evidence from Private Equity by V. Acharya, M. Hahn and C. Kehoe ; The advantage of persistence by H. Meerkatt, J. Rose, M. Brigl (BCG) and H. Liechtenstein, M. Julia Prats and A. Herrera (IESE).
(4) We have always told our students that more Olympic records would be broken if we put crocodiles behind the swimmers!
(5) For more on agency theory, see chapter 31 of the Vernimmen.
Although the debt issued by Japanese governmental bodies is the highest in the sample, at 197% of GDP, 93% of it is held locally (this figure is 44% for France), which makes it easier to bear.
In the developed world, the size of companies' debt in relation to GDP is largely due to the degree of their internationalisation and accordingly to their size (since the largest corporations are the most international): United Kingdom, France, Switzerland. Alternatively, it reflects a high level of debt compared with the cash flow generated: China, Japan, Spain.
Household debt is highest in countries which recently experienced a real estate bubble: USA, UK and Spain, as most household debt is mortgage debt.
UK financial companies’ large share of debt (194% of GDP) is noticeable, and is due to the large size of the UK financial sector and of its banks (HSBC, Barclays and RBS).
Emerging countries make up a class of their own, with a relative level of debt that is two or three times lower than that of developed countries. As for the very low level of Russian debt, this can be easily attributed to the poor governance in the country in general, which does not encourage lenders to lend (possibly a very longstanding aftertaste of the pre-revolutionary Russian bond debacle)!
Bookbuilding is now the dominant method of conducting IPOs (2). The typical sequence of events in a bookbuilt IPO is as follows: first, the bookrunner or bookrunners (via their analysts) pre-market the IPO to investors; then the bookrunner sets an indicative price range and, while the issuer’s management markets the shares to investors, the bookrunner collects bids and builds a book of demand; at the end of this process the bookrunner allots shares at a single price, which is typically at a discount to the first trading price of the shares. An essential feature of bookbuilding is that bidders exchange information about the valuation of the company with the bookrunner, and reveal their identity to him. This allows the bookrunner to direct allotments to particular bidders.
On a benign interpretation of bookbuilding, investors produce and reveal information to the bookrunner, which helps him price the IPO; he, in return, makes generous allocations (as a fraction of their demand) to these investors. Since IPOs typically rise in the immediate aftermarket, large allocations are a reward for information production and revelation. On a more jaundiced interpretation of bookbuilding, the bookrunner and investors collude to ensure a low IPO price; the bookrunner then allots cheap shares to investors who will rebate to him part of the discount by directing to him a large share of their broking business. The victim of this collusion is the issuer who suffers an opportunity loss when the IPO is unduly underpriced.
Blatant abuses of bookbuilding (‘laddering’, ‘spinning’ and ‘quid pro quo’ arrangements), which were uncovered after the IPO bubble of 1999-2000, have been outlawed by regulators. A growing body of research suggests, however, that banks still exploit the conflicts of interest inherent in their intermediary role, and the less benign interpretation of bookbuilding is gaining currency among academics.
In the last few years issuers in Europe have made an important innovation to bookbuilding. Rather than appointing the bookrunner(s) many months before the IPO, they have left the appointment until very late in the bookbuilding process, even until after the pre-marketing stage. The purpose has been to maintain competition among banks for as long as possible and to reduce, or even reverse, the information asymmetries enjoyed by a bookrunner appointed well in advance.
In their research Tim Jenkinson and Howard Jones carry out a clinical study of the first of these ‘competitive IPOs’, the €1.4 billion flotation of Pages Jaunes by its parent France Télécom, in 2004. For reasons peculiar to this transaction France Télécom was especially keen to avoid falling prey to ‘bait and switch’, the practice whereby bookrunners are appointed on the strength of a high indicative valuation, which they then reduce nearer the time of the offering when the issuer’s bargaining power is weaker. FT’s response was threefold. First it disaggregated the traditional all-encompassing role of the bookrunner by appointing an adviser well in advance of the offering, and also by engaging banks to conduct due diligence and prepare the prospectus without promising them any role in the distribution.
