Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Private Equity: Leveraged Buyouts – Part 2

When people use the term “private equity,” they are most likely referring to buyoutsA buyout is the process by which an investor or group of investors purchases the equity of a company in order to gain control of that company.  Buyouts tend to come from one of three groups; current management (of the company in question), another company, or a private equity firm.  From the perspective of an investor, private equity firms are the most relevant source of buyouts, and are the focus of this Investment Product Review.

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As discussed in the previous post1 in this series, private equity firms gather investors and organize capital in the form of a partnership, with the private equity firm serving as general partner (GP) and the investors acting as limited partners (LPs) of this fund.  The buyout fund then purchases the equity of a target company.  Generally the purchasing fund provides a portion of the purchase price of the company in the form of cash, and covers the rest of the cost of purchase by issuing debt backed by the target company’s assets.2  This use of debt is the reason these buyouts are referred to as leveraged, and allows potential buyers to target companies with prices well above their level of investible funds, with anywhere from 40-60% of a typical buyout being financed by debt.

Unlike most investments in publicly traded equity, groups that initiate buyouts do so to gain control of a company.  The usual rationale behind a buyout is that the purchasers have identified ways they can increase the value of the target firm, either by reducing inefficiencies or by providing the company with something that will help it grow (e.g., special entrepreneurial skills, an increased network, or additional assets).  For example, it is not uncommon for the private equity firm to replace part or all of a company’s existing management team following a buyout, bringing in professional managers who they believe will add value.  Another popular strategy is for the acquired company to use assets provided by the buyer to expand their business, or to prevent bankruptcy in the case of a company with a fundamentally sound business model, but that had fallen on hard times.

While there are advantages for the target firm, buyouts can also create a new set of problems.  As mentioned above, many of these buyouts are funded by issuing large amounts of debt under the name of the acquired company.  This debt can be a large burden for the firm to bear, even if the change in ownership does improve other aspects of the business.  Another issue can be the conflicts of interest of outside ownership.  Many private equity firms view acquisitions as a short-term project, and are more concerned with making a quick profit than creating a successful and sustainable company for the long term.  A common strategy of buyout firms, particularly in the wave of buyouts and mergers in the late 1980s, was for the purchasing firm to load the target company up with debt, sell various components of the company (i.e., selling off divisions of the business or hard assets), using the proceeds to pay off some of the debt, and then issuing new debt to pay a dividend to the shareholders.  This approach allowed the buyers to recover their investment and make a profit, but it was not generally a good strategy for the long-term success of the acquired company.

Once the private equity firm has acquired a target and implemented changes, the endgame is determining an exit strategy.  The two most common methods are strategic sales and initial public offerings (IPOs).  In a strategic sale, the private equity firm sells the acquired company to a firm that wants to expand into the industry, or a firm that is a competitor of the target firm.  For example, if the target company were a small specialized car company, large car manufacturers such as Ford or GM might be interested buyers.  Occasionally, another private equity firm might be interested in purchasing the acquired company, perhaps believing that there exists additional room for improvement before a final sale.  The other potential buyer may be the investing public, through an IPO.  IPOs can be an effective route, particularly if the company has sufficient name recognition (e.g., a well-known firm that had recently been taken private, such as Chrysler or Heinz).

Despite ongoing debate3 in academic circles as to whether leveraged buyouts add value to the target company, private buyouts have remained popular over the past several decades.  Over long periods of time, private equity returns have been strong relative to publicly traded equities.  As of September 30, 2013, the 25 year net returns of private equity funds was 13.39%4 per year, as compared to 10.04% on the Russell 3000,5 a broad measure of US stocks.  The measured volatility has been favorable as well, but these numbers can be deceptive as private equity returns are generally measured on a quarterly basis, while public equity volatility tends to be measured on a monthly basis, if not more frequently.  The low frequency of measurement can often lead to an underestimation of actual volatility, making private equity returns seem more stable than they actually are.  Also, as explained in the first post of this series, private equity partnerships are notoriously illiquid, which is hard to quantify but can be extremely detrimental to returns if positions need to be sold in a hurry.  Investing in buyouts can be profitable, but investors must have both the ability to tolerate high levels of risk and the ability to commit significant amounts of capital to an investment for long periods of time.  The high risk/high return profile of buyout equity is seen at a more extreme level in venture capital, which will be the next topic in this series on private equity.

References
2. The mechanics behind this are somewhat complicated, but essentially investment banks financing the deal offer the private equity fund loans contingent on the buyout deal going through.
3. See, for example, Guo, Shourun, Hotchkiss, Edith S. and Song, Weihong, “Do Buyouts (Still) Create Value”, Journal of Finance (April 2011).
4. Source: Cambridge Associates LLC US Private Equity Index
5. Source: Dimensional Fund Advisors

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

Trackbacks/Pingbacks

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    […] process of gathering money for venture capital (VC) funds is essentially identical1 to that of buyout funds, but the operations of the fund are quite different.  Venture capital […]

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