The Harsh Couch - 2016.09.13 Careless Thinkers

#1

Vladimir Putin is a strong leader in the same way arsenic is a strong drink. - Garry Kasparov

This is a companion discussion topic for the original entry at http://theharshcouch.com/thc/2016-09-13/
#2

I’m a finicky guy and here’s my finicky comments about the formula one grand prix buy out, which is really just a lecture about leverage buy-outs, masquerading as a response to Wibbly’s comment about keeping the business profitable.

First off, consider it from the buyer’s perspective. Liberty Media is a NASDAQ-listed company (NASDAQ:LMCA), so that fucks up my LBO/private equity analysis already, as the returns story for a listed company is typically different to the returns story for a private equity (PE) fund.

BUT LET’S LEAVE THAT INCONVENIENT FACT ASIDE, because PE fund leveraged buy-outs (LBOs) are an area I’m deeply familiar with and we can all pretend that this is an LBO for a bit so that I can pontificate. This will also give you some insight into how PE funds work, even if Liberty Media is not a PE fund (shhhhhh…)

Anyway, what follows is a somewhat intoxicated and possibly less than comprehensive overview of leveraged buyouts…

Why would you load a company up with a huge amount of debt when you buy it? So much debt that it’s running at a loss and not a profit? So much debt that shareholders are not getting any cash out of it in the form of dividends?

Well, that’s the way PE funds and their investors like it.

Firstly, see it from the perspective of the PE fund and the investors in that fund (limited partners = LPs).

The LPs are often pension funds, life insurers and other investors who have long term liabilities eg pensions and insurance pay outs they don’t have to start paying out for MANY years. They want to be able to park their money into PE funds who will generate a return on that money and not pay the money (and returns) back for a few years. If they invest in something that pays back returns (even if big) in a short time period, that’s a headache, because then they have to spend time/energy finding somewhere else to reinvest that cash. In short, they are long term investors trying to match the long term payback on their investment against their long term liabilities (eg payouts on pensions and life insurance).

That means that the typical PE fund is structure as follows:

  • LPs provide a commitment (say, $100m) upfront

  • The PE fund has an set period where it can invest LP funds (usually 4 - 5 years)

  • LPs’ commitments are only “called” (ie “hey, pay us some of what your promised”) as and when the fund finds deals to invest into

  • The PE fund has a targeted payout window of year 7 - 11 ie when it’s supposed to realise/sell/IPO its investment and return (ideally) cash or (less ideally) shares in the underlying companies to its LPs

That is, LPs want to park their money (or a commitment to fund money) in the fund and are happiest when they don’t get returns until around 7 years later.

How does this then influence the PE funds’ investing behaviour?

Well, as explained above, a PE fund has LPs who don’t want to get money back early. So generating an annual profit and dividends out of investments throughout the life of an investment is not something that needs to be on the menu.

It’s all about capital returns ie investing in a company, working with the company for a few years to make it bigger and better, then later generate profit by selling the company at a higher price. Only then does the PE fund return cash to the LPs in the form of “here’s your money back, plus some profit on top (less my fees, thank you very much”).

Why does this mean PE funds use a tonne of debt when buying companies? Because, assuming the company will become bigger and better, that juices up the capital return. This debt = leverage. Assuming all goes well, debt “leverages” the returns to equity. Hence “leveraged buyouts” or LBOs.

How so?

Think of it from a debt investor’s perspective. As a debt investor, best case is you get your principal loan amount + interest back. If the company makes a killing and doubles its value, you still only get the principal and interest back.

Who gets all the upside? The shareholders (ie the PE fund and its LPs).

But, if the company tanks, who gets suffers the downside? The shareholders/PE fund - they typically get nothing. On the other hand, the debt lenders get first pick of whatever value is left (capped at the value of their debt + interest).

So, if a PE fund thinks that it can drive up the value of an investment, it wants to use as much debt as possible when it buys that investment. Why? Because, when the investment value goes rocketing up, all the debt investors only get principal + interest on every dollar they funded, while the PE fund gets (a) principal plus pro rata upside value on each equity dollar it invested PLUS (b) pro rata company value less principal + interest on every dollar the lenders invested.

That is, the PE fund has “leveraged” its return via debt. The lenders’ return is capped at their principal + interest, no matter how much the value of the company goes up. On the other hand, if it all fails, the lenders are in a better recovery position (they recover first) than the equity ie the PE investor and its LPs.

Another reason to lever up as much as possible - the interest you pay on debt is tax deductible. Which means the company has a “tax shield” that reduces its tax bill, wipes out taxable income and leaves them with more cash. That cash is typically reinvested back into the business (ideally increasing the value of the business, hence the eventual profit on sale) or used to repay debt (which also increases the PE fund’s/LP’s share of the sale price ie profit on sale).

So, a PE fund buying the formula one franchise would be quiet happy to kill its profits (which are returns to equity AFTER all interest is paid), as:

  • That would maximise the PE fund’s profits when it gets around to selling the franchise in a few years

  • That makes its LP investors happiest, as they don’t want the hassle of being paid back in the shorter term

  • The tax shield generate by tax is great if you don’t need to generate profit and dividends (dividends to shareholders can typically only be paid out of profits and a few other things)

Woo woo! Debt is great. Leveraging up your buy out of a company with debt is great! If it turns out fucked, the lenders suffer more than the PE fund (as they typically fund 60 - 80% of the purchase price). If it turns out great, the PE fund gets most of the profits.

Before you look for dumb idiots/villains in this game, it also works well for the lenders because they are normally assured of a pretty good outcome, all risks considered.

Hooray for capitalism.

This game is what pays my mortgages.

And the LPs in PE funds are likely your superannuation funds.