Why the Junk Bond Market Grew
In the previous article, we discussed the junk bond market, what it is, and what its history was. Today, we will continue with this topic. More specifically, we will talk about why the junk bond market grew.
During the 1980s, there was a dramatic and rapid growth in the junk bond market. This growth was so significant that investors finally took notice of this market. They finally viewed it as an investible market with lower risk than they previously thought. You may remember from our previous article that the growth of the junk bond market was modest in the years previous.
However, in the fourth merger wave, it grew for several reasons. There were numerous studies about the growth of the junk bond market in the fourth merger wave. So, to make it simpler and easier to understand, we made this list for you.
We have created a list of the factors that affected the development of the junk bond market. You can read all about them below.
Reasons Behind The Growth of the Junk Bond Market
There were privately placed bonds.
Before the 70s, high-yield bonds were placed privately with institutional investors. These bonds had unique indenture contracts. And the contracts had restrictive covenants that varied based on the negotiation between different buyers. High-yield bonds were more difficult to market back then because of the lack of standardized contracts.
Another big factor was that these types of bonds were not certified with the SEC. What does this mean? Well, it simply means it is not possible to publicly trade them.
Because of this, high-yield bonds were somewhat illiquid. In the later part of this article, we will talk about how investment bankers realized this as an opportunity
The development of market makers.
Another great aspect that led to the improvement of the junk bond market was the presence of an active market maker.
What is an active market maker, you ask? Well, that’s a good question. It works as a liquidity agent. It works in facilitating sales between the seller and the buyer. Take the firm of Drexel Burnham Lambert as an example. The firm became a very active market maker in this very market.
Their growth in the 80s was mostly because of the firm’s involvement in this type of market. More on this later.
A Change in the Risk Perception
The growth of the junk bond market would not be possible if investors didn’t change their risk perceptions of the subject. When investors started to realize how valuable these bonds were, they began to believe that the risks associated with these types of investments were actually less than what they used to believe.
There were also a few research studies that inspected the sensitive nature of junk bonds. The results were that the risk of default was inferior than what they believed.
Deregulation
Another factor in this specific market growth is the deregulation. Junk bond markets were able to attract investment capital because of a more relaxed regulatory climate. Because of this, they were able to get investments from institutional investors who are traditionally conservative. Examples of these are pension funds. You can also look at thrift institutions and view them as a great example.
Managers were then allowed to invest in a broader range of assets. This is all thanks to the Employee Retirement Income Security Act from 1974. The assets include riskier securities. This is true as long as the portfolio was adequately varied.
Moreover, thrift institutions were able to spend in business loans and company bonds thanks to the Ganrn-St. Germain Act of 1982. Amazingly enough, a lot of thrift institutions chose not to spend on corporate bonds. However, they collected large portfolios of these securities.
Merger Demand
Lastly, there was the factor of merger demand. Those years, they found a major development in mergers and acquisitions. And as the target of mergers and acquisitions grew even larger, there was also an increase in the demand for capital to fund these purchases. You can also say the same for leveraged buyouts.
Where does the junk bond market come in, you ask? Well, investors relied on the junk bond market to administer a huge portion of this funding. They relied on these bonds heavily.
In fact, according to numerous research, over half of the junk bonds that were issued in the fourth merger wave were related to mergers and acquisitions.
The Role of Drexel Burnham Lambert in the Junk Bond Market Growth
Earlier, we talked about how investment bankers viewed the junk bond market as an incredible opportunity. One of those investment bankers was Drexel Burnham Lambert. They were very active market makers in this market.
Their famous improvement in the 80s was mostly because of its engagement in the junk bond market. They went out of their way just to make sure of the growth and the endurance of the market.
They were one of the few primary investment banks to create underwriting new-issue junk bonds. Their efforts were widely known to advertise the junk bond market as an enticing investment alternative. The efforts were led by Michael Milken, the former manager of Drexel Burnham Lambert’s Beverly Hills office.
These are only some illustration of why and how this specific market grew. It was a mixture of the factors we listed above. Namely, merger demand, deregulation, and a change in the risk perception. Let’s not forget the development of market makers and the privately placed bonds, too.
We hope that this article has aided a lot of you to understand how the junk bond market grew. To know more about the history of junk bond markets, feel free to check our article here.
In the next article, we will talk about investment bankers and highly confident letters, investment banks, and liquidity of junk bond investments. We will also talk about junk bond refinancing and bridge loans, and finally, the collapse of the junk bond market in the late 1980s.
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Junk Bond Market History
Now that we have finished our discussion about the private equity market, we will talk about the High-Yield Financing and the Leveraged Loan Market. More specifically, in this article, we will talk about the history of the junk bond market.
High-yield bonds, or also known as junk bonds, are debt securities that have below investment-grade ratings. Hence, the name junk bonds. This type of bond gets a rating of BB or worse.
Now, you may be asking what makes junk bonds important? Well, it’s pretty straightforward: the junk bond market is still a type of finance resource. This means that it can still be used to finance takeovers. It is especially useful in leveraged takeovers.
Junk bonds have played a crucial role in the fourth merger wave. To read more about the history of merger waves, please feel free to read our article here. The junk bond’s importance has significantly diminished in the years that followed.
Junk Bond Market History
Where Did the Term “Junk Bond” Originate From?
Despite it playing a merger role in the fourth merger wave, junk bonds weren’t created in this period. However, there are a lot of people who might believe this.
This is because for decades before the fourth merger wave, junk bonds were actually called “low-grade bonds”. Between the 1930s and 40s, they referred to junk bonds as “fallen angels.” By the time the 60s rolled in, the lower-grade debt that was issued to help finance conglomerate acquisitions were referred to as “Chinese paper.”
So, where did the term “junk bonds” come from? Well, according to financier Meshulam Riklis, the chief executive officer (CEO) of Rapid American Corporation, the term junk bonds was first used in a conversation that he had with Michael Milken. Milken was the former head of Drexel Burnham Lambert’s junk bond operation.
Riklis also stated that when Milken surveyed some of the bonds that the former had issued, he exclaimed “Rik, these are junk!” And so, the term was born.
