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