I was reading this article in the Gruinad about the above. Yes, it is written by someone with an agenda and yes it is a bit populist and hysterical. But nonetheless it raises questions about which I have long wondered. I have often read descriptions of “corporate raiders” who buy undervalued companies and do (allegedly) terrible things to them. This is GQ and let’s not get into the morality of it. I’m just interested in the basic economics and finance of it.
The linked article describes two strategies. In both cases the “corporate raiders” first buy a business. The first strategy they describe is that the “corporate raiders” then borrow against the assets of the business, and pay themselves out the borrowings. The second strategy is they do something like split the business into an operations company and a property ownership company, then cause the two companies to enter into a one-sided deal between them, making the operations company barely (or un-) profitable and the property company highly valuable, and then they sell off the latter.
But what the linked article does not discuss is how this makes the “raiders” any money. In both scenarios the “raiders” destroy the value in the original asset. So the money they extract is at their own expense.
If I have $1, buy a business for $1, then borrow $1 against the value of the business and pay myself $1 using the borrowings, I am back where I started. If I instead split the business and end up with one valueless business, and one business with all the assets (worth, nominally, $1) which I sell, then again I am back where I started. Either way I now have my original $1 back, plus a business with no value.
Clearly there is money to be made or corporate raiders wouldn’t bother to do it. But equally clearly, it cannot be as simple as the Gruinad article suggests.
Where is the money actually made? Is it actually as simple as that corporate raiders buy undervalued businesses and make their money on the arbitrage (albeit through the mechanisms of borrowing/splitting)? Or is there something more to it?
I am not a corporate raider, but my understanding is that it involves putting all the debt in one of the newly formed businesses and all the assets with value in the other. The business with all the debt then declares bankruptcy, and the debt holders are left holding the bag. This seems to be what happens to all the brick and mortar retailers that are doing poorly. K-mart, JC Penney, Sears, etc. They get bought, the things with value, like real estate, get put in one company. All the debt is put in a different company. The company with the debt declares bankruptcy, and the new owners now have a lot of valuable stuff and none of the debt of the previous business.
It can’t be that simple because corporate raiding has been going on for decades and lenders would be wise to this by now, and lenders would (and indeed in my experience do) take security over assets. They aren’t going to let all the assets get sold off from under them.
Here is an article about Mitt Romney and Bain Capital’s approach to leveraged buy outs (LBOs). The steps are basically:
-Find target company and convince it’s leaders to get bought out by Bain. Hefty bonuses may be involved.
-Bain puts up about 5% of money to buy the company, and borrows the rest from big banks. The company is responsible for the debt, not Bain.
-With the huge debt to service, the company has to cut costs. Bain, as management, decides what to cut and takes a huge fee for doing so. People lose jobs and benefits are cut for the remaining people.
-If the cost cutting works, then Bain sells it at a profit. If the cost cutting doesn’t work, the company goes bankrupt. Bain makes money either way, but the big banks are left holding the debt.
I think what you’re missing is they are buying undervalued assets. So a company may have $5 worth of assets and $4 worth of debt so you can buy the company for the dollar it’s worth.
Then you can look at the core business that the company does and keep that while spinning of the ancillary companies. If it’s a manufacturing business why does it own a software group or real estate? It’s better for the company to lease it’s equipment from a company who will maintain and service them rather than paying for that work in house.
Once these decisions are made the software group, the real estate holdings and the equipment and maintenance group get spun off into business that are profitable without the dead weight of the parent company. Maybe the software group has a dollar worth of IP but no debt, the real-estate group has $2 worth of assets and $1 of debt, and the equipment group has $1 in assets and $1 in debt. That leaves the original company $1 in assets and $2 in debt. So the original company declares bankruptcy and the Raider owns 3 companies worth $2 total that they paid $1 for.
Yes, but why do the banks keep funding this? Aside from all the workers who lose their jobs and benefits, the banks are the big losers. Don’t they have risk departments?
