Does Private Equity Create Wealth

1
Does Private Equity Create Wealth?

• Ron Masulis
• Owen Grad School of Management, Vanderbilt
  University
• Randall Thomas
• Vanderbilt Law School

2
Three Themes

• How private equity creates wealth
• Why publicly owned firms are not managed well
• How derivatives can destroy wealth
• (Derivatives are put call options, futures
  contracts, swaps swaptions)

3
Overall LBO Volume as a Percentage of Global MA
Private Equity Deals
LBO Volume ( in billions)
Notes Includes announced transactions excluding
withdrawn deals, share repurchases, spin-offs,
and minority stake purchases.
Source Thomson
4
Basic Steps in an LBO

• Buy up publicly held stock to concentrate firm
  ownership in a few large shareholders
• Issue new debt to raise leverage and finance
  stock purchases
• Streamline operations and sell off excess assets
  to pay back debt and high interest
• An LBO is similar to an acquisition by a
  financial Bidder Bidder with cash but no
  operating assets

5
Do LBOs Create Wealth? EXAMPLE CONGOLEUMS LBO

• Conglomerate Flooring, shipbuilding auto parts
• Pre-LBO debt level 125 MM
• Pre-LBO announcement equity value 150 MM
• Buyout premium paid on stock 460 MM
• Buyout financed with 380 MM in debt and 95 MM
  in excess cash
• 5 years later paid off debt, did 2nd LBO
• 2 years later firm liquidates - equityholders
  receive 850 MM

6
Stakeholder Winners Losers

• Management
• Stockholders
• Bondholders 0
• LBO investors (Private Equity)
• Employees Pensioners -
• Suppliers
• IRS
• LBO is not a zero sum game there is large
  wealth creation!

7
Stakeholder Wealth Effects - Evidence

• Public stockholders 56 Buyout premium
• Management
• Realizes greater gains than common stockholders
• Forced to invest substantial portion of wealth in
  stock bears large undiversified risk
• Buyout funds Returns have ranged from 20 to 35
  
• Thomas Lee had 50 for over 10 years
• Straight debt
• Bond ratings fall, but prices on average dont
  change
• If LBO protected, then either debt repurchased at
  face value or interest rate is raised these
  bonds generally gain in value
• If unprotected, bonds lose 7 of value on average
• Employees Often head count is rapidly reduced by
  substantial amount
• Suppliers usually must reduce their profits from
  sales to LBO firm
• US Government Losses substantial taxes

8
How Do LBOs Create So Much Wealth?

• Concentrates stock ownership
• Shifts board control to large shareholder LBO
  investor
• Accepts substantially higher debt leverage
• Small number of private debt investors
• Improves management incentives
• Pressures mgmt to reduce the corporate empire.
• Forces stakeholders to make large concessions
• Increases tax savings

9
LBOs Improved Corporate Governance!

• What do nearly all of the changes in the prior
  slide have in common?
• They improved corporate governance!
• Create strong incentives for CEO and Board to
• Work hard
• Take risks
• Make tough decisions to improve shareholder wealth

10
LBOs Greatly Improved Management Incentives

• Raises mgmt share ownership substantially
• Substantial upside gain potential
• Raises mgmt dollar investment in firm share
• Substantial downside risk exposure
• High leverage makes firms stock price highly
  sensitive to changes in firm value (equity
  multiplier effect)
• Board oversight of mgmt is heightened by
  restructuring board of directors these
  directors have strong incentives
• Small board, financially sophisticated, large
  stockholdings
• Reduction in free cash flows
• Substantial risk of bankruptcy in early years

11
Empirical Evidence on LBOsImproved Operating
Efficiency

• Board composition substantially changes its
  size is reduced, and mgmt is often replaced
  within 1st 3 years
• LBO firms become almost twice as profitable as
  industry competitors while privately held
• LBO firms outperform competitors in operating
  income stock returns for at least 4 years
  following going public again
• LBO firms show improved focus, sheds excess
  assets
• Tax payments are reduced substantially
• Compared to competitors, LBO firms
• Use only half the working capital (cash)
• Have larger average advertising budget
• Overall investment level is lowered
• RD maintenance expenses are unchanged!
• Leverage is permanently higher even after a
  reverse LBO

