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The VIP Ticket to a Buyout Deal

Tom Taulli May 30, 2007

Fidelity Investments, the California Public Employees’ Retirement System, and other major institutional shareholders have resisted the leveraged buyouts (LBOs) of companies like Clear Channel (NYSE: CCU), OSI Restaurant Partners (NYSE: OSI), and Herbalife (NYSE: HLF). To compensate, private equity firms have begun offering “equity stubs,“allowing existing shareholders to participate in the post-LBO entity. What does this really mean for Foolish investors?

To better understand equity stubs, let’s study an example. In late April, KKR and Goldman Sachs’ (NYSE: GS) private equity arm agreed to shell out $8 billion to acquire Harman International Industries (NYSE: HAR). Current shareholders have the option of getting $120 in cash per share or equityin the new, private company holding the assets of Harman. As much as $1 billion will be available for the equity stub.

“An equity stub is really a win-win for private equity firms and current shareholders,” said Paul Schaye, a managing director at Chestnut Hill Partners, in a Fool interview. “The private equity firms do not have to invest as much, which is important as deals get much bigger. Current shareholders also get to keep a toe in the water and that can be very helpful in getting shareholder approval on a buyout deal.”

There’s even a tax benefit. Because of IRS Section 351, investors should get tax-free treatment when rolling over shares into the private entity.

What’s the catch? Despite the advantages, investors need to realize that equity stubs are fairly rare for public shareholders. If you’ve ever seen a shareholder agreement for an LBO, you’ll definitely see the complexities.

Keep in mind that private equity firms have the resources to hire top Wall Street law firms to draft airtight agreements. These often include board seats, veto rights, shareholder repurchase rights, liquidation preferences, restrictions on the transfer of shares, and so on.

“Investors need to realize that the private equity firms will have 100% control over the direction of the company,” said Julie Corelli, a partner in Pepper Hamilton, to me in an interview. “So you are relying on the expertise of the private equity firms, as well as the management team, on these deals.”

Because retail investors will be holding shares, the SEC will require the privately held company to continue reporting its 10-Qs, 10-Ks, and 8-Ks. There’s also a good chance that the shares won’t trade on an exchange like the Nasdaq or theNYSE. Instead, there will probably be illiquid marketplaces like the Pink Sheets or the Bulletin Board.

Investors also need to understand that private equity firms will probably spend two to five years working on a deal. This usually involves outsourcing operations, cutting jobs, changing management, and divesting non-core businesses, all of which lead to the “J-curve” effect.

Confused? The “J-curve” means that an LBO probably will have negative returns in the first couple of years because of the restructuring. But if the company does improve its operations, it could fetch a healthy valuation in a sale or an IPO. So if an LBO trades on the Pink Sheets, the stock price could be quite volatile.

The debt conundrum An LBO will also have a large amount of debt on its balance sheet, which means that an investment can actually increase in value even if there’s no growth. How? Suppose XYZ does an LBO for $1 billion and borrows $800 million for the purchase. This means the private equity investor will write a check for $200 million.

Let’s say that the company continues to generate its current cash flows of $200 million per year and pays down $400 million of the debt. Now shareholders own $600 million in equity. That’s a nice return on a $200 million investment.

But problems arise if XYZ cannot pay the debt. In this case, the equity-stub holders are last in line to get any proceeds if there’s a liquidation, which could ultimately result in a worthless investment.

To deal with this problem, private equity firms perform extensive due diligence and invest in a portfolio of companies. While some deals may go bad, others will have high returns.

With firms like Blackstone and Fortress Investment Group (NYSE: FIG) raking in big bucks, I think we’ll see more equity-stub deals. Public shareholders certainly don’t want to leave money on the table.

But as with any investment, you need to make sure you do your homework. Since this is new territory, it will take even more intensive analysis compared to picking a publicly traded stock. So for Foolish investors, it’s a good idea to be highly selective when dealing with equity stubs, if at all.

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Fool contributor Tom Taulli, author of The Complete M&A Handbook, does not own shares mentioned in this article. He is currently ranked 2,817 out of 29,306 in Motley Fool CAPS.

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