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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