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Financial sponsors tend to create value in LBO transactions in three different ways: operational improvements, debt expansion and multiple expansion.
The first two forms concern improvements of the target’s financial and operational performance. The last value creation option, on the other hand, focuses on the features of the sponsor rather than on those of the target. Indeed, it does not modify the financial and operational performance of the target, and it comes from the sponsors’ broader knowledge and expertise.
The literature tends to focus on the first two ways since exit multiples are too uncertain to rely on due to the external factors affecting them. Indeed, even sponsors’ financial models tend to concentrate on value enhancement coming from developments in the target operations and a better capital structure.
The divestment price widely relies on the EBITDA at the exit. Sponsors make massive efforts to boost revenues and cut costs to sell a more profitable company with a larger equity value. An EBITDA increase can be obtained by increasing the overall sales and margins of the target.
On the revenues side, the target may offer new products or enter new markets. Furthermore, a faster way to boost sales is to make new acquisitions. At the same time, higher margins provide higher EBITDA, all else being equal. More and more private equity funds try to lower target costs by working on the headcount and managerial inefficiencies. In the end, the operational improvements label includes the following measures:
- Costs cutting and margins improvement;
- Reducing capital requirements;
- Removing managerial inefficiencies;
- Corporate refocusing;
- Bolt-on acquisitions;
- Improving incentive alignments and
- Improving monitoring and controlling.
Costs Cutting And Margins Improvement
As soon as the deal is concluded, sponsors start tightening the control on corporate spending. The main impact refers to R&D expenses and headcount. Surely, PE funds tend to make the target less bureaucratic and more efficient by reducing different expenses, such as corporate centres and employees.
Reducing Capital Requirements
Cash flows are the key element of an LBO transaction. As stated, lower NWC implies higher cash available to pay down debt. Thus, sponsors do not just try to eliminate the unnecessary costs but also try to reduce the capital needed for the day to day operations and increase the overall capital productivity.
Indeed, a better inventory and accounts receivables management leads to lower NWC and higher cash flows. Private equity-backed companies are known to have a significantly smaller amount of net working capital than their competitors.
The same applies to CapEx. Sponsors attempt to minimise the maintenance CapEx by divesting the underutilised and unnecessary assets. However, significant changes can harm the ability of the target to compete in the marketplace, and they may, therefore, produce only short-term advantages. Thus, all the measures described have to be deeply considered by the management team to avoid value destruction.
Removing Managerial Inefficiencies
Moreover, companies’ poor performance may occur from management incapabilities. More and more buyouts are driven by the opportunity to replace the existing management and improve the candidate’s efficiency. Raised operational efficiency positively impacts both target cash flows and margins leading to a higher value at sale.
Buyouts create value also by increasing strategic distinctiveness through the standard approach of refocusing on the target’s core activities.
Sponsors tend to reduce the complexity of their portfolio companies by reducing the number of activities and inefficient subsidiaries. Usually, the so-called peripherical activities are sold to third parties.
The most common way to immediately increase EBITDA is to buy new companies. Bolt-on acquisitions refer to the target acquiring new businesses to get benefits from a better market position and economies of scale.
Improving Incentive Alignments
Private-equity-backed firms are characterised by a higher equity share from the management team. Indeed, the investors encourage the management to increase its equity share in the enterprise to a significant level. Managers become owners, and their incentives are more aligned with those of the investors. The management includes both monetary and human capital within higher personal costs of inefficiency and more incentives to find smart strategic moves and larger gains.
Improving Monitoring And Controlling
Better monitoring and management control driven by a more efficient corporate governance structure reduces agency costs. Sponsors have the significant part of the capital on their hands and are deeply incentivised to execute an active role on the board of directors. The role of active investors entails some benefits which include a better evaluation of long-term strategies and tighter control over ongoing operations.
Incentives alignment plays a crucial role in the value creation process of LBO transactions and is a critical driver of lower agency costs and higher efficiency since it motivates the management to extract the greatest possible value from the target.
While financial arbitrage creates value without affecting the capital structure and the operations of the target and operational improvements generate value from enhancements in the target processes, financial leverage or the use of debt creates value by changing the capital structure of the acquired company. PE-backed firms leverage investors to network and expertise to get better financial terms than they would have had as a stand-alone business.
