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Author: Gunnar Freyr Gunnarsson
Study nr: 402785
Advisor: Peter Løchte Jørgensen
Private equity investments How do private equity funds create value within their portfolio firms
Aarhus School of Business, University of Aarhus
Department of Business Studies
June 2011
Abstract The purpose of this thesis is to explore private equity as a phenomenon by looking at
what it is, how it is structured and to investigate what activities private equity firms
can practice in order to generate value within their portfolio companies.
The thesis is split into 4 main chapters. The first part focuses on the literature around
the two main theories discussed, the optimization of the capital structure and the
agency theory. The second chapter is based on general discussions on private equity
to give the reader an insight into this asset class. The major part is dedicated to
analysis of activities that private equity firms can undertake to generate value in their
investments. In order to combine theories and reality, the third chapter is devoted to
analysis of two quite recent private equity investments, the takeover of ISS A/S and
TDC A/S. An attempt is made to evaluate the influence of the takeover by the private
equity firms by analyzing changes in the companies’ capital structure and operations.
The last chapter focuses on how private equity investments can be exited. This is an
important angle of the process as it can have a material effect on the final value of the
investments. The central subject of the chapter is an investigation of the very recent
IPO of Pandora A/S.
Based on the analysis made in this thesis it is my opinion that private equity as an
object in the financial literature has made an important contribution the development
of theories around corporate finance. Although the value generating activities
discussed cannot be confined only to private equity firms, it is clear that their
expertise in applying debt as a governance tool and implement clear and focused
strategy is vital for the value generating process in general. And with hands-on
management style, they are able to decrease the agency cost and at the same time
increase the unity between owners and employees that results in improved efficiency.
Table of contents
1. Introduction ................................................................................................................ 1 1.1 Motivation .......................................................................................................................... 3 1.2 Methodology and structure of the thesis ................................................................. 3 1.3 Limitations ......................................................................................................................... 5
2. Literature Review ...................................................................................................... 6 2.1 Private equity & Capital structure ............................................................................. 6 2.2 Private equity & Agency theory .................................................................................. 8
3. Private Equity .......................................................................................................... 11 3.1 Definition ......................................................................................................................... 11 3.2 Structure ........................................................................................................................... 13 3.3 Investment Process (Fundraising – structuring the finance) ......................... 15 3.3.1 Debt forms ................................................................................................................................ 16 3.3.2 Existing debt ............................................................................................................................ 17 3.3.3 Senior debt ................................................................................................................................ 17 3.3.4 Mezzanine debt ....................................................................................................................... 18
3.4 Types of buyouts ............................................................................................................ 18 3.4.1 LBO ............................................................................................................................................... 18 3.4.2 MBO .............................................................................................................................................. 19 3.4.3 MBI ............................................................................................................................................... 19 3.4.4 BIMBO ......................................................................................................................................... 19 3.4.5 PIPE .............................................................................................................................................. 19
3.5 Value drivers of PE funds ............................................................................................ 20 3.5.1 Value capturing ....................................................................................................................... 21 3.5.1.1 Financial arbitrage ........................................................................................................................ 21
3.5.2 Value creation .......................................................................................................................... 22 3.5.2.1 Primary levers ................................................................................................................................ 22 3.5.2.2 Secondary levers ........................................................................................................................... 28
4. Case comparison ..................................................................................................... 31 4.1 EQT Partners & Goldman Sachs Capital Partners takeover of ISS ................ 34 4.2 Nordic Telephone Company ApS (NTC) takeover of TDC ................................. 42
5. Exit strategies for PE investments .................................................................... 50 5.1 Initial public offering (IPO) ........................................................................................ 51
5.2 The case of Pandora ...................................................................................................... 54
6. Conclusion ................................................................................................................. 58
Bibliography ..................................................................................................................... 61
Appendix ........................................................................................................................... 68 1. ISS assets development ...................................................................................................... 68 2. ISS return on assets and profit margin ......................................................................... 68 3. ISS summarized financials ................................................................................................ 69 4. Net debt to EBITDA with possible results of an IPO ................................................. 69 5. ISS v/s Peers EBITDA margin .......................................................................................... 70 6. ISS profit margin v/s sales growth ................................................................................. 70 7. Development in asset base TDC v/s Peers .................................................................. 71 8. IPOs volume 2000-‐2010 .................................................................................................... 71 9. Pandora´s operational development 2009-‐2010 ..................................................... 72 10. Questionnaire and answers from Torben Ballegaard Sørensen ....................... 72
Table of figures
Figure 1: PE investments in volume 2000-2009 ............................................................ 1
Figure 2: Thesis structure ............................................................................................... 3
Figure 3: Simplified categorization of financial assets ................................................ 12
Figure 4: Average Private Equity investment size 2007-2009 .................................... 12
Figure 5: Private equity fund lifecycle (own creation) ................................................ 14
Figure 6: Cash flows in private equity ......................................................................... 16
Figure 7: Typical capital structure in LBOs ................................................................. 17
Figure 8: Factors behind value generation in LBOs (own creation) ............................ 21
Figure 9: Cash flows and their market values for two different firms with different
capital structures .......................................................................................................... 23
Figure 10: Debt to equity and cost of financial distress ............................................... 25
Figure 11: Tax shield and financial distress costs ........................................................ 26
Figure 12: Debt to equity ratio of ISS and its peers ..................................................... 37
Figure 13: ISS and peers interest coverage ratio .......................................................... 37
Figure 14: Net debt to EBITDA ISS v/s Peers ............................................................. 38
Figure 15: Return on assets .......................................................................................... 40
Figure 16: Asset turnover (ATO) and Profit margin (PM) .......................................... 40
Figure 17: ISS operating margin v/s profit margin ...................................................... 41
Figure 18: Financing and use in TDC takeover ........................................................... 43
Figure 19: TDC debt to equity ratio v/s peers .............................................................. 44
Figure 20: TDC Interest coverage ratio v/s Peers ........................................................ 44
Figure 21: TDC net debt to EBITDA v/s peers and its EBITDA margin .................... 45
Figure 22: TDC revenue and revenue growth .............................................................. 46
Figure 23: Return on assets (ROA) – TDC v/s Peers .................................................. 47
Figure 24: TDC´s asset turnover and profit margin ..................................................... 47
Figure 25: TDC revenue and EBITDA margin v/s peers ............................................. 48
Figure 26: Enterprise value and EV/EBITDA for TDC and peers .............................. 49
Figure 27: Exit strategies of leveraged buyouts 2000-2005 ........................................ 50
Figure 28: Proceeds from Pandora´s IPO .................................................................... 56
Figure 29: Artificial net equity value changes in Pandora ........................................... 57
Acronyms and definitions
PE: Private equity
LBO: Leveraged buyout
RLBO: Reverse leveraged buyout
MBO: Management Buyout
MBI: Management buy-in
BIMBO: Buy-in management buyout
PIPE: Private investment in public company
IPO: Initial public offering
GP: General partner
LP: Limited partner
FIH Erhvervsbank (FIH): FIH is Danish Bank specializing in lending to Danish
corporates
Kaupthing Bank: Was an international Icelandic bank, headquartered in Reykjavík,
Iceland. Following a major banking and financial crisis in Iceland in October 2008 it
was taken over by the Financial Supervisory authority and is now in liquidation.
Investment grade: A rating that indicates that a corporate bond has a relatively low
risk of default
1
1. Introduction
Private equity (PE) activities have grown rapidly for last three decades. Investments
on behalf of PE funds and firms have received an enormous attention both in the
media and in the financial society. The Economist, for example, in 2004 described
private equity, mainly leveraged buyouts (LBOs), as the new king of capitalism (The
Economist, 2004). Some might say that the attention is questionable but in the light of
tremendous growth in amount and volume in this kind of activities the attention is
justifiable. Between 2003 and 2007 private equity investments totaled $832 billion,
which was equal to the size of Mexico and India´s GDP´s at that time (Cendrowski
et.al. 2008). The rise of the private equity market in the years after 2000 has been
attributed among other things to the comparatively low interest rates almost
worldwide, the rise of the hedge funds and the sovereign wealth funds. It has also
been attributed to the idea of the superior governance model of private equity relative
to the public companies (Jensen, Eclipse of the Public Corporation, 1989). Due to the
financial and economic shock in 2008 there has been a significant slowdown both in
investments in PE funds and also in the activity of the funds. Figure 1 shows the
evolution of European private equity investments since 2000 both in terms of volume
and companies financed. The investments in 2009 amounted 23,4 billion euros, down
57% from the year before (EVCA, 2010).
(Source: Figure 9, EVCA, 2010, p.17)
Figure 1: PE investments in volume 2000-2009
2
The increasing volume in this segment of the financial market for the last decades is
interesting and is worth further exploration. In this study I will go carefully through
what Private Equity is and try to detect the value generating activities the PE firms
use in order to maximize the gain for the stakeholders. In order to combine theory and
practice I will use as an example of two well-known private equity takeovers,
the EQT Partners and Goldman Sachs Capital Partners takeover of ISS and Nordic
Telephone Company ApS (NTC) takeover of TDC. The process in each case will be
compared with its peers and changes in the capital structure and operational
performance will be studied. The last chapter will discuss how PE firms are able to
exit from their investments, in order to put that in context I will investigate the recent
IPO of the Danish jewelry marker Pandora.
The aim of this thesis is to obtain comprehensive knowledge of Private Equity, how it
is structured and how firms in this field of investing manage to create value within
their portfolio companies. This is an exploratory thesis with the fundamental goal to
develop a better understanding of corporate finance and private equity investments by
analyzing the key factors in the value generating process. To be able to get a deeper
understanding of the PE market, an analysis is made on the key theories behind the
ideology of PE investments.
In a research by Berg & Gottschalg (2005) they point out six areas where PE funds
create value: financial arbitrage, financial engineering (The optimization of capital
structure), increasing operational effectiveness, increasing strategic distinctiveness,
reducing agency costs, mentoring (parenting advantage).
These points will be observed with a special attention on the PE funds approach to
reduce the agency cost and optimization of the capital structure
With this in mind the problem statement of this thesis will be:
• How do private equity firms create value in their portfolio companies?
o The effect of capital structure changes in value creation
In order to answer this question I will study other questions like: What is private
equity? How is it combined and who owns PE funds? What value generating activities
can the funds use? How does PE funds exit from their investments?
3
1.1 Motivation
The motivation for this thesis comes from a deep interest in this subject, which has
not been discussed much in my study. Private equity has a huge impact on global
trade and today especially in my home country Iceland, were currency restrictions, a
paralyzed stock market and an overbought bond market, have directed investors into
putting more focus on private equity investments. The Icelandic government is also
quite heavily dependent on one of the Danish private equity investment, Pandora. In
the autumn of 2008, the Central Bank of Iceland (CBI) lent the former owner of FIH
Erhvervsbank (FIH), Kaupthing Bank, 500 million Euros, with the assets of FIH as a
collateral. When Kaupthing Bank went bankrupt in October 2008, the CBI took over
the control of FIH. In September 2010, CBI sold FIH to Danish and Swedish investors
that paid less than half of the price in cash. The reminders of the price are based on
FIH´s operational efficiency and also on the final value of the private equity fund
Axcel III (owned by FIH). The fund´s biggest investment is 57,4% of the Pandora
shares.
With this in mind I decided to take on this subject to get more knowledge and
experience in this field.
1.2 Methodology and structure of the thesis
Figure 2 here below illustrates the thesis structure. It is basically in three parts, the
first part is surrounded by the theoretical discussions, the second part is dedicated to
private equity in general and the third part attempts to put the previous discussions in
context.
Figure 2: Thesis structure
Introduc*on, mo*va*on, structure and methodology
Theore*cal framework Agency
problem theory Capital structure
theory
Private Equity in general, and the investment
process
Prac*cal examples
• ISS • TDC
Exit strategies • The IPO of Pandora
Conclusion
4
In part one the theories relevant to private equity are identified and discussed by
reviewing the existing literature in this field. The main theories considered are the
ones that are related to the capital structure and the agency cost. The second part of
the thesis is dedicated to broad private equity discussions. It starts by going generally
through what the phenomenon is and how it is structured. Then the investment
process will be reviewed and different types of buyouts introduced. The main share of
this part is however consideration of the factors that are thought of being value
creating in private equity investments. Part three represents two quite recent private
equity investments, the takeover of ISS A/S and TDC A/S. The focus of this part is to
put previously discussed theoretical points in context by studying the development in
the companies´ capital structure and operational performance before and after the
private equity funds invested in them. The last chapter will focus on exit strategies for
PE investments and the important elements that have to be kept in mind at this stage
in the process. The very recent IPO of the Danish jewelry maker Pandora will be
investigated in in order to put discussions in this chapter into context.
