Part I of this article appeared in the February 2006 edition of the Vernimmen.com Newsletter

1. A different and more efficient form of corporate governance

Why is it that companies under LBOs are better than others at improving their operating performances? We can see one key reason - improving operating performance is at the forefront of the minds of managers of such companies because the corporate governance of companies under LBOs encourages them very strongly to do so.

The corporate governance system put in place by LBO funds is based on two very ancient determinants of human behaviour:

• the stick, in the form of the weight of the LBO debt that has to be repaid. In the event of default, loan covenants have to be renegotiated and the company could even go bankrupt, something that never looks too good on one’s CV! This results in a cash culture within the company and management takes a new look at a large number of old issues – reducing working capital requirement, optimising investments, etc;
   
• the carrot, because LBO funds ask management to invest around a year's salary alongside them, and a fair portion of a manager's available assets can go into a secondary LBO.

This is what is referred to in the business as “putting on the pressure”. It focuses management’s attention on the two key features of financial success – the generation of cash and the adding of value. Reporting systems (often monthly reporting) put in place introduce a degree of shareholder control that is unheard of within listed groups. This means that any discrepancies are usually dealt with very quickly.

Agency conflicts (1) between shareholders and managers are drastically reduced by this system of corporate governance, far more efficiently than is the case for listed companies. Any listed company with an LBO financial structure would be held up as a pariah. It is also highly unlikely that it would be able to get the AGM to approve the introduction of such a staggering management profit-sharing scheme.

The cocktail often proves to be very effective, as potential gains for the management team over three to four years can be as much as several millions of euros, even tens of millions of euros for large LBOs.

The management team in fact gets the benefit of two leverage effects: the effect already highlighted, pari passu with the LBO fund, and a second effect represented by the share of profits resulting from the LBO’s performance, in the form of warrants or call options. If some of the IRR targets are achieved, this could mean a return of 1 to 4 points of the LBO fund’s IRR to the management team, depending on the IRR at the time of exit.

Going back to our earlier example, if management invests around €0.3m of equity in the LBO, it will increase its stake by 3.25 over four years (€1m) if it succeeds in increasing free cash flows by 30% over an extended period. Management will increase its stake 29-fold (€8.7m) if gets back two IRR points from the investor, and 46-fold if it negotiated a good deal for itself (€13.9m or 4 IRR points).

In short, even managers who have very spendthrift spouses can make a family fortune that will last at least two generations! Now there’s a powerful motivating factor!

Five years ago, managers were still relatively naïve in this regard, but they’ve caught on quickly and these days they often seek out LBO funds to advise them on potential ventures. If the company records an outstanding performance, the management team can expect to get more than the LBO fund managers in carried interest, which is jolly good news for them!

But of course, because there’s more to life than the mere making of money, most managers are attracted to LBOs for other reasons:

• Opportunity to be an entrepreneur, which is often difficult within a large corporation.
• Opportunity to work with shareholders who have committed themselves for several years, who can look at the company from a new angle, with whom it is possible to hold a dialogue and who leave a lot of room for manoeuvre in terms of the final and approved business plan. The comparison with certain institutional shareholders of listed companies is harsh, given their often fickle nature and slow response when it comes to understanding a company's real needs.

So all in all, it is hardly surprising to find that, today, dynamic young executives between the ages of 35 and 40 are less keen on climbing the corporate ladder of a large group than on being involved, at some stage, in an LBO.

At the same time as we’re hoping that listed companies will cut back on the number of stock options granted (a point they’ve conceded in the face of the tyranny of accountants), since these are booked as expenses under IFRS, we're also wondering whether some of them may be concerned about how they can inspire the loyalty of their best managers.

2. What are the challenges ahead for LBO funds?

We’ve identified three main challenges:

• Although remaining under LBO-management is not inevitable for a company, neither is an exit. If corporate governance under an LBO is efficient, as we think it is, it is best if it can be extended for as long as it is does not stray from its path. However, funds regularly need to sell their investments in order to return cash to their investors because, with a few exceptions, they are not listed and do not pay dividends. So they have to sell to trade players or on the stock market, or to another LBO fund.

  These are what are called secondary, tertiary and even quaternary LBOs. Is this then evidence of a bubble? No, it is merely the extension of a form of corporate governance that has demonstrated its effectiveness.

  In successive LBOs there is, however, the issue of the managers. After two successful LBOs, most managers will have made a fortune, and their enthusiasm for embarking on a third "high-wire act” will have waned considerably - they've had enough thrills! This is why new managers have to be brought in and the new team has to be grafted onto the company successfully – this is the first challenge facing LBO funds.