12
Whats Wrong at Publicly Held Companies?

• Poor corporate governance poor management
  incentives to operate the firm efficiently
• Major corporate governance mechanisms
• Board of directors Has power to hire, fire and
  set CEO compensation
• CEO compensations sensitivity to firm
  performance
• CEO and Board stockholdings

13
Public Company Board Structures Need to be
Strengthen

• Directors of public companies are generally part
  time, not financial experts, have small
  percentage shareholdings with little incentive or
  expertise to effectively monitor risk exposure
• Firms today are more complex and larger, making
  risk monitoring more difficult
• Boards do a poor job of monitoring derivative
  risk exposure in separate analysis we examine
  corporate losses from derivatives and subprime
  problems strikingly large number of firms have
  experienced problems

14
Whats Wrong with Corporate Governance at Public
Companies?

• Board of Directors are often nominated by the CEO
  (friends family)
• Board has poor incentives to work hard (little
  stock in the firm)
• Directors often not very financially
  sophisticated
• Directors are often very busy not carefully
  monitoring
• Outside directors dont know whats happening
  inside firm rely on CEO supplied information

15
Whats Wrong with Corporate Governance at Public
Companies?

• CEO incentives are insensitive to firm
  performance
• CEOs benefit from growing the empire even if
  it is not profitable
• CEOs typically own little stock
• CEOs often hold large option positions short
  term focus
• CEOs may be protected from hostile takeover

16
The Rise of Derivative Contracts

• Over the last 40 years, derivative contracts have
  emerged as a major financial instrument heavily
  traded, issued and held by corporations worldwide
• Ex. Swaps contracts outstanding exceeded 100
  trillion
• FIs in particular have been extremely active
  market participants
• Derivatives allow investors to shift particular
  risks to other investors

17
Dangers of Derivatives

• Derivatives allow a firm to dramatically increase
  risk exposure in a few minutes
• Ex. Southwest Airlines buys most of its oil in
  the forward market commits to a price today for
  delivery months into the future
• When oil prices were rising, they save millions
• When oil prices began failing substantially, they
  lost millions
• Metallgesellschaft lost 1.4 billion in oil
  futures
• Sumitomo lost 2.6 billion in copper futures
• Worldcom illegally reduced its costs using swap
  contracts by 11 billion

18
How Derivatives Make Corporate Governance Worse

• Derivative contracts allow corporations to
  rapidly add or subtract specific risks
• Financial accounting systems fail to reflect the
  risk exposures associated with these contracts
• As derivative activity has risen, it becomes more
  difficult for boards of directors and investors
  to know what risks the firm has taken on
• This allows CEOs to accept large risk exposures
  without board approval

19
FIs Have Serious Problems With Derivative Risk
Exposure

• FIs are very big buyers and sellers of
  derivatives
• Quarterly disclosure requirements for FIs are
  outdated and can be evaded
• Rapid changes in counterparty risk are possible
  in large transactions, which requires more timely
  disclosure
• Hard to evaluate FI risk levels because of
  complexity of transactions, especially
  counter-party default risk
• Moral hazard problem from government bailouts
• Little shareholder oversight because of dispersed
  ownership of FIs generally

20
Why Private Equity Improves Corporate Governance

• PE investors have large shareholdings in their
  firms
• Hire a small group of financially sophisticated
  directors with substantial firm shareholdings
• Enforce strong board oversight of CEOs
• Implement specialized internal reports
• Have high leverage, which creates an large equity
  wealth multiple
• Require senior management to hold substantial
  equity positions

21
Conclusions

• Extensive derivative usage confronts boards and
  regulators with difficult monitoring problems
• Public company boards lack the incentives, time,
  training and information to adequately monitor
  firms derivative exposure
• Private equity firms help to offset these
  governance problems by exercising strong control
  rights, decreasing board size, improving
  information flows, introducing improved risk
  management, employing financially sophisticated
  directors with strong incentives, and giving
  management greatly improved incentives