The sources used for the thesis are more or less secondary and acknowledged
academic literature within the subject of corporate finance in general. The data used
for calculations in the case comparison were collected through the Orbis1 database,
which can be accessed on campus. Orbis is a database of financial information for
over 60 million companies around the world. The companies´ consolidated financial
statements were also used when that was needed.
In relation to the last chapter of the thesis, the discussion on Pandora, Torben
Ballegaard Sørensen, the former chairman of Pandora´s board and now Deputy
Chairman, was very helpful and kindly answered few questions for me about the IPO
process and his view on private equity firms contribution to value creation.
1 http://www.bvdinfo.com/Products/Company-Information/International/ORBIS.aspx 2 http://www.blackstone.com/ 3 http://carlyle.com/ 4 http://www.kkr.com/ 5 Closed end refers to the system of the fund. Investors cannot withdraw their amounts
5
1.3 Limitations
In order to keep focus in answering the problem statement questions, a number of
limitations should be put forward.
This thesis puts emphasis on discussions of the value creation of a private equity fund
acquiring a major stake in a LBO of a publicly listed company. Other kinds of
alternative investments such as venture capital are not explored. The discussion in this
thesis also focuses more on the relationship between the private equity fund and the
portfolio companies rather than detailed technical analysis of the function of the
private equity funds itself, that could be a subject of a whole another thesis.
Chapter 4 is used to put theories and discussions into perspective, the cases of TDC
and ISS are used as explanatory examples of how certain ratios changes in the process
of being taken over by a PE fund. In order to calculate the ratios, the financial
statements of the companies were used but they were not reformulated.
This thesis is explanatory and as such it does not claim to be an exhaustive analysis of
the private equity phenomenon, it rather tries to throw light onto private equity and
the value creating activities employed by the PE funds in the portfolio firm operations.
It is also worth pointing out that the phrases PE firms, PE company and PE funds will
be used interchangeably through the thesis
6
2. Literature Review
2.1 Private equity & Capital structure
Reviews of the theories of optimal capital structure always start with the revolutionary
work of Modigliani and Miller (MM) (1958, 1963). They proved that in perfect
capital markets, the choice between debt and equity financing has no material effects
on the value of the firm or on the cost of capital.
The conditions that M&M referred to, as perfect capital markets were:
• Capital markets are frictionless
• Individuals can borrow and lend at the risk-free rate
• There are no costs to bankruptcy or to business disruption
• Firms issue only two types of claims: risk-free debt and risky equity
• All firms are assumed to be in the same risk class (operating risk)
• There are no taxes associated with security trading
• All cash flows are perpetuities (i.e. no growth)
• Operating cash flows are completely unaffected by changes in capital structure
Under these conditions, MM demonstrated the following result regarding the role of
capital structure in determining firm value:
MM Proposition I: In a perfect capital market, the total value of a firm is
equal to the market value of the total cash flow generated by its assets and
is not affected by its choice of capital structure (Berk & DeMarzo, 2007,
p.432).
Proposition II is derived from Proposition I and concerns the rate of return on equity:
MM Proposition II: The cost of capital of levered equity is equal to the
cost of capital of unlevered equity plus a premium that is proportional to
the market value debt-equity ratio (Berk & DeMarzo, 2007, p.438)
MM´s original work assumed a zero corporate tax rate. In 1963, they published a
second article, which included corporate tax effects. With corporate income taxes,
they conclude that leverage will increase a firm´s value, because interest on debt is a
7
tax-deductible expense, which lead to more of a leveraged firm´s operating income
flows through to investors. From it derives the conclusion that firms should use 100%
debt financing (Modigliani & Miller, 1963).
As one could imagine MM statements caused robust reaction from dozens of other
academics (e.g. Durand, 1959). Myers and Robichek (1966) concluded that the
assumptions behind Proposition I would not hold in the world assumed by MM. They
hypothesized that in the absence of taxes, the value of the firm would not change for
moderate amount of debt but would decline with high degree of leverage (Myers &
Robichek, 1966).
Jensen (1993) states that even though MM assumptions have been very productive in
helping the financial community to structure the logic of many valuation issues, “The
1980s control activities, however, have demonstrated that the MM theorems (while
logically sound) are empirically incorrect” (Jensen, 1993, p.878). Other researchers
have pointed out that evidence from e.g. LBOs have shown that leverage, payout
policy and ownership structure do matter when considering organizational efficiency
and therefore value (e.g. (Kaplan 1989) (Smith, 1990)). Brigham and Ehrhardt (2010)
supposed that Modigliani-Miller (MM) were theoretically right but in reality the cost
of bankruptcy exists and is directly proportional to the debt level of the firm.
Jensen (1986) discusses the importance of debt in the capital structure. From his point
of view debt can and should be used as a corporate governance tool. He argues that
managers are afraid of paying out the extra cash flow because the stock market
punishes dividend payments with stock reduction. In order to prevent the managers
from investing in projects with negative NPV, the firm should take on additional debt
that the extra cash flow would be used to pay down. He sees this use of debt as a
potential determinant of capital structure. Muscarella and Vetsuypens (1990)
reviewed reverse LBO´s and found that firms experience dramatic increase in
leverage at the LBO but the leverage ratios were gradually reduced over time.
Axelson et al. (2007) conducted an analysis of the financial structure in large buyouts.
They found no relation between leverage in their sample of buyouts and comparable
public firms. Their results suggest that capital structure in buyouts requires a different
explanation than in public firms.
8
Myers and Majluf (1984) recommend that firms should use debt financing rather than
equity financing when possible because of the information asymmetry costs. They
argue that when managers have superior information and go for an equity issue, the
stock price will fall but if the company issues safer debt such as bonds, the stock price
will not fall.
In relation to the discussions above about the different angles of the theories around
the capital structure it is interesting that in a survey by Graham and Harvey (2001),
they found that financial executives are not likely to follow the academically
proscribed factors and theories when determining capital structure. In light of this, it
will be exciting to see later on in this thesis if this is the case.
2.2 Private equity & Agency theory
The origin of the agency theory can be linked to the famous social philosopher and
economist Adam Smith. In 1776 he came up with this definition of the relationship
between owners of companies and their managers:
“The directors of such (joint-stock) companies, however, being the
managers rather of other people´s money than of their own, it cannot well
be expected, that they should watch over it with the same anxious vigilance
with which the partners in a private copartnery frequently watch over their
own. Like the stewards of a rich man, they are apt to consider attention to
small matters as not for their master´s honor, and very easily give
themselves a dispensation from having it. Negligence and profusion
therefore must always prevail, more or less, in the management of the
affairs of such company.”
(Quotation adapted from Jensen & Meckling, 1976)
Jensen and Meckling (1976) formalized this view from Adam Smith and in their
paper they conclude that the agent cannot at all times guarantee that he will make
optimal decisions from the owner´s point of view. According to Jensen and Meckling
agency costs of equity are defined as:
9
1. The monitoring expenditures by the principal
2. The bonding expenditures by the agent
3. The residual loss
Monitoring include efforts on behalf of the owner to control the behavior of the agent
to increase the alignment of interest between the agent and the owner. Among the
monitoring activities that the owner can use are budget restrictions, compensation
policies and operating rules (Jensen & Meckling, 1976). Jensen and Meckling
describe bonding as an action carried out by the agent “to expend resources (bonding
costs) to guarantee that he will not take certain actions which would harm the
principal or to ensure that the principal will be compensated if he does take such
actions” (Jensen & Meckling, 1976, p. 5). The costs related to bonding could be an
internal audit showing that the agent is acting in the interest of the principal. Residual
loss is defined as any reduction in welfare from the viewpoint of the owner that could
be related to the conflict between the agents decisions and the maximum gain for the
owner (Jensen & Meckling, 1976). Demsetz (1983) on the other hand concluded that
it would not be possible to expect any relation between ownership structure and
profitability (Demsetz, 1983).
According to Milgrom and Roberts (1992) one of the most important things in
relation to the Agency Theory is to align the interest between the owner (shareholder)
and the agent in order to reach the firm´s goals in an environment of uncertainty
(Milgrom & Roberts, 1992).
Jensen and Meckling (1976) distinguish between two approaches of the Agency
Theory, the normative and the positive. The normative aspect is mainly about how to
structure the contractual relation between the principal and the agent in order to
provide appropriate incentives for the agent to make choices that will maximize the
principal´s welfare. The positive theory is what Jensen and Meckling focus almost
entirely on. The aim of that approach is to identify a policy or behavior to merge debt
and equity holders’ interests with management and then to demonstrate how
information systems or outcome-based incentives solve the agency problem.
According to Renneboog & Simons (2005), the basics of the agency theory includes
three primary hypotheses regarding the motives of public to private transactions:
10
• Incentive realignment
• Control
• Free cash flow
The incentive realignment hypothesis states that the gains in stockholder wealth that
arise from going private are a result of offering more rewards for managers that
encourage them to act in line with the interests of the owners. The incentives could
e.g. take the form of increased ownership stake. The hypothesis of control argues that
successful implementation of supervision system by the management plays a critical
role for the shareholders wealth. The free cash flow hypothesis suggests that firms
should take on additional debt in order to force managers to pay out free cash flows.
The added leverage prevents managers from growing the firm beyond its optimal size
and at the expense of value creation (Renneboog & Simons, 2005).
Vinten (2007), on the contrary, points out that this kind of actions might lead to over-
monitoring by the large shareholder, which could reduce firm efficiency because of
poorer firm innovation. On top of that, huge debt burden might dampen the
managerial initiatives because the free cash flow now only serves the repayments on
the cost of investments in new firm activities (Vinten, 2007).
In a survey by Shleifer & Vishny (1997) they identify incentive contracts as a possible
solution for owners to get the managers to invest the investor´s capital in the most
optimal way. According to Lewellen et al (1985) negative returns are most common
for bidders in mergers and acquisitions activities where their managers hold little
equity, suggesting that agency problems can be enhanced with incentives.
Kaplan (1989) performed a study of 76 large public companies that went through
management buyout (MBO) between 1980 and 1986. He found that within 3 years
from the buyout, the companies increased their operating income and net cash flow.
He connected these operating changes to improved incentives rather than layoffs or
managerial exploitation of shareholders through inside information. These results
support that agency cost savings from better control and incentives lead to
improvement in the company´s performance. The results are in line with related
studies from Muscarella & Vetsuypens (1990) and Smith (1990).
11
Leslie & Oyer (2009) on the other hand raise question about whether incentives are
able to create value. Their study showed that companies owned by PE firms
implement much stonger incentives system for their top executives but they could not
find much evidence of these companies outperforming public firms in profitability or
operational efficiency (Leslie & Oyer, 2009).
3. Private Equity
In the following section a description of
the various aspects of private equity will
be provided in order to give the reader
insight to this particular asset class. First
there will a brief definition of private
equity, followed by a discussion of the
ownership structure and the investment
process, i.e. the fundraising and the
financing structure. Then different kinds
of buyouts will be introduced and the last
part of this chapter will then be dedicated to the value generating process of private
equity investments.
3.1 Definition
Investments in asset classes can roughly be divided between traditional and
alternative assets. The traditional ones are in most cases more liquid and easier to
understand than the alternatives one. Private equity investments are considered to be
alternative investments and suits investors that consider a longer investment horizon.
12
(Source: figure 1.2 Demaria, 2010, p.17)
Figure 3: Simplified categorization of financial assets
The concept of private equity contains different investment approaches such as
management buy-outs and buy-ins, venture capital, and development capital.
Furthermore, the investment strategies of different private equity companies differ
extremely according to their investment criteria, such as acquisition size, sector,
region, and purpose of the acquisition, which e.g. includes start-up, expansion,
buyouts and turnarounds. However, as can be seen in figure 4 the majority of funds
placed in private equity are invested in leveraged buyouts (LBOs), so referring to
private equity is often implicitly LBOs (Philippou & Zollo, 2005).