Junk Bonds in the Early 1900s
In the 1920s and 30s, approximately 17% of all new corporate bond offerings were low-grade/high-yield bonds. To finance their growth, a wide range of firms used these securities.
In 1928, around 13% of all outstanding corporate bonds were low-grade bonds. However, by the time the 40s rolled in the percentage grew to 42%.
However, it was in the 1930s when the ranks of high-yield bonds swelled. This is when the Great Depression took its toll on a large number of United States companies.
A lot of the bonds had entered the low-grade class through downgrading from rating agencies. We will discuss more of the rating process in the next articles within this topic.
The Effect of the Great Depression
As we have previously mentioned, the Great Depression has affected most of America’s companies. As the economy fell deeper and deeper into the Depression, many firms have suffered from the impact of declining demand for their goods and services.
The businesses’ ability to service the payments on their outstanding bonds were called into question. Soon, a downgrading of the debt occurred.
After the overall level of economic demand fell, the revenues of some firms declined so much. This led to firms not being able to service the interest and principal payments on outstanding bonds.
This led to a 10% rise in the default on these bonds. Naturally, the investors became disappointed with the rising default rate in a category of securities that they believed were generally low-risk.
The said investors were previously attracted to the bond market by investment characteristics. These characteristics were dependability of income and low risk of default. However, as the risk of default rose, low-grade bonds became unpopular.
The Decline of Junk Bonds
In the 1940s, the low-grade bond market started to decline. This is due to old issues retiring or the issuing corporations entered into some form of bankruptcy.
The declining popularity of the low-grade bond market made new issues difficult to market. In the years between 1944 and 1965, high-yield bonds accounted for only 6.5% of total corporate bond issues.
However, this percentage wasn’t the end of it. It declined even further by the time the 70s began. In the early 1970s, only 4% of all corporate bonds were low-grade bonds.
The low-grade/high-yield bond market’s declining popularity paved the way to one form of debt financing to certain groups of borrowers. A lot of different corporations were now forced to borrow from banks in the form of term loans. These term loans were generally shorter maturity than 20- and 30-year corporate bonds. The corporations would have preferred to issue long-term bonds.
Moreover, those who could not borrow from a bank on acceptable terms were forced to forsake expansion. Or, they were forced to issue more equity. Naturally, this had the adverse effect of diluting the shares of ownership for outstanding equity holders
Not only that, but the rate of return on equity is generally higher than debt. This means that the equity is a more costly source of capital.
Junk Bond Changes in the 1970s
In the late 1970s, however, the high-yield/low-grade market began to change. Lehman Brothers underwrote a series of new issues of high-yield corporate debt. Lehman Brothers was an investment bank that was acquired in the 1980s by Shearson.
The bonds they issued are offered by Ling-Temco-Vought (LTV) ($75 million), Zapata Corporation ($75 million), Fuqua Industries ($60 million), and Pan American World Airways ($53 million).
This event was followed by the entrance of a relatively smaller investment bank, Drexel Burnham Lambert. This investment bank started to underwrite issues of low-grade/high-yield debt on a larger scale.
The first such issue that Drexel underwrote was a $30-million issue of bonds on Texas International Inc. in April 1977.
Drexel Burnham Lambert’s role in the development was the key to the growth of the low-grade/high-yield bond market. It served as a market maker for junk bonds. This was crucial to the dramatic growth of the market.
Junk Bonds Issuance Growth
In 1982, junk bond issuance had grown significantly. It has grown to $2 billion per year. No more than three years later, the total had risen to $14.1 billion. By the time the next year rolled in, the total jumped to $31.9 million. This Is the highest level the market reached in the fourth merger wave.
However, in the second half of 1989, it collapsed. It later rebounded in 1992 and rose to new heights. Although the market thrived in the 1990s, it took a different form from being a major source of merger and LBO financing, which accounted for its growth in the fourth merger wave.
© Image credits to Anni Roenkae
Private Equity Investments & How To Replicate Them
A private equity market is a group of funds that were able to raise capital. They do this by seeking investments from several large financiers where the funds will be invested in equity positions in corporations. In this article, we will talk about replicating private equity investments.
As soon as the assets accumulate 100% of the pending equity of a public company, a going-private negotiation occurs. If you borrowed funds to acquire the deal, then that makes it a leveraged buyout or an LBO.
Private Equity Investments vs. VCF
What sets private equity apart from venture capital? The former seeks out more established companies with lengthy revenues. Meanwhile, the latter often makes investments in new companies that have limited revenues.
A club deal or a consortium deal, on the other hand, occurs when private equity funds acquire stock in a target company individually. They may also combine with other private equity firms in order to acquire a target.
Private equity returns have a tendency to surpass those of the market. We have discussed this before. One downside is that private equity funds cater only to a few investors who are usually large institutions like pension funds.
Average smaller investors are not ideal for them. The aggressive use of leverage by the funds also augments private equity returns.
What Are P.E. Investments?
Smaller or mid-sized companies with low EBITDA multiples, like value stocks, are what private equity funds tend to invest in. They do this to generate acceptable returns for their own investors. Hence, they really need to purchase target companies at prices that let them achieve a particular hurdle rate. These investments and returns also feature long holding periods.
Significant investor activism as private equity funds usually accumulates across entire companies. They have their representatives on the board while choosing managers. Can smaller investors match private equity returns through various options? Individual investors, according to Erik Stafford, duplicate several qualities characteristics of the private equity model except for activism.
According to him, portfolios made of companies with components that are just like those preferred by private equity funds earn high risk-adjusted gains. They are eclipsing the mean pre-fee equity gains. This happens when the target portfolio influence is selected to match the returns. This refers to returns that are leveraged accumulating inside private equity funds.
Anchoring on Stafford’s study, SummerHaven Index Management LLP offers an investable indicator that aims to copy the long-term gain characteristics of varied private equity funds.
Interlocked boards also affect corporate governance. But Stuart and Yim used a sample of all US publicity traded companies from 2000-2007 and discovered that firms were 42% more likely to get offers from private equity firms.
This is when they had directors that had a previous positive experience in receiving private equity bids while at other companies. But with negative experiences, the “PE Interlock Effect” disappears. They concluded that the companies which become takeover targets are based on board members and the social networks they bring to the board.
