Strongest quarter for LBOs since the credit crash

According to Preqin, Q3 2010 witnessed 498 pe-backed deals worth $66.7 bn, up 29% from Q2 and 300% from Q3 2009.

Fundraising is also up this quarter:

Bain's LBO of Gymboree looks like a slam dunk

When I read this morning that Bain Capital was buying Gymboree Corp. (GYMB) for $1.8 billion, I had never heard of the company. After reading through their 10-K and going over their stock performance, I was surprised Gymboree (a specialty retailer of children's clothing) had not been bought out earlier. This company is an almost perfect LBO target!

Existing debt consists of only about $70mm in leases. Cash flows are extremely stable. Revenues have not declined once over the last decade, growing 11% on average over the last five years. Also, over the last few years as growth has slowed, margins have improved and the company has reduced its operating leverage considerably in comparison to the earlier half of the decade. Gymboree is also less cyclical than other retail companies, possibly due to the fact that in hard times parents will rather cut their own expenses than those of their children. Finally, it's likely that improvements to GYMB's cash conversion cycle could dramatically increase value. If Bain manages to increase payable days and decrease inventories, Gymboree could possibly enjoy negative operating working capital and certainly increase free cash flow to pay down debt.

My analysis below breaks down how this LBO might work. There's obviously a lot about this LBO that we don't know yet, such as leverage, debt pricing, refinancing, and what happens to the existing cash on the balance sheet. Flipping the lease refinancing and special dividend switches in the model changes Bain's expected IRR by 10%. But even then (at 13% IRR), this is still a great LBO given my conservative assumptions (3% revenue growth, lower margins than in recent years, no multiple expansion).

If I were a merger arb, I might even consider betting another (probably financial) bidder will trump Bain's offer.

Gymboree LBO Model com

What Sara Lee tells us about the current LBO environment

About a month ago, KKR allegedly offered to buy Sara Lee for $12B, though Sara Lee's board spurned the buyout firm's advances. It's easy to see why Sara Lee might be an attractive LBO target -- it's not too leveraged, has strong brands and significant opportunities for operational improvements. My analysis (see below) shows that KKR could reasonably expect double-digit returns even if sales growth remains low. So why has KKR not raised its bid or gone hostile?

Given whats happened in the markets we should expect a sharp increase in sponsor activity. The financing market is in great shape and vintage 2005-2008 funds are flush with capital. LBO activity is in fact rebounding as total YTD sponsor backed deals are almost back up to 2005 and 2008 levels. And yet as conditions have improved, we still haven't seen the $10 billion plus mega deals that were the norm before the crisis.

Private equity certainly seems cautious about mega-buyouts. Both potential 10B+ LBOs of 2010 (Sara Lee and Fidelity National Information Systems) fell apart because of disagreement on price. One particular reason for this caution regarding mega buyouts is the pressure on the traditional mega-fund business model. Investors especially question the fee structure of these deals and, given the poor performance of many mega LBOs over the last few years, are understandably incensed by the substantial management fees on these deals.

According to Prequin surveys, a majority of LPs are reconsidering their allocation to large PE funds with some notable firms like Blackstone even returning previously paid fees. Now, with PE fundraising still weak, buyout firms are under pressure to prove their mega LBOs generate superior returns and deserve management fees of 1% or higher. The deals done today may prove to be critically important to securing funding in the future.

My analysis below shows that, although Sara Lee is an attractive LBO at $12B, those returns quickly disintegrate as price increases. In fact, price is more important to generating a return (on a percentage basis) than cost of debt or EBITDA growth.

The model below can also be downloaded as an excel file here. The operating model uses historicals to project EBITDA growth and Cash Flow / EBITDA.

Sara Lee Analysis

3G LBO of Burger King

3G's $3.3B ($4.17B total transaction value) LBO of Burger King is one of the most high-profile LBOs of 2010. This LBO is interesting for a number of reasons. For one, the acquirer, investment fund 3G (funded by a small group of Latin American billionaires), is not a part of the usual suspects one would expect to see on a deal of this magnitude. Also different from most LBOs, 3G has stated it is buying Burger King for the long-haul and is willing to wait 10 years before exiting.