(Source: EVCA, 2010, p.19)
Figure 4: Average Private Equity investment size 2007-2009
Assets
Traditional
Bonds Stocks
Specialized products
Alternative
Hedge funds PRIVATE EQUITY
Real estate Commodities, Art, etc
13
In a leveraged buyout, a specialized investment firm using a relatively small portion
of equity and a relatively large portion of outside debt financing acquires a company.
The leveraged buyout investment companies today refer to themselves as private
equity firms. In a typical leveraged buyout transaction, the private equity firm buys
majority control of an existing or mature firm and brings in their own people in board
and even into the management team. This arrangement is different from venture
capital firms that typically invest in young or emerging companies, and typically do
not obtain majority control (Kaplan & Strömberg, 2008). The focus in this thesis will
be on private equity firms and the leveraged buyouts in which they invest.
Demaria (2010) supposed that because PE firms’ investment cycles are substantially
longer and the cycles are not correlated directly to the evolution of the stock exchange
index, investors in private equity were looking for diversification and return
enhancement. But as was also pointed out there is a close link to the markets, as exists
of investments are mainly trade sales or initial public offerings (IPOs). If markets are
in downturn, public companies will make fewer acquisitions or will negotiate lower
valuations and IPOs could turn out to be very negative. Private equity is also affected
by the interest rates because of the huge amount of debt borrowed in the buyout. The
higher the interest rates, the more difficult it is for a PE firm to transform a buyout
into a profit. (Demaria, 2010)
3.2 Structure
The classic private equity firm is organized as a partnership or limited liability
corporation. Jensen (1989) argued that private equity associations were more
decentralized than public companies with fairly few investment professionals. In a
survey of 7 PE firms he found that they had only on average 13 professionals with an
investment banking background (Jensen, 1989). This has changed a bit for last years
as the PE firms have become larger but they are though still relatively small in
relation to their investments. Among the biggest firms in the world today are
Blackstone2, Carlyle3 and KKR4.
2 http://www.blackstone.com/ 3 http://carlyle.com/ 4 http://www.kkr.com/
14
The Private equity firm raises capital through a private equity fund. These funds are
structured as “closed end”5 funds in which investors commit to providing a certain
amount of money into the fund. The PE firm serves as the general partner (GP) and
manages the fund, the investor is referred to as the limited partner (LP). The PE funds
are usually created for a 10-year life span, with option of an extension. These 10 years
are then subdivided into an investment period of 5 years and a divestment period of 5
years (Demaria, 2010).
Figure 5: Private equity fund lifecycle (own creation)
In the first period of the funds life cycle the fund managers structure the fund,
introduce the business plan and strategy for investors. The investors then commit
capital to the new established fund if they believe in the management ideas. When all
necessary observation such as due diligence has been made on the target firm and
participants have negotiated the price, a capital call is made, i.e. the investors are at
this time asked to lay out their committed capital. These capital calls can be made
more than once. For example, the agreement between the buyer and the seller can be
structured in that way that payments are made in separated parts over longer period.
After the investment process has taken place the strategic, organizational and
operational changes can be made to the target firm in the so-called holding period. At
this time in the cycle there is room for operational improvements and value creation
5 Closed end refers to the system of the fund. Investors cannot withdraw their amounts until the fund is terminated.
PE fund established
Fund raising by the GP -LP´s joins the fund
Searching period
Capital Call made by GP -
paid by LP
Investment period
Holding/Restructuring
period
Disinvestment period/Focus on
portfolio firm
Harvest/Exit
15
within the portfolio company. The latest stage is the harvest or the exit of the
investment. This marks the end of the LBO investment and is an important stage in
the process since the investors will ultimately realize the returns from their investment
(Berg & Gottschalg, 2005). The exits can be of different modes that will be further
discussed later in the thesis.
3.3 Investment Process (Fundraising – structuring the finance)
In their search for potential buyout targets, the GPs look for firms with strong, stable
cash flows, market leadership and a low leverage ratio relative to industry peers. A
rather famous phrase in the field of finance is “cash is king”, that is especially true in
the case of leverage buyouts, as the cash flow is used to service the debt raised in the
deal (Cendrowski, Martin, Petro, & Wadecki, 2008).
One of the most important topics for the PE fund is the fundraising. If this stage turns
out to be unsuccessful it can have serious consequences on the investment and in
some instances might prevent the fund from going further in the investment process.
The limited partners (LPs) put up the majority of the equity part but the GP also
contribute some capital. Good track record is vital in this perspective. Funds that have
been able to generate good returns in the past have definitely competitive advantage
to others (Demaria, 2010). One might describe this as the situation when a Danish guy,
Peter L, is going to invite a stand-up comedian to his party. He knows that he can get
Casper Christiansen but his Icelandic friend also told him about a famous Icelandic
comedian named Laddi that would come for free to escape the situation in Iceland.
Peter knows that his safest bet would be the Danish performer but he is also expensive,
so it is tempting to try the Icelandic one. Although Peter is tempted his safest choice
would be the Danish performer. This example shows that although one is tempted to
go for a new PE fund, he might still invest in a fund managed by a tried-and-true GP.
After the fundraising process, than the GP takes full control of the fund and starts to
invest. The limited partners (LPs) have nothing to say in all the investment process,
which is also important because of their limited liability. A golden rule of private
equity fund is that those who are responsible for the investment process should be
members of the full-time executive team (Fraser-Sampson, 2007).
16
Incentives and fees
Figure 6 provides a view of the cash flow in private equity funds. The General partner
(GP) gets paid a management fee from the fund for the service he provides. The fee is
generally 1,5% to 2,5% per year depending on the fund size. This fee is calculated on
the fund size during the investment period, and usually on the net asset value of the
portfolio once the investment period has ended. In order to align the interest between
limited partners and the management team, a fee in form of carried interest is paid to
the management team. That fee is based on the performance of the fund and is around
20%. However, as the investors carry more risk than management team, than before
anything else is paid out of the fund, the investors are first compensated with a so-
called hurdle rate, which is between 5 and 15% (Demaria, 2010).
(Source: Figure 3.6 Demaria, 2010, p.55)
Figure 6: Cash flows in private equity investments
3.3.1 Debt forms
The use of debt financing is what most obviously distinguishes buyouts from other
transactions such as venture investments. Buyouts are often structurally very complex,
with many different layers of debt, were often the key buyout skills lay. The buyout is
typically financed with 60-90% debt, which explains the term leveraged buyout
(Kaplan & Strömberg, 2008). One of the key barriers to entry for new buyout firms is
to obtain as good terms from banks as the established players (Fraser-Sampson, 2007).
17
The typical debt structure almost always includes a portion of senior and secured
loans that are provided by a bank and also layers of junior and mezzanine debt.
(Source: Spliid, 2007, p.31)
Figure 7: Typical capital structure in LBOs
3.3.2 Existing debt
This part is often overlooked when observing PE activities. These are the debts that
are already present in the firm for the working capital purposes. Companies with high
levels of operating debt are less attractive as buyout targets. But on the other hand,
firms with low levels of debt and even a cash stack will be highly attractive. Buyout
firms typically seek to reduce the level of operating debt within a business once they
have acquired it. Operating debt finances the working capital cycle, so lowering the
stock levels can reduce the debt, also fewer debtor days or the opposite, by adding
more creditor days. Firms with a low operating debt might persuade a bank to issue
more debt in the acquisition so that equity can be released back to the buyout fund as
part of recapitalization (Fraser-Sampson, 2007).
3.3.3 Senior debt
Senior debt is a first priority debt in repayment in any liquidation of the company. It
has a greater seniority in the issuer´s capital structure than subordinated debt and is
often secured by collateral (Fraser-Sampson, 2007). Senior debts are issued in various
loan types (tranches) according to risk/return profile, repayments conditions and
maturity. For example as shown in figure 7, tranche A is the safest type of debt,
featuring a fixed amortization plan. Tranche B and C are lower-grade loans, based on
bullet payment structure. Debt tranches with bullet payments allow target companies
to take on higher debt multiples, as the payments will be made at the end of the loan
Financing Senior loans > > Mezzanine loans > > Equity and shareholders loans
Percent of capital structure 45-65 10 to 20 25-40
Expected return Euribor + 1,75-3,25% Euribor + 9-13% 15-30% (IRR)Leverage 4-5 x EBITDA 5-6 x EBITDA > 6 x EBITDA
A: Amortization 7 years Bullet loanB: Bullet loan 8 yearsC: Bullet loan 9 years
Typical capital structure in LBOs
Repayment profile
18
period, so there is a kind of payment relief in the beginning. But it does not come
without a cost, since the bullet loans carry higher interest rates. (Spliid, 2007)
3.3.4 Mezzanine debt
Mezzanine financing represents capital with a level of risk, which is positioned in the
gap between senior debt and equity. This kind of financing is junior to senior debt and
takes the form of subordinated notes from the private placement market or high yield
bonds from the public market. Due to its popularity, special mezzanine financing
funds have been raised to operate in this space (Fraser-Sampson, 2007).
Mezzanine finance is by nature cash flow lending but sometimes the lenders are
secured with operating assets in case of insolvency. This kind of debt obviously bear
higher interest rate then are paid on senior debt. Often it includes some form of equity
“kicker” in order to allow the mezzanine investor to participate in the upside of the
equity value and to compensate them for the risk taken. The existence of this kind of
financing allows PE firms to secure a gap in the financing of the deal at a price that is
less than pure equity and allows them to keep full majority control of their businesses
(Cendrowski, Martin, Petro, & Wadecki, 2008).
3.4 Types of buyouts
There is a great deal of overlap in the definitions of different buyouts. The discussion
so far has been centered on leveraged buyouts (LBOs) but certainly there are more
types. This section will try to distinguish further between these forms and definitions
of them.
3.4.1 LBO
Leveraged buyout can be defined as an acquisition of a company by an investor or
group of investors with a significant amount of the price paid by borrowed money.
The cash flow generated in the acquired firm or procedures from asset sale is then
used to pay down the massive debt. The assets of the acquired company are though
almost always used as collateral for the debt structure (Demaria, 2010). In the 1980´s
leveraged buyouts first arose as an important phenomenon due to its increased activity.
Famously, Jensen (1989) predicted that the leveraged buyouts would become the
19
dominant corporate organizational form in the future. He argued that the structure of
the PE firms were superior to those of the typical public corporations because of their
combined form of highly leveraged capital structures, concentrated ownership,
incentive systems and efficient organizations with a low overhead costs (Jensen,
1989). In a sense it can be said that all buyouts are leverage buyouts (LBOs) since all
buyouts involve use of some debt, just at different quantity.
3.4.2 MBO
Management buyout (MBO) in its purest form involves the executive team who are
managing a particular business activity, buying it out from the parent company. This
form of buyouts was especially popular in the early to mid 1990s. This method
requires the management team to put its own money into the deal but with a reward of
an equity stake. With larger funds and bigger deals, this method has become less
common (Fraser-Sampson, 2007).
3.4.3 MBI
Management buy-in developed from the MBO and is similar method apart from the
way in which the deal initially comes together. The key difference is that instead of
the management team of a business getting together to buy it, a team is put together to
buy another company operating in the same sector. Pure MBIs are rare and often fall
into the BIMBO category (Fraser-Sampson, 2007).
3.4.4 BIMBO
Buy-in management buyout occurs where outside executives join the existing
executive team to buyout a company. Much of the buyout activity falls into this
category if one applies the definition strictly. An example of this could be a former
CEO that returns to advice and help in the acquisition process (Fraser-Sampson,
2007).
3.4.5 PIPE
Private investment in public equity is a category of deals that occurs when a particular
investment instrument is created within á public company that may offer a private
equity-type return. Typically, while the company´s equity is quoted the instrument
20
itself is not. An example of this could be a private investments firm or mutual fund
that purchases firm´s equity at discount to current market value for the purpose of
raising the firm´s capital. This is called traditional PIPE and the stock equity could be
either preferred or common. Structured PIPE refers to the issue of convertible debt for
the same purpose (Fraser-Sampson, 2007).
3.5 Value drivers of PE funds
Demaria (2010) recommends that when value creation in firms is analyzed one should
put emphasis on the structure, execution and the exit of the deal. The reason behind
investments in PE funds it that they are believed to have the X factor to generate value
within their investments beyond others.
This section will discuss the various value generating activities that PE funds
undertake in their investments. Berg & Gottschalg (2005) and Renneboog & Simmons
(2005) made a comprehensive contribution to the literature in this field of PE
investments and this section will depart from their studies.
