Author: Gunnar Freyr Gunnarsson

Study nr: 402785

Advisor: Peter Løchte Jørgensen

   

Private equity investments How do private equity funds create value within their portfolio firms

Aarhus School of Business, University of Aarhus

Department of Business Studies

June 2011

Abstract The purpose of this thesis is to explore private equity as a phenomenon by looking at

what it is, how it is structured and to investigate what activities private equity firms

can practice in order to generate value within their portfolio companies.

The thesis is split into 4 main chapters. The first part focuses on the literature around

the two main theories discussed, the optimization of the capital structure and the

agency theory. The second chapter is based on general discussions on private equity

to give the reader an insight into this asset class. The major part is dedicated to

analysis of activities that private equity firms can undertake to generate value in their

investments. In order to combine theories and reality, the third chapter is devoted to

analysis of two quite recent private equity investments, the takeover of ISS A/S and

TDC A/S. An attempt is made to evaluate the influence of the takeover by the private

equity firms by analyzing changes in the companies’ capital structure and operations.

The last chapter focuses on how private equity investments can be exited. This is an

important angle of the process as it can have a material effect on the final value of the

investments. The central subject of the chapter is an investigation of the very recent

IPO of Pandora A/S.

Based on the analysis made in this thesis it is my opinion that private equity as an

object in the financial literature has made an important contribution the development

of theories around corporate finance. Although the value generating activities

discussed cannot be confined only to private equity firms, it is clear that their

expertise in applying debt as a governance tool and implement clear and focused

strategy is vital for the value generating process in general. And with hands-on

management style, they are able to decrease the agency cost and at the same time

increase the unity between owners and employees that results in improved efficiency.

Table of contents

1.   Introduction  ................................................................................................................  1  1.1   Motivation  ..........................................................................................................................  3  1.2   Methodology  and  structure  of  the  thesis  .................................................................  3  1.3   Limitations  .........................................................................................................................  5  

2.   Literature  Review  ......................................................................................................  6  2.1   Private  equity  &  Capital  structure  .............................................................................  6  2.2   Private  equity  &  Agency  theory  ..................................................................................  8  

3.   Private  Equity  ..........................................................................................................  11  3.1   Definition  .........................................................................................................................  11  3.2   Structure  ...........................................................................................................................  13  3.3   Investment  Process  (Fundraising  –  structuring  the  finance)  .........................  15  3.3.1   Debt  forms  ................................................................................................................................  16  3.3.2   Existing  debt  ............................................................................................................................  17  3.3.3   Senior  debt  ................................................................................................................................  17  3.3.4   Mezzanine  debt  .......................................................................................................................  18  

3.4   Types  of  buyouts  ............................................................................................................  18  3.4.1   LBO  ...............................................................................................................................................  18  3.4.2   MBO  ..............................................................................................................................................  19  3.4.3   MBI  ...............................................................................................................................................  19  3.4.4   BIMBO  .........................................................................................................................................  19  3.4.5   PIPE  ..............................................................................................................................................  19  

3.5   Value  drivers  of  PE  funds  ............................................................................................  20  3.5.1   Value  capturing  .......................................................................................................................  21  3.5.1.1   Financial  arbitrage  ........................................................................................................................  21  

3.5.2   Value  creation  ..........................................................................................................................  22  3.5.2.1   Primary  levers  ................................................................................................................................  22  3.5.2.2   Secondary  levers  ...........................................................................................................................  28  

4.   Case  comparison  .....................................................................................................  31  4.1   EQT  Partners  &  Goldman  Sachs  Capital  Partners  takeover  of  ISS  ................  34  4.2   Nordic  Telephone  Company  ApS  (NTC)  takeover  of  TDC  .................................  42  

5.   Exit  strategies  for  PE  investments  ....................................................................  50  5.1   Initial  public  offering  (IPO)  ........................................................................................  51  

5.2   The  case  of  Pandora  ......................................................................................................  54  

