August 14, 2014
Michael’s Stores was taken private in a leveraged buyout on October 31, 2006. At the time of LBO, Highfields Capital Partners, which owned shares in the specialty retailer, was allowed to retain its interest – worth about $200 million. Funds of two private equity firms, Bain and Blackstone, purchased the remaining shares for $5.8 billion (PitchBook Michael’s Stores company profile 7-1-14 behind a paywall). Michael’s Stores had very little long-term debt at the time it was acquired. The specialty retail chain had an enterprise value (EV) of $6.025 billion. Michael’s Stores had 2005 earnings (EBITDA) of about $550 million. The multiple at which it was acquired (EV/EBITDA) was 11.
Nearly eight years later on June 27, 2014, Michael’s Stores (now The Michaels Companies) was returned to the public market via an IPO. The shares priced at $17 and 14.5 percent of the company’s shares were sold, yielding $472 million that Michael’s Stores used to retire debt and valuing the equity in the company at $3.45 billion. Michael’s Stores had $3.69 billion in long-term debt. Its enterprise value (EV) was $7.14 billion. (My July 28 post incorrectly reported the enterprise value for Michael’s Stores as $3.45 billion). It had EBITDA of $688 million. The multiple (EV/EBITDA) was 10.4, slightly lower than the multiple at which it had been acquired despite the fact that revenue and operating margin had both increased.
The much lamented lack of transparency around private equity deals makes it difficult to figure out the precise returns to the pension funds and other limited partners in the Bain and Blackstone funds.
In the leveraged buyout, the PE funds put up $1.7 billion and Highfields Capital Partners rolled over its stake, giving the PE funds a 93 percent share of Michael’s Stores. We don’t know what the future will hold, and Michael’s shares are currently trading substantially below their IPO price. But let’s assume that the PE funds will be able to sell all of their shares to the public at $17 a share. Nearly 15 percent of the shares were sold to the public, leaving Bain, Blackstone and Highfields with 85.5 percent of the outstanding shares, worth just under $3 billion. The Bain and Blackstone funds would receive about 93 percent, or $2.73 billion. Michael’s Stores owners also did a dividend recapitalization of $800 million with $714 million going to the Bain and Blackstone funds. The total received by the Bain and Blackstone funds would be $3.44 billion (2.73 +.714).
This is a cash multiple of 2 (3.44/1.70). A cash multiple of 2 after seven and two-thirds years yields a gross annual internal rate of return (before taking fees or carried interest into account) of 9.6 percent. We don’t know how the returns were split between the LPs and the GPs in the two PE funds. LPs generally receive a return equal to the hurdle rate, typically 8%, before the carried interest is distributed to GPs and LPs. But the hurdle applies to overall fund returns, not to a particular deal, so we don’t really know how the returns from Michael’s Stores would be distributed. I reached out to the PE directors on Michael’s Stores’ board, but received no response. A guesstimate is that the LPs received a return before taking annual management fees into account of between 8 and 9.3 percent. We also don’t know the annual management fee paid by investors in these PE funds. A reasonable estimate would be a 1.5 percent annual management fee. This reduces the annual return to the pension funds and other LPs to between 6.5 percent and 7.8 percent.
However, the story does not end here. A pension fund or other limited partner in a private equity fund could have chosen to buy shares of stock in publicly traded companies instead of investing in private equity. To see whether a 7.8% return is a good return, we need to compare it to what the limited partners could have gotten by investing in the stock market.
So, how did the stock market perform? Over these same 7 and three-quarters years the S&P 400, an index of mid-cap companies with market capitalization similar to Michael’s Stores, yielded an annual return of more than 8.1 percent 1
For tying their capital up for nearly 8 years in an illiquid investment in Michael’s Stores, pension funds and other private equity investors expected to earn annual returns that beat the stock market. In the Michael’s Stores deal, however, the net annual return to the PE fund investors failed to beat the S&P 400.
1. S&P 400 on Oct. 31, 2006 was 785; on June 27, 2014 it was 1426. This is equivalent to a cash multiple of 1.82 and an annual total return of 8.1%. This figure ignores the fact that the annual dividends would have been reinvested, which would lead to a higher return in the stock market than indicated here.