The choice of Burger King is also a strange one. When BK was bought out by Bain, GS, and TPG in 2002, Burger King was an insignificant and unappreciated holding of the food and beverage behemoth Diageo, allowing the sponsors to acquire BK at a very favorable valuation. But the Burger King of today is much different. Eight years of sponsor ownership have turned BK into a lean company with few easily realized cost reductions. Furthermore, from a strategic point of view, BK has fallen far behind its rival McDonald's and requires massive amounts of capital expenditures to compete (estimated in a recent Bloomberg article to be as high as $3 billion). For more on the challenges facing 3G, go here. Perhaps most surprising is the valuation. 3G did not pick up BKC on the cheap, paying 9.4x LTM EBITDA and 8x LTM net income.

My model of the LBO is posted below. I suggest you do not try to look at it on Scribd but instead go here, and download the excel file. My analysis shows that using conservative growth assumptions and moderate cost cutting assumptions, the Burger King LBO could return 16% annually if 3G exits in five years at the same valuation (9.4x EV/EBITDA) at which it entered.

However, this return is very sensitive to Burger King's ability to cut costs, which is questionable given the rising costs in the industry as well as BKC's previous ownership (Management also expects SG&A to increase by 3% in 2011). If one assumes Burger King has to boost capex to 10% of sales and SG&A as a % of sales increases by 3%, the 15% IRR quickly disappears, even with above trend top-line growth.

That being said, I actually think this deal was a good idea for 3G if 3G manages to leverage its experience in Latin America to grow Burger King quickly in emerging markets. As Burger King grows internationally, its operating leverage from its restaurant ownership will deliver larger margins and significantly increase Burger King's valuation. But overall, like most recent LBOs, the success of the BKC LBO is heavily dependent on exogenous forces. 3G is blessed to have patient investors. It's longer term investment horizon will allow it to wait for an opportune time to exit -- which can make all the difference.

Burger King LBO Model

Going forward...

As I've learned more about finance over the last few years, I've started to shift my focus from markets and asset prices to transactions and operations. On this blog, I've written mostly on macro, geopolitical, and policy issues. Going forward, I expect to have little to say on these subjects. For one, I (regrettably) no longer have time to read as I once did (I recently graduated from school and am working full-time in finance). But more importantly, I've become increasingly interested in the details of operations, capital structure, and M&A. Perhaps the greatest reason behind this shift is that I've found I really like the way investors can influence returns by making financial or operating changes, while in macro investments an investor is merely a spectator, (though exciting as that may be in interesting times such as these the lack of control can be frustrating).

So what I've decided to do is use this blog as a forum to discuss recent M&A deals (trends, valuation, etc.), focusing mostly on LBOs and private equity activity. I'll usually build a model to back up my analysis which I will post on Scribd. The first LBO I will discuss is 3G's recent buyout of Burger King.

My Thesis: Pricing of LBOs from 1999-2009

I finally finished my honors thesis. I wrote about LBO pricing from 1999 to 2009. LBO prices (valuation multiples) rose dramatically as the amount of capital committed to private equity surged almost 10-fold after 2001. I argue that mega-buyouts, such as TXU Corp., HCA, First Data, and Freescale, were designed to avoid the increasing prices of LBOs by acquiring companies other private equity firms could not buy. My results support this hypothesis and show that after an LBO exceeds around $10 billion in Enterprise Value, the valuation of the deal becomes more favorable. After bypassing this threshold, EV/EBITDA decreases .1-.2 for every $1 billion increase in transaction value. This result is statistically significant at the .05 level.

If you are not interested in the results of my statistical analysis, you might still be interested in the first half of my paper. Section 1 gives a thorough history of private equity activity since 1980 and illustrates how the space has changed over the last 10 years. Section 2 reviews academic research on LBO performance and pricing.

