Romney "looting" example - please explain these profits

How the heck does one make millions off of investing in a company that goes bankrupt and/or gets shut down? How do the lenders get paid back, how do the numbers work? Ideally I'd like to see a model but that's obviously a bit much to ask.

Another good example is when a company borrows money, pays out a huge dividend to the PE fund that owns it, and then completely tanks (recent example was some major restaurant chain bought by one of the larger funds, can't find it on google though). Why would lenders tolerate such a use of proceeds?

 

Leveraged recaps happen all of the time -- in big businesses and small, family run operations. Sometimes, there may be some sort of clawback/escrow provision if the company tanks soon thereafter, but lenders are not idiots. These are sophisticated (supposedly) people who are looking to put $$$ to work in the debt tranches. It is not as thought the PE firms are hiding their intentions, it is just that the lenders want the return.

 

Simplified, here's how it works. Note I don't do LBOs for a living so somebody please correct me if any of this is wrong:

1) PE shop buys a company with predictable cash flows. 2) Borrows a ton of money to recapitalize the firm. 3) Company now has lots of debt on the balance sheet; the interest payments provide a tax shield and increase EV 4) PE shop uses the debt to improve the business, making it more efficient (investing in new technology or helping it to expand its footprint, etc). 5) This is usually accompanied by layoffs. 6) The company issues a special one-time dividend to shareholders to get rid of all that cash on the BS (PE shop makes $$$) 7) Now that the company is leaner and meaner, the PE shop sells the company for $$megabucks$$.

Obviously, the common worker is not pleased by this, as they do not get to share in any of the $$$. The company is saddled with debt and a few tycoons make vast sums of money.

On the flip side, returning a company to profitability is very difficult, and obviously the new healthy, growing company is better (for everyone, including employees) than a lethargic, dying business. As with any investment, sometimes there will be companies that fail and sometimes it is very difficult to find someone who wants to buy the company.

 
gamenumbers:
here's how it works.
This I understand, but you are talking about improving a company and selling it successfully. I just don't get how one can profit off of a company going bankrupt/folding, other than possibly the aforementioned leveraged recap, under any intelligent lender's terms.
 

Do what the mob does:

  • 'aquire' the joint
  • rape it of every possible resource
  • burn it down and collect fire insurance

Translate to corporate america

  • aquire company
  • sell off profitable assets
  • churn it into some BS M&A deal
Get busy living
 
UFOinsider:
* aquire company * sell off profitable assets * churn it into some BS M&A deal
selling off profitable assets i understand, so maybe that answers the question about making money off of a company that gets shut down. That is to say, maybe they bought in at such a price that a liquidation is profitable for them and the lender.

But bankruptcy specifically fucks over the lender(s), so I'm amazed that lenders would tolerate a profiting equity piece as they take a bath.

 
porsche959:
How would a PE firm exit the position when every other potential buyer sees the massive amounts of debt on the balance sheet?
Company A is worth $100MM

P/E firm aquires Company A

Sell off best parts, eliminate waste, etc -> $20MM profit (hypothetical)

Company A is still worth $100MM on paper($80MM equity + $20MM cash)

Company A may be a better company, it may tank, P/E firm does not care

Sell off company A to company B for $100MM

Company A is now Company B's problem

** This is a gross oversimplification and isn't necessarily even true, it's just how it can be spun to the unknowing public.

Get busy living
 
porsche959:
How would a PE firm exit the position when every other potential buyer sees the massive amounts of debt on the balance sheet?

Just because there is massive debt doesn't mean it's a bad business. There are plenty of businesses that default simply because of the capital structure. In a situation where a PE firm has overlevered a company and cash flow cannot support interest/debt payments, the bank can take control and be willing to sell the business for a % of the total debt amount. For example, if a PE firm bought a $5mm EBITDA business for $50MM of which $40mm was financed with debt, and the business wasn't able to grow as expected and defaulted on the loan, the bank could start a process, sell for 80 cents on the dollar ($32mm). The bank recoups 80% of it's capital and the PE firm loses $10mm. Bank is satisfied it got most of its money back, buyer is happy because unlike the first PE firm, they were able to buy in at a 6x multiple. The one who loses is the initial PE firm who bought in at 10x, and there isn't much they can do about it as the bank controls the business.