In order for PE funds to reach their goal they have to exploit the value creation
opportunities laying in their investments. Berg & Gottschalg (2005) introduced three-
dimensional framework to analyse the factors behind value creation in LBOs either
within the portfolio company or through the interaction between the portfolio
company and the PE fund.
In both studies by Berg & Gottschalg (2005) and Renneboog & Simons (2005) a
distinction is made between value capturing and value creation in PTP buyouts. Value
capturing refers to activities that increase the value without changing anything in the
underlying performance of the business e.g. financial arbitrage, breaking up of
companies or improvements in the macroeconomic environment. Value creation on
the other hand takes place in the holding period or during the PE ownership of the
company and refers to the improvement of performance of the portfolio companies.
These improvements can be further divided into primary (direct) value creation, e.g.
the ones that are easy to measure on the portfolio company´s performance or
operations, and secondary (indirect) value creation, which refers to events that are
21
harder to measure but have an influence on value generation, such as benefits of
reduced agency costs. Figure 8 gives an overview of the various factors behind value
generation in LBOs as discussed by Berg & Gottschalg (2005).
Figure 8: Factors behind value generation in LBOs (own creation)
3.5.1 Value capturing
3.5.1.1 Financial arbitrage
According to the classical world that Modigliani and Miller among others belong to,
arbitrage opportunities should not exist if markets are efficient. However, market
conditions such as information asymmetry distract this picture of the perfect market
(Berk & DeMarzo, 2007). It is therefore possible for PE funds to find an investment
opportunity where value can be generated between the buyout and the divestment
without operational changes within the portfolio company.
According to Berg & Gottschalg (2005) the financial arbitrage can be based on four
factors:
Value genera*on in buyouts
Value crea*on
Primary levers
Financial engineering
Op*mizing capital structure
Reducing corporate tax
Opera*onal effec*veness
Cost cuJng and margin
imporvements
Reducing capital requirements
Removing managerial inefficiencies
Strategic dis*nc*veness
Secondary levers
Reducing agency costs
Of free cash flow
Improving incen*ve alignment
Improving mentoring and controlling
Mentoring
Restoring entrepreneural
spirit
Advising and enabling
Value capturing
Financial arbitrage
Based on change in market valua*on
Based on private info about
porOolio firm
Through superior market
info
Through op*miza*on of corporate scope
22
• Changes in market valuation – An example of this is so called “Multiple
riding”, i.e. when investor takes company private because he expects the
valuation based on public multiples to rise.
• Private information - For example information asymmetries in management
buyouts (MBOs).
• Different expectations regarding the future performance of the business or the
industry
• Superior deal making capabilities – For example, clever firms that managed to
limit competition from other firms and are therefore able to get better deal.
Renneboog and Simmons (2005) explained value capturing with the undervaluation
hypothesis, which suggest that value generated in the public to private process is
based on the management ability to use their knowledge to develop alternative higher-
value use for the companies’ asset´s.
3.5.2 Value creation
3.5.2.1 Primary levers
Changes that are made to the capital structure or the organizational structure in the
portfolio company are referred to as value creation activities. The PE firm can
undertake various restructuring activities within the portfolio company in order to
generate value. Berg & Gottschalg (2005) divided the value creation into primary and
secondary levers where the primary refers to activities that can be directly linked to
improvements in financial, operational and strategic performance of the portfolio
company.
The literature in the field of value creation in buyouts has put a great deal of attention
to the financial engineering i.e. the optimization of the capital structure and the
minimization of cost of capital (Berg & Gottschalg, 2005). This section will try to
bring out the aspects that have been considered to influence the improvements in the
bottom line results of the portfolio companies.
23
Financial engineering
As has been discussed in this thesis, the revolutionary work of Modigliani and Miller
(MM) can be applied to understand the capital structure of PE investments and how
they create value. Their proposition I, in the world of no taxes, states that the capital
structure decision has no effect on the total cash flows that a firm can distribute to its
debt and equity holders. To illustrate this, let’s assume that two firms exist for one
year, produce identical pretax cash flows (X) at the end of that year, and then
liquidate. However, they are financed differently, company U has no debt and is
therefore unlevered, but company L has some debt in its capital structure and is
therefore leveraged. Figure 9 presents the cash flows of the companies U and L, the
split of the cash flow between debt and equity and the present values of the cash flows
(Hillier, Grinblatt, & Titman, 2008).
Company U Company L
Future cash flow Current value Future cash flow Current value
Debt 0 0 (1 + rD)*D D
Equity X VU X - (1-rD) *D EL
Total X VU X VL = D +EL
(Hillier, Grinblatt, & Titman, 2008, p.510)
Figure 9: Cash flows and their market values for two different firms with different
capital structures
If we assume for simplicity that the debt is riskless and rD is the riskless rate,
company L´s debt holders will receive (1+rD)*D at the end of the year and its equity
holders will receive what remains X – (1+rD)*D. The current value of company L is
therefore VL or the current value of its outstanding debt D plus its equity EL. This said,
a conclusion can be drawn from these assumptions under the MM Proposition I:
• Firm´s total cash flow to its debt and equity holders is not affected by how it is
financed,
• There are no transaction costs, and
• No arbitrage opportunities exist in the economy
24
Then the value of a company is maintained regardless of the nature of the claims
against it. Thus the value is determined on the left side of the balance sheet by real
assets, not by the company´s leverage ratio.
Proposition II states that cost of equity depends on three factors
• The required rate of return on the company´s assets (RA)
• The company´s cost of debt (RD), and
• The company´s debt to equity ratio (D/E)
The 1958 theory as has been discussed was highly hypothetical. But in 1963 they
introduced corporate tax, which moved their theory closer to reality. Cost of debt is
under these circumstances calculated on an after tax basis as interest payments are
now tax deductible.
Hence, under the assumptions behind Proposition I mentioned above plus an extra
assumption that no personal taxes exist, then the value of a levered firm with risk-free
perpetual debt is the value of an otherwise equivalent unlevered firm plus the present
value of the tax shield. Therefore the firm´s optimal capital structure will include
enough debt to completely eliminate the firm´s tax liabilities (Hillier, Grinblatt, &
Titman, 2008).
However, although markets may work semi-efficiently after MM assumptions, they
are certainly not perfect and costs of financial distress exist. Costs of financial distress
depend on the probability of default and the magnitude of the costs. Proposition II
argues that the expected return on equity of a levered firm increases linearly with the
debt to equity ratio, as long as debt is risk-free. Nevertheless, as figure 10 visualizes,
when debt increases so does the risk of financial distress and debt holders demand
higher return for the additional risk that they carry. The more debt present, the less
sensitive equity holders become to further borrowing, hence the slope of RE slows
down as the ratio debt to equity increases (Brealey & Myers, 2003).
25
(Source: figure 17.2 in Brealey & Myers, 2003, p.474)
Figure 10: Debt to equity and cost of financial distress
This may seem to contradict Proposition I, which argued that the capital
structure is irrelevant. But as can be seen on the figure there is a risk-return
trade-off. Any increase in the expected return is exactly offset by an increase in
risk and therefore in shareholder´s required rate of return. The required return
simply rises to match the increased risk.
The trade-off theory helps to understand the choice of capital structure. It
suggests that the debt to equity decision relies on a balance between the tax
shield and the cost of financial distress. This explains why target debt ratios may
vary from firm to firm as companies with safe, tangible assets and steady cash
flow can better handle higher debt ratios. The theory also helps to explain what
kind of companies’ goes private in LBO´s. Because of the leverage factor in the
LBO´s, the target companies for the takeovers are usually mature with
established markets, strong cash flow and low debt to equity ratio. That makes
sense according to the trade-off theory since they are exactly the kind of
companies that “should” have high debt ratios (Koller, Goedhart, & Wessels,
2010).
Figure 11 shows how the trade-off between the tax-benefits, improved discipline
and the costs of distress are relevant elements when determining the optimal
capital structure. At some point, the risk of financial distress increases rapidly
with additional borrowing and the cost of financial distress begin to take a
26
substantial bite out of the firm value. Thus, the benefits from debt may be more
than offset by the financial distress cost.
(Source: Exhibit 23.1 Koller, Goedhart, & Wessels, 2010, p.478)
Figure 11: Tax shield and financial distress costs
Berg & Gottschalg (2005) pointed out that PE firms in power of their extensive
knowledge and experience of capital markets are able to help their portfolio
companies to optimize their capital structure, for example by reducing the cost of debt.
PE firm with good track records and reputation usually has better access to capital and
often at better terms than firm that either is unknown or with bad reputation.
Renneboog & Simons (2005) discussed how value could be created for the
stockholders by transferring wealth from the bondholders. From their point of view it
is possible for companies to do so in three ways: by increasing risk in investments, by
increasing the dividend payments and by issuing debt with higher or equal seniority of
the outstanding ones. They also mention that although this wealth expropriation
theory has not gained convincing evidence in the empirical researches so far, then
some studies show that companies, which have gone through public-to-private
transactions, faced substantial debt downgrades by the rating agencies (Renneboog &
Simons, 2005).
Koller et al (2010) indicate that financial engineering can create value in three ways;
• With derivative instruments that transfer company risk to third parties, such as
forwards, swaps and options.
27
• Off-balance sheet financing that detaches funding from the company´s credit
risk and often exploit tax advantages, for example leases and securitization.
An example of securitization could be of a distressed company in the car
industry that managed to “pack” their receivables and sell to investors at better
terms than otherwise possible if the company either issued bonds or asked for
traditional bank loan.
• Hybrid financing that offers new risk-return financing combinations. For
example convertible debt, this kind of financing might be used when a great
distinction exists between management and lenders about company´s credit
risk. Creditor might be tempted to finance a company at more reasonable
terms because of the warrant included in the structure, so the debt part of the
structure is, for the lender, not the most attractive but rather the warrant
component (Koller, Goedhart, & Wessels, 2010).
Sub-conclusion
As has been discussed above, Modigliani and Miller (MM) assumed that when
corporate taxes are included and the interest on debt is deductible (tax shield), than
firm’s optimal capital structure should be 100% debt. That was built on the idea that
the value of the company increased with the amount of debt because of the
exploitation of the tax shield that improved the cash flow to investors. But as was then
pointed out, the existence of financial distress cost makes this picture biased and a
balance is needed to realize the benefits of the tax shield. According to Kaplan
(1989b) tax benefits play an important role for the value creation in buyouts. He
found that in 76 buyouts completed between 1980 and 1986 the value of the tax
benefits ranged 21% to 143% of the premium paid to shareholders (Kaplan S., 1989b).
Optimization of the capital structure and the exploitation of the tax shield do clearly
impact the bottom line results of the portfolio company, but whether these tax benefits
are confined to PE activities is highly questionable. It is very likely that in today’s
competitive environment the former owners have already exploited these tax benefits.
It can therefore be concluded that it is unlikely that PE funds are able to create much
additional value through tax benefits (Renneboog & Simons, 2005). It is more
difficult to conclude something about the wealth transfer hypothesis; the effect of this
value-creating factor is likely to be built on how the covenants behind the bond issues
28
are made. Renneboog & Simmons indicate that bondholders that suffer losses have
simply not been contractually well protected (Renneboog & Simons, 2005).
Operational effectiveness and strategic distinctiveness
As has been discussed earlier the structure of a PE investment can be split into 2 parts,
the second part can be referred to as the holding period where the PE firm can make
its impact on the portfolio firms operations. The PE firm can initiate dozens of things
that can improve the operational results of the portfolio company. Bull (1989)
conducted a study where he compared different accounting variables of companies
before and after LBO and found that the financial performance improved significantly
after the LBO. Berg & Gottschalg (2005) draw attention to number of activities that
PE firms implement in order to reduce cost and capital requirements, such as
tightened control on corporate spending, reduction in production cost, decreased
corporate overhead cost and improvements in working capital. They also point out
that sometimes during the LBO process, the PE firm use the opportunity to dispose of
incompetent management team to get rid of managerial inefficiency (Berg &
Gottschalg, 2005).
In the last couple of years the importance of strategic distinction has become more
prominent as a part of the value creation instruments for PE firms. Their vision often
leads to a strategic change such as, new market entrance, changes in production or
pricing or asset sales. These activities can help the portfolio company to improve their
focus on the financial performance and increase its value (Berg & Gottschalg, 2005).