Private Equity Investments Secondary Market
There was a time when LPs were passive investors. They invested their capital and just waited for automatic high returns. LPs are private equity funds investors. Hence, a relatively inactive market has been around for private equity investments.
The transactions here have come in different forms. For instance, an LP could adjust its portfolio by using this market to escape specific private equity investments.
This sale also involves not only the investment but also other financial commitments by LPs. This investment’s buyers could be institutions and hedge funds. The investment agreement governs the extent to which the LP can enter into such a sale.
This will demand the GP’s approval so that it would be completed. If the potential seller is a large investor, the approval is easy to get.
That’s especially true if they have made other investments with the GP and with whom the GP wants to continue to work. The sale can be relatively seamless, and the partnership can continue to function undisturbed by a switch of LPs.
Everything changed when the economy and market turned down. Now private equity managers have to work harder for their returns and they find themselves under closer scrutiny from the LPs.
Private Equity GPs
As we already know, the general partners of a private equity fund can earn a fixed income. This income is independent of the performance of the fund. Aside from that, they earn a variable income, a function of that performance.
The payment for the fixed management fees comes from committed capital. Committed capital is the money that limited partners provide. If you add limited capital and investment capital, you will get committed capital. The GP and LP have varying management fees, like a fixed percentage over the life of the fund or a decline over that time period. They calculate these fees by an application of the relevant [percentage to some base, like committed capital or some alternative.
Private Equity Firms & Takeovers
Private equity firms have been so involved in takeovers that they find themselves forming competing groups or partnerships. They also bid against each other for takeover targets. This happened in 2005, when KKR joined forces with Silverlake Partners to acquire Agilent Technologies Inc.
When KKR allowed investors to sell parts of their stakes in buyout funds in 2014, the secondary market took a step forward. This occurred through a private market that the Nasdaq OMX Group manages.
Pension funds and other institutional investors could utilize the market to sell their private equity investments to other investors, even smaller investors. Before this development, smaller investors who planned to invest in private equity could buy shares in some private equity companies that turned public.
Some examples include Blackstone Group and Carlyle. But these are shares in the private equity companies themselves compared to certain private equity funds’ investments. These investments had been large institutions’ exclusive domain.
Only in its development phase, the new markets already have plans to be open to sophisticated investors with a minimum purchase requirement. It is possible for this to mean tens of thousands of dollars, and the market should make these investments more liquid. Capital raising would logically be easier with this.
© Image credits to Anni Roenkae
Private Equity Exit Strategies Alternative
A buyer can do a private equity exit from an investment in many ways. It can be done through a sponsor-to-sponsor deal or a sale to a corporate buyer. Here are some strategies that a private equity buyer can utilize.
Alternatives to Private Equity Exit Strategies
Sale to Corporate Buyer
Private equity buyers may sell to another corporate buyer that sees the acquisition of the company as complementary to its overall business strategies. They are also known as strategic buyers and they are the mainstay of private equity exit. But just like the Great Recession of 2008 to 2009, when the company is weak and the recovery isn’t great. These kinds of buyers are difficult to find. It is during these times that they are not looking to expand and aggressively pursue their strategic growth plan. This is because they are more risk-averse when their sales growth and economic growth are weak. Now that the US corporate treasuries are growing, strategic buyers are returning to the M&A market.
Sponsor-to-Sponsor Deal
This second option is where one private equity firm sells a prior acquisition to another private equity firm. This kind of transaction is well-known in a market where there are many private equity capitals in funds seeking deals while there are also famous equity firms trying to generate returns from previous acquisitions
Public Offering
In a public offering, the private equity firm sponsors an offer in the public in the stock that it owns before the acquisition. Is this viable? The answer depends on the vitality of equities markets and the IPO markets in particular. In 2013, private equity firms made roughly half of all IPOs.
Dividend Recapitalizations
Generating returns from portfolio companies of private equity firms is something else. It is more than just cashing out the investment when it sells. Private equity firms have been recently engaging in so-called dividend recapitalizations. This is when private equity firms that have acquired companies take on more debt. Issuing bonds and using proceeds to pay a dividend to the fund investors can help acquire this debt. This was the case in September 2004, when KKR had PanAmSat issue $250 million in notes that were used to pay the investors who bought the firm just one month prior for $4.3 billion.
When private equity investors purchased Burger King, the buyers paid a $400 million special dividend in 2006. Burger King financed this through the assumption of approximately $350 million in debt. In May 2006, Burger King did a $425 million IPO which prepared the substantial debt that the company had taken on to pay the dividend. This combo of the dividend and their share of the private equity proceeds provided the private equity investors with a whopping 115% return on their three-year-plus investment.
Debt Financing and Use of “Covenant-Lite” Loans
From 2003 to 2007, during the era of private equity exit, the firms were able to negotiate very big conditions with the lender and banks that they had great connections with and to which they brought a lot of business. Aside from that, the banks were confident due to the very positive economic environment and how they were not able to understand how a business cycle works.
One of the favorable conditions here was the granting of covenant-lite loans. These kinds of loans had less restrictive covenants that require specific financial performance. This financial performance may include the maintenance of specific financial ratios. The loan agreements are liberal that they can accept in advance certain violations of the agreement by the borrower.
\But they may allow the GP to “cure” transgressions in return. This is by adding more equity to the target. Although enders were flexible during the 2003-2007 private equity boom times, they are much more strict when the economy collapsed after the subprime crisis.
Bridge Financing
Bridge financing in the context of private equity transactions is the capital offered to allow the GPs to complete the deal as they wait for long-term financing to be worked out. For this to be possible, the private equity firm secures a commitment from an investment bank. The private equity GPs and the bank typically hope the bridge financing will not be a requirement, since they will be able to syndicate a bank credit facility or simply float an offering of junk bonds.
Bridge financing is riskier than longer-term financing that is related to a closed deal. Because of this, private equity firms try to avoid using bridge financing. Once there is an agreed-upon debt availability, the private equity firm is in a position to make a commitment to the seller. They must commit to the the deal’s equity, too. It is one of the things that need to commit to.
