Tuesday, October 6, 2009

Leveraged Buyouts

Yesterday's New York Times had a story (a sad one) on the troubles at Simmons, a mattress company with a long and illustrious history in the United States.
In short, the company was targeted for a leveraged buyout by Thomas H. Lee Partners, a private equity firm, in a transaction that went awry, partly because of miscalculations by the investors and partly because of the market crisis. The article is clear about who the "bad guys" in this story are and it is the private equity investors, who profited while a good company and its employees were destroyed.

I am always suspicious when the financial press sees things in black and white, since my experience is that life is full of shades of grey, but this article gives me a chance to vent about leveraged buyouts. If the message here is that private equity investors act in their self interest, my reaction is "Duh! Who does not?". If the message is that debt is the enemy, I am afraid the culprit is not Thomas H. Lee, but the tax code, which is tilted towards debt for some reason that I cannot fathom in pretty much every market in the world.

My problem with the way leveraged buyouts have been framed by both its proponents and opponents is the focus on leverage as the center of the transaction. To me, there are three components to a leveraged buyout:
a. The change in financial leverage: Changing the mix of debt and equity can help you exploit the tax code and increase your overall value (at the expense of taxpayers).
b. Control: In badly managed firms, changing the operating characteristics, i.e. investment and dividend policy, of the firm can increase value,
c. Public to private: To the extent that being a publicly traded firm forces you to make decisions to satisfy stockholders and analysts focused on the short term (at least in theory), going private may allow firms to make hard decisions that increase their value.
A good candidate for a leveraged buyout will derive value from all three levers. It will be an under levered, poorly managed firm, where there is a substantial gap between managers and stockholders.

In a blog post from November, I pointed to an extended treatise on the topic, where I look at an LBO transaction that failed, where Goldman and KKR tried to take Harman Audio private, and failed. My conclusion was that Harman was the wrong company to target for an LBO, because it did not have significant excess debt capacity, was already fairly well managed and a big stockholder was the CEO of the company.
What does this have to do with Simmons? I think that we are making a mistake when we assume that private equity investors are brilliant villains in LBO transactions. For every winner (like Thomas H. Lee in this specific transaction), there are many losers, and I would not be surprised if private equity investors are not net winners in this process.


Anonymous said...

Great article, reminds me of the cult movie wall street.... does remind me of what drives this side of the world....MONEY, even if its at the cost of ripping people off, no actually, especially if its at the cost of ripping people, the returns just get sweater!

Compendium said...

Great Post Mr. Damodaran. The link to the NY articles was very informative. It was disappointing to see private equity behaving in such a fashion. I always thought it was "new finance".

Immortal said...

I m not surprised at all..PE has sole objective of mking profit at any cost....Prof nice article on LBO..appreciate it!!!


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