6.   Conclusion  .................................................................................................................  58  

Bibliography  .....................................................................................................................  61  

Appendix  ...........................................................................................................................  68  1.  ISS  assets  development  ......................................................................................................  68  2.  ISS  return  on  assets  and  profit  margin  .........................................................................  68  3.  ISS  summarized  financials  ................................................................................................  69  4.  Net  debt  to  EBITDA  with  possible  results  of  an  IPO  .................................................  69  5.  ISS  v/s  Peers  EBITDA  margin  ..........................................................................................  70  6.  ISS  profit  margin  v/s  sales  growth  .................................................................................  70  7.  Development  in  asset  base  TDC  v/s  Peers  ..................................................................  71  8.  IPOs  volume  2000-­‐2010  ....................................................................................................  71  9.  Pandora´s  operational  development  2009-­‐2010  .....................................................  72  10.  Questionnaire  and  answers  from  Torben  Ballegaard  Sørensen  .......................  72  

 

Table of figures

Figure 1: PE investments in volume 2000-2009 ............................................................ 1  

Figure 2: Thesis structure ............................................................................................... 3  

Figure 3: Simplified categorization of financial assets ................................................ 12  

Figure 4: Average Private Equity investment size 2007-2009 .................................... 12  

Figure 5: Private equity fund lifecycle (own creation) ................................................ 14  

Figure 6: Cash flows in private equity ......................................................................... 16  

Figure 7: Typical capital structure in LBOs ................................................................. 17  

Figure 8: Factors behind value generation in LBOs (own creation) ............................ 21  

Figure 9: Cash flows and their market values for two different firms with different

capital structures .......................................................................................................... 23  

Figure 10: Debt to equity and cost of financial distress ............................................... 25  

Figure 11: Tax shield and financial distress costs ........................................................ 26  

Figure 12: Debt to equity ratio of ISS and its peers ..................................................... 37  

Figure 13: ISS and peers interest coverage ratio .......................................................... 37  

Figure 14: Net debt to EBITDA ISS v/s Peers ............................................................. 38  

Figure 15: Return on assets .......................................................................................... 40  

Figure 16: Asset turnover (ATO) and Profit margin (PM) .......................................... 40  

Figure 17: ISS operating margin v/s profit margin ...................................................... 41  

Figure 18: Financing and use in TDC takeover ........................................................... 43  

Figure 19: TDC debt to equity ratio v/s peers .............................................................. 44  

Figure 20: TDC Interest coverage ratio v/s Peers ........................................................ 44  

Figure 21: TDC net debt to EBITDA v/s peers and its EBITDA margin .................... 45  

Figure 22: TDC revenue and revenue growth .............................................................. 46  

Figure 23: Return on assets (ROA) – TDC v/s Peers .................................................. 47  

Figure 24: TDC´s asset turnover and profit margin ..................................................... 47  

Figure 25: TDC revenue and EBITDA margin v/s peers ............................................. 48  

Figure 26: Enterprise value and EV/EBITDA for TDC and peers .............................. 49  

Figure 27: Exit strategies of leveraged buyouts 2000-2005 ........................................ 50  

Figure 28: Proceeds from Pandora´s IPO .................................................................... 56  

Figure 29: Artificial net equity value changes in Pandora ........................................... 57  

Acronyms and definitions

PE: Private equity

LBO: Leveraged buyout

RLBO: Reverse leveraged buyout

MBO: Management Buyout

MBI: Management buy-in

BIMBO: Buy-in management buyout

PIPE: Private investment in public company

IPO: Initial public offering

GP: General partner

LP: Limited partner

FIH Erhvervsbank (FIH): FIH is Danish Bank specializing in lending to Danish

corporates

Kaupthing Bank: Was an international Icelandic bank, headquartered in Reykjavík,

Iceland. Following a major banking and financial crisis in Iceland in October 2008 it

was taken over by the Financial Supervisory authority and is now in liquidation.

