When Should I Sell My Business?

When Should I Sell My Business?

Every business owner I have ever known, has sought to sell their business at the top of the market. I think this is part of the movement where many are in a constant quest to outdo others. While conceptually I understand this desire, these owners should heed the voices of some sages.

Daniel Kahneman’, “The average investor’s return is significantly lower than the market indices due primarily to market timing.” 

Warren Buffett, “Trying to time the market is a fool’s game.”

Baron Rothschild, “You can have the top 20% and the bottom 20%; I will take the 80% in the middle.”

 

What it takes to Sell at the Top of the Market

If you are determined to sell at the top and are ready to step aside at any time, the only concern is timing. However, if you have other timing considerations, e.g., retire when my business is worth $X, step aside when I am 65, then things are far more complicated.

For the market to be at the top when you reach some predetermine criteria, you need to ensure that the entire economy collaborates with you. To do this, I expect you would need to have the ear of: 

  • the President, 
  • the majority of Congress, 
  • the Chair of the Federal Reserve, the Secretary of the Treasury,  
  • the President of the European Central Bank, 
  • the German Chancellor, 
  • the President of France, 
  • the President of Russia, 
  • the President of the People’s Republic of China, 
  • the heads of the People’s Bank of China, and
  • the leaders of all the leading investment banks and hedge funds worldwide, to name a few. 

Not only would you need their ear, but you would have to persuade them that collaborating with you is in their best interests as well. Furthermore, many of these people would want something in return for a favor, and most of the people I have spoken with would be able to afford the price Vladimir Putin would expect. Finally, I have found any scheme where only one person knows of it but requires many people to ensure its success is bound to fail.

As a result, I would say that trying to sell at the top is a fool’s errand and one that should be abandoned.

 

A Contrarian View

Some have argued that selling at the bottom of the market makes more sense. The rationale is that the business owner will reinvest those assets into other assets whenever they sell their company. Thus if you want to ensure continued wealth accumulation, one should do it at the bottom of the market rather than the top.

To examine this theory, I did a simple analysis. I reviewed four dates and the market conditions. I looked at the Russell 2000 Price Earnings Ratio for those dates and indexed them with the 2000 Price Earnings Ration as the base = 100. Assuming that enterprise value (EV) to EBITDA ratios followed the Russell 2000’s PER, the EV/EBITDA ratio in 2000 was 5x, and the company had an EBITDA of $1 million in each year before the sale, the results are as follows:

Date Market Conditions Russell 2000 PER (Indexed) EV / EBITDA Multiple Proceeds ($k)
12/31/2000 After the Top of the market 100.0 5.0 $5,000
12/31/2005 Near the top of the market 58.6 2.9      $2,929
12/31/2010 Emerging from a recession 52.6 2.6 $2,631
12/31/2015 Middle of a bull market 74.7 3.7 $3,734

I then made a few more simple assumptions:

  • Transaction costs to be 30% comprising intermediary and legal fees of 10% and taxes of 20%.
  • The proceeds are invested in two funds, VFIAX – Vanguard 500 Index Fund Admiral Shares and VBMFX – Vanguard Total Bond Market Index Fund Investor Shares as proxies for a general stock and bond market investment.
  • The allocation is 70% into VFIAX and 30% into VBMFX.
  • Any funds withdrawn and any distributions are ignored as they would be the same for both funds.

Below is a chart of the S&P 500 from December 31, 2000, to December 31, 2020 to show the market’s performance over the period.

Source: Yahoo Finance

Following the investments as described above after five, ten and fifteen years the returns were:

Date Initial Value ($k) After 5 yrs ($k) Return (%) After 10 yrs ($k) Return (%) After 15 years ($k) Return (%)
12/31/2000 5,000 4,822 -3.6 4,930 -1.4 7,027 40.5
12/31/2005 2,929 2,993 2.2 4,292 46.5 5,414 84.8
12/31/2010 2,631 3,790 44.0 4,786 81.9    
12/31/2015 3,734 4,643 24.3        

 

So as it can be seen, while selling at the top, provided the greatest wealth after fifteen years, interesting the difference over 10 years was less than 3% between selling at the top and selling just after the bottom. The other points are somewhere in between. Therefore, selling at the top is not the conclusive answer we expected.

 

So what to do?

What I have always advised clients is to build a business that is attractive to buyers and can be sold. The key is to create your own redundancy, so that you can sell it, stay in a non-executive capacity and effectively “coupon clip,” or pass it on to your children or employees. You have many options and if someone comes along and offers you “silly” money, take it. But don’t worry about the “Top of the Market.”

If you want to know if your business is sellable, complete this questionnaire, and if you want help building a sellable business, contact me.

Copyright (c) 2021, Marc A. Borrelli

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Going to Sell Your Business in 2020/21 – Think Again!

Going to Sell Your Business in 2020/21 – Think Again!

Over the many years I spent advising business owners on the sale of the companies, many owners had some specific date in mind for when they would be ready to sell. Usually, this was always five years away and as a result some higher figure than what the business was worth today. Well, COVID came along and changed the game! Whatever you thought your business was worth six months ago, think again!

Many well-performing companies that maintaining their historical levels of revenue and EBITDA might find that their value is half of what it was a year ago. Why?

 

What Drives Value

Management Team

Many owners have told me how great their team was, but on inspection, the owner made all decisions and told them what to do. In that case, the owner doesn’t have a company, he has a job, and that you cannot sell.

Is the team managing indispensable or replaceable? The management team is essential, as they have to lead the company and deal with the fast-changing environment we are now facing. They need to understand and agree on:

  • the company’s strategy;
  • how each of them is executing it;
  • the company’s business model;
  • what the business’s value drivers are; and
  • when the company needs a new plan and strategy.

 

Business Model

What is your business model? How do you make money? This latter question is a great test for many because I challenge business owners to keep the answer as succinct as possible. The gold standard is Herb Keller, Founder of Southwest Airlines, “Wheels up.” With that, your employees can understand what they do helps.

