KUHN CAPITAL Thursday, October 19, 2017
Dispatches from the front

Buyouts of Buyouts by Buyouts
(10/26/2004)

The past few years have witnessed a peculiar phenomenon: buyout firms snapping up the portfolio companies of fellow buyout firms. Why is this happening now and what does it portend for M&A?

What’s puzzled us is how to explain the attraction: not knowing any better, to us it’s like kissing your sister.

KKR sells giant supermarket operator Safeway to Morgan Stanley Dean Witter. Castle Harlan buys container shipping company Horizon Lines from Carlyle for $650 million. Madison Dearborn buys Citigroup’s Great Lakes Dredge & Dock for $340 million. Headwaters acquires Tapco, manufacturer of residential remodeling products and tools, for about $715 million from Fremont Partners.

Indeed, on the surface, these deals wouldn’t seem to make sense. In theory at least, M&A deals generate value because, for example, they realize economies of scale; or they allow the buyer to extend into adjoining markets more quickly or economically than internal development would permit; or they incentivize and attract quality management; or – perhaps a less savory motivation – they eliminate competition. Whatever the reasons, at heart they all have to do with the seller or buyer/seller combination saving money and time. If there’s a saving purely due to financial engineering, it often has to do with cheaper credit, also something that results from greater scale.

But this late spate of buyouts of buyouts by buyouts doesn’t deliver on any such operating or strategic rationale. By definition, they can’t: both the sellers and buyers are financiers, not managers or operators. The buyer is acquiring the future cash flows of stable, rather mundane businesses with current management retained in place. They’re not betting on – for example – the gifted R&D skunk works of a Star Wars contractor, the inspired management of an Amazon, or the novel business model of an eBay. So they’re not buying innovation or hockey stick projections, or even economies through industry consolidation, and they’re not looking to exploit the operating advantages of combining businesses. They’re just passing the reins from one top hat to another.

Because these financial buyers can’t bring anything to the table but money, they have typically operated at a disadvantage to operating buyers in seller’s auctions: they can’t justify the prices paid by buyers who anticipate tangible operating benefit.

So why are we seeing so many such deals now? The answer may have to do, as you may expect, with financial engineering. The factors that drive these deals seem to be: 1) Lots of aging buyout fund sellers; 2) Lots of huge buyout fund buyers; 3) Ever cheaper, more available bank debt.

Old buyout funds may be motivated to sell a large property merely because the fund is winding down after five years or so, moving into its golden years, and the partners need to “show the money” to the fund's limited investors. Many such big funds are currently moving into this later stage. Even if these aging funds could re-leverage their portfolio companies at cheaper interest rates themselves, and thereby increase cash flow, there’s only one way to exit and close the fund – sell.

Second, some of these buyout funds have gotten so big that on certain deals, they’re the only ones with enough equity to sit at the table. Many of them can certainly bring more financial firepower to the table than competitors in the seller’s industry. That fact may explain why we’re also seeing historically high levels of cooperative behavior among buyout bidders who combine purchasing resources, then share the spoils. Used to be, buyout guys competed with each other as industry competitors continue to do.

Last, bankers are starting to get too easy again, engaging as they will in their cyclic proclivity to extend huge quantities of leverage at miserably low interest rates: the amount of leverage used in these deals is creeping into the 80% debt/debt + equity range: if this sort of deal later goes south, the bankers own a gutted business, but if it performs as expected, best case the banks’ interest earns 4% or 5%. Maybe because of this commodity-like herding behavior, Peter Drucker observes that the banking industry, net net, has never earned money (along with the airline industry).

So we think that what’s at least partly prompting these strange deals is an unusual combination of aging funds, very big transactions, and cheap, available debt. Having said that, we not sure we’re comfortable with the trend. We don’t see these deals making a contribution to lower prices, better quality or the creation of jobs, and we wouldn’t want to be stockholders in the banks left holding the bag. Of course, these deals can be very, very profitable for the buyout firm principals and their limited partners.

Ryan Kuhn


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