Investment grade: A rating that indicates that a corporate bond has a relatively low

risk of default

 1  

     

1. Introduction

Private equity (PE) activities have grown rapidly for last three decades. Investments

on behalf of PE funds and firms have received an enormous attention both in the

media and in the financial society. The Economist, for example, in 2004 described

private equity, mainly leveraged buyouts (LBOs), as the new king of capitalism (The

Economist, 2004). Some might say that the attention is questionable but in the light of

tremendous growth in amount and volume in this kind of activities the attention is

justifiable. Between 2003 and 2007 private equity investments totaled $832 billion,

which was equal to the size of Mexico and India´s GDP´s at that time (Cendrowski

et.al. 2008). The rise of the private equity market in the years after 2000 has been

attributed among other things to the comparatively low interest rates almost

worldwide, the rise of the hedge funds and the sovereign wealth funds. It has also

been attributed to the idea of the superior governance model of private equity relative

to the public companies (Jensen, Eclipse of the Public Corporation, 1989). Due to the

financial and economic shock in 2008 there has been a significant slowdown both in

investments in PE funds and also in the activity of the funds. Figure 1 shows the

evolution of European private equity investments since 2000 both in terms of volume

and companies financed. The investments in 2009 amounted 23,4 billion euros, down

57% from the year before (EVCA, 2010).

(Source: Figure 9, EVCA, 2010, p.17)

Figure 1: PE investments in volume 2000-2009

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The increasing volume in this segment of the financial market for the last decades is

interesting and is worth further exploration. In this study I will go carefully through

what Private Equity is and try to detect the value generating activities the PE firms

use in order to maximize the gain for the stakeholders. In order to combine theory and

practice I will use as an example of two well-known private equity takeovers,

the EQT Partners and Goldman Sachs Capital Partners takeover of ISS and Nordic

Telephone Company ApS (NTC) takeover of TDC. The process in each case will be

compared with its peers and changes in the capital structure and operational

performance will be studied. The last chapter will discuss how PE firms are able to

exit from their investments, in order to put that in context I will investigate the recent

IPO of the Danish jewelry marker Pandora.

The aim of this thesis is to obtain comprehensive knowledge of Private Equity, how it

is structured and how firms in this field of investing manage to create value within

their portfolio companies. This is an exploratory thesis with the fundamental goal to

develop a better understanding of corporate finance and private equity investments by

analyzing the key factors in the value generating process. To be able to get a deeper

understanding of the PE market, an analysis is made on the key theories behind the

ideology of PE investments.

In a research by Berg & Gottschalg (2005) they point out six areas where PE funds

create value: financial arbitrage, financial engineering (The optimization of capital

structure), increasing operational effectiveness, increasing strategic distinctiveness,

reducing agency costs, mentoring (parenting advantage).

These points will be observed with a special attention on the PE funds approach to

reduce the agency cost and optimization of the capital structure

With this in mind the problem statement of this thesis will be:

• How do private equity firms create value in their portfolio companies?

o The effect of capital structure changes in value creation

In order to answer this question I will study other questions like: What is private

equity? How is it combined and who owns PE funds? What value generating activities

can the funds use? How does PE funds exit from their investments?

 3  

     

1.1 Motivation

The motivation for this thesis comes from a deep interest in this subject, which has

not been discussed much in my study. Private equity has a huge impact on global

trade and today especially in my home country Iceland, were currency restrictions, a

paralyzed stock market and an overbought bond market, have directed investors into

putting more focus on private equity investments. The Icelandic government is also

quite heavily dependent on one of the Danish private equity investment, Pandora. In

the autumn of 2008, the Central Bank of Iceland (CBI) lent the former owner of FIH

Erhvervsbank (FIH), Kaupthing Bank, 500 million Euros, with the assets of FIH as a

collateral. When Kaupthing Bank went bankrupt in October 2008, the CBI took over

the control of FIH. In September 2010, CBI sold FIH to Danish and Swedish investors

that paid less than half of the price in cash. The reminders of the price are based on

FIH´s operational efficiency and also on the final value of the private equity fund

Axcel III (owned by FIH). The fund´s biggest investment is 57,4% of the Pandora

shares.

