Rapacious Finance Capital At Work

This very interesting Business Week article details the rapacious behavior of private equity firms. One nice touch: DynCorp was among the companies that the vultures hit.

Thornton, Emily. 2006. “Gluttons at the Gate.” Business Week (30 October).

“Three weeks after giant private-equity firm Thomas H. Lee Partners agreed to buy an 80% stake of Iowa Falls ethanol producer Hawkeye Holdings in May, Hawkeye filed registration papers with the Securities & Exchange Commission to go public. The buyout deal hadn’t even closed yet, but Thomas H. Lee was already looking forward to an initial public offering expected to generate a huge profit on its $312 million investment. The firm didn’t just cross its fingers and wait, however: It took $20 million from Hawkeye as an advisory fee for negotiating the buyout and a $1 million “management fee” — and will soon take about $6 million to meet its own tax obligations. All told, Thomas H. Lee will collect payments of around $27 million by yearend — despite Hawkeye’s having earned just $1.5 million in the six months through June.”


“These are crazy times in the private-equity business. It used to be that buyout firms would spend 5 to 10 years reorganizing, rationalizing, and polishing companies they owned before filing to take them public. Thomas H. Lee couldn’t have created much lasting economic value in the three weeks before the filing, but that didn’t stop it from writing itself huge checks from Hawkeye’s ledger. Thomas H. Lee and Hawkeye declined to comment.”

“Buyout firms have always been aggressive. But an ethos of instant gratification has started to spread through the business in ways that are only now coming into view. Firms are extracting record dividends within months of buying companies, often financed by loading them up with huge amounts of debt. Some are quietly going back to the till over and over to collect an array of dubious fees. Some are trying to flip their holdings back onto the public markets faster than they’ve ever dared before. A few are using financial engineering and bankruptcy proceedings to wrest control of companies. At the extremes, the quick-money mindset is manifesting itself in possibly illegal activity: Some private equity executives are being investigated for outright fraud.”

“Taken together, these trends serve as a warning that the private-equity business has entered a historic period of excess. “It feels a lot like 1999 in venture capital,” says Steven N. Kaplan, finance professor at the University of Chicago. Indeed, it shares elements of both the late-1990s VC craze, in which too much money flooded into investment managers’ hands, as well as the 1980s buyout binge, in which swaggering dealmakers hunted bigger and bigger prey. But the fast money — and the increasingly creative ways of getting it — set this era apart. “The deal environment is as frothy as I’ve ever seen it,” says Michael Madden, managing partner of private equity firm BlackEagle Partners Inc. “There are still opportunities to make good returns, but you have to have a special angle to achieve them”.”

“… success has lured more money into private equity than ever before — a record $159 billion so far this year, compared with $41 billion in all of 2003, estimates researcher Private Equity Intelligence. The first $5 billion fund popped up in 1996; now, Kohlberg Kravis Roberts, Blackstone Group, and Texas Pacific Group are each raising $15 billion funds.”

“Now that the largest firms have as much as $30 billion in assets, their 1% to 2% management fees alone guarantee hundreds of millions of dollars annually. The average pay of a managing general partner at a big private-equity firm rocketed to $6.1 million in 2005, up 93% from 2004, according to compensation research outfit Holt Private Equity Consultants. Jostling with the old familiar names like KKR, Carlyle Group, and Texas Pacific are fast-rising firms like Vector Capital, Veritas Capital, and Tennenbaum Capital Partners.”

But for now, business is booming, and signs of excess are popping up all over. The most glaring are the dividends. Once unthinkable, the $1 billion threshold has been crossed several times now. Most recently, in June, Clayton, Dubilier & Rice, Carlyle Group, and Merrill Lynch collected $1 billion just six months after buying rental car company Hertz Corp. for $15 billion. With the dividend, the trio earned back almost half of the $2.3 billion they put up in cash.

“Fees, meanwhile, are getting bigger and more creative. Nowadays, when a private-equity firm buys a company, it typically collects a toll for giving itself advice on the deal, sometimes more than investment bankers receive. Blackstone Group took $45 million from Celanese Corp. for its advisory work on its own deal in 2004, more than twice the $18 million Celanese paid Goldman Sachs, its adviser. Warner Music paid its owners, Bain Capital, Thomas H. Lee, and Providence Equity Partners, a $75 million advisory fee.”

“Private-equity firms are beefing up charges for management expertise, too. In 2005, a trio of private-equity owners of SMART Modular Technologies collected nearly $3 million for this purpose, more than the $2 million in total that the five members of the company’s management team earned that year.”
“Private equity firms even charge companies for no longer taking their advice. Specialty pharmaceutical maker Warner Chilcott’s four private-equity owners — Bain Capital, Donaldson, Lufkin & Jenrette Merchant Banking, JPMorgan Partners, and Thomas H. Lee — recently collected $27.4 million as compensation for terminating their advisory arrangements when the company went public in September, even though the company is unprofitable.”

“As the list of occasions for gathering fees and dividends grows, many firms are going to the well often, sometimes within months of their previous collection. At satellite operator Intelsat Global Services, a pack of private-equity owners — Apax Partners, Apollo Management, MDP Global Investors, and Permira Advisers — accumulated $576 million in dividends and fees in multiple installments within a year of buying it for $513 million in 2005. This, despite the company’s posting a $325 million loss last year. Intelsat has $360 million in cash, while its debt has doubled, to $4.79 billion. The new load led to multiple cuts in the company’s credit rating. In February, Intelsat said in filings with the SEC that it reduced its workforce by 20%, laying off 194 people, to “optimize margins and free cash flow”.”