Next, what is your Flywheel? Jim Collins described it as follows,

“The premise of the flywheel is simple. A flywheel is an incredibly heavy wheel that takes huge effort to push. Keep pushing and the flywheel builds momentum. Keep pushing and eventually, it starts to help turn itself and generate its own momentum–and that’s when a company goes from good to great. We all know success is based on focus and hard work. But dive a little deeper and the flywheel concept can provide clarity and help drive strategy for any business in any industry. Here’s why. A flywheel is also a self-reinforcing loop made up of a few key initiatives. Those initiatives feed and are in turn driven by each other, and build a long-term business.” 

Amazon’s flywheel was described as follows in The Everything Store“. . . Bezos and his lieutenants sketched their own virtuous cycle, which they believed powered their business. It went something like this: lower prices led to more customer visits. More customers increased the volume of sales and attracted more commission-paying third-party sellers to the site. That allowed Amazon to get more out of fixed costs like the fulfillment centers and the servers needed to run the website. This greater efficiency then enabled it to lower prices further. Feed any part of this flywheel, they reasoned, and it should accelerate the loop.”

The point to note is that “Feed any part of the flywheel, and it should accelerate the loop.” What is your flywheel and where is it not functioning well?

With that established the next questions to ask are:

  • Is the business model still the right model?
  • If your business model is a legacy model, what is it worth?
  • Is there an emerging model complementary or competitive with the legacy model, and when could it take over?

 

Employees

The employees need to be passionate about the company, its mission, vision, and reason for existing. Culture and core values are essential! If your employees live the core values, know the company’s mission, vision, the reason for existing, and how it makes money, they will go the extra step and you can drive decision making down to where the information is. With this knowledge, the employees knowing that they will make choices in the best interests of the organization. Enabling decision making further down the chain of command increases the agility of your teams and improves performance.

With the rapidly changing environment due to COVID’s accelerating effects, the business landscape has changed, and to respond, companies need new strategies, actions, capital plans, and human capital requirements. If your employees can feed the information up through the organization and adjust to the conditions on the ground, the organization has a higher chance of success.

 

Customers

What brand equity do you have? Do your clients buy because they want your brand, or are you just a commodity. Are you like Apple and Patagonia with loyal clients who will put stickers of your brand on their cars? How well do your customers and prospects know your brand? Are you visible across all available digital platforms, and does the purchasing decision-maker quickly see your band? How engaged are your customers? Are you attracting substantial traffic to your site, and are they buying on it? What is your cost of customer acquisition across all channels, is it cost-effective, and can you move them to lower-cost channels? How would your customers rate their experience? Are you providing an experience along with the service or product? Is your customer experience rating improving or declining? Is there a difference between your customer experience seamless across online and offline interactions? Is it dependent on third-party providers? All these questions can help you understand your position in the market with customers. The more engaged and loyal your customers the higher your value.

 

Processes

What skills or capabilities does your company have that make your business work? Are they an asset to others, or do they give you a sustainable competitive advantage? To survive, organizations will have to adopt Kaizen – a culture of continuous improvement – and becoming efficient learning companies. Are you a “first mover,” a disruptor, or are you being disrupted? Strategic plans, budgets, variance analysis, processes, and data-driven decisions are critical. Are you sufficiently managing cyber risk, and does your security match your digital ambitions? Are you dependent on third parties for critical data? The plans and budgets may change a few times as we move through the business landscape changes, but having responses produced by employee knowledge and data will result in the organization responding better than those that are winging it!

 

Outperforming Peers

Your organization must be a top performer in its sector. A devastating realization for many business owners is that not all companies are sellable. If you are not at the top of the pack and you don’t have any significant assets, then you may not be sellable at any price! Know how your peers perform and decide where you outperform them. Does the business have unique features that the competitors do not? Are your competitors more formidable with great resources? Do you have vendor contracts and relations that add to the value of your company?

Many years ago, I sold a company that had twice the profit margin of any of its peers. It had different processes and so the lowest percentage of working capital among its peers. Buyers fell over themselves to acquire it, and it realized over twice multiple of the industry leader.

 

Other Drivers

  • Sales, are they growing? What pricing power do you have? Has the company created new products or lines of business recently? What is driving your growth, and is ti sustainable?
  • Do you “own” your customer data? Are you generating proprietary data that could be of value?
  • Is the market growing or receding? What changes in the market could pose challenges for your business?
  • Corporate Long-term Outlook – Does the future look rosy, or are headwinds approaching? Do you have the capital – financial and human to realize your strategy?

 

So What Has COVID Done?

COVID has triggered a recession more significant than the 2009 Great Recession, disrupting supply chains, changing historic demand drivers, and purchasing methods. These changes are driving digital transformation faster than at anytime as companies try to adjust to working from home, selling to customers in a virtual world, maintaining supply chains in a virtual world with continued buffering from traffics, closed borders, and logistics chaos. As a CEO of a large tech company recently stated, “We are witnessing what will surely be remembered as a historic deployment of remote work and digital access to services across every domain.” As I have said before, COVID has accelerated trends by 5 – 10 years and recent data show that in about eight weeks, we have vaulted five years forward in consumer and business digital adoption. As a McKinsey report recently said, “The COVID-19 recovery will be digital: A plan for the first 90 days.

Without a successful digital transformation, companies will be left behind and migrating to irrelevance in most industries. In the face of accelerating change, corporate values are also in constant flux as the market responds to new information. Thus it is essential to keep top of mind the value your business is creating, how you make money and your flywheel.

As companies work through their digital transformation, many leaders have a clouded understanding of what drives their business’ value. If the organization doesn’t understand what drives value in a rush to develop new strategies, make new investments, and encourage cultural and organizational changes, efforts can be misplaced, destroying value rather than creating it. Also, there is often confusion within the organization as to what drives value when the organization is bifurcated between legacy and emerging models while facing unprecedented external challenges.