 
Best Response

I'm delighted you asked this question because I have been extremely frustrated reading and listening the comments about how Bain makes big money when the companies fail. Here is the way LBOs currently work in the middle market. Note that it was likely different twenty years ago and perhaps the larger deals had different restrictions, but I doubt it was materially different.

Situation A: Acquired Company Grows 1) PE Firm acquires Company ABC. They do so by putting up equity (in the form of investor funds) and borrowing debt from lending institutes. Lenders often set limitations on the minimum amount of equity that must be put in by the PE firm to ensure that the PE firm has dollars at risk. Right now in the middle market, they usually require somewhere between 35-45% of the purchase price to come from invested equity. 2) ABC operates as it normally would with guidance from the PE firm in the form of a board of directors. As the business continues to grow, it hires more employees, expands product lines / services, whatever. The board encourages management to find ways to improve profitability, whether it be by implementing six sigma, lean manufacturing, implementing price increases, consolidating facilities, whatever. The cash flow generated from the business is used to pay off interested and debt. 3) After numerous years, the amount of debt on the business has been reduced substantially through ongoing operations. Furthermore, ABC is worth far more because it is now a larger business generating more profits. PE firm sells it or takes it public at a valuation greater than the initial purchase price.

In this situation, everyone wins. PE firm makes money three ways: A) Fees, B) Paying down debt from operating profits, and C) selling ABC for more than they bought it for. Similarly, the lenders are happy because they were paid interested and all of their principal was returned. Employees are "happy" because they didn't lose their jobs (unless they were bad employees and lost it in the normal course of doing business).

Situation B: Acquired Company Falters 1) PE Firm acquires Company ABC in the same manor as described above (debt and equity). 2) ABC operates as it normally would, but a recession hits and demand for its products/services falls drastically. In order to make interest payments and remain profitable, ABC is forced to cut costs. Headcount reductions occur, pay is slashed, facilities closed, inventory levels reduced, whatever it takes to stay afloat. 3) While tremendous cash flow is not generated, it is enough to service the quarterly debt payments and keep the lights on. 4) Ultimately, the PE firm sells ABC for less than they bought it.

In this case, the outcome can vary significantly. The PE firm will recoup any money generated from the sale that is in excess of the outstanding debt (debt gets completely paid off first). In some cases, the PE firm will not even get their initial investment back, other times they may turn a small profit. If the selling price is greater than the outstanding debt on the business, the lenders will come out whole, having received both interest and their principal back. If not, the lenders will receive all of the proceeds, and whether or not they make money will depend on how much they were able to recover. For the employees, they arguably come out the worst -- some lost their jobs, some took pay cuts, or had 401(k) matches disappear, or had pensions frozen, etc.

Situation C: Acquired Company Fails 1) PE Firm acquires Company ABC in the same manor as described above (debt and equity). 2) ABC operates as it normally would, but a recession hits and demand for its products/services falls drastically. In order to make interest payments and remain profitable, ABC is forced to cut costs. Headcount reductions occur, pay is slashed, facilities closed, inventory levels reduced, whatever it takes to stay afloat. 3) Cost cutting is not enough, and ABC is no longer able to make its debt payments (or cover its covenant restrictions). This triggers a clause in the Credit Agreement with lenders, and the interest rate on the debt instantly goes up even further. The lenders get spooked and demand a plan from the PE firm that demonstrates how ABC will return to profitability. 4) The plan is implemented but not achieved. The lenders A) take over ABC and become the new owner, or B) force the PE firm to liquidate ABC and recover as many assets as possible. 5) ABC is sold off in whole or in parts to the highest bidder. If no bidder is found, ABC goes out of business and is stripped of its assets. The PE firm loses its investment, the employees lose their job, and the lenders recoup as much as possible.