With this in mind I decided to take on this subject to get more knowledge and

experience in this field.

1.2 Methodology and structure of the thesis

Figure 2 here below illustrates the thesis structure. It is basically in three parts, the

first part is surrounded by the theoretical discussions, the second part is dedicated to

private equity in general and the third part attempts to put the previous discussions in

context.

Figure 2: Thesis structure

Introduc*on,  mo*va*on,  structure  and  methodology  

Theore*cal  framework  Agency  

problem  theory  Capital  structure  

theory  

Private  Equity  in  general,  and  the  investment  

process  

Prac*cal  examples  

• ISS  • TDC  

 Exit  strategies  • The  IPO  of  Pandora  

Conclusion  

 4  

     

In part one the theories relevant to private equity are identified and discussed by

reviewing the existing literature in this field. The main theories considered are the

ones that are related to the capital structure and the agency cost. The second part of

the thesis is dedicated to broad private equity discussions. It starts by going generally

through what the phenomenon is and how it is structured. Then the investment

process will be reviewed and different types of buyouts introduced. The main share of

this part is however consideration of the factors that are thought of being value

creating in private equity investments. Part three represents two quite recent private

equity investments, the takeover of ISS A/S and TDC A/S. The focus of this part is to

put previously discussed theoretical points in context by studying the development in

the companies´ capital structure and operational performance before and after the

private equity funds invested in them. The last chapter will focus on exit strategies for

PE investments and the important elements that have to be kept in mind at this stage

in the process. The very recent IPO of the Danish jewelry maker Pandora will be

investigated in in order to put discussions in this chapter into context.

The sources used for the thesis are more or less secondary and acknowledged

academic literature within the subject of corporate finance in general. The data used

for calculations in the case comparison were collected through the Orbis1 database,

which can be accessed on campus. Orbis is a database of financial information for

over 60 million companies around the world. The companies´ consolidated financial

statements were also used when that was needed.

In relation to the last chapter of the thesis, the discussion on Pandora, Torben

Ballegaard Sørensen, the former chairman of Pandora´s board and now Deputy

Chairman, was very helpful and kindly answered few questions for me about the IPO

process and his view on private equity firms contribution to value creation.

1 http://www.bvdinfo.com/Products/Company-Information/International/ORBIS.aspx 2 http://www.blackstone.com/ 3 http://carlyle.com/ 4 http://www.kkr.com/ 5 Closed end refers to the system of the fund. Investors cannot withdraw their amounts

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1.3 Limitations

In order to keep focus in answering the problem statement questions, a number of

limitations should be put forward.

This thesis puts emphasis on discussions of the value creation of a private equity fund

acquiring a major stake in a LBO of a publicly listed company. Other kinds of

alternative investments such as venture capital are not explored. The discussion in this

thesis also focuses more on the relationship between the private equity fund and the

portfolio companies rather than detailed technical analysis of the function of the

private equity funds itself, that could be a subject of a whole another thesis.

Chapter 4 is used to put theories and discussions into perspective, the cases of TDC

and ISS are used as explanatory examples of how certain ratios changes in the process

of being taken over by a PE fund. In order to calculate the ratios, the financial

statements of the companies were used but they were not reformulated.

This thesis is explanatory and as such it does not claim to be an exhaustive analysis of

the private equity phenomenon, it rather tries to throw light onto private equity and

the value creating activities employed by the PE funds in the portfolio firm operations.

It is also worth pointing out that the phrases PE firms, PE company and PE funds will

be used interchangeably through the thesis

 6  

     

2. Literature Review

2.1 Private equity & Capital structure

Reviews of the theories of optimal capital structure always start with the revolutionary

work of Modigliani and Miller (MM) (1958, 1963). They proved that in perfect

capital markets, the choice between debt and equity financing has no material effects

on the value of the firm or on the cost of capital.