If 2008 taught us anything, it is that the big banks and big investment companies demonstrate the guiding principal of committees and collectives - the average intelligence is slightly less than that of the lowest member. Willful blindness may also come into play. Deep analysis seems to be sadly lacking, and competition for the next great payoff overcomes reasonable caution.
For example, an interesting read would be Barbarians at the Gate - the value of the company (RJR Nabisco) was falling because of tobacco’s rightfully declining reputation, despite that at the time (1989) cigarette sales were still fairly high. Company accounting was deliberately manipulated to understate profitability, making it a gravy train for insiders.
Greyhound, or A&P were tired old companies that owned real estate they’d bought as far back as the 1920’s. By GAAP the value was carried on the books at the purchase price, despite inflation. Meanwhile, bus stations and downtown grocery stores were located in places where real estate values had skyrocketed. Savvy corporate raiders recognized this.
Another factor since the heyday of corporate M&A (mergers and acquisitions) is steadily declining interest rates. In the 50’s and 60’s and earlier, the staple income of “widows and orphans” was stocks that paid consistent dividends and bonds paying a reliable 4% interest. Recently, markets frequently change and dividends are unreliable, and stock values bear less relation to earnings - the principal value of shares is to sell them later for appreciated value. Interest rates near zero have made it difficult to live off interest, if inflation hasn’t destroyed the principal in regular increments.
The interest rate issue is what made “junk bonds” so attractive. The risk may be high, but the consequent interest would be lucrative if -it’s a gamble - the firm does make a go of it. Those sub-prime mortgage bonds were just a repeat of this - but with sufficiently faulty logic to claim they were more reliable. “What are the odds all these people will default on their mortgages all over the ocuntry at once?” Well, if you arrange it right - pretty good.
So short answer - willful blindness driven by greed, and search for a decent return in a market where consistent dependable returns are in short supply.
Sure, but in the example the bank that lent money to the original company is a different bank than would lend money to the raider. The raider doubled their money and is a good person to loan money too. The original lender had 20% down on their loan on a company that appeared like it was going to be around for a while so it made sense for them to loan money too.
In May 2000 Four men bought Birmingham’s best-known car factory from BMW for a tenner. BMW paid Phoenix £500m, as an interest free loan, to get the company back on its feet. It later emerged that the funds had been misallocated and the loan had to be written off.
Five years later around 6,500 workers lost their jobs, along with countless others in the supply chain after they racked up debts of more than £1 billion.
The directors had paid themselves around £42 million in pay and pension perks over the course of the car firm’s five-year descent into the abyss. Much of the money came from the taxpayer, ether directly or via a bailed out bank. Deloitte was fined over £14m in 2013 over its involvement as accountants
In one of his early books, Michael Lewis describes working in a London office pushing securities to institutional investors. The company analysts told him about a good choice, and he sold a lot of these securities to a fund manager for a German banker. Then the securities tanked - turns out, surprise, they were crap.
He asked the analysts, and they said “well, we got had to get rid of them because they were crap. We all got our bonuses.” Then he had to tell the German. The German guy screamed at him over the phone. That’s when Lewis had his big revelation - all the guy could do to him is scream over the phone. No matter what he did, the results were fine for him.
The system looks out for itself. I suspect a lot of “refinanced” buyouts trade on the historically good name of the firm that is doing a Titanic, the banks are selling the junk bonds on to unsuspecting funds. The next trick is to manage the firm so as to run up any lines of credit as much as possible. When the fan gets hit, someone else is holding the bag and the debt.
If you have a company that is going nowhere, sometimes the real-estate is worth more than the company. You asset strip, the company is now worthless, but not yet in debt. Sometimes it closes before going into debt. Sometimes it borrows from the superannuation fund. Sometimes it exists on trade credit and goes bust owing suppliers.
Sometimes the company is sold to retail investors, and only the suckers loose.