Indeed, sponsors assist the management in negotiating bank loans, underwriting bonds, going public and even selling stocks. Lenders tend to deal more efficiently with financial sponsors thanks to their better treatments. Indeed, the marginal agency costs are reduced by the presence of PE funds since they establish long-term relationships with lenders and are less incentivised to transfer wealth from debt investors to the equity ones. Thus, PE-backed corporates show a higher debt to equity ratio than similar stand-alone firms. Debt provides benefits and risks. In particular, it generates value from:
- Debt Tax Shield and Management discipline
- Lower agency costs.
Debt Tax Shield And Management Discipline
The cost of debt in the form of interest payments is – for the vast majority of countries – fiscally deductible. Instead, the cost of equity in the shape of dividends cannot be deducted from taxable earnings. Thus, all else being equal, debt has a significant economic advantage over equity provided by the interests tax shield.
Lower Agency Costs
Moreover, an amount of debt greater than the ordinary disciplines the existing management, driving managers to utilise free cash flows properly. Indeed, the availability of discretional free cash flows leads managers to overinvest in negative NPV projects and tolerate more mistakes.
Debt increases the mandatory interest payments and reduces the discretional cash flows within an implicit tighter control over management activities. To conclude, sponsors have several ways to create value and, usually, combine some or all of them to get the most out of the investment. Their knowledge, expertise and network lead to value creation opportunities and potentially high returns.
Financial arbitrage indicates returns generated from differences in the valuation of the target occurring between the beginning of the investment and the disinvestment or exit. The valuation of the target depends on:
- Market valuation of the peer group of comparables
- Different expectations regarding the business or the industry
- The negotiation process.
Financial arbitrage referring to these factors may generate value in LBOs. The first type of financial arbitrage does not apply to the target but to the investors. Indeed, the value creation does not imply financial and operational improvements of the target. Sponsors predict future public valuation multiples better than their counterparts and generate value by selling at a higher price the same company. Moreover, sponsors have the knowledge to arbitrage successfully within private markets or between public and private markets.
The second type of financial arbitrage refers to the divestment phase and is an external lever of value creation since it does not affect the target performance. The sponsor becomes the seller during the divestment period and has a broader knowledge of the company than the buyout investors. Indeed, it captures value from deeper information regarding the expected financial performance of the portfolio company.
The last type of financial arbitrage is linked to the excellent dealmaking abilities of financial sponsors. Sponsors have an established network within the private equity industry and huge expertise. They usually spend a significant amount of time searching for the right candidate, while trying to limit the competition. Indeed, the broader the competition, the higher the acquisition price. Thus, the most established players in the private equity industry may use their expertise, knowledge and networks to identify suitable targets, limit commercial and strategic competitors and manage the negotiation process to capture value from the target.
When all of these factors work together, the effects can be powerful for the LBO investors:
Carillion’s Collapse: It’s The Management, Stupid!
When UK-based construction company Carillion PLC finally hit the buffers after months of pointless government efforts to prop up the public sector contractor, it wasn’t long before the finger of blame again pointed to Public Private Partnership (PPP) projects for the financial mess.
It’s a familiar argument that is promoted reflexively in a lot of the UK press because it fits an anti-corporate narrative. It follows the line that when public authorities invite private sector businesses to design, build and operate a public asset, the result will be huge profits for the contractor, its bankers and its shareholders while the public sector carries the bag for bailing out projects when they fail.
In the case of Carillion, that narrative got a boost from a National Audit Office report this week that stated that there’s still insufficient evidence to show that the UK’s Private Finance Initiative (PFI) program delivers value for money. It also said that the cost of PPP/PFI to taxpayers comes to £200bn, a particularly uninformative claim, considering that the equivalent public sector contracting almost always goes over budget and costs taxpayers untold billions of pounds through inefficiency, non-delivery and cost overruns, yet is rarely reported about in the press.
Boost for Nationalist Agenda
The NAO report will boost the Labour Party’s current position that all such projects should be nationalized, whatever the cost.
The only problem with the way that this has been reported is that PFI is not why Carillion collapsed.
In fact, the main reasons for Carillion’s collapse are that it failed to deliver on a wide range of contracted services, so it wasn’t being paid, even as it took on more projects and more and more debt, estimated to total £900m. The company also continued to boost dividends, despite a widening pension deficit, which now sits at £587m. Finally, Carillion incurred cost overruns and delays in the delivery of many public sector projects, of which only three were PFI.