LBOs From 1999 to 2009

A Shift in American Conservatism

Over the last decade, the Republican party has not lived up to its conservative values regarding fiscal issues. Until recently, the far right-wing focused increasingly on social issues. Consider, for example, Bush's gaping budget deficits. Or better yet, the rise of politicians such as Huckabee or Palin, both of whom's appeal is their social conservatism. Both can be described as either uninformed, undistinguished, or both in the fiscal realm. Given recent developments in GOP politics, it seems this trend has finally reversed, though ironically this reversal may not be as good for the deficit as one might expect.

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Grantham on Bubbles

Jeremy Grantham of GMO has made some interesting comments recently on bubbles. In this FTfm interview, Grantham argues there is nothing more damaging to an economy than a breaking asset bubble. In his Q1 2010 quarterly letter, Grantham identifies bubbles in US equities, emerging nation equities, and commodities. Grantham also recommends continued allocation to these assets, a strange recommendation considering Grantham is a value investor, who traditionally shy away from overpriced assets.

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Kraft-Cadbury Was a Good Deal Despite Recent News

Much ado has been made about the Kraft-Cadbury deal. The consensus seems to be (especially after the overlooked pension shortfall) that Kraft overpaid for Cadbury and, even worse, used its own undervalued stock to do so. Recently, Kraft revealed CEO Irene Rosenfeld's compensation for 2009 was $26.3 million, up 41% from 2008. The compensation committee "heavily weighted the significant effort and the ultimate acquisition of Cadbury" to determine the payment. To some, the Kraft-Cadbury deal is the perfect example of empire building, suggesting that Rosenfeld executed the Cadbury deal to increase revenue (which generally determines CEO compensation) without much attention to the price. This criticism reflects the common conception that most M&A destroys value and is driven by ego and compensation. In my opinion, this view is misguided, both for M&A generally and Kraft specifically.

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A Few Words on the SEC's Suit Against Goldman

Reading the SEC's allegations against Goldman (available here), I was reminded of the case against Bear Stearns hedge fund managers Cioffi and Tannin. From the excerpts of emails given by the prosecution during this case, it seemed that Cioffi and Tannin clearly deceived investors. However, the defense argued that the prosecution's damning quotations had been taken out of context and did not reflect the concrete views of the defendants. Furthermore, it was difficult to link these discussions to actually proving that the managers mislead investors. Cioffi and Tannin were acquitted of any criminal wrongdoing.

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Expect LBOs to Make a Comeback

I've been unable to post recently because I've been finishing a long thesis on LBO pricing from 1999-2009. I will post the paper on this blog in the next coming weeks. Until then, I thought I'd share my outlook for private equity activity going forward.

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Russia's Rising Influence in Its Near-Abroad

It seems as if Russian-American relations have improved significantly over the last year. The rhetoric coming out of Russia towards the US has been much milder. Russia has shown increasingly strong support for sanctions against Iran. Most importantly, Obama and Medvedev signed the new START treaty about a week ago in Prague. Perhaps Obama's push to "reset" relations with Russia have worked. However, I doubt that's the case. A country as driven by realpolitik as Russia would never compromise on personal politics alone. A closer look reveals Russia has reason to be accommodating given its strong successes in securing its "near-abroad" over the last year.

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Economic and Market Update with Prof. Spellman

I've started working with Dr. Lewis Spellman (LewSpellman.com) in a variety of capacities. One thing we're doing is putting together general market updates for various presentations of Dr. Spellman. Here is what we came up with for the beginning of March 2010:

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Perspectives on Chinese Currency Manipulation

Recent actions by members of Congress attempting to force Obama to tax Chinese imports if China does not revalue its currency have re-ignited the debate on Chinese currency manipulation. A few clearly opposing stances have emerged:

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Valuation Matters

It's common sense that equity returns depend on the starting valuation. In other words, mean returns from an asset class mean little for an asset where returns are mostly dependent on capital gains. When capital gains are a significant proportion of total returns, starting valuation should be more important than historical performance. It seems simple and obvious, but most investors who are allocating a long-term portfolio still don't pay enough attention on valuation.

