Forget about the ROI; the return on pillage is all that counts...
TO PARAPHRASE the famous Willie Sutton quotation: Why rob a company? Because that's where the money is.
After four years of rising stock prices, you might wonder how private equity investors keep on finding companies cheap enough to deliver decent returns on their investment.
According to Thomson Financial, private equity firms bought 654 companies previously listed in the United States last year. But were they bargains? Were they bought cheap enough to produce a decent return on their $375 billion cumulative price tag?
The answer is, it doesn't matter. And this is the great thing about being a private equity investor. It doesn't have to be about the Return on Investment or the ROI. There's always the RFP, or Return from Pillage.
So far, RFP has come in the form of "management" fees and "dividends" paid by recently-privatized companies to the privateers who privatized them.
Wall Street Journal reporters Greg Ip and Henny Sender described these innovative forms of compensation in an article of July 2006. They took Burger King as their example. Here's how private equity investors got it their way with Burger King.
First, Burger King paid the private equity folks $22.4 million in "professional fees", apparently for shepherding the company from the public wilderness into the loving arms of private equity owners.
Then, after three years of restructuring and other voodoo – and three months before releasing Burger King back to the public – Burger King paid the investors a $367 million dividend. You might exclaim, "Zowie, what a turn around to be able to afford to pay yourself almost a gazillion Dollars!" But you should exclaim, "Zowie, you loaned money to Burger King to pay almost a gazillion Dollars to their own owners!" That's because Burger King borrowed the money for the dividend, the sort of thing that apparently is possible at the late stage of a credit bubble.
Finally, as a parting gift of sorts, Burger King paid the investors $30 million to terminate their agreement. Because after all, there is only so much improvement an operating company can take.
All in, according to the Wall Street Journal, the private equity investors squeezed $448 million in dividends and fees out of The King before the company went public again. The Journal went on to list Warner Music, Simmons Bedding and Remington Arms as other companies that paid big dividends to private equity investors that were largely funded with borrowed money.
And, as The Journal reminded readers, the parent of Hertz also borrowed money to pay its private equity a dividend – this one amounting to $1 billion. As luck would have it, the dividend was paid about the same time the company was reporting a loss, due at least in part to the interest on the mountain of debt incurred in the buyout itself.
That's the problem with owning an operating company; the demands of running the company can detract from all that creative financing.
Take Intelsat Global Services. Private equity investors paid $513 million for the company in 2005 according to a Business Week cover story published in 2006. Within a year the "investors" scored $576 billion in fees and dividends. Sadly, the owners had to deal with operating details like credit rating cuts as the company's debt load doubled. Then it had to lay off 194 people for "operational" reasons. No wonder private equity owners often take their companies public again. Who needs the headaches?
New York Times columnist Floyd Norris recently put a number on the private equity dividend mania, and that number – the amount of money companies borrowed to pay dividends to their owners – was $26.9 billion in the first quarter of this year. At that rate, Return from Pillage this year will easily surpass last year's $56 billion, a figure that towers over the less than $20 billion borrowed for dividends as recently as 2003.
The beauty of RFP, as Mr. Norris points out, is that the private equity investors can make money even if the company itself goes under, or has to layoff scads of employees.
But who would loan money to a company that borrows money at one end and pays it to its owners out the other? Sophisticated institutions and hedge funds, of course!
Banks and other entities simply pool their money, divvy up the loans into pieces, and sit back to reflect upon their own sophistication. For these "leveraged loans" to be paid off, all that has to happen is that things continue to go swimmingly. Operating companies must make enough money to service the debt over time, or a happy event must make it possible to service the debt all at once. And as long as happy events – like IPOs and leverage loans – remain possible, then non-public companies can continue to generate a huge RFP for the private equity owners.
No wonder the most important question in the private equity world is no longer is "What is our ROI?" but rather, "What would Willie Sutton do?"