Private Equity Paper Danielreddy

8/4/2019 Private Equity Paper Danielreddy

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1 | P a g eD a n i e l R e d d y

I n d e pe n d e n t S t u d y

Private Equity Investment

And The

Dividend Recapitalization

Value In

Or

Value Out?


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A Brief History of Private Equity:

Investors have been acquiring businesses and making minority investments in privately held

companies since the dawn of the industrial revolution. Merchant bankers in London and Paris financed

industrial concerns in the 1850s; most notably Credit Mobiler, founded in 1854 by Jacob and Isaac

Pereire, who together with New York based Jay Cooke, financed the United States Transcontinental

Railroad. Andrew Carnegie sold his steel company to J.P. Morgan in 1901, which in many experts minds

was arguably the first true modern buyout. Later, J.P. Morgan's J.P. Morgan & Company would finance

railroads and other industrial companies throughout the United States. In certain respects, J. Pierpont

Morgans 1901 acquisition of Carnegie Steel Company from Andrew Carnegie and Henry Phipps for

$480 million represents the first true major buyout as they are thought of today.

Even though such private equity transactions have been occurring for a very long time, the

original organization of the private equity market began in 1946, due in part to the inadequacy of other

options or sources of long-term financing for new businesses. There was a need in the markets and that

need was starting to be met in an organized way (supply/demand). In a response to an economy fresh on

the heels of World War II, and having to absorb millions of recently discharged servicemen, the

American Research and Development Corporation (ARD) was founded.

According to D.H. Hsu and M. Kenney: The prime movers supporting ARD were Ralph

Flanders, then president of the Boston branch of the Federal Reserve and trustee at MIT, Georges Doroit,

a professor of industrial administration at Harvard Business school, Karl Compton and Merrill Griswold

(Hsu & Kenney, 2005). These founders firmly believed that providing management skill and experience

was as critical to the overall success of new business as was a source of adequate funding. According to

one of ARDs founders, Ralph Flanders, the need for ARD was of paramount importance. In 1946, Ralph

Flanders summarized the need for ARD as follows:

During my last year of my incumbency as president of the Federal Reserve

Bank of Boston, I became seriously concerned with the increasing degree

in which the liquid wealth of the nation is tending to concentrate in fiduci-

ary hands. This in itself is a natural process, but it does make it more and more

difficult as time goes on, to finance new undertakings. The postwar prosperity

to America depends in large measure on finding financial support for that

comparatively small percentage of new ideas and developments which give


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promise of expanded production and employment, and an increased standard

of living for the American people. We cannot float along indefinitely on the

enterprise and vision of preceding generations. To be confident that we are

in an expanding, instead of a static or frozen economy, we must have a reason-

ably high birth rate of new undertakings.

Flanders felt very strongly that if other sources of capital were not made available for new

companies or individuals to reach out to, then the American economys growth would be stuck in slow-

motion. Private Equity (PE), when used correctly, can help fund innovation which in turn helps create not

only economic growth for the future, but also helps people create and implement new innovative ideas

that increase the general publics standard of living. If you were to look back to 1946 and compare the

average Americans standard of living and compare it to 2011, you would see that huge strides have been

made. This isnt to say that Private Equity is the sole reason for this great nations prosperity over the

years, but it has certainly played an important role.

ARD was not the only dedicated Venture Capital organization created in the aftermath of World

War II. According to Business Week: A few wealthy East Coast families also established professional

venture capital operations ("Dynasties unify," 1946). The three operations were Rockefeller Brothers,

Inc. (RBI), J.H. Whitney, and Payson & Trask (P&T). According to the New York Times: The Family

fund that would prove to be the most significant was RBI ("Research venture gets," 1946), which later

was reorganized and renamed Venrock. One reason for RBIs success in comparison to ARDs was that

unlike ARD many of RBIs overall investments tended to be in certain government related fields where

they could rely on their strong family connections in Washington (Lewis, 2002). ARD itself ended up

having modest success in raising fresh capital for investment. By 1959 the first Small Business

Investment Company (SBIC) was formed, but these were primarily established to manage the venture

capital investments of wealthy families and did not seek institutional capital.Throughout the 1960s,

SBICs attracted mainly wealthy individuals and families rather than institutional investors.