  Frans Bonhomme, the French leader on the plastic pipes and joints segment, is preparing to launch its fifth LBO since 1994, under a new management team that has been in place since 2003. Nevertheless, its operating performances continue to improve:

  
  

Is this an unusual case? On today's market, yes, but cases like this could be more frequent, if LBO funds succeed in rising to their second challenge.

• The second challenge is to demonstrate that LBOs are capable of surviving a severe economic crisis, like the crisis that hit Europe in the early 1990s. In other words, it must be shown that the system is viable even when economic conditions are not the average to good conditions we’ve experienced over the past 10 years.

Today, the LBO is often seen as a type of roulette where the right numbers always come up. Everyone seems to have forgotten about the risk. It is true that the list of LBOs experiencing difficulties is a very short list of small businesses - Serap, Photo Services, De Vecchi Editions, etc.

This is without doubt a sign of a bubble, as are arrangements under which banks agree to free cash flows that do not cover the payment of non-capitalised financial expenses, or managers who start negotiating their share of profits before looking seriously at how to go about implementing operational improvements.

But what happens, in the event of an economic crisis, to a company that has had its reserves depleted on a regular basis by leverage recapitalisation or repeated LBOs, which has working capital and margins that are so highly optimised that there's only one way to go and that's downwards? How does the management team behave when its expectations of capital gains are suddenly dashed, faced with a shareholder wanting to break up the company and/or sell it off to a trade player, but under no circumstances wanting to inject more equity into it in order to allow the company the time it needs to get back onto its feet? Does the LBO corporate governance system not become the most dangerous system in such circumstances, as it serves to discourage management which soon understands that "the game is up"? This results in a very defeatist attitude, just at a time when management should be galvanising all of its energies.

This risk is naturally increased by the increased speed of asset turnover (periods during which the same fund holds onto assets for 18 to 24 months are no longer rare) which is not compatible with industrial strategies aimed at creating a strong foundation for the company's strategic position.

In short, just as the quality of a ship is judged on how it holds out in a storm, the next major economic crisis will be the real test of whether LBOs really are an efficient system for organising a company over the long term.
Once this challenge has been successfully overcome, a third challenge awaits LBO funds.

• If the LBO corporate governance model is more efficient than that of listed companies, there is no reason why it shouldn’t gradually be extended to more and more companies. As early 1989 (2) the visionary Michael Jensen, predicted the decline of the listed company and the emergence of other models, in particular the LBO, for this very reason. Clearly, not all sectors are suitable for LBOs. For example companies involved in areas such as banking, insurance, pharmaceutical research and oil exploration would not be ideal candidates for LBOs, even though, in times of euphoria, there will always be overenthusiastic LBO funds keen to have a go. There are however many other situations in which LBOs would be possible, especially among the large corporates themselves, and not only through hiving off their divisions, which is what happens today.
  LBO funds will need to be more highly leveraged than is currently possible with existing prudential ratios for credit institutions. Market forces are already encouraging greater leverage (junk bonds, securitisation, CDOs, etc.), which is obviously the way forward. LBO funds are also going to need more equity. At the moment, equity capital firms are queuing up to invest in LBOs. However, in the next 5 to 10 years, the increasing size of LBOs could mean that there just isn’t enough equity to go around and investors may not be as ready to invest in illiquid investments. Current advice is not to exceed 5 to 10% of invested assets in unlisted or illiquid investments. Failure to ease this restriction could curb the growth of LBOs.
  
  This brings us to the third challenge facing LBO funds – finding a way of providing their investors with greater liquidity in order to attract more investors and/or more equity. One way of doing this would be through an IPO, which does not come without its own problems (risk of trading at a discount, which is what happened to Wendel Investissement, complexity involved in valuing shares in this sort of company given the way assets are spread across a number of sectors, rather unorthodox consolidated financial structure). LBO funds are starting to go down the IPO road in the USA, where Appolo and Carlyle have both raised funds on the stock markets.

  And so, we get the paradoxical situation where LBO funds, after having gradually encouraged the delisting of a large number of companies, now start boosting stock exchanges by listing themselves, in order to provide their investors with liquidity and raise funds so that they are able to carry on buying up standard listed companies. This shift towards very strong reintermediation, even if still in the realms of science fiction although the first signs are there, is sure to raise a few smiles. Here is yet more proof of the ability of capitalism to evolve and adapt to changing circumstances.

(1) For more on agency theory, see chapter 32 of the Vernimmen.
(2) Eclipse of the public corporation, Harvard Business Review, September – October 1989, pages 61 to 74.

