Download Does PE Create Value.Apr 08

Does Private Equity Create Wealth?

Ron Masulis
Owen Grad School of Management,
Vanderbilt University

Randall Thomas
Vanderbilt Law School
1
Three Themes

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How private equity creates wealth
Why publicly owned firms are not
managed well
How derivatives can destroy wealth
(Derivatives are put & call options,
futures contracts, swaps & swaptions)
2
Overall LBO Volume as a
Percentage of Global M&A
$4,000
25.0%
LBO Volume ($ in billions)
20.0%
$3,000
$2,819
$2,725
$2,636
$2,500
$2,095
$2,062
15.0%
$2,000
$1,504
$1,500
$1,000
$1,257
$855
$664
$1,319
10.0%
% Private Equity Deals
$3,342
$3,500
$1,040
$936
5.0%
$422
$500 $302
$323
$233 $249
0.0%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
$0
Global M&A
% Private Equity Deals
Notes: Includes announced transactions excluding withdrawn deals, share repurchases, spin-offs, and minority stake purchases.
Source: Thomson
3
Basic Steps in an LBO

Buy up publicly held stock to concentrate firm
ownership in a few large shareholders

Issue new debt to raise leverage and finance
stock purchases

Streamline operations and sell off excess
assets to pay back debt and high interest

An LBO is similar to an acquisition by a
financial Bidder – Bidder with cash but no
operating assets
4
Do LBOs Create Wealth?
EXAMPLE – CONGOLEUM’S LBO

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Conglomerate: Flooring, shipbuilding & auto
parts
Pre-LBO debt level: $125 MM
Pre-LBO announcement equity value $150 MM
Buyout premium paid on stock: $460 MM
Buyout financed with $380 MM in debt and
$95 MM in excess cash
5 years later paid off debt, did 2nd LBO
2 years later: firm liquidates - equityholders
receive $850 MM
5
Stakeholder Winners & Losers

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
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Management +
Stockholders +
Bondholders 0
LBO investors (Private Equity) +
Employees & Pensioners Suppliers –
IRS –
LBO is not a zero sum game – there
is large wealth creation!
6
Stakeholder Wealth Effects Evidence

Public stockholders: 56% Buyout premium

Management:


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Buyout funds: Returns have ranged from 20% to 35%

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Realizes greater gains than common stockholders
Forced to invest substantial portion of wealth in stock – bears large
undiversified risk
Thomas Lee had 50% + for over 10 years
Straight debt:



Bond ratings fall, but prices on average don’t change
If LBO protected, then either debt repurchased at face value or interest
rate is raised – these bonds generally gain in value
If unprotected, bonds lose 7% of value on average

Employees: Often head count is rapidly reduced by
substantial amount

Suppliers usually must reduce their profits from sales to
LBO firm

US Government: Losses substantial taxes
7
How Do LBOs Create So Much Wealth?

Concentrates stock ownership

Shifts board control to large shareholder – LBO
investor

Accepts substantially higher debt & leverage:
 Small number of private debt investors

Improves management incentives

Pressures mgmt to reduce the corporate
“empire”.

Forces stakeholders to make large concessions

Increases tax savings
8
LBOs Improved Corporate
Governance!
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What do nearly all of the changes in
the prior slide have in common?
They improved corporate governance!
Create strong incentives for CEO and
Board to



Work hard
Take risks
Make tough decisions to improve
shareholder wealth
9
LBOs Greatly Improved
Management Incentives

Raises mgmt % share ownership substantially


Raises mgmt dollar investment in firm share

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Substantial upside gain potential
Substantial downside risk exposure
High leverage makes firm’s stock price highly sensitive
to changes in firm value (equity multiplier effect)
Board oversight of mgmt is heightened by restructuring
board of directors – these directors have strong
incentives

Small board, financially sophisticated, large stockholdings

Reduction in free cash flows

Substantial risk of bankruptcy in early years
10
Empirical Evidence on LBOs:
Improved Operating Efficiency

Board composition substantially changes & its size is
reduced, and mgmt is often replaced within 1st 3 years

LBO firms become almost twice as profitable as
industry competitors while privately held

LBO firms outperform competitors in operating income
& stock returns for at least 4 years following going
public again

LBO firms show improved focus, sheds excess assets

Tax payments are reduced substantially

Compared to competitors, LBO firms :


Use only half the working capital (cash)
Have larger average advertising budget

Overall investment level is lowered

R&D & maintenance expenses are unchanged!

11
Leverage is permanently higher even after a reverse LBO
What’s Wrong at Publicly Held
Companies?


Poor corporate governance – poor
management incentives to operate the firm
efficiently
Major corporate governance mechanisms:
 Board of directors: Has power to hire, fire
and set CEO compensation
 CEO compensation’s sensitivity to firm
performance
 CEO and Board stockholdings
12
Public Company Board Structures
Need to be Strengthen

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Directors of public companies are generally part
time, not financial experts, have small
percentage shareholdings with little incentive or
expertise to effectively monitor risk exposure
Firms today are more complex and larger,
making risk monitoring more difficult
Boards do a poor job of monitoring derivative
risk exposure – in separate analysis we
examine corporate losses from derivatives and
subprime problems – strikingly large number of
firms have experienced problems
The Rise of Derivative Contracts

Over the last 40 years, derivative contracts
have emerged as a major financial instrument
– heavily traded, issued and held by
corporations worldwide

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Ex. Swaps contracts outstanding exceeded $100
trillion
FIs in particular have been extremely active
market participants
Derivatives allow investors to shift particular
risks to other investors
16
Dangers of Derivatives

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Derivatives allow a firm to dramatically
increase risk exposure in a few minutes
Ex. Southwest Airlines buys most of its oil in
the forward market – commits to a price today
for delivery months into the future –

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When oil prices were rising, they save $millions
When oil prices began failing substantially, they
lost $millions

Metallgesellschaft lost $1.4 billion in oil futures

Sumitomo lost $2.6 billion in copper futures

Worldcom illegally reduced its costs using swap
17
contracts by $11 billion
How Derivatives Make Corporate
Governance Worse
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Derivative contracts allow corporations to
rapidly add or subtract specific risks
Financial accounting systems fail to reflect the
risk exposures associated with these contracts
As derivative activity has risen, it becomes
more difficult for boards of directors and
investors to know what risks the firm has
taken on
This allows CEOs to accept large risk
exposures without board approval
18
FIs Have Serious Problems With
Derivative Risk Exposure
•
FIs are very big buyers and sellers of derivatives
•
Quarterly disclosure requirements for FIs are
outdated and can be evaded
•
•
Rapid changes in counterparty risk are possible in
large transactions, which requires more timely
disclosure
Hard to evaluate FI risk levels because of
complexity of transactions, especially counterparty default risk
•
Moral hazard problem from government bailouts
•
Little shareholder oversight because of dispersed
ownership of FIs generally
Why Private Equity Improves
Corporate Governance

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PE investors have large shareholdings in their
firms
Hire a small group of financially sophisticated
directors with substantial firm shareholdings

Enforce strong board oversight of CEOs
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Implement specialized internal reports
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Have high leverage, which creates an large
equity wealth multiple
Require senior management to hold substantial
equity positions
20
Conclusions
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Extensive derivative usage confronts boards and
regulators with difficult monitoring problems
Public company boards lack the incentives, time,
training and information to adequately monitor
firm’s derivative exposure
Private equity firms help to offset these
governance problems by exercising strong control
rights, decreasing board size, improving
information flows, introducing improved risk
management, employing financially sophisticated
directors with strong incentives, and giving
management greatly improved incentives