3.5.2.2 Secondary levers
Berg & Gottschalg defined the secondary levers as: “levers of value creation (that) do
not have a direct impact on financial performance, but influence value creation
through primary levers” (Berg & Gottschalg, 2005, p.24). In this context, the focus of
this section will be on how the PE firms can use their knowledge and experience to
reduce the agency costs within their portfolio company in order to increase their value.
29
Agency cost
Many researchers have identified the reduction of agency costs as a key value driver
in buyouts. Agency cost reflects the conflict of interest between management, owners
and other stakeholders in the firm. The cost results in a loss of efficiency that reduces
the advantage of debt (Brigham & Gapenski, 1990). The root of the agency problem
as has been discussed earlier, is the separation of ownership and control, where the
manager becomes an agent for the owner (Shleifer & Vishny, 1997).
Berg & Gottschalg (2005) specify a few factors that LBOs can influence in order to
reduce the agency cost. For example by increasing debt, the waste of free cash flow
can be limited. Jensen (1989) concluded that debt is a powerful tool for change and
can be used to directly force managers to put all their effort in running the company
efficiently in order to reduce debt. Jensen stated that managers tend to spend the
additional cash flow in projects with negative NPV instead of distributing it to the
shareholders. He argues that companies that take on additional debt keep their spirit
going since they need to refocus on their strategy and structure so they can meet the
debt payments (Jensen, Eclipse of the Public Corporation, 1989). But as has been
discussed and Berg & Gottschalg (2005) draw attention to, the existence of financial
distress costs makes things more complex. High leverage can both cause managers to
drop projects with positive NPV because of risk aversion and caused companies to
overlook good investment opportunities because of stretched budget (Berg &
Gottschalg, 2005).
Incentive alignment and mentoring
The alignment between the management and the shareholders (owners) plays a crucial
role in successful buyouts. Jensen (1989) indicates that PE firms are efficient in
linking management bonuses to cash flow and debt retirement. In many buyouts, the
management team is encouraged to take on equity stake in the company in order to
align their interest with the owners. The argument for this method of reducing the
agency cost is to set the management focus on future strategic performance.
Management tolerance for inefficiency within the firm will also be on the bottom of
the scale and they feel that they are fighting for their own benefits (Muscarella &
30
Vetsuypens, 1990). This is in line with Smith (1990) who conducted a study on 58
Management Buyouts (MBOs) of public companies during the period of 1977 to 1986.
His findings revealed that there exists a positive relationship between management
ownership and the performance of the firm.
Berg & Gottschalg (2005) on the other hand pointed out the contrary, that financial
performance could decline when management ownership soars. This is due to the fact
that increased equity stakes might be of that size that it affected the management’s
personal budget dramatically, which could make them more risk-averse.
One of the characteristics of PE firms is that highly skilled and experienced
professionals with deep knowledge of the financial markets often manage them. How
the PE firm manages to be a mentor for their portfolio companies plays an important
role in whether the buyout will be successful or not. Among the advantages that the
PE firms have are:
• Huge network of financial within the industry and financial institutions that
can be used to get more favorable borrowing terms and also to appoint
experienced board members,
• Experience in running businesses with stretched budget and the awareness of
the importance of selecting top management team to improve the portfolio
companies’ efficiency ((Berg & Gottschalg, 2005) (Jensen, Eclipse of the
Public Corporation, 1989)).
Sub-conclusion
This section has discussed the various factors PE firms can use in order to create
value within the portfolio companies. The debate on private equity has often solely
been about the capital structure changes that are adherent to LBOs. But as has been
reviewed there are other things such as reduction of the agency cost by implementing
incentive systems and strategic changes that have become more and more important
for the value generating process.
31
4. Case comparison
In order to put the theories and discussions revealed in this thesis into perspective it is
interesting to make a connection to the real world. This section will therefore attempt
to do so by exploring two recent PE investment cases, the EQT Partners and Goldman
Sachs Capital Partners takeover of ISS and Nordic Telephone Company ApS (NTC)
takeover of TDC. The intention is to compare changes in the companies´ capital
structure and operational performance with their peer group.
The construction of this section will follow Koller et al. (2010), Penman (2010) and
Vinten (2007) thoughts on multiple analyses. There are a few things that have to be
kept in mind when a multiple comparison analysis is made. First it is important to
build a peer group of comparable firms that have operations similar to the target firm,
secondly, relevant measures within the companies have to be identified to calculate
the multiples and at last it is recommended, to use an average of the multiples used for
the comparison (Penman, 2010). The focus in this part will be on developments of
different ratios of growth, operational performance and capital structure. The peer
group used to compare with ISS was quite difficult to identify since none of their
competitors operate in more than one of ISS´s business areas. I decided to follow
credit analysis from Standard & Poor’s (2006) that defined Compass Group6 ,
Sodexo7, and Rentokil Initial8, as ISS´s core competitors although they differ in size,
revenue and product offering. It was easier to identify a peer group for TDC A/S as it
was possible to get a list of peers from the Orbus database. I decided to focus on well-
known Nordic/European competitors, Deutsche Telecom, France Telecom, Telecom
Italia, Telenor, Teliasonera, Swisscom and Belgacom.
6 Compass Group is a British catering and support services company with more than 380.000 employees and market share in 50 countries. http://www.compass-group.com/ 7 Sodexo is a French catering, health care and sports & leisure company with 380.000 employees and market share in 80 countries. http://www.sodexo.com/group_en/default2.asp 8 Rentokil Initial is a British service company with over 78.000 employees and market share in 50 countries. http://www.rentokil-initial.com/
32
Operational performance
The following ratios will be used to observe the changes in operational performance
of the companies:
!"#$%& !" !""#$" !"# = !"# !"#$%&!"#$% !""#$" Equation 1
Return on assets is a profitability ratio that measures the net income generated per
dollar of the company´s assets. The ratio is useful in comparing companies within the
same industry and can give indication of how effectively companies are using their
assets. There are especially two factors that affect ROA, the profit margin (PM) and
asset turnover (ATO) (Penman, 2010).
!"#$%& !"#$%& (!") = !"# !"#$%&!"#"$%" Equation 2
!""#$ !"#$%&'# (!"#) =
!"# !"#$! !"#$% !""#$"
Equation 3
Profit margin (PM) illustrates how much of the income from sales is kept as income
after subtraction of costs and asset turnover (ATO) measures the ability of assets to
generate sales (Penman, 2010). The limitations of these measures are that they do not
separate the effects of operating and investing decisions from the effects of financing
decisions.
The last profitability measure that will be reviewed is the EBITDA margin. Since
EBITDA excludes non-cash flow items such as depreciation, it removes the effect of
financial structuring and can therefore be defined as a pure cash flow measure. It is
stated that the buyout industry invented this measure in the late 1980s as they were
looking for a measure that could specifically indicate the ability of a company to
service certain level of debt (Fraser-Sampson, 2007).
!"#$%& !"#$%& =
!"#$%&!"#$% !"#"$%"
Equation 4
33
Growth ratios
Company´s ability to deliver growth is critical in relation to value creation. But
growth can only create value when a company´s new projects or acquisitions generate
returns that are above the cost of capital. The main components of growth can be split
into overall market expansion in the market segments, market share performance9 and
mergers & acquisitions10 (Koller, Goedhart, & Wessels, 2010). The following ratios
will be observed to understand development in the companies’ growth.
!"#$% !"#$%ℎ = !ℎ!"#$ !" !"#$!
!"#$" !"#$%&´! !"#$! Equation 5
!""#$" !"#$%ℎ =
!ℎ!"#$ !" !""#$"!"#$" !"#$%&´! !""#$"
Equation 6
Capital structure
The analysis of a company´s capital structure is different from both the profitability
and growth analysis in a way that the focus is now on ratios that indicate the
likelihood of default. As has been discussed, the main characteristic of LBOs is the
extensive use of debt. It is therefore informative to look at different ratios that can
give an insight into the companies´ situation.
!"#$ !" !"#$%& !"#$% = !"#$% !"#$
!"#$ + !"#$%& Equation 7
Debt to equity ratio (D/E) gives an indication of company´s financial leverage and it
shows how the company has financed its assets in the past (Penman, 2010).
!"# !"#$ !" !"#$%& = !"#$% !"#$!"#$%& Equation 8
As stated by Axelson et al. (2007) practitioners like to focus on multiples that indicate
debt relative to cash flow. The net debt to EBITDA ratio shows approximately how
long a time it would take to pay down all debt overlooking interest payments, taxes,
depreciation and amortization.
9 Refers to changes in company´s market share 10 Refers to revenue growth that has been bought externally
34
!"#$%$&# !"#$%&'$ !"#$% = !"#$!"
!"#$%$&# !"#!$%! Equation 9
In order to understand the company´s ability to meet interest payments the interest
coverage (solvency) ratio is calculated. It measures the number of times operating
earnings cover the interest requirements (Koller, Goedhart, & Wessels, 2010).
Company´s value
!" !" !"#$ ! ! = !"#$%&%'($ !"#$%
!"#$ ! ! Equation 10
Enterprise value to EBIT(D)A is a good ratio measure of a company´s value. Koller et
al. (2010) argue that the enterprise value should be divided by EBITA instead of
EBITDA. From their point of view most companies cannot compete effectively unless
they set aside capital to replace worn assets (depreciation). Despite that, EV/EBITDA
is commonly used among practitioners so both multiples are calculated for the
comparison.
4.1 EQT Partners & Goldman Sachs Capital Partners takeover of ISS
In 2005 PurusCo, a holding company controlled by EQT Partners (EQT) and
Goldman Sachs Capital Partners (GS Capital Partners), acquired ISS A/S. EQT and
GS Capital Partners are the principal shareholders and hold 54% and 44% of ISS A/S
share capital respectively. The remaining approximately 2% of the share capital is
held by certain members of the Board of Directors, the Executive Group Management
and a number of senior officers of the Group through director and management
investment programs (ISS A/S, 2010).
EQT is a leading private equity group in Northern Europe and together with a network
of industrial advisers EQT implements its business concept by acquiring or financing
good medium-sized to large companies in Northern and Eastern Europe, Asia and the
United States. EQT´s strategy is to develop their portfolio companies by applying an
industrial strategy with focus on growth. EQT has invested in more than 85
35
companies and exited around 40. The Goldman, Sachs Group, leading global
investment banking, securities and investment management firm manages GS Capital
Partners (ISS A/S, 2010).
ISS is one of the largest Facility Service Providers in the world and employs more
than 520.000 people in over 50 countries across the world. The company´s strategy is
to offer facility services on an international scale to meet customers’ needs. Their core
business is cleaning services, security services and facility management services.
PurusCo offered the shareholders of ISS A/S a price of 465 DKK11 for each share that
was at that time 31% premium over the share price at the announcement date. The
deal was finished on the 26th of July and the shares were then delisted from the
Copenhagen Stock Exchange. In the legal papers that were issued along with the offer,
the consortium claimed that their objective was to make ISS the world leading
provider of services, cleaning, catering, office support and property services, through
both organic growth and acquisitions. Further they insisted that they believed that ISS
was best positioned as an unlisted private company to achieve this goal (PurusCo A/S,
2005). Ole Andersen, who was the director of EQT Copenhagen office, said that they
were interested in ISS A/S because they believed in the strategy that had been
initiated by the company and they also thought that they would be able to increase
their organic growth (Spliid, 2007).
The bond market reaction to the takeover announcement was not surprising. It was
expected that the company’s debt would soar and the outstanding bonds were
punished with a steep decline in ISS bonds value. ISS Global, the parent company of
ISS A/S that issued the bonds, had 7,1b DKK in equity and 1,8b DKK in cash flow at
the time of the takeover. In the transactions associated with the buyout, the
consortium set up a holding company (PurusCo), which acted as the bidder in the deal
and all financing flew through it in the beginning. The capital structure of PurusCo
was 7,7b DKK paid in equity from the consortium and 15,3b DKK in new loans.
Further, PurusCo received 7b DKK from ISS Global A/S in the form of dividend
payment, at the same time the name of the holding company was changed to ISS
11 The original offer was 470DKK but with a notice that if dividends would be paid the tender offer would be lowered. In the meantime, the board of ISS A/S decided to pay divdend of 5DKK which resulted in final offer of 465DKK (PurusCo A/S, 2005).