The above three situations are an oversimplification, but it is essentially the way private equity works. There are a few important things to mention though:

A) When the PE firm initially acquires a company, it pays itself a transaction fee. This is a nominal amount in relation to the ultimate purchase price. Also, because the PE firm is the new majority owner of the company, they are essentially paying the fee to themselves.

B) The PE firm charges the Company an ongoing monitoring fee every quarter or in some cases month. This fee is also a relatively insignificant amount. Combined with the transaction fee, the PE firm is not going to even come close to getting their initial investment back on these fees.

C) The PE firm is NOT permitted to issue a dividend to itself without prior consent of the lenders. The cash sitting in in ABC's bank accounts is classified as collateral, controlled by the lenders and to be used for general business purposes. In order for PE firm to pay a dividend, it needs to get lender consent. If ABC sells off a division or an asset, the proceeds also are held as collateral by the lenders. Unless the lenders are extremely dense, they will NOT permit the PE firm to "bleed the company dry" and strip it of its cash. It is a very rare occurrence for the PE firm to make a profit on an investment if the lenders do not. This is because the equity sits below the debt on the capital structure and the debt is paid off first.

D) After the PE firm sells the company, the capital structure is entirely determined by the new buyer rather than the seller. For this reason, it is unfair to judge a PE firm on the performance of a business after it is sold. The PE firm is attempting to grow the company as best it can, which includes ensuring it is competitive in the marketplace. If the company fails after the PE firm sells, it is likely because 1) the new buyer put more debt on the business than it was able to pay off, or 2) the business failed to remain competitive (perhaps through industry disruptions such as technology, a recession, etc.). Companies that are on the verge of bankruptcy don't generate a high selling price so it isn't in the PE firms best interest to destroy the businesses they own.

E) When the PE firm acquires a company, it utilizes debt to fund the purchase price. While the company will also have a revolving credit facility (similar to a credit card with a limit), debt is generally not used to fund the ongoing operations of the business. Cash flow generated from operations typically funds the growth (or additional equity issued by PE firm).

Again, the above is how the Leveraged Buyouts that I do tend to work. Based on these mechanics, it is impossible to make a profit by simply buying a company with debt and striping it down. I'd love to see a similar post from someone that works at a turnaround shop or a megafund.

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 
CompBanker:
I'm delighted you asked this question because I have been extremely frustrated reading and listening the comments about how Bain makes big money when the companies fail. Here is the way LBOs currently work in the middle market. Note that it was likely different twenty years ago and perhaps the larger deals had different restrictions, but I doubt it was materially different.

Situation A: Acquired Company Grows .. ..

Again, the above is how the Leveraged Buyouts that I do tend to work. Based on these mechanics, it is impossible to make a profit by simply buying a company with debt and striping it down. I'd love to see a similar post from someone that works at a turnaround shop or a megafund.

What a fantastic post!!!

If only we had like 5 CompBankers on this site

 
bortz911:
Why would lenders tolerate such a use of proceeds?

And where do you think the money for the recap comes from? It just comes from lenders, who are asked by PE if they are willing to swap some equity for debt. Lenders do a return analysis on their own model / assumption and lend or not.

Equity guys don't just put a gun on lenders' face to get their recap.

Did people overborrow or lenders overlend? That's the question you should be asking.

 
MiniMonkey:
bortz911:
Why would lenders tolerate such a use of proceeds?

And where do you think the money for the recap comes from? It just comes from lenders.

Equity guys don't just put a gun on lenders' face to get their recap.

Did people overborrow or lenders overlend? That's the question you should be asking.

thanks for contributing absolutely nothing
 
bortz911:
How the heck does one make millions off of investing in a company that goes bankrupt and/or gets shut down? How do the lenders get paid back, how do the numbers work? Ideally I'd like to see a model but that's obviously a bit much to ask.