As you develop new strategies, plans, etc., ensure that you have metrics to measure the organization’s performance in the core business and its migration. If you are too focused on the new pivot, the core could start to underperform. A recent study by McKinsey & Co. says, “Business leaders must do the hard work of revising business strategies, reallocating resources, monitoring outcomes, and otherwise enhancing corporate performance over the long term,” to create value.

Many leaders try to reposition the organization as SaaS or recurring revenue businesses to realize higher multiples. However, if on examination, the company has not repositioned itself and is just imitating, then the leaders don’t know where the value creation lies. Understand your value creation is a competitive advantage and should drive everything.

A recent study by The National Center for the Middle Market at Ohio State University found that middle-market companies with a strategic approach to their digital transformation grew faster than their peers. While over half of the executives surveyed said digital transformation was necessary, less than 10% believed it was critical to their company’s strategy. Sadly, this reflects a failure to tie digital transformation to value creation.

As I used to say in my talk “Why Selling Your Business Is Like Dating at 50,” remember you want the buyer to fall in love with the business because then the price is no longer such a driver. Thus, you need to know what outside observers value in your business and use that to guide strategy. It may not be what you think it is. I remember early in my investment banking career looking at Playboy for a client. Our client was not interested in magazines or bunnies, but they wanted cable TV distribution. At that time, there were only about 30 channels, and they were all taken; however, Playboy was on just about every cable box.

So keep in mind:

  • Who is the ideal buyer?
  • How can my business add value to that company or companies?
  • Where should I invest in my company to ensure that these buyers will find my business attractive?

 

The Outlook

The economic downturn has buyers looking for bargain purchases, according to a recent study by Deloitte of 1,000 executives at corporations and private equity firms about current deal activity and expectations for the next 12 months. However, for those owners who are planning to exit at prices they expected six months ago, those plans will have to be put hold while they work to return the value of their businesses to prior levels. Unfortunately for some, they will not have the energy to recreate the organization and drive value once more, given their age and shape of their organizations. Those organizations will probably be unsellable and die.

For those that can capitalize on the change and drive value, the outlook is good. I hope you are in the latter.

 

Copyright (c) 2020. Marc A. Borrelli

 

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To Buyback or Not Buyback, That is the Question?

To Buyback or Not Buyback, That is the Question?

As part of The CARES Act, Congress imposed restrictions on stock buybacks. There was bipartisan support for this idea. Billionaire Mark Cuban argued that the rule for any company that receives federal assistance is, “No buybacks. Not now. Not a year from now. Not 20 years from now. Not ever.” Senate Minority Leader Chuck Schumer declared on-air: “Our motto in this is ‘workers first.’ …. These buybacks, they infuriate me. We should not be allowing them to do buybacks, raise corporate salaries.” Sen. Elizabeth Warren said that any corporate recipient of government assistance should be “permanently prohibited from engaging in share repurchases.” President Trump joined the chorus arguing, “I am strongly recommending a buyback exclusion. You can’t take a billion dollars of the money and just buy back your stock and increase the value.” However, others have argued that this policy is The Worst Coronavirus Idea.”

 

How it Happened

The airline industry was the poster child for arguments against buybacks.  Airlines for America, which represents major U.S. passenger and cargo air carrier companies, requested government assistance because of (i) the coronavirus crisis, and (ii) several of the largest carriers had used the majority of their free cash flow on share buybacks over the last decade. Given that airlines have a propensity for going bankrupt with over 60 since 1991, and being unprepared for hard times including the Sept. 11, 2001, attacks and the volcanic eruption in Iceland in 2010 that disrupted air travel, building up cash for a rainy day hasn’t been part of their plan.

Airline Free Cash Flow ($MM) Share Buybacks ($MM) Buybacks/FCF
Southwest Airlines Co. 15,103 10,650 71%
Alaska Air Group, Inc. 4,948 1,590 32
Delta Air Lines, Inc. 23,186 11,430 49%
United Airlines Holdings, Inc. 11,526 8,883 77%
American Airlines Group, Inc. (7,935) 12,957 N/A
JetBlue Airways Corporation 2,347 1,771 75%

Source: FactSet

However, airlines weren’t the only ones spending free cash flow on share buybacks. As can be seen below, nearly 50% of the saving from the 2017 Tax Cut and Jobs Act went to share buybacks.

Arguments For Buybacks

Share buybacks are very popular. According to Federal Reserve data compiled by Goldman Sachs, over the past nine years, corporations have acquired more of their stocks – $3.8 trillion—than every other type of investor (individuals, mutual funds, pension funds, foreign investors) combined. So why do they do it?

  • An efficient way to return money to shareholders. By reducing the number of shares outstanding in the market, a buyback lifts the price of each remaining shares.

  • A Valuable source of cash. Donald L. Luskin and Chris Hynes made this argument in a Wall Street Opinion Editorial. It has to be the worst reason I have heard. If people need cash, they can sell their shares on the market; they don’t need the company to repurchase them.

  • More tax-efficient than dividends. If the shareholder has held the shares long enough to qualify for long term capital gains treatment, this is true. Dividends are taxed at 22% while the tax rate for capital gains is 0%,15%, or 20% depending on the taxpayers’ level of income.

  • Management captures the share bump. An analysis by the SEC revealed that executives, on average, sold five times as much stock in the eight days following a buyback announcement as they had on an ordinary day. According to SEC Commissioner Robert Jackson Jr., “Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement.”

  • Boost management’s compensation. Following the adoption of Milton Friedman’s idea of “creating shareholder value,” more and more companies granted CEOs large blocks of company stock and stock options to align management with the corporate goal. However, with large portfolios of their own company’s stock, the desire to manipulate the share price with share buybacks was a temptation few CEOs could resist. As a recent article noted, “Today, the abuse of stock buybacks is so widespread that naming abusers is a bit like singling out snowflakes for ruining the driveway.”

Arguments Against Buybacks

  • Deprives companies of liquidity. As a recent Harvard Business Review article noted, when companies undertake buybacks, they deprive themselves of the cash that might help them cope when sales and profits decline in an economic downturn.