36
Funding A/S and it also took over the ISS Global A/S obligations, consequently the
outstanding bonds. So all of the sudden the company that guaranteed the bond issue in
the beginning became heavily indebted. The results of these practices were that
Standard & Poor’s (S&P) downgraded the bonds to junk due to the increased risk of
the borrowings, leading to even more reduction in value for the bondholders. As can
be understood, the bondholders were furious. In 2004 when the bonds were issued,
ISS stated that it was their intention to keep the company´s investment grade from
S&P and the bondholders argued that this behavior of the new owners in the process
was nothing but a fraud. The former CEO of ISS later said that when new owners take
over the company their rules apply and there is nothing that the CEO can do about it.
What the bondholders could have done in order to protect themselves is actually just a
matter of a more detailed reading over the covenants of the bond issue. At this time in
Europe, corporate bonds contracts nearly never contained a so-called “Change-of-
Control (CoC)” clause. It was though a rather well known clause in the US. If the ISS
bond issue had had this kind of clause, the bondholders would have been able to react
to the actions of the new owners by insisting repayment of the bonds on the grounds
of changes in the ownership of the company. The bondholders had to pay greatly for
this experience but this event also changed the scope of the corporate bond issues in
Europe. The use of this CoC clause increased from being used in 7% of the issues in
Europe at the time of the ISS takeover, to 32% within next 14 months (Spliid, 2007).
If we look further at the changes that have happened in the management of ISS since
the buyout and start by exploring changes in the capital structure, then we can see
from figure 12 that the debt played critical role in the deal and has done since in the
company´s financing.
37
Figure 12: Debt to equity ratio of ISS and its peers
At the time of the takeover, subordinated bonds were issued, a senior loan of 6.3b
DKK and another high yield loan of 3.4b DKK, both with maturity in 2016. These
loans were taken in addition to the outstanding bond and amounted to a total of 10b
DKK with maturity in 2010 and 2014 (Spliid, 2007). As can be seen from figure 12
ISS debt to equity was similar to the peer group until 2005 when it soars dramatically,
and it has been on this level ever since. Due to Rentokil´s negative equity for the last
few years they were cut out in the comparison here. When companies are so heavily
financed with debt as ISS, it is appropriate to look at other ratios such as the solvency
ratio, or the interest coverage ratio.
Figure 13: ISS and peers interest coverage ratio
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38
It can be seen in figure 13 that the increase in debt has not been followed by the same
growth in operating income. In the year before the takeover the EBITDA covered the
interest payments nearly 6 times, which was at that time better solvency ratio than the
peer group had. But after the ownership changes, the ratio have declined and the
interest coverage is now just below 2 times the EBITDA. This means that ISS have to
rely a lot on robust cash flow in order to avoid financial distress, a solvency ratio
below 1 means that the company is not capable of serving the interest payments from
its cash flow.
The last capital structure multiple that will be reviewed in relation to the buyout of
ISS is net debt to EBITDA. It measures how long a time (in years) it will take to pay
down all debt and is an indication of the company´s ability to serve its debt with its
cash flow.
Figure 14: Net debt to EBITDA ISS v/s Peers
As can be seen in figure 14, while its peers have had quite stable debt to EBITDA
ratio, then ISS went from being able to pay down all debt in less than 3 years to
needing nearly one decade to pay down all debt. That is without putting aside
amounts for depreciation, interest payments etc. But it is also important so look at the
development in EBITDA after the takeover. We can see that they have managed to
moderately increase the cash flow so this ratio has improved for the last years.
The year of 2009 proved to be a huge test for ISS capital strength, as they needed to
secure refinancing of the 2010 debt issue that they took over at the time of the LBO.
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39
In a normal situation this would probably not have been of any concern at all, but due
to the effects of the financial crisis that started in the autumn of 2007 it was clear that
a hard work was needed to convince investors that ISS was in good shape. It was
decided by the board of ISS to issue new senior debt that amounted 525m EUR in
order to settle the outstanding debt issue with maturity in September 2010. But that
was not enough since the outstanding amount was 850m EUR. To fill the gap it was
decided to use a so-called off-balance sheet financing by carrying out an asset
securitization of its receivables (ISS A/S, 2009, p.9). The purpose was to “pack” ISS
receivables in different countries and sell them to investors. Koller et al. (2010)
discuss that this method is primarily used by companies to get better loan terms than
otherwise be able to get via the traditional methods such as bank loans and more debt
issue. In the mid year of 2009, ISS announced that they had successfully issued the
new senior debt with maturity in 2014 and that the first part of the receivables-backed
program had immediately been sold, that amounted to 150m out of the 350m EUR
needed to fill the gap. (ISS A/S, 2009, p.14).
Development in ISS operational performance
As has been discussed earlier in this thesis, a couple of studies have argued that the
financial performance of the portfolio firms improves considerably after the LBO.
Bull (1989) for example compared different accounting variables of portfolio
companies and found positive effects after the LBO.
This part will observe some multiples that can give more insight into the development
of ISS operational performance pre and post the LBO. Figure 15 presents the progress
in ISS return on assets (ROA) compared with its peers. ROA is a measurement of how
efficiently company´s assets are used.
40
Figure 15: Return on assets
We can see that following the takeover ISS had problems in keeping the same growth
in profit as in assets. Appendix 1 illustrates that the ISS asset base has been growing
steadily since 2003 and if we look at the development in asset turnover ratio (ATO)
and the profit margin in figure 16 it can be seen that it is not likely that slowdown in
sales is an influential factor. It is more likely that the decrease in the company´s profit
is the reason behind the poor ROA.
Figure 16: Asset turnover (ATO) and Profit margin (PM)
It is therefore interesting to look at the operating margin and the profit margin to
understand this development of ISS operational ratios. Figure 17 is a good example of
how extensive use of debt can harm the company´s bottom line results. It is quite
obvious that the heavy financial expenses have made it difficult for ISS management
to generate satisfactory returns. Earnings before interest and taxes (EBIT) have been
solid and in line with the increase in revenue, while the bottom line (profit) has had
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41
tougher times, with an average decline in profit of nearly 9% since the LBO compared
with a average increase of more than 10% in revenue12.
Figure 17: ISS operating margin v/s profit margin
In ISS´s 2007 annual report it is stated that the plan is to reduce the company´s
financial leverage on a multiple basis through growth in the operating profit and
improvements in cash flow, operating margin, organic growth and acquisitions (ISS
A/S, 2007, p.16). The financial crisis that began in 2007 has probably played a role in
the owners’ plans for the operational performance of ISS as was expected that they
would exit at least part of the investment by listing it on the Danish stock exchange in
2007. Nevertheless, the IPO was at that time postponed, probably due to the
turbulence in the financial markets (Ibison, 2007). But earlier this year the CEO of
ISS, Jeff Gravenhorst announced that the board was considering an IPO13 in order to
reduce the company´s financial leverage. It is expected that they will be able to get
close to 13.3b DKK from the IPO, which would be used to reduce the company´s
30.6b net debt (Wienberg, 2011). Given the current conditions this would mean that
net debt to EBITDA would become close to its rival or 3.5 approximately14 as was
visualized in figure 14 above.
After reviewing these multiples it is interesting to see that the new owners managed to
increase the company´s cash flow robustly since the LBO despite quite hostile
12 See appendix 3 for more details 13 On the 17th of march 2011 they announched further delay on their IPO plans due to market conditions. (Nordea , 2011) 14 See calculations and figure in appendix 4
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42
financial environment during the credit crisis. But more notably to see the effects of
the high leverage ratio on the company´s bottom line. Due to the industry´s fairly low
EBITDA margins15, slowdown in sales growth quickly distorts the bottom line
results.16
4.2 Nordic Telephone Company ApS (NTC) takeover of TDC
TDC is a Danish provider of communication and entertainment solutions such as
fixed telecommunication, mobiles, Internet, mobile data and digital-TV. The company
operates in all of the Nordic countries (except from Iceland) with over 10.000
employees. When it comes to the history of TDC and its formers it can be concluded
that they are keen on big activities. In 1994 a TDC former, state-owned Tele Danmark
went for the largest share issue ever to take place outside a home country. In 1997 the
company went into a strategic partnership with American company, Telco Ameritech,
simultaneously the company was fully privatized. Telco Ameritech later joined forces
with an even larger American Company, SBC. In 2000 the name was changed to TDC
and in 2004 SBC sold its shares that meant that the company no longer had one
controlling shareholder (TDC, 2011). In 2005 TDC went through the biggest
European LBO ever (Spliid, 2007).
After an informal hint from the board in 2005 that the company might be for sale,
numerous private equity funds immediately showed an interest in acquiring TDC. It
was clear that the race was going to be interesting. The market expected a rival
between the funds, which was reflected in the share price. In late November it was
announced that the board of TDC would recommend an offer from the Nordic
Telephone Company (NTC) of 382 DKK or enterprise value of 97b DKK. NTC is a
holding company controlled by a consortium of numerous private equity funds, Apax
Partners Worldwide LLP, Blackstone Group, Kohlberg Kravis Roberts & Co. (KKR)
L.P., Permira Advisers and Providence Equity Partners Limited. To be able to delist
the company from the stock exchange it was necessary for the consortium to get more
than 90% of the shareholders to agree on the offer. But due to the resistance of one
big shareholder ATP, (Danish pension fund) simply 88,2% of the shareholders agreed
15 See EBITDA margin calculations and figure in appendix 5 16 See appendix 6 for figure and calculations on profit margin v/s sales growth
43
to the offer, which led to the strange situation of an LBO company that still had to be
listed (Spliid, 2007).
In order for NTC to finish the takeover they needed to get financing of 95b DKK. As
was discussed in the case of ISS A/S, bondholders are quite vulnerable for leverage
buyouts unless they are protected via the CoC clause or other similar clauses. In light
of the heavy criticism that the takeover of ISS received because of the handling of the
bondholders, it was decided that NTC would secure that TDC bondholders would not
suffer any losses in the process. So out of the 95b DKK, 12,9b DKK were used to pay
down outstanding bonds that would have due date in 2006. The financing structure
can be seen in figure 18.
(Source: Figure 38 p. 336 in Spliid (2007)
Figure 18: Financing and use in TDC takeover
The structure of this takeover is similar to the case of ISS apart from the treatment of
the bondholders. A special dividend amounted 43.5b DKK is paid from TDC to the
shareholders. What is different in this case is that due to NTC failure to get total
control of the company the minority shareholders receive 5.1b DKK so NTC will end
up with 38.4b DKK in special dividend. So the holding company receives total 80.9b
DKK through an equity injection from the private equity funds and new loans (Spliid,
2007).
The capital structure will now be explored in order to understand the development in
several ratios. The main characteristic of LBOs is the massive increase in debt and by
looking at figure 19 it can be seen how the debt to equity ratio has evolved since the
takeover.
Financing B.DKK Use of financing B.DKKPaid-in Equity 16,4 Paid to shareholders 67,1Long-term financing 48,5 Refinancing of outstanding loans 18,3Mezzanine loan 15,2 Cost due to the takeover 3,9Execution of employee options 0,8 Dividend to minority shareholders 5,1Company´s own funds 14,1 Accrued interest 0,6Total 95 Total 95
44
Figure 19: TDC debt to equity ratio v/s peers
This figure shows how TDC debt ratio increased dramatically following the takeover.
As might have been expected these changes concerned the credit rating agencies that
reacted quite rapidly and the credit ratings of TDC fell below investment grade. The
external debt that was used in the takeover was more expensive than the TDC´s
current loans so its interest burden went from 5,7% to 6,6% (Spliid, 2007). Figure 20
shows how the company´s coverage ratio evolved after the buyout compared with its
peers.
Figure 20: TDC Interest coverage ratio v/s Peers
The figure shows both the original peer group but also the peer group average when
Belgacom has been excluded. Due to their remarkably different ratio for some of the
years it was decided to show also the peer group without their effect. In such a limited
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45
group as this is, with just 7 companies, the abnormal behavior of just one firm has so
much weight. It is clear that when the owners are making a plan for their LBO
investments they look deeply to the company´s cash flow ability to serve debt. In case
of the NTC takeover they were obviously right in the way that they have managed to
increase the cash flow that has then been used to pay down debt so they have been
able to keep the interest coverage ratio from the risky area. In light of this it is
interesting to look at figure 21 that shows net debt to EBITDA along with the
development of the company´s EBITDA margin.