If the private equity firm does not have immediate access to the total amount of equity capital needed to complete the deal, it may go to a bank and ask it to temporarily provide the additional needed equity, called bridge equity. Obviously, the recipient has to pay the bank the necessary fees to make this equity capital available. A commitment for the total acquisition amount to the seller once the bank makes the commitment.
Delaware General Corporation Law Rule 251H
When it comes to tender offers, private equity buyers have long been in a disadvantageous position relative to strategic buyers. These private equity buyers face several risks. Risks such as that the deal would or not be approved by selling stockholders in a closing-out second-step transaction.
Bridge financing must be secured by private equity bidders without the benefit of the assets of the target for collateral support. This is because they do not get such access and sport until the deal is done. This bridge financing can be expensive, and this caused many private equity firms to avoid the tender offer.
The Rule 251h grant buyers that get a simple majority of a target’s shared in a tender offer. This is so to quickly close rather than wait for a shareholder vote. This contributed to the competitive feature of financial buyers. Examples of these are private equity firms or strategic buyers who are using debt financing. As opposed to compared to strategic buyers who may be using their own cash or stock. It also reduced the possibility of expensive time delays that make it more expensive and uncertain in the takeover process.
We hope that this article about the private equity exit has helped you a lot! See you on the next one.
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Club Deals and Private Equity Fund Partnership
Club deals or “consortium deals” are used by private equity firms. Private equity funds either acquire stock in a target company individually or combine with other private equity firms to acquire a target. The combination deals let them spread out the risk. It is also important since many funds require only a certain percentage. For instance, 10% of a fund’s assets can be invested in any particular investment.
A billion fund, or a large equity firm by any standards, would be limited to acquisitions of a maximum of $1 billion for 100% acquisition. This is if it chose not to use debt to complete the transaction. If this is the case, they may opt to combine forces with other private equity firms when they are trying to complete a large acquisition.
Examples of Private Equity Fund Partnership and “Club Deals”
For instance, Silver Lake Partners in 2005 completed the second-largest LBO up to that time. The company combined with six other private equity firms to acquire Sungard Data Systems. They did so for $10.8 billion.
Blackstone Group, Kohlberg Kravis & Roberts, Texas Pacific Group Goldman Sachs Partners, and Providence Equity Partners. These are just the other private equity firms that participated in the takeover.
Private equity firms form competing groups or partnerships because of their too much involvement in takeovers. They also bid against each other for takeover targets. Let’s take a great example from 2005. That year, KKR combined with Silverlake Partners to acquire Agilent Technologies Inc.’s semiconductor products business. They did so for $2.6 billion.
Agilent Technologies Inc.’s Acquisition
As a part of a focusing strategy, Hewlett-Packard spun off this company in 1999. Agilent Technologies pursued a focusing strategy in 2005 when it decided to try selling out its chip unit and lighting business.
William Sullivan, their CEO, said that Agilent was trading a 25% to 35% discount to its peers, considering that it was a diversified company. Giving the company increased sell-offs was key to lowering the discount that the market was applying to his company.
KKR and Silverlake won the contest in which they were bidding against two other buyout groups. One featured Brain Capital and Warburg Pincus, while another had Texas Pacific Group, CVC Partners, and Francisco Partners as participants.
For others, like Officer, Ozbas, and Sensoy, club deals tend to lower the pool of potential demanders for target companies. Hence lowering the prices that targets are getting in the market. Their study concludes that target shareholders receive 10% less of pre-bid value and 40% lower premiums.
This may mean that private equity buyers might be colluding to lower prices they pay for targets. These results were, however, not consistent with other results.
For instance, Boone and Mulherin failed to find lower target prices. This was after analyzing a sample of 870 publicly traded targets from the year 2003 up until 2007. They think that these results are because of the changes in the market. Like the increased use of go-shop provisions and the availability of stapled financing. The latter could even eliminate some of the benefits club deals may have over single buyers.
“Club Deals” Over the Recent Years
Club or consortium deals have become less popular in recent years. Private equity firms do not have complete control as much as they do when they acquire the target by themselves. They learned that dealing with other owners can make the transaction and the management and subsequent sale more complicated. Diverse views on how the company should be managed, the appropriate time, and way to seek an exit have made more private equity firms bypass this option.
Private Equity Business Model
The business model is relatively simple. Compared to some of the leading names in finance work in this industry and often lucrative compensation. First, for the private equity buyers, have contacts with investors and sales skills. This will let them convince institutional investors to invest a portion of their capital into one of their private equity funds.
Next, find undervalued targets where they can be directly assisted by poor management in the target company. Perhaps it is facilitated by weak governance of corporations, where the managers may have run the company in a way that hindered its potential.
The moment that an acceptable target is found and there is an agreed-upon acquisition price. The GPs secure the debt capital using relationships they have with various banks. Funds are able to acquire this capital at very low rates. This is with the help of recent expansionary monetary policy for the Federal Reserve and global central banks.
Buying Undervalued Targets
Private equity buyers use cheap debt to buy undervalued targets. There are also plus points if the targets do not already have significant debt. Since they may want to have the target to acquire more debt which can be used to pay themselves a “dividend”.
Private equity firms love when the market rises. It lets them buy at one price, and then a few years later, sell the target in an elevated market at a higher price than what they paid.
Then, they conduct this business in a good economy with a rising market. Once they have the chance, they flip the target, higher debt, and all, onto a buyer.
In the 2000s, financing the deal was done at low costs, and this magnified their returns on the relatively small equity investment that they made. When the market is rising, and the cost of debt is low with an ample supply of capital available, private equity industries are at the advantage. Dealmakers may seem smart and are asking for too much, but the steps in the process are very simple.
Other Exit Strategies for Private Equity
One way a private equity buyer can exit from an investment is through a sale to a corporate buyer. The buyer sees the acquisition as a complement to its business strategy. Another is a sponsor-to-sponsor deal. This is where one private equity firm sells a prior acquisition to another private equity firm. Another is by means of public offerings. This is where the private equity firm sponsors a public offering in the stock it owns in its previous acquisition.