30 years ago, the largest US company by market value was IBM. Today, it is General Electric, 11 time bigger with a market capitalisation of $370bn. In Europe, BP, with market capitalisation of €185bn has taken the top ranking slot from Siemens which 30 years ago was worth €18bn :

These figures illustrate the shift from an economy based on industry (8 out of 10 groups both in the USA and in Europe were industrial groups in 1975) to an economy were services are dominant: 5 out of 10 and 4 out of 10 respectively in 2005, of which a total of 6 were banking groups. This explains why Germany, home to 7 out of the 10 largest European capitalisations in 1975 no longer has any of its groups in the top ten.

A last word: big oil is really big oil: 5 groups out of the top 20 are oil groups in 2005 (3 in 1975) and 3 of them have always been in the top 20 slots (Exxon, BP and Shell).

There has been a huge increase in the number of M&A deals over the last 10 years, both in Europe and the USA (1). Many of them involved large corporations, resulting in changes in their capital structure. A key issue is the choice of payment method (cash or shares), which will determine who controls the merged company and also the level of its debts. Mara Faccio and Ron Masulis collected data on mergers and acquisitions in Europe between 1997 and 2000. Their study (2) looks at the factors that determine the choice of the means of payment.

In Europe, there is very wide diversity in the capital structure of companies (3), which makes it very fertile ground for a study of this nature. It is important to note that the authors did not limit themselves to continental Europe, and included the UK in the study. UK companies account for two-thirds of M&A deals over this period. However, we see no substantial difference between the behaviour of UK companies and that of companies in continental Europe in this regard.

The first thing to note about European M&A deals is the prevalence of cash as a means of payment. For around 80% deals, consideration was in cash only, compared with 11.3% for acquisitions paid in shares and 8.4% with a cash/paper mix. Compare this with the USA where cash comprised the whole of the deal consideration for 58% of deals (4).

Usually companies making cash offers for acquisitions do not have enough ready cash to pay for them and so they need to borrow. As a share offer corresponds to a capital increase, the choice of payment method comes down to a choice of financing method for the new merged entity. Accordingly we can expect that the criteria on which the choice is based will include criteria that have already been widely studied for capital structure.

The issue of shares could thus result in the dilution of the controlling power of the main shareholder. This is especially true when this shareholder has between 20 and 60% of the voting rights in the company – below that, the majority shareholder does not generally exercise any real control, and above that, its control is such that dilution will not have much of an impact on it. These are very general thresholds and only apply to Europe (they are much lower in the USA). The study confirms that companies with less concentrated capital structures tend to use cash more when making acquisitions.

When the target itself has a concentrated capital structure, a share offer results in the creation of a large block, which could be potential threat to control. The authors note that bids on unlisted companies are more frequently cash bids. This is also the case when subsidiaries are taken over, as the seller generally needs cash.

The debt capacity of company is a growing function of the value of its tangible assets, the growth of its revenues and its diversification. Accordingly, very large companies are generally more diversified, which gives them greater debt capacity. Companies with a greater debt capacity usually make cash bids. The authors also draw attention to the fact that a banker on the board of a company leads to a substantially larger share of cash in the deal consideration.

Finally, according to signal theory (5) there will be greater use of shares in mergers involving companies in the same sector. When a buyer is involved in a different business from that of the target, the owners of the target are less keen on taking shares as they don’t have a good understanding of the buyer’s sector. There is also empirical evidence for this.

(1) See chapiter 42 of the Vernimmen.
(2) Faccio M and Masulis RW, The choice of payment method in European mergers and acquisitions, The Journal of Finance, June 2005.
(3) For more details see the Vernimmen.net Newsletter n° 8.
(4) Andrade G, Mitchell, M and Stafford, E, New Evidence and Perspectives on mergers?, Journal of Economic Perspectives, vol.15, 2001.
(5) For more information on the signal theory, see chapter 32 of the Vernimmen.

We know that factoring is a financial management technique which involves outsourcing the management of a company’s accounts receivable to a factor. The factor acquires the accounts receivable, handles recovery and bears any losses as a result of bad debts (1).

Reverse factoring is a less well-known practice.

A company convinces a factor to offer its services to the company’s suppliers, which, as suppliers, have accounts receivable from the company recorded on their books. The factor acquires these, with or without recourse, thus providing the company’s suppliers with instant cash. This is good news for them as they’re often small- to medium-sized businesses. The arrangement amounts to access to a bank loan, which is often difficult and expensive to obtain via the normal channels, and for such small companies, the securitisation market is not an option! The factor is taking a risk on the company and not on its suppliers, as it’s only buying the accounts receivable from the company.

In these circumstances, the company is often able to get its suppliers to grant it longer payment periods and/or lower prices. This reduces working capital requirement by extending supplier credit, reducing net debt on the balance sheet and/or improving operating margin. And as a consequence of all that, ROCE is always improved by as much.

(1) For more on factoring, see the Vernimmen.com Newsletter n° 8.