By 1977 concern had risen in regards to the supposed shortage of capital in the capital markets

available to fund new ventures. Then in 1978 a revision of the Department of Labors decision pertaining

to the prudent man provision of ERISA governing pension fund investing stoked an almost immediate

burst in demand for small-company stocks and new issues in general. This enabled partnerships to exit

more of their investments, distribute funds to investors, and raise new partnership capital. Then in 1980

another hurdle was removed by the Department of Labor, stating that limited partnership investments

were to be granted a so called safe harbor exemption from plan asset regulations. These regulations in


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the past had made it so that all venture managers had to become registered advisers, and as such they

were prohibited from receiving performance-related compensation. With that restriction/hurdle out of the

way, it led to outside managers of plan assets in the venture arena being paid proportionately to their

success, which was a vital element in the venture capitalists mode of doing business. Finally, also in

1980, Congress lifted another extremely important restriction that had been imposed on partnerships by

the Securities and Exchange Commission. Due to the fact that registration under the Investment Advisers

Act is not required when an adviser has 14 or fewer clients, many of the partnerships had decidedly

restricted their size to 14 limited partners. The Small Business Investment Incentive Act of 1980

redefined private equity partnerships as business development companies, thus exempting them from the

Investment Advisers Act.

In the aftermath of this regulatory liberalization, private equity investing exploded. Between 1980

and 1999, the United States private equity market grew from about $5 billion to more than $175 billion in

investments! As the private equity markets developed, they were seemingly broken down into two distinct

animals: Venture Capital Firms (VCs) & Leveraged Buyout Firms (LBOs). The case to be discussed in

this paper deals entirely with the latter (LBOs). LBOs occupy a different place in the corporate lifecycle

than VCs do. LBOs are generally created with the goal of taking public firms or specific divisions of the

firms private. Most of the acquisitions are done through a majority of borrowed funds. During the 1980s

LBOs had their moment in the sun. LBO activity ran ramped, reaching unprecedented levels. While

researching this run-up in LBO activity in the 80s, I discovered that there are seemingly manyexplanations for their explosion. Some experts refer to the so called rise of the institutional investor

(Donaldson, 2004), a return to specialization (Shleifer, & Vishny, 1991), and the eclipse of the public

corporation (Jensen, 1999). In my view a combination of these factors is more likely the cause than any

one factor.

As anyone who has studied the markets and is familiar with the technology boom of the 90s

knows, the 90s was the time when the VC firms had their moment in the sun. So many start-up

companies associated with the internet craze came about during this decade. The sad thing is that most of

them are long gone by this point. The end problem for the markets was that no one really new how to

value these internet companies. When you do a valuation on a company using a discounted cash flow

model, you use a great deal of past financial and industry data to determine a large portion of your inputs

for the valuation. Considering the fact that this was a new form of company and a new industry

altogether, there was no historical data to look at and no industry trends or comparative analysis to

consult. Analysts had no idea what the end ramifications of the new industry would be or how it would


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develop. So imputing the main driver of these cash flow models (growth estimates) was extremely

difficult. When U.S. public equity markets crashed, so did VC fund commitments and venture-backed

IPOs. In other words, the VC investments disappeared as they realized that their estimates of earnings,

growth and value were way too optimistic in many cases. They walked away, which increased the already

dramatic downturn in the markets into a free-fall. As the chart below shows, total VC investment dropped

off of a cliff in 2000. Since that time VC investments have been quite slow to recover.

As this slow recovery for VC firms persisted into the first decade of the twenty-first century,

global private equity investments boomed. This time, though, it was mainly Leveraged Buyouts taking

place and not new VC investments. The growth continued mainly due to a global liquidity glut and the

availability of rock bottom interest rates (cheap borrowing costs). According to Thomson Financial, in

2006, private equity LBO funds accounted for more than $750 billion of announced deal volume

worldwide, 18% of the global total. In the U.S., nearly one-quarter of mergers and acquisitions announced

in 2006 were LBOs. Nine of the ten largest private equity deals ever have occurred since the year 2004,

including the largest at the time, Blackstone Groups $38.9 billion buyout of Equity Office Properties

Trust.