The conditions that M&M referred to, as perfect capital markets were:

• Capital markets are frictionless

• Individuals can borrow and lend at the risk-free rate

• There are no costs to bankruptcy or to business disruption

• Firms issue only two types of claims: risk-free debt and risky equity

• All firms are assumed to be in the same risk class (operating risk)

• There are no taxes associated with security trading

• All cash flows are perpetuities (i.e. no growth)

• Operating cash flows are completely unaffected by changes in capital structure

Under these conditions, MM demonstrated the following result regarding the role of

capital structure in determining firm value:

MM Proposition I: In a perfect capital market, the total value of a firm is

equal to the market value of the total cash flow generated by its assets and

is not affected by its choice of capital structure (Berk & DeMarzo, 2007,

p.432).

Proposition II is derived from Proposition I and concerns the rate of return on equity:

MM Proposition II: The cost of capital of levered equity is equal to the

cost of capital of unlevered equity plus a premium that is proportional to

the market value debt-equity ratio (Berk & DeMarzo, 2007, p.438)

MM´s original work assumed a zero corporate tax rate. In 1963, they published a

second article, which included corporate tax effects. With corporate income taxes,

they conclude that leverage will increase a firm´s value, because interest on debt is a

 7  

     

tax-deductible expense, which lead to more of a leveraged firm´s operating income

flows through to investors. From it derives the conclusion that firms should use 100%

debt financing (Modigliani & Miller, 1963).

As one could imagine MM statements caused robust reaction from dozens of other

academics (e.g. Durand, 1959). Myers and Robichek (1966) concluded that the

assumptions behind Proposition I would not hold in the world assumed by MM. They

hypothesized that in the absence of taxes, the value of the firm would not change for

moderate amount of debt but would decline with high degree of leverage (Myers &

Robichek, 1966).

Jensen (1993) states that even though MM assumptions have been very productive in

helping the financial community to structure the logic of many valuation issues, “The

1980s control activities, however, have demonstrated that the MM theorems (while

logically sound) are empirically incorrect” (Jensen, 1993, p.878). Other researchers

have pointed out that evidence from e.g. LBOs have shown that leverage, payout

policy and ownership structure do matter when considering organizational efficiency

and therefore value (e.g. (Kaplan 1989) (Smith, 1990)). Brigham and Ehrhardt (2010)

supposed that Modigliani-Miller (MM) were theoretically right but in reality the cost

of bankruptcy exists and is directly proportional to the debt level of the firm.

Jensen (1986) discusses the importance of debt in the capital structure. From his point

of view debt can and should be used as a corporate governance tool. He argues that

managers are afraid of paying out the extra cash flow because the stock market

punishes dividend payments with stock reduction. In order to prevent the managers

from investing in projects with negative NPV, the firm should take on additional debt

that the extra cash flow would be used to pay down. He sees this use of debt as a

potential determinant of capital structure. Muscarella and Vetsuypens (1990)

reviewed reverse LBO´s and found that firms experience dramatic increase in

leverage at the LBO but the leverage ratios were gradually reduced over time.

Axelson et al. (2007) conducted an analysis of the financial structure in large buyouts.

They found no relation between leverage in their sample of buyouts and comparable

public firms. Their results suggest that capital structure in buyouts requires a different

explanation than in public firms.

 8  

     

Myers and Majluf (1984) recommend that firms should use debt financing rather than

equity financing when possible because of the information asymmetry costs. They

argue that when managers have superior information and go for an equity issue, the

stock price will fall but if the company issues safer debt such as bonds, the stock price

will not fall.

In relation to the discussions above about the different angles of the theories around

the capital structure it is interesting that in a survey by Graham and Harvey (2001),

they found that financial executives are not likely to follow the academically

proscribed factors and theories when determining capital structure. In light of this, it

will be exciting to see later on in this thesis if this is the case.