Second, it invited banks to compete for bookrunner roles just before pre-marketing; it then appointed them only after pre-marketing, and did so on the basis of the quality of each bank’s feedback and of the bookbuilding range each bank proposed for the offering. Third, FT threatened to withhold fees from each bank if the final IPO price was set outside that bank’s proposed bookbuilding range. These moves were designed to mitigate the bargaining power of the bookrunners, broaden the pre-marketing of the offering, and incentivize banks to provide accurate pricing information. The outcome in this IPO was that there was almost no change between the proposed price ranges of the banks and final pricing, that the IPO was pre-marketed very widely and that there was not a jump between the issue price and initial trading levels.
A number of European IPOs have followed Pages Jaunes in some of these innovations, notably by the separation of advisory and bookrunning roles and by the late appointment of bookrunners. These IPOs have been dubbed ‘competitive IPOs’. They have drawn criticism from regulators and market participants on the grounds that they may merely delay ‘bait and switch’ until later in the IPO process.
In their research, Tim Jenkinson and Howard Jones study the design of the Pages Jaunes IPO. A number of its untraditional features (e.g. the engagement of an adviser, the appointment of multiple bookrunners and the payment of ‘incentive fees’) had precedents in Europe. However, they conclude that its real innovations, namely the late appointment of bookrunners and the fee incentives for the accuracy of banks’ pricing ranges, are effective only if used together. Without this incentive, the banks may propose an unachievably high indicative price range in an effort to be appointed, which means that ‘bait-and-switch’ is delayed but not eliminated. ‘Competitive IPOs’ since Pages Jaunes have not included an explicit incentive for pricing accuracy. However, in all such offerings, the late appointment of bookrunners is likely to have led to increased marketing efforts during the pre-marketing, while banks are still competing for the bookrunner role.
Competitive IPOs represent an incremental change to the bookbuilding process. The bookrunner is still able to incentivise the production and revelation of information useful to the pricing of the IPO. However, the disaggregation of the traditional role of the bookrunner, the late appointment of bookrunners, and the incentive for accuracy of pricing represent attempts by issuers to optimize their contract with the appointed banks and promote effort and honesty. These moves attest to the fact that the conflicts of interest paradigm is now shaping market practice
(1) Tim Jenkinson, Howard Jones, European Financial Management, vol. 15, n° 4, 2009, pages 733 à 756.
(2) For more, see chapter 30 of the Vernimmen.
As all our readers know, convertible bonds are bonds that can be redeemed at the investor’s choice in cash or in shares of the issuer (1). These instruments are hybrid instruments as they sit between debt and equity. The largest problem for issuers with a convertible bond is that it is very likely to remain debt (i.e. to be redeemed in cash) if the company is in difficult financial situation (as most likely the share price will not therefore have performed enough) and be converted in equity only if the financial performance is good. Therefore for lenders (and rating agencies) and us in a financial analysis convertible bonds remain considered as debt up until they are converted in equity (or are deeply in the money).
Investment bankers have recently created a new product that solves this drawback of convertible bonds. This product “contingent capital” is a convertible bond that mechanically turns into equity if certain events happen or certain ratios are breached by the issuer.
These products have been initially developed for financial institutions to help them enhance their solvency ratios. Typically, a bank would issue a bond that would convert automatically in equity if the core tier one ratio of the bank falls below for example 5%. This bond clearly helps the solvency of the institution when times are tough. Lloyds issued such product.
Based on that idea of triggering event, other products can be imagined to increase the solvency of an issuer: senior debt that stop paying coupon in difficult time, senior bonds that turns into preferred shares, or even debt that is repaid with a specific asset (and not in cash). The idea is always the same: provide the issuer with additional margins for maneuver if its financial situation is deteriorating.
To design the product, a key question is to define the triggering event. For financial institutions, the reference to solvency ratios seems to be obvious. Nevertheless, it should be noted that the definition and calculation of these ratios may evolve in time creating uncertainty on the triggering event in the future. Some have imagined that the conversion into equity could be at the discretion of the regulator if it believes that the institution is undercapitalized (but will regulators accept such roles?).
These products are still at their very start and the appetite of investors to buy such instruments is still to be demonstrated. Obviously the pricing of the product is very difficult.
But if they develop effectively they could become interesting also for corporate. We had seen in 2005/2007 years some corporates issue deeply subordinated bonds showing that there is a demand for corporates to issue products that preserve their solvency.
(1) For more on convertible bonds, please see chapter 29 of the Vernimmen