Private Equity and the F amous Dividend Recap:

With all the talk these days about debt and its now burdening effect on the consumer and the

capital markets, the question of whether or not these leveraged buyouts and dividend recapitalizations that

are financed almost entirely by debt are truly creating value for the company and its shareholders or

destroying value is extremely important. In most cases the private investors involved in these transactions

create value for themselves regardless of the implications for the company or its shareholders. A tool that

has gotten a lot of criticism over the years used by private equity firms called a dividend recapitalization

or dividend recap for short is one of the value destroying types. This particular form of leveraged

recapitalization involves a private equity-owned company that decides to issue new debt in order to pay

its financial owner or group of owners a special dividend. The impetus for leveraged buyout firms to

carry out dividend financings, the private equity transactional equivalent of anabolic steroids, is

seemingly clear. Besides being able to earn back a portion of their initial equity investment, often in a

short time frame, a firm can return cash back to its limited partners. Another issue with the dividend recap

is that the dividends are paid in excess of actual annual free cash flows; thereby altering the firm in

questions financial structure. Both the entities cash may be removed and substantial loads of debt


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assumed in the process. The fact that the dividend is not covered by the free cash flows creates a

leveraging of the firms financial structure, which can easily affect the financial flexibility of the firm

negatively.

One may ask, with rates as low as they are and the after-tax cost of debt capital low, arent these

transactions just plain old good financial engineering? No way! Because by altering the firms financial

structure they are then robbed of financial flexibility, which has a real tangible cost. A firm creates value

for itself and shareholders by being able to produce free cash flows. How can depleting the equity cushion

aid the firms purchase of new productive capital or resources that will in the end help it produce new and

added free cash flows? How will these newly structured firms be able to gain access to capital for

expansion and other such value-generating business activities, given that their balance sheets are now

loaded to the hilt with fresh unsustainable debt? How will they be able to truly compete and grow in acompetitive landscape when they cant gain the required access to capital at a competitive price that

would allow for important projects to proceed? One would think that the board of directors who are

supposed to be acting in the best interests of their shareholders would step in. In many cases though they

are ultimately tempted by the upfront cash dividend and promises of future cash riches, which it seems

that banks are all too eager to lend.

According to Bank of America, one of the largest beneficiaries of the fee income associated with

these sorts of deals, they point to the acceptable 6% default rate of companies that go through these

transactions. So has the ultimate objective of companies today become not to default? Firms such asHCA Inc., who have been through these dividend recaps, may not have actually defaulted, but they have

been placed in a precarious position structurally and may never fully recover. Other examples include

such names as Burger King, KB Toys, Warner Music, Burlington Coat Factory and many more, who have

enriched the private equity firms involved, yet have forever changed or in some cases dismantled once

solid, position leading companies.

My view of the role of good private equity funds is that they should improve companies

operationally and lower the cost of capital for those that are financed inefficiently. Seemingly there would

be no squabble with these private equity funds earning these returns if they were in fact building

enterprises or creating jobs. But alas they do not make their fortunes by creating or discovering new life

saving drugs or creating new and innovative businesses that will help drive this economies future growth

prospects. Rather they gain it by simply trading existing assets amongst themselves for their own personal

gains!


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Many of these private equity firms are once again dabbling in certain deeds that got Wall Street

and big business fat cats in trouble in the post Enron era, such as conflicts of interest, inadequate

disclosure, shady accounting methods, influence peddling and much more.

In the end for corporations the only way to create sustainable growth is for the company in

question to earn an increasing amount of free cash flows. This really takes place through a growing

capital base which can earn a steady and normalized cash based Return on Invested Capital higher than

the firms cost of capital. In reality the dividend recaps are by definition the antithesis of value generation.

They steal actual capital resources instead of allowing the firm to maximize its opportunities with actual

value-creating capital.

Case Summary:

In the following two cases I am going to look at two very different companies that were taken

private in LBO deals through private equity investment, where one company (HCA) has seemed to have

made it through the process, albeit with much larger amounts of debt and a totally different capital

structure, while the other (LIN) could not and was taken into bankruptcy in 2008. Both of these

corporations were taken private for similar reasons and in a similar fashion. Whether or not the actions of

these groups of private investors actually added value to these two corporations is the real question.