  • The share price boost is short-lived. A study by the research firm Fortuna Advisors found that five years out, the stocks of companies that engaged in substantial buybacks performed worse for shareholders than the shares of companies that didn’t.

  • The propensity to buy when the price is high and not when it’s low. Companies tend to overpay for their shares, diluting return to shareholders. The is overwhelming evidence that substantial buyback companies usually create less value for shareholders over time.

  • Lack of investment in things that grow shareholder value. Those companies that reinvested a higher percentage of their cash generation into capital expenditures, research and development, cash acquisitions, and working capital delivered substantially higher total shareholder return than those that reinvested less.

  • Lack of Imagination by Management. If the best use of the company’s money is share buybacks, then unless the shares are undervalued (20%+), management has effectively given up on planning to grow the company in new markets or products, through acquisition or investment. Such a strategy is a reflection of failed management.

 

Conclusion

 

From the above, it is apparent that there are few good reasons for share buybacks other than to boost management’s earnings. Hopefully, the current environment will cause management to reflect and do their jobs more efficiently so that there is real shareholder growth. As the Atlantic article pointed out.

“Craig Menear, the chairman and CEO of Home Depot mentioned on a conference call with investors in February 2018, their “plan to repurchase approximately $4 billion of outstanding shares during the year.” The next day, he sold 113,687 shares, netting $18 million. The following day, he was granted 38,689 new shares and promptly sold 24,286 shares for a profit of $4.5 million. Though Menear’s stated compensation in SEC filings was $11.4 million for 2018, stock sales helped him earn an additional $30 million for the year. 

By contrast, the median worker pay at Home Depot is $23,000 a year. If the money spent on buybacks had been used to boost salaries, the Roosevelt Institute and the National Employment Law Project calculated, each worker would have made an additional $18,000 a year. But buybacks are more than just unfair. They’re myopic. Amazon (which hasn’t repurchased a share in seven years) is presently making the sort of investments in people, technology, and products that could eventually make Home Depot irrelevant. When that happens, Home Depot will probably wish it hadn’t spent all those billions on buying back 35 percent of its shares. “When you’ve got a mature company when everything seems to be going smoothly, that’s the exact moment you need to start worrying Jeff Bezos is going to start eating your lunch,” said the shareholder activist Nell Minow.”

 

Copyright (c) 2020, Marc A. Borrelli

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Private Equity, Not Delivering What They Promise?

Private Equity’s financial model, more than any other, defines the Western political landscape. The bankruptcy of Borden this week once more raises the issues of Private Equity and does it deliver what it promises.

 

What is Private Equity

It is a sizeable unregulated pool of money, who do one of the following:

  • Invest in or buy companies and improve their operations and profits, seeking to sell the company at improved valuation;

  • Invest in or purchase companies and restructure them, trying to recoup gains through dividend pay-outs or later sales of the companies to strategic acquirers or back to the public markets through initial public offerings;

  • who scours the landscape for companies, buy them, and then use extractive techniques such as price gouging or legalized forms of elaborate fraud to generate cash by moving debt and assets like real estate among shell companies;

  • lend money and act as brokers, and are morphing into investment bank-like institutions.

Some are public companies.

PE takes underperforming companies and restructures them, delivering needed innovation for the economy. Also, PE invests in early-stage companies, helping to build new businesses with risky capital. With pools of capital, companies are improvable, and many funds have created successful companies. However, only the small-scale funds do this. There are exceptions to the rule, where PE has built financialized scalable businesses, like chain stores that roll up an industry, i.e. Staples. However, now there is a debate, does PE execute the creative destruction which should lead to better products, services, and companies, or does it just lead to Destruction!

 

How Did Private Equity Evolve?

Private Equity, as we know it today, was originated by William Simon. Simon is considered one of the most influential American political figures of the 1970s and early 1980s, a brilliant innovator in politics, finance, and how to produce ideas in American politics. Simon was an accountant, a nerd, an apocalyptically oriented conservative financier, who was a bond trader and top executive at Salomon Brothers in the 1960s and 1970s. Simon went into politics in the 1970s, a leader at the Treasury Department under Nixon and Ford. He became the President of the Olin Foundation, the key conservative foundation.

In 1982, Simon became the leader of the financial revolution. He organized the first large scale leveraged buyout, which shocked Wall Street. Simon and his partner acquired Gibson Greeting cards from RCA for $80 million. Using Simon’s political credibility and connections, they invested $330,000 each and borrowed the rest from Barclays Bank and General Electric. Immediately they paid themselves a $900,000 special dividend, made $4 million on the sold the company’s real estate assets, and gave the company’s management 20% of the shares as an incentive grow share value. Eighteen months later, Gibson did an IPO, valuing the company at $270 million. Simon cleared $70 million personally in a year and a half from a $330,000 investment.

Wall Street was amazed, and Gibson became the starting gun for the mergers and acquisitions PE craze of the 1980s. With Wall Street’s love affair with PE, came the consultants. Today, BCG, McKinsey, and many of the other management consulting firms work with PE firms.

 

The Case For Private Equity

In the 1970s, with an inflationary environment and a growing flood of imports into the U.S., the belief that US businesses were well run collapsed. In 1970, Milton Friedman put forward the shareholder value of the firm, a theory that the only reason for the corporation to exist is to maximize shareholder value. In 1976, Michael Jensen, argued in “Theory of the firm: Managerial behavior, agency costs, and ownership structure,” that leveraging firms would impose fiscal discipline wasteful management; and placing ownership in the hands of a few would force managers to be attentive to the efficient operation of the corporation. Thus Jensen is considered the intellectual patron saint of PE.

With these arguments in place, private equity has long argued that it is releasing tied-up capital into the economy, making firms more efficient, incentivizing management appropriately, and making the US economy more efficient.

 

The Case Against Private Equity

Toys “R” Us is a current example of what PE does. In 2005 a group of PE firms acquired Toys “R” Us through a very leveraged acquisition. By 2007, while still immensely popular, Toys “R” Us was spending 97% of its operating profits on debt service. While the PE firms owned Toys “R” Us, they were not responsible for the loans or the companies pensions. Also, Toys “R” Us would pay fees to the PE firms of $500 million. Between debt service and fees, there was no money left. The company stopped innovating, maintaining its stores, and started cutting costs aggressively so it could continue making the debt and fee payments.

