July 28, 2014
The theme of this year’s European Private Equity and Venture Capital Association (EVCA) symposium held in Vienna in June was “Private Equity as a Transformational Force.” Speakers emphasized the industry’s need to develop partnerships with the companies it acquires and deliver value for all stakeholders. EVCA is concerned that the private equity industry has an image problem: it is seen as focusing on investor returns with a callous disregard for the jobs of workers and the interests of the company and its other stakeholders. EVCA wants to tell the public that PE delivers economic growth and jobs. It wants to “Encourag[e] the private equity industry to look beyond returns and recognize its role as a global influencer and agent for progress …”.
The audience for this industry image do-over is regulators and policy makers. In Europe, private equity is dealing with implementation of the EU’s Alternative Investment Fund Managers Directive (AIFMD). In the U.S., provisions of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) that affect private equity advisors were implemented in August of 2012. Recently, the Securities and Exchange Commission announced that its examinations of private equity fund advisors turned up evidence of extensive misbehavior and possible fraud. There are calls on both sides of the Atlantic for businesses and wealthy individuals to pay their fair share of taxes. Policy makers are under pressure to shut down tax havens and close the tax loophole that allows private equity partners’ gains to be taxed at the lower capital gains rate. There won’t be much sympathy for private equity titans if they are seen as only in it for the money.
Unfortunately for the private equity industry, it will have to change its behavior if it wants to fix its image problem. The industry relies to a great extent on financial engineering to reduce tax liabilities or goose returns – burdening companies with excessive amounts of debt, causing portfolio companies to issue junk bonds to pay dividends to their PE owners, stripping companies of real estate and other assets, charging high fees for monitoring and advisory services, aggressively pursuing tax loopholes – to generate profits. Even when a deal sours for the portfolio company, financial engineering can prop up private equity’s earnings.
The June 26, 2014 IPO of craft retailer Michael’s Stores, taken private in 2006 by PE firms Bain and Blackstone, provides a case in point. At the time it was acquired, Michael’s Stores was the largest arts and crafts specialty chain in North America, with 1,108 stores employing about 43,100 associates and $3.9 billion in sales. Its high sales revenue, healthy profits, and low debt made it an attractive takeover target. Bain and Blackstone beat out the competition, acquiring the specialty chain for $5.8 billion or $44 a share. Minority shares held by a hedge fund and Michael’s management brought the total valuation to $6 billion (PitchBook Profile Michael’s Stores – behind a paywall). With the housing bubble already bursting and a full-blown recession just a year away, Michael’s Stores found itself saddled with at least $4 billion in debt. Between February and November 2007, the company experienced a net loss of $84.6 million compared to a net income of $108.3 million for the same period in 2006, just before the takeover. Interest expense was the cause of the decrease in net income. Without it, net income would have been positive. The chain appeared to be in trouble during the recession, but its private equity owners contributed no additional equity to help it through (Primack, Term Sheet June 27, 2014).
Michael’s Stores filed to go public in March 2012, but the planned IPO was canceled in December 2013. Michael’s finally went public in June 2014, still carrying long-term debt of $3.7 billion. Despite the booming stock market, the company’s shares priced at just $17, giving Michael’s Stores an enterprise value of $3.45 billion. In its nearly eight years of PE ownership, the company’s share price declined by 60 percent. The once profitable company was no longer generating profit. (PitchBook profile Michael’s Stores).
No need to feel badly for Michael’s Stores PE owners, however. The chain may be doing poorly, but its private equity owners managed to turn a profit.
According to Dan Primack (Term Sheet, June 27, 2014), the PE funds sponsored by Bain and Blackstone “committed approximately $1 billion of equity to the deal, the rest of which was leveraged financing.” The vast majority – typically 98 percent – of the equity in these funds comes from investors; the PE firms and their partners have very little at risk. In 2013 the PE funds “pulled out $714 million via a dividend recap.” That is, Michael’s Stores, generating revenue but not profitable as it struggled with its already high debt had to take on more debt to pay its PE owners a dividend that amounted to 70 percent of their investment. In its filing with the SEC shortly after the buyout, the specialty retailer listed among the risks it faced the possibility that its PE owners would “cause us to distribute funds at the expense of our financial condition”.
And then there are all the fees Michael’s Stores paid – fees of the kind that the SEC is currently investigating. At the time it was acquired, Michael’s Stores entered into an agreement for the PE sponsors to provide management services until December 31, 2016 for an annual management fee to the PE companies of $12.0 million plus reimbursement for expenses. This is in addition to $60 million in transaction fees connected to being acquired that Michael’s Stores had to pay. Plus, the management agreement specifies that if the company goes public or is sold, the PE sponsors get to collect the fees for the remaining years of the contract even though the services will never be provided. In addition to management fees collected while PE owned the stores, Primack reports that when the company went public, it paid the PE firm sponsors $30 million to cover the years remaining in the contract. With the dividend recap and the fees, the PE firms came out ahead even at $17 a share.
Of course the “concrete examples” that EVCA wants to showcase, where private equity increased employment and created value for stakeholders and the economy, do exist. Rosemary Batt and I highlight several examples in our book Private Equity at Work: When Wall Street Manages Main Street. What makes the difference? Value creation occurs mainly where a PE fund acquires a smaller company or takes over a distressed company. The price paid for the company is low, and the company has few assets that can be used as collateral for debt. As a result, relatively little debt is levered on the company. On the other hand, opportunities to improve operational performance by introducing professional management practices, implementing modern IT and accounting systems, and providing the know-how to move from local to national distribution networks abound. Sometimes, in the case of distressed companies in economically important industries, private equity is able to initiate transformative changes.
If the private equity industry is serious about improving its image, more PE firms will need to take a leaf from the playbook of PE sponsors that make modest use of debt, forego dividend recapitalizations, do not burden portfolio companies with outrageous fees, and invest in upgrading portfolio company skills, technology and equipment.