Private Equity Tricks
Hi guys,
I'll keep it simple... what tricks will private equity managers use to make returns look bigger, improve balance sheet, legally decrease taxes, make money out of thin air, etc... Please share secret sauce ingredients.
Comments appreciated & looking forward to a constructive debate.
Magic
.
But also magic
What do you mean by subscription line on exit?
Imagine you draw on the sub line and distribute proceeds to LP 1-2 months early before sale proceeds come in...sounds bit risky
I came across an interesting example where a smaller-mid cap European PE fund sold a brand and the entire trademarks portfolio of a recently acquired company a to the unknown offshore company b for X millions. Company a has made X millions "on paper", but it never got that money, because since the sale, the a has been paying royalties to b for the use of the brand (the royalties has been deducted from the purchase price). Afterwards, the a got the brand and its trademarks' portfolio back by using another interesting maneuver. The b has undertaken the recapitalization of the company a and invested its brand in a's capital. As a result, offshore company b became (50%) owner of a.
The tricky part of this maneuver is that before the recapitalization, b re-valued and increased the value of the previously purchased brand for 3X.
... magic
Right now reading about Cerberus and their practices...
Didn’t understand any of that. Will drink my coffee then re read
Would be very interested to read about Cerberus's practices. Do you have a good resource?
Google their firearms deal that went bankrupt
Slap 11x EBITDA in debt financed by Jefferies
So true...
Not really cheating...but counting tax distributions in excess of what you actually owe in taxes as dividends for your IRR and MOIC calculations. Did this recently on a portfolio company we exited
I was going to share this one - because it's not cheating, but it's total bullshit. Especially when the GP just counts tax distributions, period, as capital returned for the purpose of IRR calc. Seen that one done, couldn't believe it.
The smart LPs have started to ask for returns as if all portcos were C-corps.
Curious to hear more about this, as I’m not as up to speed on the tax component as an LP.
Just connecting this comment and the one above. How is tax distributions counted as a dividend and a return of capital, should be one or the other.
May be some other ways of going about it but what I've seen most commonly (depends on pre/post close legal structure):
Seller rollover into the deal doesn't benefit from the goodwill-related tax basis step-up in the company's assets, so they get taxed at a higher effective rate (no goodwill amort) than the fresh equity coming into the business. The PE firm grosses up the total tax distribution to what the total tax burden would be if all equityholders paid that effective rate, then they pocket the spread between their actual tax liability and the amount the rate implies. The theoretical rationale on the sponsor side is that all distributions to shareholders should be made on a pro rata basis, but if the tax liability isn't equal, then you get unequal distributions.
And to answer the question a bit more directly from an IRR perspective, that's really excess cash coming out of the company, which the lenders would generally have at least some sort of a say in keeping in the business depending on the credit docs. You're returning money to investors before it really "should" be (i.e. on exit or a permissible dividend).
yep this is correct. Basically, the PE firm calculates the highest possible tax rate among all the shareholders and then makes a distribution to everyone as if they were in the highest tax bracket. The ones that don't actually owe that money can pocket the cash and count it as a dividend
So in this situation you are just getting cheated out of the delta in tax payments essentially?
Is this relatively rare as this would only happen in a PE to PE sale where the selling PE firm keeps a % of the company or the management team stays on and rolls their equity into the new ownership structure?
"Cheating" is a bit of a stronger word than I would use; it's usually a negotiated point during documentation. It can some times be a bit disingenuous if a sponsor puts a model in front of you (I work for a credit fund) showing the full benefit of the goodwill tax shield, and you make a leverage determination based on that FCF profile only to find out down the road that they plan on taking the benefit for themselves. That's relatively rare though.
Haven't gone back and looked at exactly how many of our recent deals this has come up in, but it's common enough to be something that we usually ask about (how they intend on treating tax distributions). The rollover scenario is very common though at least in our segment of the market. The vast majority of deals we do have the sellers rolling over some of their proceeds.
I don't understand this whatsoever...where can I read up on it or get knowledgeable?
I'm not in PE, just coming out of UG, but very interested in this. Do you have a link where I can read more about this?
Expanding on the subscription line comment, GPs increasingly use this as a tool to boost IRRs by deferring LP capital calls. For instance, when a GP makes an investment, they will fund using the sub line and call capital from LPs at some point in the future (usually 3-12 months). This creates an inherent IRR benefit and usually can add anywhere from 100-300bps of return, which, mind you, can be the difference between a GP generating carry or not. While optically this helps returns, it also creates a funding misalignment with LPs that did not realize their funding curve would get pushed out due to this financial engineering. LPs have caught onto this misalignment and now it's becoming more commonplace for GPs to show returns that are gross of sub line leverage, as well as providing an option for LPs to invest in feeder funds that are not able to use sub line leverage.
In my experience this was and is usually done in a fundraising process. Got some investments that are not doing great but not a year old? Mark them at cost. Mark other things at above cost that LPs or others may or may not ask questions And if public markets are good. Then mark them lower later (post audit and after you’ve secured said fundraising). Usually the argument is the company WAS doing better but hit a rough patch in the next three months. Oh but that was after LPs committed to the next fund? Oops. My bad. There are a number of studies that have said that this is quite a practice at times of fundraising so even “dumb” LPs are wise to it. Selective comps with public companies? Check. I know this sounds super basic and JV but it is how it is.
Hope this helps.
I have seen dividend recaps whose funds are re-invested into the same company using a fund's recycling provision only counted once for MOIC purposes. Imagine investing $100M. After 6-9 months, you do a recap and get $30M of equity returned to the fund. 6 months later, you do an add-on acquisition and re-invest the $30M of equity. Then you say, "oh yeah, we invested a total of $100M of equity here"...
Funny money
"Adjusted EBITDA"
It's amazing how many costs are in fact just one-time expenses or exceptional items according to GPs.
Oh boy! "hey, how come these $3m dollars in marketing spend are making their way back into our adjusted Ebitda?" "it's non recurring mate!" "but aren't we doing the same event next year and another 2 that are even bigger than this one?" "......."
"Community Adjusted EBITDA"
Dividend recaps
Very short sighted of a PE firm to do anything that "tricks" the people funding them into believing their IRR is higher than it really is. Same deal with fucking over lenders and saying "lol gotcha" when a lender brings up an issue. Like yeah...you can legally get away with it but you probably shouldn't because you'll damage your reputation long term and the PE community is very small.
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