In 2017, the company went under, liquidating all its stores and firing all its workers without severance. What destroyed the company was financiers and public policies that allowed the divorcing of ownership from responsibility.

The management consulting companies today work with PE firms, not to innovate products and services, but provide methods for legal arbitrage and price gouging. If a certain kind of price gouging strategy worked in a pharmaceutical company, a private equity company could roll through the industry, buying up every possible candidate and quickly forcing the price gouging everywhere.

As conceived, private equity was about getting rid of the slack, which allowed American managers had to look out for the long-term, fund research, and experiment with production techniques. PE replaced slack with staggering debt schedules providing and massive upside for higher stock prices, and no downside for the owner-financiers should the company fail. The goal has become to eliminate production in favor of scalable, profitable things like brands, patents, and tax loopholes, because producers – engineers, artists, workers – are cost centers. By moving production offshore to lower-cost countries, production is eliminated. There are stories of how PE took apart factories in the midwest and shipped them to China.

Borden, which declared bankruptcy this week, is relying on monies earmarked for employee pension to survive as it staggers under the debt load and fee commits of PE.

So what is the evidence?

The 2010s have been the Decade of Private Equity

The 2010s have been characterized by:

  • corporate mergers;

  • aggressive activist investors;

  • out-of-control CEO pay;

  • maximizing shareholder value; and

  • awash in private equity deals.

While private equity (PE) deals have been part of the financial landscape for decades and some of the biggest PE deals on record — TXU Energy, First Data, Chrysler, Alltel, Hilton Worldwide — took place in the frothy years before the 2008 financial crisis.

However, what changed in the 2010s was less the size of the deals as their proliferation. In 2009, private equity firms completed 1,927 transactions worth $142 billion, according to the financial data firm Pitchbook. By 2018, there were 5,180 PE deals worth $727 billion.

Why so many deals? The main reason is with all the capital injected into the system by QE and its progeny; most PE firms are holding more capital than they know what to do with. According to Bain & Co., private equity firms have an astonishing $2 trillion in “dry powder” that they need to deploy. The second reason is that there are fewer big deals available, so firms have had to move downmarket to find companies willing to be bought out. The majority of the transactions in the past few years have been for less than $500 million.

This private equity gold rush is on, fueled by cheap debt and enthusiastic investors. A lawn care chain might get half a dozen calls and emails a week from business brokers and “searchers.” A regional bank auctioning off a business with $15 million in profits might pitch two hundred prospects, receive fifty letters of intent, and take twelve separate private equity firms to management meetings, ending in a sale price that the majority of bidders considers crazy. And the most fabulous prize of all—a software company—could sell for many multiples of revenue, regardless of profitability.

A recent survey of institutional investors found that:

  • 49% expect private equity to outperform the public equity market by an incredible 4 percent p.a.

  • 45% believe PE will outperform by 2–4 percent p.a.

  • 6% think returns will be comparable.

The survey didn’t ask if investors thought PE might underperform, which is stunning given that data from Cambridge Associates shows that private equity returns have lagged the Russell 2000 index by 1% and the S&P 500 by 1.5% per year over the past five years. As a result, institutional investors have flooded private markets with capital, about $200 billion p.a. of new commitments. The result is soaring prices for private companies of all shapes and sizes.

What makes this dangerous is:

  1. Debt. The average PE deal is 65 percent debt-financed. This level of leverage provides companies with no margin of safety. Most companies’ cash flows are too volatile and unpredictable to sustain high debt levels for long. Also, the recent tax reform caps interest deductibility at 30 percent of EBITDA, which for most firms translates to about 5x EBITDA of debt. In any downturn, when EBITDA declines, these firms will struggle to survive.
  2. False accounting to conceal the riskiness of these leveraged bets. While transparent, liquid, public markets determine valuations of public equities, PE firms determine the value of their own portfolio companies. Unsurprisingly, they report far lower volatility than public markets.

The three premises that underlie the current private equity boom are:

  1. PE firms make money by improving the companies they buy;
  2. PE is less volatile and less risky than public equity; and
  3. PE will significantly outperform every other investment.

There is near complete consensus on these three points among academics, investors, and PE firms.

PE firms relentlessly promote the idea that they can restructure companies and orient them toward long-term growth rather than short-term results. Is that the case, and what does the data show?

 

Do Private Equity Firms Improve Companies’ Operations?

Daniel Rasmussen, a private equity skeptic, studied to see the effect private equity firms had on the companies they bought. Using a database of 390 deals with more than $700 billion in enterprise value, he examined these three premises to see if data supported them.

Rasmussen found:

  • 54% had slowing revenue growth;

  • 45% had contracting margins; and

  • 55% showed Capex spending as a percentage of sales declining.

In 70% of deals, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5x EBITDA to 5x EBITDA. The increased level of debt imposes repayment costs on the company while the PE firms pulled out fees and dividends that had no bearing on what the PE firm has achieved in terms of improved performance. Not all debt is bad; there is an optimal capital structure for every company that maximizes the value of the interest tax shield while minimizing the risks of financial distress. The majority of private companies have too little leverage. While the effective use of debt was key to private equity’s past success, debt is a double-edged sword. If used judiciously, it can provide significant benefits; however, if applied in large chunks regardless of the underlying company, it can create massive problems. The result – bankruptcy. Some of the significant bankruptcies of the 2010s were:

  • Toys “R” Us;

  • Chrysler;

  • Gymboree;

  • Sports Authority; and

  • Linens ’n Things.

When the Limited announced it was shutting down its 250 stores in 2017, throwing its employees out of work, Sun Capital Partners Inc., its owner, reported that it had nearly doubled its money, thanks to the dividends and fees it had paid itself.

Thus most private equity firms, by increasing leverage, are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth.