2.2 Private equity & Agency theory

The origin of the agency theory can be linked to the famous social philosopher and

economist Adam Smith. In 1776 he came up with this definition of the relationship

between owners of companies and their managers:

“The directors of such (joint-stock) companies, however, being the

managers rather of other people´s money than of their own, it cannot well

be expected, that they should watch over it with the same anxious vigilance

with which the partners in a private copartnery frequently watch over their

own. Like the stewards of a rich man, they are apt to consider attention to

small matters as not for their master´s honor, and very easily give

themselves a dispensation from having it. Negligence and profusion

therefore must always prevail, more or less, in the management of the

affairs of such company.”

(Quotation adapted from Jensen & Meckling, 1976)

Jensen and Meckling (1976) formalized this view from Adam Smith and in their

paper they conclude that the agent cannot at all times guarantee that he will make

optimal decisions from the owner´s point of view. According to Jensen and Meckling

agency costs of equity are defined as:

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1. The monitoring expenditures by the principal

2. The bonding expenditures by the agent

3. The residual loss

Monitoring include efforts on behalf of the owner to control the behavior of the agent

to increase the alignment of interest between the agent and the owner. Among the

monitoring activities that the owner can use are budget restrictions, compensation

policies and operating rules (Jensen & Meckling, 1976). Jensen and Meckling

describe bonding as an action carried out by the agent “to expend resources (bonding

costs) to guarantee that he will not take certain actions which would harm the

principal or to ensure that the principal will be compensated if he does take such

actions” (Jensen & Meckling, 1976, p. 5). The costs related to bonding could be an

internal audit showing that the agent is acting in the interest of the principal. Residual

loss is defined as any reduction in welfare from the viewpoint of the owner that could

be related to the conflict between the agents decisions and the maximum gain for the

owner (Jensen & Meckling, 1976). Demsetz (1983) on the other hand concluded that

it would not be possible to expect any relation between ownership structure and

profitability (Demsetz, 1983).

According to Milgrom and Roberts (1992) one of the most important things in

relation to the Agency Theory is to align the interest between the owner (shareholder)

and the agent in order to reach the firm´s goals in an environment of uncertainty

(Milgrom & Roberts, 1992).

Jensen and Meckling (1976) distinguish between two approaches of the Agency

Theory, the normative and the positive. The normative aspect is mainly about how to

structure the contractual relation between the principal and the agent in order to

provide appropriate incentives for the agent to make choices that will maximize the

principal´s welfare. The positive theory is what Jensen and Meckling focus almost

entirely on. The aim of that approach is to identify a policy or behavior to merge debt

and equity holders’ interests with management and then to demonstrate how

information systems or outcome-based incentives solve the agency problem.

According to Renneboog & Simons (2005), the basics of the agency theory includes

three primary hypotheses regarding the motives of public to private transactions:

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• Incentive realignment

• Control

• Free cash flow

The incentive realignment hypothesis states that the gains in stockholder wealth that

arise from going private are a result of offering more rewards for managers that

encourage them to act in line with the interests of the owners. The incentives could

e.g. take the form of increased ownership stake. The hypothesis of control argues that

successful implementation of supervision system by the management plays a critical

role for the shareholders wealth. The free cash flow hypothesis suggests that firms

should take on additional debt in order to force managers to pay out free cash flows.

The added leverage prevents managers from growing the firm beyond its optimal size

and at the expense of value creation (Renneboog & Simons, 2005).

Vinten (2007), on the contrary, points out that this kind of actions might lead to over-

monitoring by the large shareholder, which could reduce firm efficiency because of

poorer firm innovation. On top of that, huge debt burden might dampen the

managerial initiatives because the free cash flow now only serves the repayments on

the cost of investments in new firm activities (Vinten, 2007).

In a survey by Shleifer & Vishny (1997) they identify incentive contracts as a possible

solution for owners to get the managers to invest the investor´s capital in the most

optimal way. According to Lewellen et al (1985) negative returns are most common

for bidders in mergers and acquisitions activities where their managers hold little

equity, suggesting that agency problems can be enhanced with incentives.