© Image credits to Steve Johnson
Compensation of Private Equity GPs
Now that we have discussed the Seller versus Private Equity Fund Valuations and Negotiations, let us move on to other important topics of The Private Equity Market. For today’s article, we will discuss the Compensation of Private Equity GPs. Let’s get started.
Compensation of Private Equity GPs
In the most common scenarios, general partners of a private equity fund can earn different types of income. For one, they can earn a fixed income. This income is independent of the performance of the fund. Regardless of how the fund is doing, the fixed income is still the same.
Secondly, partners can earn a variable income. It is a function of that performance. There are also what’s called management fees. Usually, these fees are paid from the committed capital and are fixed.
Committed capital is the money that limited partners provide. This is usually composed of lifetime fees and investment capital. It is important to know that the arrangement for the management fee is between the general partner and the LP. This can vary depending on what they have agreed on.
For instance, the management fee could be a fixed percentage over the life of the fund. Or, in more common instances, the fee could decline over that time period.
So, are the fees calculated? Well, they are usually calculated through means of applying the relevant percentage to some base minus the cost basis of investments that have already been disposed of. This could be the committed capital or another alternative such as net invested capital, which is defined as the invested capital. Invested capital is capital that has already been invested.
Variable Fees: Carried Interest
Now, there are also other ways for general partners to earn income. Aside from fixed management fees, GPs also have the right to several variable incomes. These are most commonly referred to as performance-based income.
Usually, and the most controversial is carried interest. This is earned from gains on the transactions that were conducted by the general partner. Now, as for how the general partners can actually earn income from this source usually depends on the agreement with the LPs.
For instance, it is possible that the general partner cannot earn this type of income unless the limited partner has already received their capital. Additionally, if a hurdle rate was agreed to, the amount could be higher.
Now, a carry level is the percentage of the applicable profit that is used to calculate the earnings of a general partner. Commonly, carry levels are at twenty percent.
Oftentimes, you would hear that general partner are paid based on 2/20. That means that the 2 would be the fixed percentage while the 20 refers to the variable component that is based on the 20% carry level.
There will also be instances where general partners are allowed to take some profits early. This is resolved by the carry timing.
However, if the limited partners do not receive their capital, then it is possible for them to get back some of these early paid profits. This is, of course, contingent to the fact that the original agreements between general and limited partners have clawback provisions.
Variable Fees: Monitoring and Transactions Fees
There are also monitoring and transaction fees. These are what make up the remainder of the variable income that the general partners receive. General partners do the monitoring.
They oversee the operations and performance of the companies that they have acquired. Usually, limited partners are also entitled to these fees. In fact, they receive the bulk of the fees, which is at eighty percent most of the time. These fees are usually based on some multiple of financial performance measures, such as EBITDA.
Additionally, for each completed transaction, the general partners have the right to charge a transaction fee. It can be structured so that there is a total transaction fee and part of the total is shared with the limited partners.
LP “Activism” and the Evolving Private Equity GPs Business
There was a time when limited partners were relatively passive investors. They invested their capital and waited for the automatic high returns.
The strong equity markets gave the general partners, or private equity managers a way to easily meet the expectations of the clients or the limited partners. However, all of these changed when the economy and market turned down.
These days, private equity managers or general partners have to work harder for their returns. Oftentimes, they find themselves under closer scrutiny from the limited partners.
As expected, the limited partners want more detailed breakdowns or explanations. They want to know more about each transaction, and how each of those will generate good returns. Additionally, LPs also want to be updated on the progress of each transaction.
This is especially true for government pension fund limited partners. It may also be less applicable for university endowment limited partners.
This is because government pension funds are the leading providers of capital to private equity funds. It is also true that limited partners are more active now than they used to be. In the past, they were almost totally inactive.
Activism that Requires Private Equity Firms
Part of that activism is requiring private equity firms to cancel some of the charges that had contributed in the past to slip past inattentive LPs. As we have already discussed, when the market is strong, and the limited partners see good returns, they tend to be less keen on monitoring fees and expenses that are charged by the general partners.
However, this is very unfortunate because limited partners own an obligation to the employees they represent to receive the highest returns they can. They also have the obligation to prevent general partners from siphoning off money through the fees of the limited partners they should have not agreed to pay in the first place. This is an issue that the Securities and The Exchange Commission has been focusing on more.
In the next article, we will continue our discussion of The Private Equity Market. And we will focus on Private Equity Fund Partnerships and “Club Deals”. See you then!
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Seller versus Private Equity Fund Valuations and Negotiations
For private equity companies to make a better return for their investors. Target companies should be purchased by them at a price that lets them achieve a certain hurdle rate. As mentioned, venture funds often make investments in new companies that might have limited revenues. While private equity firms seek out more established companies that have lengthy revenue, if not a profit, history.
It is possible for private equity firms to think that a target is poorly managed. So when this happens, there might be a hap between the value that the firm thinks it can achieve through a new management installation team. And the enactment of certain necessary changes in company operations. And the current value of the target based on its unadjusted future cash flows. This discrepancy might offer the basis for some flexibility in deals and allow for an agreed-on price.
Risk-adjusted Present Value of the Company’s Cash Flows
On the other hand, if the target is managed properly and both parties know of the risk-adjusted present value of the company’s cash flows. Then it is less likely for the seller to be provided with the full value of the company while still letting private equity buyers make great returns on investment. For instance, in 2006, the Salt Lake City-based Huntsman Corp. A $13 billion industrial company, broke off negotiations with private equity firm Apollo Management LP. Huntsman. It lost its money in 2005 and could not negotiate well with Apollo at a price that private equity firm thought makes sense.
The same case was experienced by the grocery store chain Albertsons who could not agree with various private equity buyers, causing bidders to back out. Later the same year, a deal was struck with an investment group to sell the company for a revised price of $10.97 billion. Sellers who wish to sell their companies to private equity firms have to willingly accept a price. That will let these firms make more room to generate a return with another sale of the business in the next years to come. Even if making valuation mistakes is inevitable, private equity buyers still tend to be careful. With regards to overpaying since their gains principally come from the difference between their purchase price and an eventual resale price. As well as money received from the company way before the resale.
