To be polite, that’s not quite how it works. An LBO firm raises capital from institutions and very wealthy individuals and charges them a fee of 2 percent of assets, plus 20 percent of the gains. Then the LBO finds a company that it thinks is poorly managed and undervalued, and it buys control by offering a 20 to 30 percent premium over the current stock price. If the purchase price is $6 billion, typically the LBO firm puts up a billion and borrows the rest (hence the “leverage”).
Then the smart, young LBO guys dissect the company. They cut costs, redesign products and lay off people. If all goes according to plan, the company will prosper and they can resell their shares back to the public at a higher price, or to some other company or a rookie LBO fund at a much higher price. In the 1980s, the LBO game was high risk/high reward, and took years to play out.
The problem is that LBO firms and their investors are impatient. So, being ingenious guys, they have figured out how to get their money back faster. They can charge the acquired company hefty fees for their invaluable management guidance. Or they can have the acquired company sell a junk-bond issue–for the sole purpose of paying the LBO firm a special dividend.
One example of this formula is the purchase in 2002 of Burger King by an LBO consortium for $448 million. Within two and a half years, the consortium had earned all that back by charging Burger King unspecified “professional fees” and quarterly management fees, and taking a big special dividend, for which the company had to borrow to pay. This May, the consortium sold a portion of Burger King back to the public at $17 a share, which valued its remaining investment at $1.8 billion–four times the original cost.
The only problem is Burger King isn’t doing so great. The stock closed last week at a little over $15. But so what? The consortium has already made a bundle. After the IPO, Burger King paid it an additional $30 million for terminating the management agreement.
The Burger King saga is not unusual. Since 2003, companies acquired by LBO firms have borrowed $70 billion primarily to pay dividends to their LBO owners. Can this business model succeed in the long term? I don’t think so. The LBO fund borrows heavily to take control of a second- or third-rate company, cleans it up, ravages it for fees, then leverages it up further by selling debt, and pays itself a big dividend. The whole process is debt on debt.
Money is now pouring into private equity at the rate of $200 billion a year in the United States and Europe. Eventually that sum will be leveraged up to a trillion, because it has to be. Why? If it wasn’t, the return on LBO capital would be lousy. Fortune magazine calculates that from 1976 to 2004, Kohlberg, Kravis Roberts & Company, the Tiffany of LBO firms, earned its investors a 185 percent return–which is pretty mediocre for a 28-year period, and would have been much lower if their money had not been leveraged by a factor of five.
Private-equity returns are moving from feast to famine. I calculate that the median return for LBO funds was 16 percent in the period from 1986 to 1996, 8.2 percent in the last 10 years and only 1.6 percent in the last five. The big money that follows success always kills the golden goose, and the LBO goose is dying. People just don’t know it–yet.
So LBO mania is a big bubble, one carrying an enormous amount of pension fund and endowment money. Mind-boggling leverage on mostly cyclical companies suggests that in the next recession, the game is up. LBO investors will get burned. So will the banks and junk-bond owners. A bust will not be a trivial event for the U.S. and European economies because there are a couple of trillion dollars of LBO debt out there. The mood brings back unpleasant memories. There are so many amateurs, so many no-good brothers-in-law raising LBO fund money, the genre reminds me of tech in the late 1990s. Look out below.