Kaplan (1989) performed a study of 76 large public companies that went through

management buyout (MBO) between 1980 and 1986. He found that within 3 years

from the buyout, the companies increased their operating income and net cash flow.

He connected these operating changes to improved incentives rather than layoffs or

managerial exploitation of shareholders through inside information. These results

support that agency cost savings from better control and incentives lead to

improvement in the company´s performance. The results are in line with related

studies from Muscarella & Vetsuypens (1990) and Smith (1990).

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Leslie & Oyer (2009) on the other hand raise question about whether incentives are

able to create value. Their study showed that companies owned by PE firms

implement much stonger incentives system for their top executives but they could not

find much evidence of these companies outperforming public firms in profitability or

operational efficiency (Leslie & Oyer, 2009).

3. Private Equity

In the following section a description of

the various aspects of private equity will

be provided in order to give the reader

insight to this particular asset class. First

there will a brief definition of private

equity, followed by a discussion of the

ownership structure and the investment

process, i.e. the fundraising and the

financing structure. Then different kinds

of buyouts will be introduced and the last

part of this chapter will then be dedicated to the value generating process of private

equity investments.

3.1 Definition

Investments in asset classes can roughly be divided between traditional and

alternative assets. The traditional ones are in most cases more liquid and easier to

understand than the alternatives one. Private equity investments are considered to be

alternative investments and suits investors that consider a longer investment horizon.

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(Source: figure 1.2 Demaria, 2010, p.17)

Figure 3: Simplified categorization of financial assets

The concept of private equity contains different investment approaches such as

management buy-outs and buy-ins, venture capital, and development capital.

Furthermore, the investment strategies of different private equity companies differ

extremely according to their investment criteria, such as acquisition size, sector,

region, and purpose of the acquisition, which e.g. includes start-up, expansion,

buyouts and turnarounds. However, as can be seen in figure 4 the majority of funds

placed in private equity are invested in leveraged buyouts (LBOs), so referring to

private equity is often implicitly LBOs (Philippou & Zollo, 2005).

(Source: EVCA, 2010, p.19)

Figure 4: Average Private Equity investment size 2007-2009

Assets

Traditional

Bonds Stocks

Specialized products

Alternative

Hedge funds PRIVATE EQUITY

Real estate Commodities, Art, etc

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In a leveraged buyout, a specialized investment firm using a relatively small portion

of equity and a relatively large portion of outside debt financing acquires a company.

The leveraged buyout investment companies today refer to themselves as private

equity firms. In a typical leveraged buyout transaction, the private equity firm buys

majority control of an existing or mature firm and brings in their own people in board

and even into the management team. This arrangement is different from venture

capital firms that typically invest in young or emerging companies, and typically do

not obtain majority control (Kaplan & Strömberg, 2008). The focus in this thesis will

be on private equity firms and the leveraged buyouts in which they invest.

Demaria (2010) supposed that because PE firms’ investment cycles are substantially

longer and the cycles are not correlated directly to the evolution of the stock exchange

index, investors in private equity were looking for diversification and return

enhancement. But as was also pointed out there is a close link to the markets, as exists

of investments are mainly trade sales or initial public offerings (IPOs). If markets are

in downturn, public companies will make fewer acquisitions or will negotiate lower

valuations and IPOs could turn out to be very negative. Private equity is also affected

by the interest rates because of the huge amount of debt borrowed in the buyout. The

higher the interest rates, the more difficult it is for a PE firm to transform a buyout

into a profit. (Demaria, 2010)

3.2 Structure

The classic private equity firm is organized as a partnership or limited liability

corporation. Jensen (1989) argued that private equity associations were more

decentralized than public companies with fairly few investment professionals. In a

survey of 7 PE firms he found that they had only on average 13 professionals with an

investment banking background (Jensen, 1989). This has changed a bit for last years

as the PE firms have become larger but they are though still relatively small in

relation to their investments. Among the biggest firms in the world today are

Blackstone2, Carlyle3 and KKR4.