Deals Outside Auctions and Proprietary Deals
Dealmakers like investment bankers might represent a potential seller who is looking for a clean and smooth sale and is not interested in a very public auction process. Usually, these dealmakers approach private equity firms and represent that they have a proprietary deal that the private equity buyer may be interested in. But when the potential seller is a public company, this deal might only be temporary since Revlon duties should be considered. M&A laws and the time when an auction is required are all the expertise of private equity firms.
Still, during times like when a founder who holds considerable equity in the company wants to sell in a quick and smooth transaction. Such deals may be more appealing to private equity firms. But deals outside auctions are usually the clear minority. As previously mentioned, there can be a competitive bidding process occurring. Even way before the public announcement of the potential sale of a firm and the start of the formal auction.
Private Versus Public Deals
The usual deal when it comes to private equity business is large-scale, going-private, and involving a public target. Although that is essential in the private equity business. More common transactions are actually private deals that involve acquisitions from founders of businesses. Some are from other sponsors or venture capital-sponsored firms.
Private sellers, especially closely-held founders are becoming prevalent, and it has provided private equity buyers with increased risk. One possible reason is that most of these include a survival clause. A survival clause indicates that the representations made by the seller may survive for only a limited time after the closing period. These clauses are more normal in acquisitions of public companies that worked in compliance with US securities laws. And the penalties posed for false financial disclosures throughout the operation of the company. Meanwhile, when it comes to private companies, many concerns in terms of the reliability of the data in the seller’s financials may occur.
For buyers in 2011, survivability clauses became a bigger concern since the Delaware Chancery Court decided that the survival clause is a kind of law. That limits the ability of the buyer to push through with breach of contract claims. New York, California, and other states, however, have not agreed with their view of how limiting these clauses could be.
Insurance Carrier
Now, brokers of insurance like Marsh McLennan are aware of the characteristics of these policies. That buyers want and are now creating and pricing them. This is due to the newfound demand from private deals. Moreover, these insurance companies which brokers work with have paid out claims. In that way, buyers of policies are more assured with the thought that if they have a problem and need to rely on their insurance, it likely will pay. For bigger policies, buyers will have to syndicate the policy. And include various insurance carriers to bind the level of insurance they require.
In Europe, survival clauses are really common and management, which has some equity in the deal, may bear this obligation. Meanwhile, in the US, when managers realize that after the deal goes through. They will have a new employer, and there is a tendency that they make their own relevant disclosures. Or tone down aggressive representations made by the seller so they won’t have the bosses they don’t want.
Reverse breakup fees are also commonly used by sellers in agreements with private equity buyers. This helps create an incentive to ensure that the buyer convinces the bankers to give the needed debt capital to complete the deal.
© Image credits to Steve Johnson
History of the Private Equity and LBO Business
For the past few weeks, we have been discussing Leveraged Buyouts and the types of LBO risks. Now that we have completed our discussion about that, it is time to move on to The Private Equity Market.
The next series of articles will continue the discussion of going-private transactions. We will first focus on the role of private equity firms and the role they played.
Over the past quarter of a century, private equity firms have played a huge role in the takeover market. It has been proven that these firms were able to attract large amounts of capital. Not only that, but these firms have proven to pursue takeovers in an extremely aggressive manner.
History of the Private Equity and Lbo Business
If you think about it, it wasn’t so long ago when the modern private equity business started. It is not that old, as of yet. However, we also have had highly leveraged transactions for a while now, which means using large amounts of debt to purchase businesses is not a novel concept.
In a previous article, we have discussed how Henry Ford managed to do a highly leveraged transaction to help him regain control of his company back in 1919. As you might have guessed, this was years and years before the term “leveraged buyouts” and “private equity” even became a thing in the world of finance.
It was noted that the first leveraged buyout did not take place until 1955 when McLean Industries acquired both the Pan-American Steamship Company and the Waterman Steamship Company. At the time, Malcolm McLean, who runs McLean Industries financed these acquisitions. He got the money from the proceeds of the sale of McLean Trucking, his previous trucking company.
McLean Trucking
McLean Trucking was sold because the current regulations at that time strictly prohibit a trucking company from owning a steamship company. It had to choose between his old company or owning a new one.
Not all of the funds to acquire Pan-American Steamship Company and the Waterman Steamship Company were from McLean’s own pockets, though. He also had bank debt and the issuance of preferred stock.
Amazingly enough, McLean was also able to use the cash and assets of the companies he targeted to help pay down the buyout debt. It truly was a great example.
Fast forward to the 1960s and 70s, other dealmakers studied and learned from this very example. Many started their own investment firms and then did similar types of buyouts.
This included many dealmakers with high profiles such as Victor Posner of DWG Corporation and Warren Buffet (Berkshire Hathaway) used similar leveraged financing structures. A few years later, many followed their footsteps. This includes Mesa Petroleum’s Boone Pickens and Reliance Insurance’s Saul Steinberg, to name a few.
That’s when leveraged deals started. Even bankers at Bear Stearns started to do it. Some banks like Henry Kravis and Jerome Kohlberg even left the bank to start their own firm (KKR) or the Kravis and Roberts firm.
The KKR firm formalized the model of the LBO firm. It is a business model that later became known as private equity. As expected, KKR’s success has attracted many competitors. This has led to a segment of the financial services industry that we recognize today as the private equity market.
The Private Equity Market
The mergers and acquisition boom that occurred during the year 2003-2007 has been fueled substantially by private equity firms. The subprime crisis fallout has caused a decline in the private equity market but rebounded steadily as the recovery took hold.
So what is the private equity market, exactly? It is a collection of funds that have raised capital by soliciting investments from a variety of large investors. The funds are then invested in equity positions in companies.
Now, when the said investments acquire a hundred percent of the outstanding equity of a public company. Then it is referred to as a going-private transaction. On the other hand, if or when the equity is acquired by using some of the investment capital of the private equity fund. These deals are called a leveraged buyout or an LBO. It’s also the same with borrowed funds.
These deals are very common investments for private equity funds. It is so common, in fact, that these funds are now more often referred to as LBO funds.
Not only that, but these private equity funds may also be used for other investments. This includes providing venture capital to nascent businesses. Oftentimes, funds that are raised for this purpose are referred to as venture capital funds.