The idea that PFI was to blame for Carillion’s collapse and that taxpayers are now on the hook for the many public sector projects is going to stick, even though it’s nearly as inaccurate as the claim that the company, its investors and its bank finance providers are profiting from the company’s demise.
The Guardian, for example, singled out three PFI investments, including two troubled hospital construction projects, for their contribution to the collapse of the company. These included the £335m rebuilding of the Royal Liverpool University Hospital and the £350m Midland Metropolitan Hospital, both of which ran into expensive delays.
But the media focus on Carillion’s mishandling of three PFI contracts ignores the larger issue, which is the company’s own inability to manage risks associated with the delivery of any of its services.
There is a legitimate debate around whether PFI and its successor, PF2, deliver value for money to public sector institutions such as The National Health Service (NHS). This is because of the higher financing costs for private sector borrowing and thus the significantly higher cost to NHS trusts of having the private sector operate and maintain these assets once they are built.
Bottom Line Focus
At the end of the day, what matters most is the company’s ability to deliver. We’ve seen this before when another opportunistic PFI company, Jarvis, got in over its head and collapsed.
There have been more than 130 health-related PPP projects in the UK since the PFI scheme was established in 1992. Almost all of the large hospital projects were delivered on time and on budget using PFI during the Labour government from 2001 to 2010. This was followed by a sharp fall in waiting lists for surgery and other essential healthcare services across the country.
The issue in this instance should not be the delivery model, but rather the company that is responsible. In Carillion’s case, there is ample evidence that when it came to running the projects that were at the core of its business, nobody effectively managed the rising costs and declining receivables, even as they inexcusably boosted the dividend in each of the 16 years since the company was founded.
The end result, while enriching a few investors, was a precipitous share price decline since the middle of 2017 that more than erased those gains. The company’s lenders are also reported to have started writing down the £835m of committed bank facilities and £140m in short-term facilities, though their exposure could be much higher.
Business as Usual?
Despite all the handwringing, there is no shortage of public sector contractors who will happily take over the many public sector construction and support service contracts that Carillion’s collapse will require the government to put up for tender.
This will follow an established protocol that is designed to ensure that essential services are not interrupted. The larger, more troubled Carillion projects will take longer to renegotiate but will ultimately find replacement companies to deliver them. Work interruptions are likely to be limited, and people who have been laid off as a result of the collapse will quickly find new work, particularly given the current healthy state of the labour market. The takeaway from all of this is simply that bad businesses, whatever their line of work, go to the wall and better ones replace them.
Whatsapp Launches New Venture Aimed at Businesses
Whatsapp has launched a new app targeted at businesses, called the Whatsapp Business App, which they claim will enable companies to “communicate more efficiently” with present and potential customers.
This forms part of Whatsapp’s wider strategy to branch out into the corporate world. It plans to use the app to generate new revenue by charging businesses for using the extra communication tools that will enable them to better connect with their customers.
Although the app is set for worldwide release, at present it will only be available in Indonesia, Italy, Mexico, the UK and US. It includes a feature which indicates a business is authentic with a green tick badge next to their name.
Amex: Troubled Credit Card Company Reports $1.2bn Net Loss
On Thursday, American Express, or Amex, reported a net loss of $1,197m in the fourth quarter, the first net loss the company has experienced for 26 years.
Although the company stated that revenue from interest expenses was up 10% to $8.8bn, Amex said recent reforms to the US tax code meant the company incurred extra costs, including a repatriation cost on its foreign assets as well as a devaluation of its deferred tax assets. It estimates total costs amounted to $2.6m.
For the full year, net income was $2.7bn compared with $5.4bn the company earned in 2017. However, even with the estimated $2.6m the company claims it incurred from the recent tax charge, net earnings were still $5.3bn, $100m lower compared to last year.
In New York, American Express shares (AXP) took a near 1% tumble at the beginning of trade with shares finishing the day on $99.90. JPMorgan Chase and Goldman Sachs anticipate greater earnings for 2018.
“Overall, we believe the Tax Act will be a positive development for both the U.S. economy and American Express” said CEO and chairman Kenneth Chenault. Chenault also said he will be leaving Amex in “very strong hands” when his successor, Steve Squeri takes over next month.
American Express has suffered from an ever-reducing share in the credit card market and ended its 14-year relationship with American warehouse chain Costco who in 2016 made an agreement with the market leader, Visa.
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