GOING BACK TO SCHOOL
After a 20-year hiatus from the classroom, I recently had the opportunity to reconnect with my most influential professor from graduate school, Dr. Allen Michel. Dr. Michel, an internationally recognized expert on mergers & acquisition related matters and a professor at Boston University Graduate School of Management, asked me to speak to his graduate students on “what leads to a successful acquisition.” I decided the best way to address this topic was to walk the class through MCM’s approach to investing in micro-cap privately held companies. To be successful, we spend a lot of time sourcing acquisition candidates that have specific attributes we find attractive and do our best to mitigate risks inherent in this market. To that end, MCM has been very fortunate since our founding in 1992 for having generated very strong returns for our shareholders while experiencing virtually no losses of invested capital; providing me some credibility as I prepare to address the class. My plan was to discuss MCM’s mission statement along with the investment attributes MCM seeks in acquisition candidates, our internal process of identifying industries of interest, our rationale in determining how to structure transactions to moderate risk and, ultimately, how we work alongside management teams to create shareholder value during our ownership period, which is generally 4-7 years.
Then, as he always had, Professor Michel kicked off his finance class by discussing a recent article in the WSJ to stimulate discussion amongst the students. He decided to make my first lecturing assignment a bit trickier than I would have hoped by inquiring who has read the recent WSJ article: Debt Fuels Dividend Boom; [Private Equity] Firms Collect Payouts, and Investors Get Yield; ‘Reminiscent of the Bubble Era’. This common but sometimes controversial practice is known as a “dividend recapitalization,” whereby private equity owned companies raise cash by issuing high yielding debt with the proceeds being distributed in the form of dividends to private equity firms. The dividend recapitalization has seen explosive growth, often as an avenue for private investment firms to recoup some or all of the money they used to purchase their stake in a business.
Within the past two years, over $90 billion of debt has been raised to fund “dividend recapitalizations” with over $54 billion being raised in the first 9 months of 2012. The first 25 minutes of class was a vibrant discourse covering a gamut of views on this practice centered on the premise that the practice reduces the credit quality of a company while only benefiting a select few. Professor Michel did not take a position on the topic but rather encouraged the students to debate whether it was the right of the private equity firms to perform this practice, whether it was ethical to leverage up a company’s balance sheet making for a riskier company, creating a potentially more stressful environment, etc.
Having been in the private equity business since 1998, I thought I would opine on the discussion. If structured in a prudent fashion, a dividend recapitalization can be an appropriate practice. It is a private equity’s firm responsibility to prudently determine an appropriate level of leverage for its portfolio companies. MCM typically invests up to 50% in equity in our transactions; an amount we feel approximates a prudent amount of leverage to generate attractive returns for all shareholders (management included) while not burdening the company or inhibiting its ability to grow. MCM has never utilized the maximum amount of leverage the market would have supported in any of our transactions in an effort to manage the risk-reward equation in a deal. I would also like to make the following points:
- Successful private equity firms have a long history of owning and operating highly leveraged companies; it is our business model to identify ways to increase the cash flows of a business to pay down the increased leverage post-transaction;
- The vast majority of private equity backed companies doing dividend recapitalizations today are in far better financial shape than similar companies that did dividend recapitalizations in mid-2000’s;
- The average debt of companies that consummated dividend recapitalizations in 2012 are 4.2 times earnings, materially below the 5.4 times earnings at the peak of the credit bubble in 2007 (per Standard & Poors)
Clearly, this blog deviated from my original intent which was to walk you through MCM’s investment strategy and what, in our opinion, leads to a successful transaction. I guess this means I will be writing another blog shortly. Stay tuned.