These investments might not necessarily use the borrowed fund, and exclusively use the fund’s capital. However, having such an equity investment may allow the target company to have improved access to debt markets. This is, of course, after it secures the equity investment from the private equity fund.
Fund as a Majority Position
Moreover, the fund might also take a minority or a majority position in the company. Most of the time, venture capital investments may also contain incentives. This includes, but is not limited to stock options.
Now, these incentives may enable the investor who assumes the risk to enjoy greater profits if the business turns out to be successful. However, it is also important to keep in mind that there are a lot of differences between private equity funds and venture capital funds. These differences are paramount and should always be considered.
Another important quality of private equity funds is that it seeks out investments that are undervalued. For instance, these could be whole companies that are not trading at values commensurate with what the fund managers think is possible. Or, it could also be divisions of companies that want to sell the units due to a change in strategy. It may also be a need for cash. We will discuss the various sources of income that private equity firms earn a little later in the next series of articles.
In the meantime, we hope that this article has helped you learn about the history of the private equity and leveraged buyout business.
© Image credits to Steve Johnson
Intra-Industry Effects of Buyouts
The modern private equity business is not so old, as the first leveraged buyout took place in 1955. This was when McLean Industries, run by Malcolm McLean, acquired the Pan-American Steamship Company and the Waterman Steamship Company. He financed these acquisitions with the proceeds of the sale of his trucking company, McLean Trucking. He also did this through bank debt and the issuance of preferred stock. Since then, dealmakers started forming their own investment firms to do similar types of buyouts. The high-profile ones included Warren Buffet and Victor Posner. They were followed by Boone Pickens and Saul Steinberg. A few bankers at Bear Stearns also did leveraged deals. Their success attracted many competitors and led to a segment of the financial services industry we know today as the private equity business.
Effects of Buyouts
There are various impacts of horizontal mergers on the stock prices of competitors. A study by Slovin, Sushka, and Bendeck investigated 128 buyout bids from 1980-1988. 78 of the buyout bids were from managers, while 50 were from outsiders. They found that while target returns were significantly higher when the bids came from buyout firms, this had no impact on rivals. The authors concluded that bids led to positive valuation effects for rivals and that these effects were not that different in outsiders or management bids. These positive valuation effects were due to new information about the industry and firms in it were being created by the buyout, and the price paid to target shareholders.
In another study by Harford, Stanfield, and Zhang, a large sample of 586 LBOs over the years 1991-2006 were studied, and they found that these provide a signal to other firms about M&As and LBO opportunities in the industry. They also concluded that LBOs have the possibility to lead other M&As. one way to interpret this is that potential bidders might believe that other companies in the industry might present good profit opportunities if the firm that underwent the LBO had so much “slack” that it could afford to take on significant debt service obligations.
Leveraged Capitalizations
On the other hand, research conducted by Brown, Fee, and Thomas analyzed a sample of 355 LBOs and 43 leveraged recapitalizations from 1980-2001. Results have shown significant negative returns for suppliers of the LBO firms. Those with significant supply relationships with the LBO firms were more negatively affected. This can be analyzed as maybe, post-deal, the firms that went through a buyout would have more bargaining power. It can also be interpreted as the post-LBO companies being forced to pressure suppliers to handle the higher debt service. The authors also concluded that the companies which supplied companies that went through leveraged recapitalizations have no significant response to the deal. These recapitalization firms, which are larger than LBO companies, might have enjoyed buying power over suppliers.
Private Equity Market
Private equity companies gave a substantial part of the fuel for the M&A boom from 2003 to 2007. It then declined with the fallout from the subprime crisis but bounced back as the recovery took hold.
The private equity market refers to a collection of funds that have raised capital by soliciting investments from different investors where the funds will be invested in equity positions in companies. A going-private transaction then occurs when these investments acquire 100% of the outstanding equity of a public company. When the equity is accumulated through an investment capital of the private equity fund but mainly borrowed funds, this is called a leveraged buyout or an LBO. Many refer to the funds as LBO funds since these deals are such common investments for private equity funds.
These funds may make other investments, such as providing venture capital to nascent businesses. Funds established for this purpose are sometimes called venture capital funds. These kinds of investments may use the fund’s capital exclusively without using borrowed funds. But with this equity investment, the target company may enable itself to have more access to debt markets. This may happen after securing the equity investment from the private equity fund. It is possible for the fund to take a minority or a majority position in the company. Usually, venture capital investments contain incentives, such as stock options. These enable the investor who assumes the risk to enjoy greater profits if the business becomes successful. However, a lot of dissimilarities between private equity funds and venture capital funds happens.
Private Equity Funds vs. Venture Capital Funds
It is necessary to know the difference between private equity funds and venture capital funds since both are users of private equity. equity. Both are organized as limited partnerships, with the general partner making the investment decisions. However, there are plenty of very significant dissimilarities between the two.
Private equity funds look for undervalued investments like whole companies that are not trading at values commensurate with what the fund managers think is possible. These could also be divisions of companies that want to sell the units due to a change in strategy or a need for cash. One example was in 2002 when the international liquor conglomerate Diageo realized that there was not a lot of synergy between its liquor brands and the burgers and fries in its Burger King division. The Texas Pacific Group and Goldman Sachs Group purchased Burger King from Diageo in 2002 for $1.5 billion.
Generally, private equity fund managers raise capital from various institutional investors. Usually, they charge their investors “2 and 20”. This means 2% of invested capital and 20% of profits. 20% of profits is referred to as carried interest.
On the other hand, venture funds often make investments in new companies that may have limited revenues. The companies they invest in are often startups. Private equity firms seek out more established companies that have lengthy revenue, if not a profit, history. They usually invest together in a syndicated manner and undergo have several rounds of funding as a company goes through stages in its development.
Venture funds also go through shorter investment horizons and additional capital is only given if the company meets its milestones.
© Image credits to Anni Roenkae
Types of LBO Risk
LBOs have many risks that can be broken down into two main types. These include business risk and interest rate risk. The first one is defined as the risk that the firm going private will not generate sufficient earnings to meet the interest payments and other current obligations of the firm.
