LBOs: Winners and Losers in the Buyout Game

    by Robert Benjamin

    Corporate mergers and leveraged buyouts (LBOs) occurred at a frenzied pace in 2006, rivaling the record-setting year of 2000 and contributing to the stock market’s substantial gains last year. More than a quarter of these transactions involved private-equity firms seeking to profit by taking publicly traded companies private.

    And so far this year, LBOs are continuing at the same frenetic pace.

    For investors, there have been winners and there have been losers in this unprecedented increase in private-equity activity. In general, high-yield bond investors have benefited from the buy-out boom, public stockholders have seen limited gains, and investment-grade bondholders have been perhaps the most at risk from the overnight downgrading of their holdings.

    This has been reflected in the varying experiences of some of our managers at T. Rowe Price. Here’s how some T. Rowe Price portfolio managers have been coping with the wave of LBOs, and what it means to investors in general.

    LBOs: How They Work

    Leveraged buyout deals essentially boil down to financial re-engineering of public corporations, with private-equity firms—at times hand-in-hand with companies’ managements and boards of directors—buying quality companies with clean balance sheets at relatively cheap stock prices and then financing the takeovers with high-yield bonds.

    The scale of the buyouts this year has already eclipsed the last big LBO wave in the 1980s that peaked with the $31 billion takeover of RJR Nabisco. Over just the last two years, private-equity firms have raised an estimated $400 billion, according to The Leuthold Group, a provider of market research and analysis.

    With the ability to leverage their capital four to five times, private-equity firms’ potential purchasing power may now range from $2 trillion to $3 trillion, according to various estimates. That is a stunning figure as measured against the roughly $13 trillion total capitalization of the stocks on the New York Stock Exchange.

    Last year’s private-equity takeover of the Hospital Corporation of America, valued at $33 billion including debt assumption, set a record. That was surpassed in February when Equity Office Properties Trust, the largest owner of U.S. office buildings, was bought by the Blackstone Group for $39 billion including debt. A $45 billion buyout of TXU Corporation, the giant Texas utility, is pending approval. And even larger companies have already been rumored as potential takeover targets.

    Meanwhile, conditions promoting the growing number of private-equity leveraged buyouts show few signs of abating, among them:

    • A worldwide flood of liquidity;
    • A large inventory of U.S. companies that cleaned up their balance sheets by reducing debt levels after the stock market sell-off in the early part of this decade;
    • Easy credit—in a low-interest environment—that buyers can use to leverage acquisitions;
    • Pressure to escape both tighter government regulation of public companies under Sarbanes-Oxley legislation and public demands for limiting compensation of public-company CEOs; and
    • Not least, the growing participation of pension plan investors in private-equity deals in an effort to boost their returns.

    Figure 1.
    U.S. Private-Equity
    Fundraising (1990-2006)

    Investor Pros and Cons

    In many cases, the benefit to investors holding shares of a company being acquired is an immediate increase in the value of the shares.

    If the acquisition target receives or is expected to receive rival bids, the stock could continue to appreciate until only one rival is left standing. Acquisitions can be an excellent way to realize hidden value in a stock, particularly among smaller and mid-size companies, which are not always closely monitored by market researchers.

    The downside for long-term investors is that the company that they expected to own (and hopefully benefit from) for years is no longer available for investment. The acquiring company may not be as attractive, and the investor may be forced to reinvest the sale proceeds in companies whose long-term prospects are also not as favorable.

    In addition, mutual fund investors who own equity funds with multiple takeover targets may find themselves with substantial taxable capital gain distributions at the end of a given year.

    The Winners

    In private-equity LBOs, one investment manager’s losses may be another’s gains. Last year’s $3.4 billion takeover of Education Management Corp.—a large operator of for-profit, post-secondary vocational schools—is illustrative.

    When Education Management’s new owners issued 10-year bonds paying 10.25%, Mark Vaselkiv, manager of the T. Rowe Price High Yield Fund, saw a favorable investment opportunity that ultimately proved rewarding. His confidence in these securities was bolstered in no small part because T. Rowe Price had been one of the company’s largest stockholders, and its analysts had had strong relationships with the firm’s management for years, according to Mr. Vaselkiv.

    High-yield bonds historically have been issued by companies with a lot of fundamental problems and competitive challenges. But private-equity LBOs—in which the acquired company’s investment-grade bonds typically are downgraded to junk—have contributed to the best high-yield environment in years, according to Mr. Vaselkiv.

    From the high-yield manager’s view, the buyouts are bringing into this asset class a greater number of high-quality businesses with clean balance sheets and few liquidity issues in the foreseeable future. This includes larger, better capitalized, better managed companies that have better competitive positions in their respective industries and the ability to support the new debt.