Because isnt that the goal of private equity investment: to add value for the shareholders and to

restructure companies into healthier cash flow producing entities?

CASE 1 HCA INC.

The first case that I will discuss is in reference to HCA Inc. Accounting for about 4% of total

U.S. hospital admissions, HCA is the largest private hospital owner and operator in the United States. It

operates 164 hospitals and 106 outpatient centers, offering a broad range of health services. HCA has

operations in 20 states and in England, but a majority of its operations are in the Southern U.S.,

particularly in Florida and Texas. HCAs outpatient services make up a large 38% of total patient

revenue.

The hospital operator had been under private equity ownership before, completing a $5.1 billion

leveraged buyout in 1989. According to Business Week, when HCA went public again in 1992, it handed

its backers at the time (including units of Goldman Sachs Group Inc., JP Morgan Chase & Co.) a more

than eightfold gain. HCA was taken private again in 2006 for about $30 billion with an equity check that

was only worth 15% of its purchase price! Last year before the company was taken public again, HCA


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paid out a total of 4.7$ billion in special dividends (3 separate times in one year totaling the 4.7bill). The

total almost equaled the near $5.5 billion in equity used by the group of private investors to initially take

HCA private (the rest of the $30 billion was all debt funded). The obvious next step for the group of

investors (Kohlberg Kravis Roberts & Co., which trades as KKR & Co. and Bain Capital LLC) was to

take HCA public again. The IPO went forth on March 9, 2011, offered at the high end of its range at $30

per share, making it the largest private equity backed IPO in the U.S. ever. A total of 126.2 million shares

were sold, 2.2 million more than expected. According to the Wall Street Journal, Underwriters had set out

to price the deal between $27 and $30 a share. Of the shares sold, 38.5 million, or 30%, were sold by

prior owners, so those proceeds won't even benefit the actual company! According to data from Dealogic,

the deal raised a total of $3.79 billion. The obvious problem to me is that the raised $3.79 billion wouldnt

even cover the $4.7 billion in new debt that had been added to HCAs balance sheet to pay for the special

dividends (all done in one year). The IPO would really be just added gravy or icing on the cake for this

group of private investors, adding to their already enormous returns, gained by leveraging HCA to the

hilt.

Before I get into the valuations of HCA at 2006 and again in 2010, I want to discuss the way that

HCA financed the dividend recaps in 2010. In the last of a stream of dividends paid out to private

investors, HCA Inc. used a specially formed company to pay a $2 billion dividend to its private-equity

owners. The payout plan is another indication of the dizzying heights in 2010s junk-bond sales boom.

According to Thompson Reuters , companies have raced to issue a record number of junk bonds and in

some cases have provided less protection for investors than in the past. The dividend, HCAs third this

year, will be financed through the sale of $1.5 billion in JUNK debt maturing in 2021 and the use of

HCAs credit lines. The new debt will be funded by HCAs operations and could be very risky for new

HCA debt holders. The new debt lacks collateral or guarantees from the operating subsidiaries and will be

structurally subordinated to existing HCA debt. These new bonds will also have limited protections

against future debt issuances and dividends. According to a reporter from the Wall Street Journal, the debt

issuance is yet another sign of irrational exuberance in the junk markets. According to Thomson

Reuters, in 2010 companies globally have sold $264.9 billion, 50% more than in 2009. The previous

record was $186.4 billion back in 2006 before the credit crisis.

For my case analysis, I went back and downloaded all of the relevant financial data for HCA up

to 2006. My intent was to value the company using a 2-stage free cash flow to the firm model (to value

the companies operating assets) while using the same valuation model to value the company in 2010

when HCA was again taken public, to see how the company would be able to grow going forward with


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such a large amount of debt on the books and how much the shift in HCAs capital structure would affect

overall value.