Figure 21: TDC v/s peers net debt to EBITDA and TDC´s EBITDA margin
As can be seen, in 2006, the year following the takeover the net debt to EBITDA ratio
increased significantly. That is a pretty normal behavior in LBOs as has been
discussed before but what is more interesting to see here is the EBITDA margin. Ever
since NTC took over they have managed to improve the EBITDA margin. The factor
behind this improvement at TDC is their focus on reducing cost, for example by
reducing employee cost. Full time employees have been reduced from 15.422 in 2005
to 10.423 at the end of 2010 (TDC A/S, 2010, p.20). The management has also been
focused on lowering debt by selling units that do not fall under the criteria of being
core assets. Since 2003 the asset base of the peer group measured in the companies´
home currency has increased on average by 4,5% while TDC´s asset base has
decreased by 3,4%17. In 2010 net interest bearing debt were lowered by 1/3 or 10.9b
DKK that was paid out of the positive cash flow and proceeds from divestment of one
17 See appendix 7
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46
of their subsidiaries. The managements effort of reducing the company´s debt has
been well rewarded as the company received a credit rating upgrade from the rating
agencies and now again hold an investment grade rating (TDC A/S, 2010, p.5). It
looks like the pressure from the additional debt has encouraged the management team
to do better in terms of efficiency of the cash flow, which has made the fight with the
increased interest payments look quite easy.
In light of the discussion above about the TDC management team´s ability to improve
efficiency of the cash flow it is interesting to look further at numerous operational
measures. Figure 22 shows how TDC´s revenue has evolved over time along with its
revenue growth against its peers.
Figure 22: TDC revenue and revenue growth
Revenue growth was quite stable until NTC´s takeover, but the reason for the
reduction since is primarily related to the management strategy of sharpening the
company´s focus by selling assets that do not belong to their core operations (TDC
A/S, 2010). The next figure shows TDC´s return on assets (ROA) or the ratio of net
revenue generated with the company´s assets compared with its peers.
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47
Figure 23: Return on assets (ROA) – TDC v/s Peers
By looking at the development of the ROA it is noticeable that some of the underlying
factors tend to be quite volatile. It is therefore helpful to look at the asset turnover
ratio (ATO) and the profit margin (PM) below. While TDC´s ATO ratio is rather
stable over time, although slightly under the peer group average, its profit has
fluctuated a lot and is the main explanation for the volatility in ROA. In 2004, the
year before the takeover the company announced a decent drop in its operating
expenses that led to the jump in profit and in 2007 TDC sold one of its subsidiaries
(asset sale), so the jump in operating income that year is based on one off profit from
that sale.
Figure 24: TDC´s asset turnover and profit margin
But what is most interesting is to look at the development of TDC EBITDA margin
compared with revenue. As can be seen in figure 25 the management team in TDC
has done an excellent job in maintaining a robust growth in the EBITDA margin
despite the decrease in revenue. This is even more remarkable when the evolvement
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48
of the peer group margin is considered along with TDC. We can see that at the same
time as TDC is admirably increasing their margin from the takeover; the peer group´s
margins have decreased.
Figure 25: TDC revenue and EBITDA margin v/s peers
In the context of the stable improvements of the cash flow for the last few years it is
not so surprising that NTC announced in 2010 that they were going to undertake a
market sale of a part of their holdings in TDC. They managed to sell 210m shares for
the price of 10.7b. DKK, approximately 29% of their ownership and they now hold a
stake of 59.1%. This is an important milestone both for TDC and NTC as this at least
marks a beginning of a change in the company´s ownership and for the shareholders
of NTC, as they will now start to realize the profits of their investment. At this turning
point it is interesting to look at the historical valuation multiple of enterprise value to
EBITDA (EV/EBITDA) for TDC. The EV/EBITDA multiple takes into account the
total value of the firm, not just the equity value and is therefore irrelevant to the
capital structure of the companies and is useful in this context. Figure 26 shows how
TDC´s EV/EBITDA was relatively low compared to its peers in the year before the
buyout, which might explain the NTC´s interest in taking it over at that time.
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49
Figure 26: Enterprise value and EV/EBITDA for TDC and peers
Today is seems like TDC is slightly more expensive than its peers, which might
illuminate why NTC decided to start decreasing their holdings in the company. Given
the price of the shares they sold in 2010 it can be concluded that the investment has
been successful. The original equity contribution from NTC was 16.4b DKK, the
market cap of the sold shares in last December was 10.7b DKK and that was only
29.1% of their ownership in TDC. Given that they would get the same price for the
remainder of their shares, they then would have more than doubled their original
equity contribution in the beginning.
After reviewing these multiples it is obvious that the change in the capital structure of
TDC by taking on extensive debt in the buyout did encouraged the management team
to be more focused and efficient in running the company. As has been discussed the
company´s revenue has declined because of NTC´s strategy of selling assets that do
not fulfill the criteria of being part of core operation. The results of these strategic
changes have proved to be right when looking at the improvements in the company´s
cash flow margin, not least when looking at the development in the peer group
performance and that the world has been suffering from a financial crisis at the same
time.
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50
5. Exit strategies for PE investments
“To understand KKR, I always like to say, don't congratulate us when we
buy a company. Any fool can buy a company. Congratulate us when we
sell it and when we've done something with it and created real value.”
Henry Kravis, Co-Chairman and Co-CEO of KKR & Co
A harvest or exit is an event where the investors and management of a company sell at
least a portion of their shares to public or corporate buyers. This provides an
opportunity for PE funds to realize returns from their investments and is therefore an
important aspect of the private equity process. Figure 27 is based on a study by
Kaplan & Strömberg (2008) where they studied exit strategies of buyout companies,
their results shows that the most common way today is to exit via sale to a strategic
nonfinancial buyer, then sale to another private equity fund and third is initial public
offering (IPO) (Kaplan & Strömberg, Leverage buyouts and private equity, 2008).
Figure 27: Exit strategies of leveraged buyouts 2000-200518
Sales refer to exit activities that can further be divided into trade sales, secondary
sales and buybacks (Schmidt, Steffen, & Szabó, 2007). When the PE fund decides to
sell an asset to a strategic investor, it is called trade sale. The strategic buyer is often
interested in the synergies that can be realized in and after the takeover. These
18 The time period refers to the year of orginal LBO, i.e how LBO investments made in the years 2000-2005 have been exited.
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51
synergies can come from additional market share gains or market access that would
otherwise take many years to obtain (Pindur, 2007). Secondary sale is when a PE firm
decides to sell their portfolio company to another PE firm. This has become more and
more popular for the last two decades. Among the reasons for its increased popularity
can be difficulties in exiting through an IPO and the PE firm´s need to liquidate assets
because of its contractual life span (Renneboog, Wright, Simons, & Scholes, 2007). In
a recent survey among PE executives in UK, four out of five or 80% expected to sell
their portfolio companies via trade sale this year (Javed, 2011). The advantage of
sales against an IPO is that it offers fast exit opportunities and is usually made in
private so the firms are able to get rid of the external pressure that follows the stock
market flotation ((Pindur, 2007) (Schmidt, Steffen, & Szabó, 2007)).
But as was pointed out by Renneboog et.al (2006), the most popular way of selling
large portfolio companies is through an IPO. This is consistent with results from
Harford & Kolasinski (2010) that investigated a large sample of US private equity
exits from 1993-2001 and found that 90% of the portfolio companies were exited
through an IPO.
5.1 Initial public offering (IPO)
The decision to go for an IPO is seen by many private-firm managers and
entrepreneurs as a milestone for their company and for their career. There is a sense of
prestige and pride that comes from taking a company public, as it signifies that a firm
has achieved a high level of historical growth. First and foremost, the IPO process
gives companies way to raise large amount of capital rather quickly. On top of that,
by going public, the company will generally be able to obtain better terms in their
financing since rating agencies will normally accord higher ratings to firms with
publicly traded stock (Cendrowski, Martin, Petro, & Wadecki, 2008). But going
public is also a step towards the separation of ownership and control that might lead
to an agency problem as described by Jensen & Meckling (1976).
An IPO brings liquidity in for the PE funds as they can sell their shares to other
investors, though in some instances, the funds are required to hold at least some of
their position in so called “lock-up” period. This is done both to keep the knowledge
on board and also to maintain stability in the stock price. The IPO creates an
52
opportunity for the company to induce top talents to join their forces with employee
stock options or other incentive programs. The stock options can be used to align the
interest of executives with the company as they may benefit greatly from the
appreciation of an equity stake (Cendrowski, Martin, Petro, & Wadecki, 2008).
But the benefits of an IPO do not come without a cost. In today’s markets it is
expected that the monetary cost can be around 10% of the overall IPO offering
amount. The costs contain compensation fees to the underwriters and legal costs
regarding the paperwork. And another major change is that the company now has to
disclose its accounts and be prepared to answer demanded analysts about the
company´s performance (Cendrowski, Martin, Petro, & Wadecki, 2008).
In my conversation with Ballegaard (2011) he mentioned that from his point of view
the main benefits of exiting thru an IPO is that value immediately comes visible and
cashable, but the major drawbacks is the massive amount of time that the management
have to spend to live up to the stock market´s requirements. He also said that stock
market volatility could shift the management focus and caused frustration within the
company (Sørensen, 2011).
The role of the underwriter in the process aside from marketing the IPO is that they
are responsible for conducting due diligence on the private firm, assisting lawyers
with regulatory filings and determining the size of the IPO offering. In addition to this,
the underwriter generally attempts to ensure stock price stability in the days following
the offering, with special emphasis on protection against stock price deterioration.
In order to ensure stock price stability in the days following the IPO, underwriters
frequently use a strategy informally called the “Green shoe” option or the “over-
allotment” option as legally stated. It is a call option where the underwriter is allowed
to buy additional shares from the issuing company at the offering price. If there is a
strong demand for the shares at the time of the IPO, the underwriter can increase the
supply by selling up to 15% of the offering size in the IPO, thus creating a short
position. If prices in the after-market stay above the offering price then the
underwriter exercise the over-allotment option in order to avoid loss. The other way
of the option is to reduce downward pressure on prices in the aftermarket. If the stock
begins to trade below the offering price, the offering is said to have a “broke issue”,
then because of the short selling in the IPO, the underwriter can now step in and
53
support the stock by partially or fully covering the short position. Since the
underwriter only buys shares at or below the offering price, covering the short
position in this way can be profitable (Aggarwal, 2000, Cendrowski, Martin, Petro, &
Wadecki, 2008).
Draho (2004) splits the IPO mechanism into three categories; book-building, auctions
and fixed-price offerings. The book-building process main characteristic is that
discretion is given to the underwriter and the issuer to price and allocate the shares. In
order to get a feeling for investors’ interest in the IPO, the underwriter sets up a road
show were the issuing firm´s executives introduce the company and the underwriter
presents the details regarding the offers size and preliminary offer price range.
Afterwards, the underwriter starts to collect orders and “build the book”. The
company´s executives and the underwriter then set the final offer price and number of
shares to be sold, which is based on the results of the book building. Fixed price
mechanism differs from the book-building process in the way that the price is set
beforehand and the underwriter in this case is more of an advisory partner than
actually being the seller of the IPO. Auction is the form which the issuer and the
underwriter have the least knowledge on the results of the IPO. Investors make an
offer by stating how many shares they want to buy and a limit price. The offer price is
then decided by the intersection of the demand curve and the fixed supply, so all
investors that submit an offer above the offer price have their orders filled, and the
ones that were at the offer price will receive shares up to their limits (Draho, 2004).
Timing is an important element in an IPO, consequently on value realization of PE
investments. In a rather famous article, Myers & Majluf (1984) argued that
information asymmetry between firm insiders and investors affected timing of a
company´s share issue. They claimed that firm´s managers tended to know more
about the company´s value than the investors and the firm´s will to sell equity was
perceived by investors to be overvalued. At some point the managers might
experience situation where they had the opportunity to invest in projects with positive
NPV but which would be offset by the “old” shareholders loss. Then under certain
circumstances the managers would refuse to issue shares for the positive investment
opportunity, just to protect the “old” shareholder and simultaneously, reduce the
firm´s value (Myers & Majluf, 1984).
54
Companies that are going for an IPO also need to consider a numerous other things
such as market conditions. The IPO volume has fluctuated a lot over the last decades
with either a massive volume at one time versus times with minimum scale activity19.
Lowry & Schwert (2002) studied IPOs and found that similar types of firms are likely
to choose a similar time to go public and that previous successful IPOs are a
motivation for others to make a decision to go public, which might explain partly the
fluctuations in volume. Draho (2004) argues that this pattern can either be explained
with general macroeconomic trends or a company´s increased demand for capital.