In addition to Rasmussen’s study, a 2013 survey of 317 LBOs by researchers at the University of Texas found “little evidence of operatin
g improvements subsequent to an LBO. . . . Our results suggest that effecting a sustained change in capital structure is a conscious objective of the LBO structure.”
Also, Bain & Company’s 2017 global private equity report came to similar conclusions. Bain compared deal model forecasts for revenue and EBITDA with the results for PE deals in their proprietary database. More than two-thirds of the time, PE deals never realized the EBITDA forecasts made at the time of purchase. However, this underperformance didn’t affect investors, as almost two turns of multiple expansion at sale sheltered them. As Bain wrote, “GPs [private equity fund managers] were lucky to make up the shortfall in margin expansion through unforeseen multiple expansion.” A paper by Brian Ayash and Mahdi Rastad in 2019 noted that companies bought by private equity are ten times more likely than comparable companies to go bankrupt.

Rasmussen claimed is a new paradigm for understanding the PE model is, “As an industry, PE firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt. As a result, or in tandem, the growth of the business slows. That is a simple, structural change, not a grand shift in strategy or a change that requires any expertise in management.”

Matt Stoller noted, “The goal in PE isn’t to create or to make a company more efficient, it is to find legal loopholes that allow the organizers of the fund to maximize their return and shift the risk to someone else, as quickly as possible.”

In other words, whatever rationale private equity might have once had, the 2010s exposed an industry that cared about lining its own pockets — often at the expense of the companies it bought. It has become dealmaking for its own sake.

 

Does Private Equity Offer Lower Risk?

Risk and return are generally related, and financial products that offer high returns at low risk are likely to deliver on neither promise. Due to “loss aversion,” humans are twice as sensitive to losses as they are to gains. Since the public equity markets are very volatile, loss aversion doesn’t do well in that environment.

PE firms, using their own employee “Experts,” rather than the public markets, determine the prices of their portfolio companies. Predictably, volatility is dramatically lower volatility. The judgment of a valuation firm employed by the PE firm replaces the chaos of the public markets. Think back to the rating firms and CDOs of the 2000s to reflect how well this works out!

To put this difference in valuation to context, consider the 50+% drop in energy prices in 2014 and 2015. The S&P 600 Energy Index dropped 52 percent during the period from December 31, 2012, to September 30, 2015. Yet as of September 30, 2015, PE energy funds valuations were:

  • 2011 vintage – marked up on average to 1.1x multiple of money invested (MoM)

  • 2012 vintage – marked at 1.0x MoM; and

  • 2013 vintage – marked at 0.8x MoM.

Thus, PE energy funds almost universally claimed to have dramatically outperformed the public equity market, not even recognizing half of the losses exhibited in public markets.

Institutional investors value these “smoothing effects”; however, some investors refer to this as the “phony happiness” of private equity.

In a recent paper, George Washington University professor Kyle Welch argues that portfolio managers “have incentives to obfuscate systematic risk and to choose investments that appear low-risk.” If PE firms adopted fair value accounting standards, Welch showed the reported volatility of private equity would double. The PE secondary market provides examples of this increased volatility.

Some PE investors argue this smoothing is ok if everything comes out right in the end. To the extent that things do come out right in the end, reducing some volatility along the way is not so problematic. However, not seeing the actual situation encourages complacency, allowing valuations and leverage levels to climb because the consequences of those decisions are unrealized. A lack of short-term accountability means a delayed reckoning, with all the chips coming due down the road. And there are warning signs that all might not end up so well.

 

Does Private Equity Offer the Best Returns?

In the long run, private equity has performed well. From 1990 to 2010, PE returned 14.4% p.a., compared to 8.1% per year for the S&P 500 index. This 6.3% outperformance was net of fees, implying that the gross returns were more like 20% p.a.

However, past performance is a far worse predictor of future returns than prices. With increased capital, the prices paid for PE assets have increased. In 2007, the average purchase price for a PE deal was 8.9x EBITDA. Deal prices reached 8.9x again in 2013 and are now nearing 11x EBITDA. Private market valuations have been equal to or greater than public market valuations since 2010. As noted above, since 2010, private equity has, on average, underperformed the public equity market. Like all assets classes, arbitrage disappears as more people seek it.

The relative performance of private equity is contingent on size, leverage, and valuation. An analysis by the Canadian Pension Plan Investment Board (CPPIB) and the Abu Dhabi Investment Authority (ADIA) of 3,492 private equity transactions from 1993 to 2014 found that private equity deals are different on two key quantitative dimensions from public equity investments.

  1. PE firms acquire companies that are significantly smaller than broader public benchmarks. The median market capitalization of a company in the S&P 500 and Russell 2000 is $41 billion and $2 billion, respectively. However, the median enterprise value of PE deals is only $250 million. Only about fifteen private equity investments have ever been larger than the maximum market capitalization of the small-cap index.
  2. PE deals are significantly more levered than typical public equity. The CPPIB and ADIA found that the average ratio of net debt to enterprise value at inception has been approximately 65 percent. The typical Russell 2000 small-cap company is levered at about 16 percent while the median large-cap company in the S&P 500 has 18% leveraged.

These two factors have been constant since the early 1980s. Differences in size and leverage explain only about 50 percent of private equity’s historical outperformance of public equity markets. What has changed is valuation. Private equity firms have historically bought companies at much lower valuations than the broader public markets.

With the increase in prices, transactions require more debt, increasing interest costs, and the risk of bankruptcy. The effect of increased acquisition costs can be looked at as follows:

  • Analysis by a PE firm found that over half of deals done at valuations of more than 10x EBITDA lost money and that the aggregate MoM was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors).

  • Comparing the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between the purchase price and vintage year return, a strong inverse relationship.

  • Examing PE-backed companies that IPO, Rasmussen’s data showed the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.