I have no idea how (or if) it’s a factor, but there’s also the concept that the banks which underwrite such ventures also tend to be “too big to fail.”
Interesting. A lot of the answers here make no more sense than the Gruinad examples but from the answers that do make sense, it sounds like it’s basically recognising undervalue and ruthlessly realising it. Along with perhaps ripping off unsecured creditors.
I knew a girl way back when who said her father was one of the pioneers of “bond stripping”. Basically, a bond (sometimes?) consists of regular payments and a final payoff of the principal. The company would buy bonds, separate out each of the “coupons” for each interest payment, and the final payment, and sell these individually to investors looking for less than a full schedule of payouts. Presumably the money could be made in the difference between current market value and the rate the bond was originally issued at, plus people would pay for the convenience.
Yep, this is basically it. Most people don’t like it because of the ruthlessly realizing it part and because a lot of legacy companies have their pension plan as the largest unsecured creditor.
It doesn’t make sense for this to be legally possible.
If Company A owes debt to a bunch of lenders, and now Company A splits itself into Company A1 and Company A2, then ISTM that both A1 and A2 should be on the hook for the debt incurred by Company A. I don’t see how Company A could get away with arbitrarily assigning it’s debt to A1 and not A2.
If Company A sells a lot of its assets, then it would make sense that the creditors have no claim on the assets which were sold. But if those assets were sold at market value, then Company A is still in the same position as it was in terms of debt/assets. And if it was sold at below market value (to the corporate raiders themselves) then that sounds like fraud and should be legally actionable.
Personally I suspect that what’s really happening is that corporate raiders are targeting companies which might benefit - or might be harmed - by radical financial restructuring. The steps they take are high risk/high reward, and when they succeed people don’t talk so much about the financial maneuvering, but when they fail then someone gets burned, and that someone complains a lot about it.
I could be wrong. But it’s hard to imagine it’s as simple as is being presented in this thread.
On further reflection, it’s possible that what happens in some cases is superficially similar but fundamentally different than the above.
Suppose a company already consists of multiple divisions, and some of the debt is currently the responsibility of some of the divisions, and those divisions are unprofitable. In theory, the company could have those divisions declare bankruptcy and walk away from the debt, but the current management is committed to those divisions and doesn’t want to do this. (Frequently, the money-losing indebted divisions are old time “flagship” divisions, but whose time has passed.) So they effectively let the profitable sections of the company subsidize the debt for the money-losing divisions. Enter the cold-hearted corporate raiders who are not committed to anything in this company besides profit, and they shut down the indebted sections of the company and leave the profitable ones running (or sell them).
So in a sense it’s similar to what posters have been describing, but it only works because because the debt was never the responsibility of the broader company to begin with. I remain highly skeptical that a company can walk away from debt for which it’s legally responsible by simply dividing itself into smaller entities and assigning the debt to unprofitable ones.
I’ll try to break it down. The first strategy you refer to–“borrow against the assets of the business, and pay themselves out of the borrowings.” Is describing what is known as “dividend recapitalization.” This is a financial transaction which essentially converts equity into debt. The basic concept is you’re taking a company with stable positive EBITDA and free cash flow, and going to a lender asking to take out a loan against that. The lender will go over your books and determine your numbers are right, and issue you capital. You now have debt to repay, but you also have liquidity.
This liquidity isn’t intrinsically bad or good. It is just liquidity. A typical scenario like this you won’t see negative press about would involve a private equity firm taking an ownership over a company that has good EBITDA and free cash flow, but limited capital. One way to get more capital is to issue new shares, but this dilutes ownership stake in the company. Another way is to take on traditional debt by issuing corporate bonds. But yet another option is to do a dividend recap as I’ve already described. In this “good” example, the PE firm uses that capital to either invest in growth of a division of the company that has a lot of potential, and then realizes an increase in the valuation of the company as say, a new product makes it to market. The company increases in value enough that the PE firm can sell their stake out at a profit, the company is making more money and is able to pay its debts and enjoy the greater growth.