Factors such as strong economic growth and rising stock markets indicate investors´
interest to provide capital to fund risky businesses, and firms should at these times
take the advantage to seek capital for coming investments. Renneboog & Simons
(2005) point to a research that showed PE funds disbeliefs in managing to exit their
investment through a sale or an IPO in times of turbulent markets.
With this in mind I will now shift to a discussion about a recent example of Pandora´s
A/S IPO that took place in the autumn of 2010. I will go through their process of
going public by exploring the Prospectus issued in relation to the IPO along with the
company´s annual reports. As previously discussed, Torben Ballegaard Sørensen20
former chairman and now deputy chairman of the board also inspired this discussion.
I attended a seminar where he went through the story of Pandora and afterwards he
cordially answered questions regarding Pandora´s IPO.
5.2 The case of Pandora
The beginning of Pandora can be tracked down to 1982 when its founders, Per and
Winnie Enevoldsen opened jewelry shop in Copenhagen. Only few years later they
employed their first designer and started to create their own products. In March 2008
the company had a breakthrough in its operations when they completed the
acquisition of Pilisar ApS and Populair ApS. After the completion of the merger, a
private equity fund, Prometheus, controlled by Axcel Management A/S, became the
biggest shareholder in the company. They took over control of close to 60% in the
fund while the Pandora´s founders and other old shareholder held the rest. Following
the merger, Axcel and the other shareholders made a new structural plan for the 19 See appendix 8 for an overview of the IPO volume between 2000 and 2010 20 See appendix 10 for transcript of Q&As
55
company, which included an ambitious growth strategy for the future. Since the new
plan was set they have managed to increase the production capacity, extend their
product offering and increase their market presence. At the same time they have
managed to strengthen their financial performance both in terms of revenue and
profitability, EBITDA increased by more than 50% between 2009 and 2010.
Appendix 9 illustrates further Pandora´s operational improvements since 2009,
although not fully comparable due to the structural changes that have taken place
within the company for the last years.
The offering
The IPO was the second biggest in Western Europe in 2010. During the year of 2010
close to 100 companies worldwide had postponed or withdrawn its scheduled IPOs
because of the market circumstances and the fear that the effects of the financial crisis
still would exist (Zijing & Gammeltoft, 2010). The growth in Pandora’s operations
was both noticed by the financial community and the media and in the beginning of
2010 it was a strong rumor that the company was considering going public. One of
Axcel´s managing partners commented on that rumor by saying that selling stake in
the company through an IPO might be a preferred exit for the private equity firm
(Bloomberg L.P., 2010). In my conversation with Mr. Ballegaard he pointed out that
the board of Pandora did consider alternative ways in seeking capital, such as selling a
stake to another industrial buyer but as he said: “we saw IPO as the most obvious and
best-valued route” (Sørensen, 2011).
The offering price was determined through book-building process. The underwriters
collected expressions of interest from institutional investors before deciding the price
range. After they had scrutinized the interest, the indicating offering price range was
set to be between 175 DKK to 225 DKK per share. Following the book-building
process, the offering attracted strong interest from investors and offer price was set to
be 210DKK (Pandora A/S, 2010). According to Ballegaard they decided to go for an
IPO at this time as they thought that the worst effects of the financial crises were over
and the sentiment was improving (Sørensen, 2011). That turned out to be a successful
decision as the shares soared by more than 25% on the first day of trading. Proceeds
from the offering can be seen in figure 28.
56
Figure 28: Proceeds from Pandora´s IPO
More than 5000 new shareholders joined the shareholder´s group at this time but
Prometheus, the selling shareholder still holds 57.4% of the company´s shares after
the IPO, so they are still hold a leading position within the company. Following the
IPO they agreed not to reduce their ownership for 360 days afterwards (lock-up
period). As is discussed in the Prospectus the company relies upon certain key
personnel and in order to encourage them to put all their effort and ability into
developing its operations, Pandora has implemented a long-term incentives program,
which is the reason for them buying back shares in the IPO.
The total cost of the offering process was thought to be around 500m DKK. The
company intends to use their proceeds, approx. 600m DKK to acquire its distribution
subsidiaries in Australia and Germany. The Australian investment was expected to
amount to around 210m DKK and to acquire the majority of the German distribution
channel they expected to spend over 300m DKK. In addition to this they have an
option to acquire the remaining shares in the operation in 2015. The company entered
into a PUT option contract with the owner of the remaining shares that is categorized
as financial liability with carrying amount of 435m DKK today, calculated as the
present value of the estimated cash flow if the option will be exercised. The total
investment in this operation is therefore expected to end up being close to 900m DKK.
The calculation of the net equity value of the remainder of the shares in this German
operation is based on method described in the company´s Prospectus p.143 and is
following:
Adjusted EBITDA (x 3)
- Interest bearing debt at 31.december 2014
= Net equity value
(Pandora A/S, 2010, p.143)
Shares sold ( exl. overallotment option) 47.409.927 9.956.084.670 DKKCompany 2.857.142 599.999.820
Selling shareholder (Prometheus) 44.552.785 9.356.084.850 Over-allotment Option granted 6.682.917 1.403.412.570 DKKTotal shares offered with overallotment option exercicsed 54.092.844 11.359.497.240 DKK
Proceeds from the IPO
*In addition Pandora bought shares for their long-term incentive program
190.476 39.999.960 DKK
57
Torben Ballegaard Sørensen (2011) used similar method when he illustrated with a
simple example how private equity funds calculate value of their investments. By
using a mix of imagination and facts we can try to calculate the net equity value
increase in the Pandora investment from 2008 when Axcel joined as a shareholder
until before the IPO.
Figure 29: Artificial net equity value changes in Pandora
Based on this method mentioned in the company´s prospectus for the IPO and Mr.
Ballegaards´ explication it can be seen how dramatically the net equity value could
have increased during this short period of time because of the increased EBITDA.
This is obviously heavily based on the multiple choices, but seven times EBITDA is
thought to be a fair estimation.21
Sub conclusion
This chapter has focused on the exit routes that PE firms tend to use when harvesting
from their investments. Sale to another PE firm or to an industrial buyer is the most
common way but an IPO is the most popular for big exits. The IPO of Pandora is a
clear example of this. The purpose of the equity sale was in this instance not to pay
down debt as so often in PE investments, but to seek capital for expansion and to
acquire important units that were not under control of the parent company. In the
conversation with Ballegaard, it was clear that it was their opinion that they would get
the best price by going for an IPO. It turned out to be a successful floatation for the
company and the PE fund, Axcel.
21 Mr.Ballegaard mention this was a fair multiple in his speech at IFMA meeting with him on 17.may 2011. ABG Sundall estimate this multiple at 8.7 times EBITDA in their valuation (ABG Sundall Collier, 2011)
Year 2008 2010 GrowthRevenue 1.904 5.162 271%EBITDA 778 2.040 262%
Multiple 7 7
Enterprise value 5.446 14.280 262%Net interest bearing debt 2.688 2.413 -10%Net equity value 2.758 11.867 430%
58
6. Conclusion
As discussed in the introduction the aim of this study was to explore how private
equity works, how PE firms manage to create value within their portfolio companies
and to investigate if there is a connection between the theories and reality. The
discussion regarding Private equity is most often surrounded and limited to the
importance of debt in the process. But this asset class has more aspects than just debt.
I have tried in this thesis to throw light upon the actions of the PE firms and how they
use existing theories in corporate finance to exploit the value creating opportunities
lying in their investments.
Modigliani and Miller (MM) capital structure irrelevance theory was an important
contribution to the field of corporate finance, although some of their conditions are
quite unrealistic in today´s environment. Before they came up with their theory it was
widespread understanding that debt above certain limits would reduce the firms value,
but as MM exposed, that is not the case. In my opinion it can be concluded that this
contribution to the corporate finance literature has been one of the most influential
theories of the ideology behind private equity.
The purpose of the extensive use of debt in PE investments has been widely discussed
among academics and different views have been brought up. MM for example, later
suggested that in a world with corporate taxes, companies could be able to increase
their value by utilizing fully the tax deduction of the interest paid. In today’s´
informative and competitive environment it is my belief that this is not a key subject
for the value creation within firms. It is at least not isolated to PE firms and their
portfolio companies but rather what every firm must strive for to be able to compete.
However as Renneboog & Simons (2005) pointed out, value can be created for the
stockholders by transferring wealth from the bondholders, for example by increasing
risk in investments, by increasing the dividend payments and by issuing debt with
higher or equal seniority of the outstanding ones. This is exactly what happened in the
ISS takeover when the additional debt used in the process was combined with the one
that had been issued, which led to a downgrade from the rating agencies and caused
the bondholders a great damage.
59
By exploring the development and key ratios in ISS and TDC capital structure, it is
obvious that the strategy behind the investments and implemented by the PE funds,
differed a lot. The emphasis in the ISS operations has been on growth in revenue,
assets and employees while on the other hand the new owners of TDC decided to
narrow the company´s focus to the Nordic region as their core operational area. They
have regularly sold assets that do not belong to their core operations and used the
proceeds from the asset sale to pay down debt, which has led to reduced revenue and
asset base. ISS debt to equity ratio is still at the same high level as after the takeover
but TDC´s has managed to decrease its ratio significantly and is now on similar level
as before the takeover, which has resulted in a credit rating upgrade from the rating
agencies. The consequences of these differences will most likely result in different
access to new capital for the companies´. TDC is more likely under these
circumstances to get better terms and probably easier access to capital than ISS due to
its distinctions in leverage ratios.
Another theory that was discussed in this thesis and has made a substantial
contribution to the evolution of private equity investments is Jensen & Mackling´s
(1976) theory of the problem of separating ownership and control. The theory states
that the success of a company is based on its ability to align the management and
owners interest. Many have mentioned this theory as the core reason for LBOs. In
relation to this, Jensen (1986) put forward an assumption, which I agree with, that
debt is used as a governance tool in order to reduce a company´s agency costs and
creates more efficiency. By studying the cases of ISS and TDC it can be seen that in
both instances the EBITDA cash flow has been increased after the LBO, although the
improvement in ISS´s cash flow is more likely due to its acquisition driven growth. It
is especially interesting to see the development in TDC´s EBITDA margin that has
been constantly improving since 2005 while its peer group´s margins have been
declining. From my point of view this shows that additional debt along with a clear
and focused strategy can help management to be concentrated, which leads to more
efficient operations in the company.
After working on this subject for last few months it is my conclusion that private
equity as a phenomenon has been important to the evolution of corporate finance. The
structure and ideology behind the investments made by the PE firms are often quite
radical and some might even say that the firms live on the edge when looking at the
60
extensive use of debt in their investments. But due to the PE funds limited life span
they are required to be focused and deliver outstanding operating results relatively
quickly. In order to encourage the management team to follow the same path, the
funds implement incentive systems where the employees are rewarded for improved
operational performance. So debt is used as a governance tool to prevent waste of the
company´s cash flow. This is in line with my conversation with Ballegaard (2011)
about PE firms main competences in generating value, he said: “… they make a clear
strategic due diligence and potential analysis, they zoom on the critical value
drivers…, they put (in) the best people in board and management, and drive
EXECUTION rigorously - the owner, board and management is fully aligned to
realize the strategic plan
When it comes to the exit of their investment it is important to choose the right time.
The case of Pandora showed how successful an IPO could be, and on the other hand it
was interesting to see how quickly things can change. Just a few months later the
board of ISS A/S were forced to withdraw its IPO plan due to changed market
conditions. This can have vital effects on the private equity funds performance.
That said it is my conclusion that the private equity firms are today able to create
value within their portfolio companies by using their expertise in applying debt as a
governance tool and implement clear and focused strategy. And with hands-on
management style, they are able to decrease the agency cost and parallel increase the
unity between owners and employees that results in improved efficiency.
I think it is appropriate to end this thesis of private equity with a quotation from
Johannes Huts, head of European operations at KKR (Kohlberg Kravis Roberts), one
of the world largest PE firms.
“In 1980s private equity firms generated value simply by being able to buy companies relatively cheaply and later selling them at a better price. In the 1990s a lot of value was generated through what you could broadly call financial engineering. Today the markets are fairly efficiently priced, and financial engineering is no longer a differentiating factor. Everyone can do it and everyone has the same tools. So the way the private equity creates value today is by fundamentally changing businesses and driving growth.”
(McKinsey & Company, 2006, p.2)
61
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