In valuing HCA with financial data from 2006 I came up with a total firm value of $29.77, billion

about .2 billion less than the group of private investors valued the company when they took it private in

2006 (see attached spreadsheet #1). The main driver of this free cash flow model is the growth rate used

to project future cash flows. What I built into the model was the option to use an internal rate of growth,

calculated by: Return on Capital * Reinvestment Rate. This fundamental measure of growth measures the

growth rate in after-tax operating income, as long as the reinvestment rate and return on capital remain

relatively stable. The growth in operating income is a function of both how much a firm reinvests back

(reinvestment rate) and how well it reinvests its money (the return on capital). I added an option in the

model to use the historical rate of growth in EBIT over the last 5 years as well as an outside estimate ofgrowth (either ones own estimate or an analysts). In the model there is a built-in option to assign

weights to each growth rate used (whether or not you choose to use all three or just two or one). I feel that

this creates a more consistent estimate of growth. For example, if your fundamental growth rate is

reasonable but you feel the company may be able to grow beyond that rate due to industry characteristics,

economic situations or government regulations or lack thereof in that specific industry, then you can add

in your own estimate of growth as well and give that a weight in the overall weighted average calculation

of growth going forward. All analysis/valuation is subjective in nature and trying to come up with the

exact growth rate at which the firm will grow earnings is impossible. But you can make your estimates of

earnings growth better by using more than one option.

So before HCA was taken private, the companys operating assets were worth about $30 billion

dollars (which is right about where the market valued them as well at the time). This of course is before

the company was leveraged to the hilt with debt. So we now go out four years to 2010 and value the

company to see if all of these shenanigans have really made HCA more valuable or less. If the company

would have been left to its own devices and grown at my assumed 5% over the last 4+ years and did not

accumulate all of the debt that it did, would it have fared better?

What I decided to do was to run two separate models with the 2010 data. Both were the same

style of model as the one used for the 2006 valuation (2-stage free cash flow to the firm). But where they

differed was in the amount of debt used. First, I valued HCA using all of the 2010 data except for the

excessive debt levels obtained through the dividend recaps. In other words what would the company be

worth if it hadnt gone private and been loaded up with all that debt or still been taken private, but had not

been plundered and pillaged by its private investors?


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The answer to that question is that without the immense amount of debt, HCAs operating assets

would have been worth $44 billion dollars with an equity value per-share of $78. To explain further, I

used the 2006 pre-takeover debt levels in the first valuation and assumed that HCA, who had been paying

down outstanding debt from 2002 through 2006, would continue to do so going forward. The second

model in 2010 used the actual debt levels that are the reality as of 2010 due to the dividend recaps. In the

model, HCAs total firm value drops by about $5 billion dollars and the equity value per-share is halved

to $35 dollars per-share! Morning Star analyst Michael Waterhouse has a fair value or intrinsic value per

share rating of $32 per-share. I also used a lower cost of equity in the model using pre-takeover debt

levels due to the fact that in my eyes, the lower levels of debt and positive equity values made the overall

operations of the firm less risky. With the added debt load HCAs financial flexibility was far less then it

would have been had it not taken on all the added debt.

So the question for investors becomes whether or not this new HCA with the extremely high

levels of debt can operate and grow at a healthy pace, as well as what kind of return are they going to see

from the companies shares? While its not unusual for companies like HCA that exit LBOs to have

more total debt than total assets, it means that they will need to pay down that debt with cash flows

instead of using the cash flows to pay a dividend to shareholders or buy back its shares in the open

market, thus limiting potential returns for shareholders in the near to mid-term future.

Unlike many companies that have the same situation occur to them, HCA will be able to operate

going forward, but at a much lower rate of growth than may have otherwise been possible. HCA doeshave a few good things going for them that will help lift them out of this financial mess of a balance

sheet. But I do feel that current management will be walking on thin ice and any small slip could have

disastrous consequences for HCA.

Unlike some other buyouts associated with the boom years that had less predictable income

streams, HCA has reported between 5% to 6% revenue growth every year while it was private, except in

2010 when it slowed to a minuscule 2.1%. Coincidently, 2010 was the year HCAs group of private

investors loaded up and borrowed $4.7 billion in debt to fund three separate large dividends. HCAs

private investors did however increase profit margins, returns on capital, and free cash flow by selling

underperforming assets, controlling costs, cutting capital expenditures, and focusing on higher-margin

outpatient services, which will help the company going forward.

Longer term, HCA should benefit from having the majority of its locations in the fast-growing

Sun Belt, with about half of its operations in Texas and Florida. Additionally, the 65 and older population


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is the fastest growing demographic in the U.S. Since this segment overwhelmingly dominates hospital

admissions, the acute care industry should see increasing patient volume during the next decade or so.