That’s a “good” PE transaction.
A “nefarious” one, a PE company takes ownership of a company and issues a dividend recap, saddling the company with debt and they pocket all the recap money (as they are entitled to–one of the things unique about a dividend recap is shareholders have no fiduciary duty to the company to reinvest dividends, it’s considered the shareholders property at the point it is issued.) Now, the company itself is still looking at positive EBITDA and free cash flow or a lender generally would not have issued the loans to cover the dividend recap. Now let’s say the PE firm wants out, most likely if they bought the company with leverage, and then did a dividend recap, it’s unlikely they’re actually “in the black” just off that transaction. They might be, but not always. What they can now do is say, determine a specific division of the company that can easily be “packaged and sold” to another company intact, isn’t part of the company’s “core business” so they sell it off. This gives them more capital on the corporate balance sheets. They then issue another special dividend from those proceeds, this one they do not need to take debt out for–they are funding it with the sale of assets. They take even more dividends out now. Now the company is smaller and has lower revenue. It may still be positive EBITDA and free cash flow but now the original loan that was taken out, the company is going to have a harder time paying. The PE firm is unconcerned because now they are exiting the company, with the two big dividends issued they have made a huge profit, and can now sell the company at a slight loss or for maybe a little more than they paid for it–depending on how hot the economy is it may still sell at a slight gain even loaded with debt and asset stripped, or maybe they’ll take the company public again. Either way, they get out now with their money. The company is crippled because of the decisions they’ve made. This is the sort of private equity transaction that generates negative headlines.
To understand why the lenders would ever loan money to fund dividend recapitalizations–the lenders are generally looking at it like this–many PE firms aren’t actually taking these loans out to do this shitty thing, so lots of them will actually get paid back. Then as insurance against that not happening, as creditors of the company they get some claim on the company’s assets in a bankruptcy. Further, it can take many years for a company crippled in this way to collapse, and during that time they will often keep paying their debt coupon payments, so the lender is getting some of its money back with each payment. It may never get fully repaid, but after 2-3 years maybe 50% of it is repaid, and then in bankruptcy they’re able to get the rest out. Hard to say, for the lender what matters is that their portfolio of debts makes them money overall, some individual debt issuances will lose them money and that’s fine, they can take risks, they’re banks they have the money to take risk.
I think Hyde has it right. The company does not split into A1 and A2. It instead holds all the debt as A, and sells off the division that is less relevant to the business. (Otherwise, yes, legal action might make all parts of the business legally liable.) So for example RJR Nabisco - don’t recall the details, but they were in the tobacco business (RJR) and assorted bakery businesses (Nabisco). They also owned a lot of peripheral businesses.
It’s a form of irony that when the insiders looked at taking the company private in an LBO, certain division presidents realized they weren’t included in the discussions and the potential bonus-generating gravy train. The core tobacco business was incredibly profitable, and hid this with profligate spending - corporate jets, celebrity golf junkets for executives and customers, etc. Some non-tobacco subsidiaries had normal profit levels, so were better a target for selling off to generate a cash burp, as *Hyde describes. This signaled to some executives their divisions, with them still as CEO, were destined to be sold off to help pay for the buy-out. As a result, they were happy to take their insider knowledge and collaborate with KKR on a rival bid.
A company seeking to expand by buying a subdivision from another company will of course not want to acquire a share of its debt. A lender deep in debt to a failing company should be watching the company to ensure it does not milk the assets this way so that there is nothing left to collect on.
Presumably there are legal remedies - i.e. “you were loaned money based on the following income estimates; substantially changing them by selling off income assets would change the resulting income. If you entered the agreement with this course of action in mind (i.e. sales negotiations had already started and you failed to inform the lender) then this was a bad faith deal.” IANAL but this seems like a reasonable action with a good chance of winning. At very least, it may freeze the proceeds from the sale to prevent it being paid out in dividends until the lawsuit is settled.