There are many investments PE firms make, knowing the business will eventually go bankrupt. In these scenarios, the PE firm isn't seeking a high terminal multiple but rather maximizing cash flow to pay dividends. You see a lot of corporate divestitures like this where a corporation has a legacy division that is declining (i.e. wireline division at an AT&T) and hurting their overall top line. PE firm buys extremely cheap (less than 1x EBITDA) for a declining, legacy division with no infrastructure. Although it continues to decline under PE ownership, it is now more nimble and able to maintain margin and positive cash flow. Costs are eventually cut to an extreme level to maximize revenues for the duration of customer contracts/backlog, cash flow is used to pay down debt and pay dividends, and then the company is forcefully put into bankruptcy when all the customers have left... and either an auction or liquidation occurs. Since the bank debt was mostly paid down through cash flow, they recoup the rest of their money through the auction/liquidation. If there's nothing left after the banks get paid back, the sub debt and vendors (open AP) get fucked. Also the employees are upset because the business was milked to maximize cash flow, not to sustain business for the long term and now they are out of a job (hence PE"s bad rep, although one could argue that AT&T would have shut down the division years ago if they hadnt been able to sell it, so PE actually saved the jobs for several more years).

bortz911:
Another good example is when a company borrows money, pays out a huge dividend to the PE fund that owns it, and then completely tanks (recent example was some major restaurant chain bought by one of the larger funds, can't find it on google though). Why would lenders tolerate such a use of proceeds?

Lenders wouldn't allow a huge dividend knowing that it is going to tank and they wouldnt get their money back. These types of situations happened a lot prior to the recession during the big LBO days. When the recession hit, PE didn't get hit as hard as banks since most LBO businesses were capitalized with more debt than equity. Those days of over leveraging and high levered buyouts are long gone and most lenders require an equity cushion now. Leveraged recaps are still common, but nowadays, banks are more careful and cautious than they used to be for good reason.

 
PEguy2011:
lengthy explanation
Thank you thank you thank you. You're basically the only one in this thread who specifically answered those 2 questions, and this is something that I've occasionally wondered about for months if not years. I just never got around to starting a thread on this. so again, thanks for clearing up this murky corner of the PE business ...
 

This should be front paged and added to FAQ best threads list.

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
duffmt6:
This should be front paged and added to FAQ best threads list.

Except every post before Compbanker's was either wrong or not right...

I think a majority of these bankruptcies have to do with multiple variables that aren't directly linked to Bain. Some of these bankruptcies have been years after Bain sold off the investment. At that point, the new owners would have had enough time to do whatever they wanted with the company.

 

Dividend recap is much harder to do now, most lenders not have strict covenants that limit dividend recap.

I don't know if Bain exclusively in distressed companies, but there are PEs that invest primarily in distressed companies. A lot of times the PEs know they're buying companies that are destined for BK, but they'll only pay 20 cents on a dollar for their debt, and they can either liquidate the company hoping to cashing in more than 20 cents, or they can due an equity swap and try to restructure the company to make it healthy again.

Also, so far most people are just talking about the carry interest that the PEs get when they sell these companies, let's not forget Bain also charges probably 2% management fee on the committed capital during the commitment period (if committed capital is $5 billion, they'll charge $100 million in management fee even if the capital is not drawn). The management fee usually gets reduced after the commitment period, but we're still talk about huge sums here.

Another thing to add is, carry interest is pure upside and no downside. The PE funds get 20% on the profit (after returned capital, management fee and preferred returns), and nothing if they don't make a profit, so they're willing to take huge risks.

 
gshocksv:
I don't know if Bain exclusively in distressed companies, but there are PEs that invest primarily in distressed companies. A lot of times the PEs know they're buying companies that are destined for BK, but they'll only pay 20 cents on a dollar for their debt, and they can either liquidate the company hoping to cashing in more than 20 cents, or they can due an equity swap and try to restructure the company to make it healthy again.
gshocksv, thanks to you too, it hadn't occurred to me that some of these "bain takes over company, company fails, bain makes money" situations may have been executed through debt acquisition rather than buying up shares
 

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