Thanks to its operations in Florida, HCA also sits in one of the largest Medicare markets in the U.S., as

the Census Bureau estimates its 65 plus population will approach 30% of the state's total population by

2030. A nationwide obesity epidemic also adds a tailwind for cardiovascular related hospital services. As

a result of healthcare reform, many analysts expect an increase in health services from the approximately

30 million uninsured patients expected to gain health-insurance coverage.

Even with all of these positive points for HCA, a big negative is HCAs capital structure, which I

believe puts equity holders at an extreme risk. HCAs IPO added about $3 billion in new equity capital,

but even so HCA by my estimate will still have a negative book value and debt to capital ratio. The

biggest problem still remains the overall financial health of HCA. Despite its stable operating cash flow,management has a small margin of error. HCA faces more than $12 billion in cumulative debt maturities

through 2015. With about $2 billion in free cash flow annually, HCA probably will be forced to refinance

a large portion of its debt obligations. With nearly all available cash going toward debt service, HCA's

dismal cash position isnt likely to improve any time soon. HCA may have made it out alive, but it is my

opinion that the shares are currently fairly priced and I would not recommend purchasing the stock until a

sizeable discount (or margin of safety) is made available due to the risk associated with the excessive debt

load.

Case #2: Linensn Things:

Linens 'n Things (LIN) was one of the nation's leading large-format specialty retailers of home

textiles, housewares, and decorative home accessories. In 2005, the company operated over 500 stores in

45 different states as well as five Canadian provinces. Linens 'n Things maintained impressive growth

during the 1990s but stalled out during the beginning of the 21st century. When a series of initiatives

failed to turn things around, the merchandiser opened the door to potential buyers in 2005, agreeing to be

acquired in February, 2006 by a newly formed entity controlled by Apollo Management, L.P. Affiliates of

Apollo Management, L.P., National Realty & Development Corp. and Silver Point Capital Fund

Investments LLC collectively contributed approximately $648.0 million in equity, while the remainder of

the $1.3 billion deal was financed with debt.

At the end of 2005 Linens 'n Things had a total of $2.13 million in debt on its balance sheet, and

after the acquisition by Apollo Management, the companys debt level jumped to $733 million. As

discussed earlier in the paper, this added level of debt to firms can alter or negatively impact their


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financial flexibility. This seems to be exactly what happened with Linens 'n Things. According to a

statement by Linens 'n Things management in the 2006 prospectus; In connection with the Transactions,

we incurred significant indebtedness and became highly leveraged. After the acquisition the retailer had

$1.5 billion in total liabilities compared to $809 million in total equity!

Just two years after being taken private, the once largely successful retailer filed for bankruptcy

in May of 2008. While the Clifton, N.J., company had $2.8 billion of annual sales, profit was sagging and

its debt level of $856 million long-term at the end of 2007 was seemingly becoming increasingly difficult

to manage. The business model of the No. 2 household retailer had been broken, unable to withstand the

assemblage of forces pulling it apart. In addition to a worsening economy, a deteriorating balance sheet,

and deteriorating credit markets, the company was facing stiff competition from the likes of Bed, Bath &

Beyond, the top industry player, as well as trying to contend with the home furnishings departments ofMacy's Inc., J.C. Penney Co., Target Corp. and Wal-Mart Stores, Inc.

Just like with the first case (HCA), my objective was to value Linens & Things with pre-

takeover debt levels and then value them again using the added debt to see how much value was being

destroyed by adding so much debt so quickly to its already deteriorating balance sheet and business

model. I used a 2-stage free cash flow to the firm model, which is best suited for firms where varying

levels of debt are expected to be the reality going forward. Again the major driver of this type of

valuation model (growth rate) was derived using a weighted average rate of growth attained through three

separate estimate options of growth (fundamental, outside analyst estimate, historical). For the Linens &Things model I normalized the capital expenditures at the firm due to the fact that they were extremely

volatile, especially in the last year (2004-2005). I also used a normalized reinvestment rate due to the

same issue as was the case with the capital expenditures.