  • According to Preqin, PE executives said their biggest challenge was valuations (their second most significant challenge, worrisomely, was the “exit environment”). Joe Baratta, Blackstone’s global head of private equity, said “this is the most difficult period we’ve ever experienced. . . . You have historically high multiples of cash flows, low yields. I’ve never seen it in my career. It’s the most treacherous moment.” Regardless, Blackstone Capital Partners VII raised $18 billion in 2015, its largest fund

PE companies paying high prices for targets and using debt to fund the purchase appears to look like a bad strategy. In Rasmussen’s view, 2015, 2016, and 2017 vintage years are likely to return close to zero percent per year if history is a guide.

 

Conclusion

The evidence shows that PE firms are just adding debt: the supposed improvement in incentives and managerial alignment is more marketing than substance. While debt can have a disciplining effect and can enhance returns on suitable investments, the amount of debt being used in most PE transactions today is excessive. Also, debt reduces a company’s long-term capital flexibility. The “discipline of debt” and “long-term thinking” are mutually exclusive goals. Finally, it is ironic that the same PE firms making these arguments—Blackstone, KKR, Apollo—have themselves gone public.

There are two outcomes for all of this:

  1. Collapse – When the business cycle finally turns, the consequences for the thousands of companies carrying private equity debt are likely to be severe. The debt loads are more oppressive and not sustainable, especially if the companies sacrificed growth for debt service.
  2. Political – if the Democrats take the Senate or the presidency — or both — the private equity model is going to be under attack. Elizabeth Warren has already put forth a proposal to rein in private equity — the “Stop Wall Street Looting Act.” Among other things, it would give workers rights when bankruptcy takes place and would put private equity firms “on the hook for the debts of companies they buy.”

In this decade of growing income inequality, nothing symbolized the gap between the haves and the have-nots like private equity. When it can walk away enriched while companies it owns go bankrupt — is that the way capitalism is supposed to work? This failure of capitalism results in more considerable resentment in the population. Of course, the carried interest benefit does nothing to mitigate the complaint.

Thus, politicians on both sides of the aisle are seeking to restructure PE and effectively the philosophy of the American political economy by returning to excellence in production, l instead of excellence in manipulation. However, this a huge task with many monied and powerful vested interests. When the Obama administration talked of removing the carried interest loophole, Steve Schwarzman at Blackstone compared such a plan to “The Invasion of Poland by Germany in 1939.” While Donald Trump ran on removing the carried interest loophole, the Tax Cuts and Jobs Act of 2017 left it untouched. According to the President, there was no interest in changing it.

While I’ll admit that I’m rooting for private equity to get a comeuppance similar to the one that took place in tech after the Nasdaq decade, I am concerned that the price inflicted on the PE investors will be minor compared to the damage inflicted on the overall economy, workers, and companies that never had a stake in the upside. However, I am sure that if there is a comeuppance, PE will not take the blame.

 

Copyright (c) 2020, Marc Borrelli

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To the shock and horror of many in the business community, top CEOs from the Business Roundtable stated two weeks ago that Shareholder Value is not Everything. These CEOs, including the leaders of Apple and JPMorgan Chase, argued that companies must also invest in employees and deliver value to customers.

The Business Roundtable is trying to redefine the role of business in society — and how an increasingly skeptical public perceives companies. Breaking with decades of the Friedman Doctrine, which holds that a firm’s only responsibility is to its shareholders, the Business Roundtable stated that companies should no longer advance only the interests of shareholders. Instead, companies must also invest in their employees, protect the environment, and deal fairly and ethically with their suppliers.

This shift in corporate ideology comes at a moment of increasing tension in corporate America, as big companies face mounting discontent over income inequality, harmful products, and poor working conditions.

There have been many arguments for and against this stand, i.e., Why Maximizing Shareholder Value Is Finally Dying, Corporations Can Shun Shareholders, But Not Profits, Stakeholder Capitalism Will Fail If It’s Just Talk, and We must Rethink the Purpose of the Corporation.

Personally, however, I think that this is a move in the right direction for the following reasons.

The Friedman Doctrine is backward.

Shareholder value is the result of corporate purpose and Mission and cannot be the purpose and Mission. Simon Senik’s “Start with Why,” in my opinion, best describes how to develop a corporate mission. An example of what happens when a company game up is mission and followed the Friedman Doctrine was Imperial Chemical Industries, who changed its mission from “We aim to be the finest chemical company in the world“ to “We aim to Maximize Shareholder Value“ in the 1990s. Prior to the change, ICI was considered one of the finest companies in Britain, today it no longer exists having been slowly sold off many parts to repay its debt before finally being sold to AkzoNobel in 2008.

 

Few stakeholders within the organization.

If the maximization of shareholder value is the corporate Mission, then there are few within the organization, other than some high-level employees, who have a stake in the Mission. Working to increase the wealth of others is not something most employees get behind. It reminds me of the old joke:

Employee: “Nice new car, boss”

Boss: “Well, if you set yourself targets, work hard, stay focused, next year I’ll be able to buy an even better one.”

Employees are only attracted to the company with this mission by what they will get, i.e., money or career advancement, so there is little commitment to the organization. If the expected benefits aren’t delivered or someone else offers more money, the employees will move on, increasing employee turnover. As a result, with few employees embracing the Mission and no other purpose, nothing is of importance to quality, service, and profits fall, decreasing brand value and shareholder value. Employees who embrace the Mission and are satisfied will serve customers better, increasing brand value. Employee happiness and business success are linked.

 

Few stakeholders outside the organization.

If the employees see no value in the Mission, customers and suppliers don’t. If the Mission is only to make money, customers and suppliers understand the Mission as a goal of extracting more value from them. Thus, they move from commitment to the organization (i.e., putting an Apple sticker on your car) to engaging with the company because there is no better alternative. If the company gets into financial trouble, they are less likely to support it, but rather let it fail. Working with suppliers is a relationship with the power moves back and forth and both parties treat it with care knowing they will be on the receiving end at some point. However, if shareholder value maximization is the only goal of the organization, suppliers abandon that relationship knowing the company has in its behavior.

 

Lack of Investment in Interesting products.