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The Political Importance of Financial Reform

Today at 2:00pm ET, exactly 2 years after the collapse of Bear Stearns in March 2008, Senate Banking Committee Chairman Chris Dodd will unveil his financial reform bill. This bill promises to bring sweeping change to all major US banks. Even Morgan Stanley and Goldman Sachs will not be spared as the bill is said to contain a provision that hinders these firms from revoking their bank holding company charter they adopted during the financial crisis.

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Netanyahu's Political Attack on Obama

I firmly believe the Obama administration cannot react strongly enough to right-wing Israelis' recent "insult" against American leadership in the Middle East. I am referring, of course, to Israel's settlements announcement during Biden's visit last week. This is not the first time Netanyahu has pulled something like this:

Right-wing governments in Israel have regularly embarrassed high-level U.S. officials by making announcements about new settlement activity during or just after their visits. But it usually happens to secretaries of state. It infuriated James Baker, confounded Condoleezza Rice, and appalled Madeleine Albright. When I [Martin Indyk, former Ambassador to Israel] served as Albright's ambassador in Israel, during Bibi Netanyahu's first term as Prime Minister, he announced a major extension to an existing West Bank settlement as she departed Israel after one of her efforts to move the peace process forward. When she heard the news, she called me on an open line and shouted: "You tell Bibi that he needs to stop worrying about his right wing and start worrying about the United States."

But this time is more significant than when Albright was Secretary of State during the Clinton years. This announcement directly attacks Obama's basic foreign policy -- that engaging diplomatically is more fruitful than the unilateralism of the Bush years. By undercutting Obama's pending diplomatic achievements and fueling domestic criticism of Obama as a weak leader, Netanyahu's actions are much more damaging to Obama today than they were to Clinton in the 1990s.

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The CBO's Analysis of Obama's Budget

The CBO has released its analysis of Obama's 2011 budget. The CBO estimates Obama's budget will significantly raise fiscal deficits over the next 10 years. In 2011, Obama's deficit is only $140B greater than the CBO status-quo. Over the next decade, however, the difference between Obama's budget and the CBO baseline scenario is expected to reach up to $500B.

The stark difference between Obama's budget and the CBO baseline gives fodder to Obama's critics, particularly the tea-party movement. But a closer look reveals that the source of the disparities between the status-quo and Obama's budget is not what one would expect and has little to do with Healthcare reform or increased government spending.

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A New Carry Trade

4 days ago, the Reserve Bank of Australia raised rates to 4%. This move wasn't a big surprise and didn't get the same press as when the RBA was the first central bank to raise rates after the financial crisis in 2009. 2/3 of economists polled by Dow Jones expected the move. The RBA had stated before it would continue to raise rates as the economic recovery continued.

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Average US Deficit Over Last 25 Years Was 10%

Rob Arnott from Research Affiliates wrote recently that one of the greatest problems with the US debt statistics is government accounting. In his words, "off-balance sheet spending is what got Enron executives thrown in jail, but I suppose if you write the laws while you're doing the off-balance sheet spending you can make it legal. That takes the average deficit to 4.5% of GDP over the last quarter century. 2% deficit is not a problem because GDP grows at 2% a year. 4.5% can grow out of sight...If you add-in the GSEs, the average deficit is 8% of GDP over the last quarter century. If you include unfunded entitlements, social security and medicare, you're up to a 10% average over the last quarter century."

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EM M&A Activity

Considering how much growth has come from emerging markets over the last five years, it's strange that EM M&A activity has been so much lower than Western M&A activity over the last five years. Emerging market IPOs have long dominated the West. Just last quarter, Asian IPOs amounted to $70B, much more than the $16B of the US. 6 of 2009's 10 biggest IPOs were in EM. But EM M&A has never been equal to European or US M&A for any full quarter. Q1 2010 might well be the first quarter to break this trend. For the first 1.5 months of the year, EM M&A has equaled 40% of global M&A activity, about equal to US + European M&A for the same time period.