Valuing the retailer with pre-debt takeover levels produced an intrinsic value per-share of $23 and

a market value of equity of $1.2 billion. This would have pegged the firms shares as overvalued at the

time considering the shares were trading at $26.32. In my view the estimate obtained from the valuation

model used is probably closer to the true intrinsic value of the firm than where the market valued it at the

time. My reason for feeling this way is that the business was deteriorating fundamentally due to strong

levels of competition and deteriorating profitability.

Looking below at the embedded chart from my analysis, one will see visually that all of the

profitability ratios have steadily declined since January of 2000. The only measure of profitability that has

not steadily declined but held flat at best is the gross profit margin. Another key that led me to believe


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that the company was having trouble was the fact that their ROE was actually less than their cost of

equity, which shows that management was investing in this expansion of stores at an overall return that

was less than the cost of funding the projects. This in itself was destroying value at Linens & Things

before the LBO came along and destroyed even more value. No wonder they had to file for bankruptcy!

They were being destroyed on the inside as well as from outside investors. And when the LBO added the

extra leverage and the economy went into a tailspin it was just too much for the struggling chain to deal

with.

Now if you add in the $733 million in added debt from the LBO deal, the value of Linens &Things drops off the cliff. The value per-share drops down to a little over $10 and the equity value in the

company drops significantly. Whether or not this group of private investors used the debt to pay out a

special dividend like in the HCA case seems really irrelevant to me, and if they did pay out a special

dividend they hid it very well. Regardless, the added debt taken on in the LBO destroyed value in the firm

just the same. Overall the added leverage crippled the companys capital structure and destroyed any real

ability to restructure itself in a positive value generating way.

Closing Thoughts:

Private equity has the ability to really help both investors and the economy when it functions in

an ethical manner. When private equity firms make long-term investments in companies with the intended

agenda being to help them grow their businesses, including increasing R&D spending, developing new

products and business strategies, hiring superior management, cutting costs and creating more efficiencies

and increasing capital spending on value generating projects, they in turn create value, not destroy it. This

growth-orientation often results in jobs created or saved, and additional growth by healthier, more

profitable companies. When functioning as they should, private equity buyout funds can play two distinct

and important roles in the U.S. economy. In the real, physical economy of factories and offices, private

equities operations can further the productive use of existing assets and resources, usually by identifying

companies with untapped potential. By making additional investments in assets and future value

generating projects, they in turn would be reorganizing the firms operations in ways that increase their

value. But as of late they tend to use increasingly alarming levels of debt to finance their deals and then

leave these obstructive levels of debt for the companies to deal with.


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The U.S. economy just went through a massive recession/credit-crisis, where excessive debt

levels were at the heart of the overall problem. Yet we seem to have learned nothing from that experience

and are at it again! Private equity is a big key to the success of our nations economy over the long term.

Instead of flip-flopping highly leveraged assets with each other, private equity funds need to be redirected

to more suitable and economically sensible activities, such as funding innovative companies that cant get

the funding from the public markets yet, due to a lack of financial information or earnings history.

My end conclusion on the dividend recapitalization process is that it extracted value from these

two companies instead of creating it. The new debt did nothing but destroy value within both of these

companies: the very exercise extracts value right out of the business while adding value to only a select

few private investors, leaving the companies to pay off the debt on their own. Instead taking undervalued

companies private and, by cost cutting, creating new and improved efficiencies across the supply chain,adding new markets and products, value adding acquisitions, and then retaking the firm public seems a

much more superior way to not only create value for the firm but to create value for the shareholders as

well. While the U.S. is seemingly slowly but surely losing the competitive international battle, it would

seem that making a case that self-dealing is the way out would be quite absurd. Creating tax incentives

that are aimed at enhancing productive capital and R&D should be at the forefront of lawmakers and

congresses minds and agendas. If nothing is done and things continue the way they are, the long term

prospects arent good for anyone.


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The private equity advantage. (2008, December). Retrieved from

http://www.pegcc.org/wordpress/wp-content/uploads/moodys-report-2008-the-pe-advantage.pdf
http://www.pegcc.org/wordpress/wp-content/uploads/moodys-report-2008-the-pe-advantage.pdfhttp://www.pegcc.org/wordpress/wp-content/uploads/moodys-report-2008-the-pe-advantage.pdf

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