“Many firms tap the public stock markets to bail their companies out of debt. Thomson Financial estimates that 55% of the proceeds from this year’s buyout-backed IPOs were used, at least in part, to make payments to financial owners and creditors, vs. 21% of non-buyout-backed IPOs.”

“The case of San-Francisco’s Bare Escentuals Inc. shows how reliant firms have become on public stock investors. In 2005 the cosmetics maker took on $412 million in debt, mostly to pay its owners, Boston’s Berkshire Partners and San Francisco’s JH Partners, a total of $309 million in dividends and “transaction fees” in two installments eight months apart. The payments were a stretch for a company that earned only $24 million in 2005. In September, 2005, Standard & Poor’s revised its outlook for the company to “negative” from “stable,” citing its “very aggressive financial policy”.”

“Yet Bare Escentuals’ owners, who bought the company in June, 2004, kept coming back to the trough. In June, 2006, despite S&P’s decision in May to lower the company’s credit rating from to B to B- and the company’s soaring debt-payoff costs, Bare Escentuals began to borrow again to pay its owners even larger amounts: a $340 million dividend, $218,00 in management fees, and $1.8 million in stock for arranging the dividend.”

“Medical-device maker Alphatec Holdings Inc. went public in June, 15 months after being bought by Healthpoint Capital Partners Inc. In 2005, Alphatec paid Healthpoint a total of $2.6 million in various advisory fees and rent. Its stock has plummeted 63%.”

“Similarly, government services provider DynCorp International Inc. filed its preliminary prospectus seven months after Veritas Capital Fund bought the company for $775 million in cash and $75 million of preferred stock in February, 2005. DynCorp paid $12.1 million in fees in 2005, even though it posted a loss of $3 million from February to April that year. DynCorp International’s stock has tumbled 22% since its May IPO. Veritas Capital President Robert B. McKeon attributes the company’s flagging stock price to an overall decline in the IPO market and in shares of middle-tier defense companies.”

“Some buyout firms have loaded up companies with so much debt that they’re ending up in bankruptcy or are about to. Already, a number of companies have been forced into Chapter 11 because their growing debt left no room to deal with operational challenges such as sudden spikes in raw material prices.”

“In February, 2004, for example, 16 months after San Francisco’s Fremont Partners bought nutrition-bar maker Nellson Nutraceutical Inc. for $300 million, the company borrowed $100 million in part to pay Fremont a dividend of more than $55 million, according to a creditor’s filing in bankruptcy court. Nellson rationalized the dividend as a way to provide Fremont “an early return of capital” and to reduce Fremont’s “risk in the investment,” according to the filing.”

“But Nellson’s energy bar sales went into a tailspin not long after the dividend. Eight months later, it was breaking loan agreements, according to bankruptcy filings. It filed for Chapter 11 protection in January. Fremont and Nellson declined to comment.”

“As one might expect, the fallout of the bankruptcy has been painful. Nellson owned a plant in tiny upstate Ira, N.Y., and was the town’s largest employer, according to Cayuga County legislator Paul Dudley. The plant shut down in March, 2005, and the space remains vacant. Says Dudley: “It was a good source of employment for about 100 people. How many were able to get new jobs I don’t know. This is a rural community, and people no longer have the luxury of working [just] two miles from home.” On Oct. 16, the U.N. issued a warning about the potential economic dangers facing countries because of private equity firms’ short investment time horizons.”

“Buyout shops have always been associated with job losses, but they’ve always rationalized them as necessary steps to make companies stronger. There’s no way to defend what some critics allege has become a new tool in the private equity kit: intentionally driving target companies into bankruptcy to seize control of their assets. The name for the practice on Wall Street is “loans to own.” By making a secured loan directly to a company, a firm can vault itself to the top of a company’s capital structure. Should the business go under, loan holders have first dibs on the remaining assets; only after they take their cuts are the claims of creditors with unsecured debts considered. With so much money in private equity right now, “more firms are interested in take-control strategies,” says Lisa G. Beckerman, partner at law firm Akin Gump Strauss Hauer & Feld.”

“At Radnor Holdings Corp. in Radnor, Pa., debts to private-equity firm Tennenbaum Capital Partners have sparked controversy. Radnor makes disposable cutlery, Styrofoam cups, and the like. In October, 2005, Tennenbaum made a $25 million equity investment in Radnor that allowed it a seat on the company’s board. Two months later, it lent Radnor $95 million, with Radnor’s machinery and property used as collateral. Then in April, 2006, it lent an additional $23.5 million as high fuel, transportation, and resin prices squeezed Radnor’s profit margins. To make ends meet, Radnor shuttered one plant and reduced its workforce by 10%, or 67 people. Radnor declined comment.”

“By August, the company was forced to file for protection under Chapter 11. Soon afterward, Radnor announced it had accepted a $225 million bid from Tennenbaum for all of its assets. A group of unsecured creditors allege in a filing with the bankruptcy court in Delaware that Tennenbaum engaged in a “carefully scripted effort to force the debtors to shed legitimate arms-length financial and other obligations in order to facilitate Tennenbaum’s acquisition of the debtors’ cleansed assets”.”

“John Adler has to straddle many competing interests. As director of a private-equity team at the Service Employees International Union, he’s responsible for keeping the union’s returns strong. He also might be buying into some of the very investment firms that could jeopardize jobs of the people he serves. For now, though, he’s taking the excesses of the private-equity market in stride. Says Adler: “Putting the right opportunities together with the right capital can really be a good situation for our members. Private equity owns a huge swath of the economy, and it’s growing”.”

1 comment so far

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