This category considers factors like competitive factors within the industry. This includes greater price and nonprice competition. This category also considers cyclical downturns in the economy. Companies with very cyclical sales or companies that are in very competitive industries tend not to be good LBO candidates.
The other type of LBO risk, which is interest rate risk, is the risk that interest rates will rise, thus increasing the firm’s current obligations. This is important to firms that have more variable-rate debt. Interest rate increases could force a firm to bankruptcy even when it experienced greater than anticipated demand and held nonfinancial costs within reasonable bounds.
The interest rates’ level at the time of the LBO is a guide to the probability that rates will rise in the future. For instance, interest rate increases are more likely if interest rates are low at the time compared to the interest rates at peak levels.
Return to Stockholders from LBOS
Studies regarding returns to stockholders from LBOS usually highlight the abnormal returns to pre-buyout shareholders. They also focus on premiums as measured by the difference between firm values derived from the final takeover stock price as compared to the preannouncement stock price. The premium analysis can be complex depending on how the preannouncement price is determined and the extent to which the study allows for the preannouncement price runup.
Researchers handle this by using a preannouncement price that involves an anticipation window like two months before the announcement. There is interestingly a difference between the results from the abnormal returns and the premiums studies, but it is justifiable. Research with the use of cumulative abnormal returns already incorporates an expectation of a firm’s return which, in turn, reflects how the market values post-buyout profitability.
A popular study by DeAngelo, DeAngelo, and Rice analyzed the gains to both stockholders and management from MBOs. The sample was a total of 72 companies that attempted to go private between 1973 and 1980. As mentioned, the premium paid for their sample was 56%, which was higher than the premium data presented for more recent years. Results show that managers are willing to offer a premium.
Private Companies Dominated the Buyout Market
In the 200s, private equity companies dominated the buyout market. They are popular for being more careful buyers. The same study found that an average change in shareholder wealth around the announcement of the deal was 22%. Over a longer time period around the announcement, the total shareholder wealth change was approximately 30%. It is consistent with the results for various studies about M&As. Moreover, the announcement of the bid being withdrawn results in the decline of shareholder wealth by 9%.
In another research, Travlos and Cornett showed the statistical significance and negative correlation between abnormal returns to shareholders and the P/E ratio of the firm relative to the Industry. To interpret, the lower the P/E ratio, compared with similar firms, the greater probability that the firm is poorly managed.
The researchers analyzed the low P/E ratios as reflecting greater room for improvement through changes such as the reduction of agency costs. Some of these gains in efficiency may be accumulated by privatization. Then, these gains become the source of the buyout premium..
Return to Stockholders from Divisional Buyouts
Again, MBOs are deals where a group of management purchases apart from the parent company. Most of these purchases are criticized because they are not “arm’s length” deals. Parent company’s managers are usually accused of giving special treatment to a management bid.
The parent company may spurn the closeout process and acknowledge the executives’ proposal without requesting other higher offers. One way to check whether these exchanges are really to investors’ greatest advantage is to take a gander at their investor riches impacts.
In 1989, researchers Hite and Vetsuypens tried to show if divisional buyouts had adverse effects on the wealth of parent stockholders. Most researchers believe that divisional buyouts may present opportunities for efficiency-related gains as the division becomes removed from the parent company’s layers of bureaucracy. This is likely to be valuable to the managers of the buying group but does not deny the often-cited possibility that a fair price was not paid for the division. A fair price is may the one which is derived from an auction.
Divisional Buyouts
The scholars were not able to find evidence of a reduction in shareholder wealth following divisional buyouts by management. In their analysis, these indicated that division buyouts result in a more efficient allocation of assets. The existence of small wealth gains indicates that shareholders in the parent company shared in some of these gains.
Briston, Saadouni, Mallin, and Coutts did not support the positive view of a management buyout from the lens of parent company shareholders. In their study, a sample of 65 MBOs in Great Britain over the period 1984–1989 was used. The results showed that parent company stakeholders experienced negative returns following MBO announcements. This result contradicts the other types of selloff announcements. Implying that this may be parent company managers giving their former colleagues a better deal than they offer non-affiliated buyers
Post-LBO Firm Performance
Several studies showed substantial operating performance improvements when management buyouts occurred in the 80s. Some of the early studies tackled Kaplan and Lichtenberg and Siegel’s study. Both found improvements in financial performance following the management buyouts. The same results were also presented by later researchers, like Guo, Hotchkiss, and Song. Who analyzed 192 leveraged buyouts that were completed during the period 1990–2006. Aside from concluding that the deals were less levered than their 1980s predecessors. They also found that the operating performance of the firms that were taken private was at least as good as matched industry companies. They consider this performance to gain a result of large positive returns that yielded their investors.
For instance, Gao et al. found an 11% increase in EBITDA/sales relative to comparable firms. The positive outcomes on LBO execution were not simply limited to U.S. LBOs.
Research Discoveries for LBOs
Different research has shown up at comparable discoveries for LBOs in various European nations. For example, Great Britain, France, and Sweden, this result raised debates in some scholars. Who questioned whether the companies that were studied were the only ones that had publicly available financial statements made them a biased sample. The companies that have financial statements published could have sold public debt or go through a subsequent transaction like an IPO.
In a study conducted by Cohn, Mills, and Towery, a subsample of 71 companies that underwent an LBO that had both tax returns and financial statements available were used. The results were coherent with the prior research. It showed that the following forms did show substantial improvements in financial performance.
For example, they found a 9% improvement in mean return on sales over a two-year period after the buyouts. Then, they focused on a broader sample of 317 companies taken private in an LBO. Including the previous 81 with both tax return and financial statements available. And others that had only tax return data available.
They concluded that there was no evidence of meaningful performance improvements for this larger sample. This may mean that the companies whose financial statements were public have been performing better. This let them issue public debt or even go public again. Others may not have performed as well and may not have been able to pursue such transactions.
All in all, Cohn, et al. found that the positive view of LBOs that has prevailed in the world of M&A research for many years may have been overly sanguine. LBOs may strengthen dealmakers and investors of private equity and managers of these private equity firms. But they may not have any positive impact on the companies themselves.
© Image credits to Anni Roenkae