    The Losers: “Stolen” Stocks?

    On the other hand, the Education Management LBO was viewed much differently by John Laporte and Brian Berghuis, managers of the T. Rowe Price New Horizons and Mid-Cap Growth Funds, respectively.

    These fund managers view themselves as long-term buy-and-hold investors, and they say that “stolen” isn’t too strong a word to characterize that takeover.

    Both equity managers had been enthusiastic about the company’s long-term prospects, having acquired much of their positions in the stock when it was selling at a per share dollar price in the high teens to low twenties.

    Even though Education Management was bought out at about $43 a share—an approximate 16% premium over its trading average—they considered the price far too low. They think it could have been worth $60 or more per share in three to five years.

    Similarly truncated gains in buyouts are becoming more common for mid- and small-cap fund managers. All together, T. Rowe Price’s three small-cap funds lost 47 different companies to mergers and acquisitions last year.

    Among these deals, Mr. Berghuis was particularly vocal in opposing the buyouts of both Education Management and Fairmont Hotel & Resorts. The latter sold for $3.9 billion or about $45 a share, a 28% premium. Mr. Berghuis believes its true value would have been $65 by the end of 2007.

    Figure 2.
    Total Number of Private-Equity
    LBO Deals (1995-2006)

    Shortly after the buyout, Fairmont’s private owners sold some of its underlying real estate for $1.7 billion and entered into long-term contracts to manage the hotels sitting on much of that land.

    Mr. Berghuis complains that the private-equity players, in essence, “took a lot of their capital, not their equity, off the table three months after the deal, and now it’s obvious to me that this company was not worth $65 as we thought, but it was probably worth much, much more. It’s hard to believe that the board of directors didn’t know when this company went private that they could sell some of the underlying real estate for tremendous sums… . Deals like that just don’t happen very quickly.”

    It is the “insider” deals, the buyouts in which management is a partner, that Mr. Berghuis and Mr. Laporte find most worrisome, because of the potential for real conflict of interest.

    On average, premiums in private-equity buyouts are running about 10% to 15%, compared with the 25% range paid by public companies making strategic acquisitions, according to Mr. Laporte. Insiders sometimes pocket the difference. The critical question, according to Mr. Laporte: Is management representing shareholders or itself in trying to line their pockets?

    Table 1. Recent Large LBO Transactions
    Company ($ Bil)
    Equity Office Properties 39.0
    HCA 33.0
    Kinder Morgan 22.0
    Albertson’s 17.0
    Freescale 16.5
    TDC* 15.3
    Hertz 15.0
    GMAC* 14.0
    Univision 13.7
    Sungard 11.8
    VNU*** 11.1
    *A Danish telecommunications firm now owned by the Nordic Telephone Co.
    **General Motors Acceptance Corp.
    ***A Dutch media research firm.

    Sources: J.P. Morgan, T. Rowe Price.

    Bond "Event Risk"

    Investment-grade bond managers also have become increasingly concerned about the threat that this LBO boom poses for their portfolios.

    They have seen portfolio disruptions and have incurred losses when high-quality corporate bonds are downgraded, a result of the debt piled on to the acquired companies.

    Downgrades can occur even when companies are merely rumored as takeover targets.

    A Lehman Brothers study of the largest leveraged buyouts during 2005 and 2006 showed that “bonds underperform significantly when a transaction is announced.” The underperformance averaged 4% in the month of the announcement, the study says.

    Thus, high-grade bond investors now have to consider the risks from such events, and be careful not be too concentrated in companies or industries that may be takeover targets. The irony is that companies that are ordinarily desirable from a credit standpoint in the investment-grade market are often the same ones that the private-equity funds are looking to take private.

    Buyout Backlash

    Meanwhile, some T. Rowe Price fund managers are becoming more active in opposing leveraged buyouts.

    In January, Henry Ellenbogen, co-manager of the T. Rowe Price Media & Telecommunications Fund, criticized a proposed leveraged buyout of Clear Channel Communications, Inc., for $18.7 billion.

    Also in January, John Linehan, manager of the T. Rowe Price Value Fund, was among investors who rejected a takeover of Cablevision Systems Corporation by the Dolan family.

    “I don’t mind a takeover,” Mr. Linehan said at the time, “but here’s a bid that doesn’t reflect the true value of the company.”

    In March, Mr. Laporte and Mr. Berghuis—whose funds have been long-term shareholders of Laureate Education, Inc. (LAUR), a Baltimore for-profit education company—opposed a proposal to take the company private at what they viewed as a bargain price.