The Friedman Doctrine has led to many companies killing off research centers, which generated great benefits unidentified at the start. Ten years ago, the majority of technology products were offshoots from two places, Xerox Parc and Bell Labs, both of which no longer exist because of the Friedman doctrine. Between share buybacks and dividends, corporate investment in new areas has fallen. Google, SpaceX, and a few other companies have stepped into this space, but it is far more limited, thus limiting the future growth potential for the US.

 

Lack of Training.

Thirty years ago, when I graduated from college, many companies had training programs which took in graduates and trained them over several years. These programs knew that most of the trainees would leave the organization and thus canceled under the Friedman Doctrine. However, I would argue that these programs had three positive results:

  1. Well Trained Employees. A common complaint today is that graduates don’t know anything; however, I would say we didn’t know more, but we benefited from such programs.
  2. Loyalty to the Organization. Employees who moved on had developed a commitment to the organization that had trained them. Over the years they referred work to it and would engage with that company because of the feeling towards it.
  3. The camaraderie with their fellow trainees. Employees who went through the training program built a camaraderie with their fellow cohorts, which lasted a lifetime. I have met many accountants who came through the training programs provided by Arthur Anderson and still talk about their classmates and the connections they made. This camaraderie further built referral networks that benefited those that stayed behind and the training organization.

 

Lack of Integrity.

I recently heard Kirk Lippold‘s definition of integrity, which is:

“Integrity defines leadership. Without uncompromising integrity, failure becomes the natural default to success. It’s not just doing the right thing at the right time for the right reasons, even if no one is looking. That’s ethics. Integrity is doing all those ethical things regardless of the consequences.”

If the Mission is to maximize shareholder value, then I believe the organization develops a modus operandi of maximizing profit as the proxy for shareholder value. Since profit is measured monthly and quarterly, the corporate focus becomes more short term and undertakes anything to cut costs and maximize revenue. Thus, companies lose their integrity, sacrificing what makes them special for money, and losing customer loyalty and brand value. Recent examples of this would be Wells Fargo fake accounts scandal, and the Boeing and the 737 Max. An example of long term brand damage is the Sun Newspaper and Liverpool boycott, and many others. For a an example at what lack integrity can do see The Whistleblower (trailer is below) which based on a true story. Thus to quote Timothy 6:10, “For the love of money is the root of all evil.”

An example of a Mission leading shareholder value is Johnson & Johnson’s response at the time of the Tylenol recall. J&J’s Mission is to “. . . solutions that create a better, healthier world.” Living that Mission, created goodwill and tremendous brand loyalty within the US. A company’s brand is its reputation, and damage done takes a very long time to recover, destroying shareholder value.

Therefore, I think that the Business Roundtable is correct; Shareholder Value cannot be the purpose of the organization. If the company focuses on its Mission and engages its employees, customers, and suppliers, increases in shareholder value should result. Shareholder value should be measured, and companies should see how they are doing, but it is one metric and should not be the purpose. Further, in my opinion, the Friedman doctrine has done untold damage to the US over the years. Private Equity Groups, which own over $2.5 trillion of companies globally, primary focus on Shareholder Value has had mixed, if not harmful, results for their investment companies.

 

© 2019 Marc Borrelli All Rights Reserved

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I believe that being “Sell Ready” is the only way for business owners to maximize value on exit, and all companies need to be “Sell Ready” even if their owners don’t intend to sell because life is Uncertain.

  • There is a common belief that we control our lives and destiny; however, if we are objective, we can see that luck is an important determinant, and life is Uncertain. Recently, the uncertainty of life was brought home to me twice. A high school friend of mine, Marty Davis, owned a scrap metal business, and we had recently reconnected after 35 years through Facebook. We planned to get together soon as he was now living in North Carolina. A week later, I learned that a palette of copper had fallen off a forklift truck, killing Marty instantly.

  • A month ago, a member of my Vistage group, Mike, an ex-marine and fit in his 40s, pulled over on I-75, not feeling well. He suffered a major heart attack and was dead by nightfall.

Life is Uncertain, but are we ready for it? In most cases not, even Prince wasn’t, dying with no will, albeit a plethora of advisors surrounded him. However, Uncertainty is more than death; it includes Disability, Divorce, Partner Disputes, Running out of Energy, etc. There is no excuse for not being preparing for Uncertainty! Also, the disregard it shows to your family and employees is undoubtedly not the legacy one wishes to leave. If you are “Sell Ready,” it doesn’t matter in what form Uncertainty arrives, you will be positioned to survive.

So what is Sell Ready? I define Sell Ready as those companies that realize a price higher than their value. As Warren Buffett said, “Price is what you pay, Value is what you get” so for a seller I take that to mean, Price is what you get, and Value is what you give up, i.e. in 2008 at the height of the crises, Ford debt was selling for 35 cents on the dollar – price definitely less than value. On the other hand, HP’s acquisition of Autonomy for $11.1 billion, 79% premium over market price – price exceeding value. If you are Sell Ready, you want to be like the Autonomy shareholders.

I will expand on “Sell Ready” and what that means in future posts, what it is, how to be “Sell Ready,” and the benefits. Stay Tuned.

 

© 2016 Marc Borrelli All Rights Reserved

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There is a war for talent. How do you attract talent to your company and have them apply for jobs there? You have to show why they should consider you, who you want, what you offer, and how your current employees feel.

Are you killing your firm’s WFH productivity?

Are you killing your firm’s WFH productivity?

Productivity remained during WFH with COVID. However, further analysis found that hourly productivity fell and was compensated for by employees working more hours. What was the culprit – Meetings. Want to increase productivity, have fewer meetings.

EOS is just that, an Operating System

EOS is just that, an Operating System

For those of you who are not aware of EOS, it is the Entrepreneurial Operating System. It seeks to improve businesses by getting six components aligned to enhance business operations. The six are: the vision the people the issues traction - meetings and goals...

What has COVID done to Company Culture?

What has COVID done to Company Culture?

COVID has affected everyone. However, companies need to examine if they have lived their core values during COVID, how they are reinforcing them in a WFH environment, and especially with the onboarding of new hires.