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Social Instability in the New Normal

John Mauldin has a great quote from Greek lawmakers regarding the debt crisis (from Reuters):

"Greek opposition lawmakers said on Thursday that Germans should pay reparations for their World War Two occupation of Greece before criticizing the country over its yawning fiscal deficits.

"How does Germany have the cheek to denounce us over our finances when it has still not paid compensation for Greece's war victims?" Margaritis Tzimas, of the main opposition New Democracy party, told parliament."

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Scars from Contagion Fears

Much has been written on the fate of Greece and the other PIGS. It is clearly a watershed year for Greece. Jim Rogers predicted years ago that the euro would fail because of the inability of forcing member states to follow the Maastricht treaty and the inability of currencies to adjust to fiscal imprudence. The 2009 recession is the first time the self-restraint of EU member states has been tested. But, as the media often reminds us, at issue with Greece is not just the integrity of the EU and the euro, but the socio-political stability of the whole country.

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The Fed's War on Inflation Expectations

When the Fed more than doubled its balance sheet during the financial crisis, many believed inflation was unavoidable. Since then, the dollar has fallen 15% and gold, other commodities, and commodity-linked currencies have soared. But the inflation expectations that moved markets throughout 2009 were never justified by data, with economic data indicating deflation was the real concern.

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Two Watersheds for the West

Lewis Spellman believes the major trends in financial markets during 2009 will reverse in 2010 because of (1) the Fed's exit and (2) sovereign debt issues. Over the last few weeks, sovereign risk and the Fed's exit strategy have brought uncertainty into markets: the S&P500 is down, the VIX is up, and the dollar is rallying as investors flood back into dollar-denominated assets. Will this reversal continue as Spellman predicts?

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Goldman Sachs and the Volcker Proposal

Peter Lattman and Kate Kelly report on pg. C1 of the Journal today: "The [Volcker] proposal, debated on Capitol Hill last week, is short on detail. But, should it become law, it could have by far the biggest impact on Goldman [Sachs] ... The firm's private-equity exposure exceeds that of the world's largest buyout firms. Goldman has roughly $14 billion of corporate and real-estate private-equity holdings on its balance sheet ... Under Mr. Obama's proposal, banks would likely be free to manage customer money earmarked for private-equity funds. But Goldman would have to divest its own holdings, a complicated task. One alternative would be to spin out its private-equity arm, according to people familiar with the firm. Goldman could also give up its bank-holding-company license to avoid spinning out the private-equity business."

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Female Employment Now Greater than 50% of Workforce

One trend often-cited during the recession is that men have lost their jobs much quicker than women. Over the past 24 months, the number of female payroll employees fell 2.6 million, while the number of men fell 5.8 million. Intuitively, this makes perfect sense since the recession has heavily affected man-intensive manufacturing and construction industries, while also bringing educated women back into the workforce (according to the NYTimes). However, this relative surge in women's employment is not specific to the current recession. In fact, the same effect occurred during past recessions. Economist Casey Mulligan estimates recessions are the only times in recent history when women can significantly gain market share.

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Positive NFP Number: Maybe Next Month

As I wrote about last month, economists keep expecting NFP (nonfarm payroll) numbers to come in positive though this has yet to happen (except the paltry 4,000 increase in November but that was a revision and doesn't count). For the NFP January numbers that came out last Friday, analysts at BoA, DB, JPMorgan, Barcap, and MS were predicting in excess of 25,000 new jobs were added during January. Just like in December, NFP numbers have disappointed at -20,000 jobs.

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Non-Farm Payrolls

This mornings NFP (non-farm payroll) unemployment numbers were expected to be positive. Consensus was that the report would show an increase of 10,000 jobs. Tyler Durden reports that Stifel Nicholas argued there was a "strong chance of a +100k" increase that could even be as high as +316,000 due to seasonal factors. It is surprising therefore that this morning's NFP number came in at -85,000.

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