    “We have serious concerns with how the buyout process was conducted...the collaboration of 10 private-equity firms in the transaction, and the conflict of interest brought about by the participation in the transaction of LAUR’s chairman and CEO,” the two fund managers wrote to Laureate’s board.

    As a result of the opposition, the offer price was slightly increased, but the two portfolio managers continued to oppose it. Nonetheless, the buyout was approved by Laureate Education shareholders in mid-July.

    In his annual report letter toT. Rowe Price Mid-Cap Growth Fund shareholders at the end of 2006, Mr. Berghuis wrote that private-equity players are “preying on the weaknesses of our financial system. Public markets today are dominated not by shareholders who are focused on long-term values but by traders who are motivated by short-term factors and inclined to sell companies for quick and modest premiums.

    “Managements of target companies are often motivated by the allure of not having to answer to the short-term vicissitudes of the public markets and [by] the significant equity stakes they are offered by private equity in the going-private process. The investment bankers in some cases are rewarded for advising on the transaction, writing fairness opinions, arranging debt financing, and providing equity—sometimes all in the same deal,” Mr. Berghuis wrote. The net result can be a much less desirable company, he added: “Many companies remain private for very short periods, and many engage primarily in balance sheet manipulation or tax arbitrage as a means of adding value before returning to public markets at valuations comparable or higher than their prior public values—in spite of their vastly increased debt levels.”

    Potential Unwinding

    While post-LBO companies generally appear to be doing well at the outset of 2007, there is worry about a potential unwinding of the factors fueling the buyouts.

    All the money now flowing into private-equity deals is a “red flag,” Mr. Berghuis believes, with the potential for a recession to cause some of these highly leveraged enterprises to fail.

    For private-equity investors, he says, an unwinding of the LBO boom could be like the sudden end to the game of musical chairs. “At some point,” he says, “the music stops, there are 10 people in the room and only six chairs.” But Mr. Vaselkiv, whose high-yield shareholders have benefited from the LBO boom, notes that such games must play themselves out for that to happen. In the meantime, it is a question of closely watching risks.

    Twenty years ago, he notes, the high-yield market almost collapsed after a wave of very aggressive leveraged buyouts led to the worst performance in the market’s history, so there is concern that over the longer term this positive development could lead to a period of speculation. “The deals will get riskier and riskier, more and more debt will be piled on balance sheets, and ultimately that will lead to more failures and higher default rate,”Mr. Vaselkiv says. Right now he feels the opportunities outweigh the risks, but that could change over time.

    The Market Ahead

    Where are LBOs taking the market? It depends, in part, on how far down the road you want to look.

    Some T. Rowe Price managers perceive the merger and buyout trend as positive for the stock market, at least in the short run. When you combine these deals with very strong corporate balance sheets and significant investor liquidity, these managers feel you come up with a recipe for significant buying power for stocks in the months ahead.

    Those worried about LBOs concede that, in the near term, stocks appear to be poised to outperform other asset classes because equity is priced so cheaply relative to debt. However, Mr. Berghuis believes that this “private-equity stampede” remains a temporary phenomenon. He says the liquidity in today’s capital markets has vaulted this structure to center stage, but in time conditions will change, and so will the prominence of private equity and its impact on companies.

    Just what will happen in the stock market if the prominence of private equity changes?

    Figure 3.
    Total Value of Private-Equity
    LBO Deals (1995-2006)

    No one can predict when that will happen, but some managers do predict the present trend will eventually end when risk-taking is curtailed, possibly by a recession or a sharp unanticipated rise in credit defaults that brings more risk awareness into financial market prices. And one manager notes: “History suggests that the longer it lasts, the more abrupt the transition to more rational behavior and returns that are more consistent with long-term averages.”

    Implications for Investors

    It is possible that heightened LBO activity—which often targets small- to mid-sized companies and those perceived as being undervalued—has artificially extended recent performance trends in the stock market.

    For example, small-cap shares, in modern history, have outperformed their larger peers in periods that lasted between five and seven years, but the current small-cap cycle of outperformance has lasted nearly eight years. Similarly, value stocks have surpassed growth stocks, especially technology and health care, for about seven years. These trends have inflated relative valuations for small and value stocks and, potentially, their risks.

    Investors looking for solid corporate fundamentals, as opposed to merger targets, may now find more attractive fare among large-cap and growth stocks.

    Owning a company that is acquired may be profitable in the short run, but investors don’t need to change investment strategies by deciding to focus on companies that they think could be acquired. Broadly speaking, a well-diversified portfolio is likely to include some exposure to the type of smaller, value-oriented firms that become takeover targets.

    This strategy will also balance the risks involved in pursuing such companies, and provide some cover if the LBO boom abruptly ends.

→ Robert Benjamin