2 http://www.blackstone.com/ 3 http://carlyle.com/ 4 http://www.kkr.com/

 14  

     

The Private equity firm raises capital through a private equity fund. These funds are

structured as “closed end”5 funds in which investors commit to providing a certain

amount of money into the fund. The PE firm serves as the general partner (GP) and

manages the fund, the investor is referred to as the limited partner (LP). The PE funds

are usually created for a 10-year life span, with option of an extension. These 10 years

are then subdivided into an investment period of 5 years and a divestment period of 5

years (Demaria, 2010).

Figure 5: Private equity fund lifecycle (own creation)

In the first period of the funds life cycle the fund managers structure the fund,

introduce the business plan and strategy for investors. The investors then commit

capital to the new established fund if they believe in the management ideas. When all

necessary observation such as due diligence has been made on the target firm and

participants have negotiated the price, a capital call is made, i.e. the investors are at

this time asked to lay out their committed capital. These capital calls can be made

more than once. For example, the agreement between the buyer and the seller can be

structured in that way that payments are made in separated parts over longer period.

After the investment process has taken place the strategic, organizational and

operational changes can be made to the target firm in the so-called holding period. At

this time in the cycle there is room for operational improvements and value creation

5 Closed end refers to the system of the fund. Investors cannot withdraw their amounts until the fund is terminated.

PE fund established

Fund raising by the GP -LP´s joins the fund

Searching period

Capital Call made by GP -

paid by LP

Investment period

Holding/Restructuring

period

Disinvestment period/Focus on

portfolio firm

Harvest/Exit

 15  

     

within the portfolio company. The latest stage is the harvest or the exit of the

investment. This marks the end of the LBO investment and is an important stage in

the process since the investors will ultimately realize the returns from their investment

(Berg & Gottschalg, 2005). The exits can be of different modes that will be further

discussed later in the thesis.

3.3 Investment Process (Fundraising – structuring the finance)

In their search for potential buyout targets, the GPs look for firms with strong, stable

cash flows, market leadership and a low leverage ratio relative to industry peers. A

rather famous phrase in the field of finance is “cash is king”, that is especially true in

the case of leverage buyouts, as the cash flow is used to service the debt raised in the

deal (Cendrowski, Martin, Petro, & Wadecki, 2008).

One of the most important topics for the PE fund is the fundraising. If this stage turns

out to be unsuccessful it can have serious consequences on the investment and in

some instances might prevent the fund from going further in the investment process.

The limited partners (LPs) put up the majority of the equity part but the GP also

contribute some capital. Good track record is vital in this perspective. Funds that have

been able to generate good returns in the past have definitely competitive advantage

to others (Demaria, 2010). One might describe this as the situation when a Danish guy,

Peter L, is going to invite a stand-up comedian to his party. He knows that he can get

Casper Christiansen but his Icelandic friend also told him about a famous Icelandic

comedian named Laddi that would come for free to escape the situation in Iceland.

Peter knows that his safest bet would be the Danish performer but he is also expensive,

so it is tempting to try the Icelandic one. Although Peter is tempted his safest choice

would be the Danish performer. This example shows that although one is tempted to

go for a new PE fund, he might still invest in a fund managed by a tried-and-true GP.

After the fundraising process, than the GP takes full control of the fund and starts to

invest. The limited partners (LPs) have nothing to say in all the investment process,

which is also important because of their limited liability. A golden rule of private

equity fund is that those who are responsible for the investment process should be

members of the full-time executive team (Fraser-Sampson, 2007).

 16  

     

Incentives and fees

Figure 6 provides a view of the cash flow in private equity funds. The General partner

(GP) gets paid a management fee from the fund for the service he provides. The fee is

generally 1,5% to 2,5% per year depending on the fund size. This fee is calculated on

the fund size during the investment period, and usually on the net asset value of the

portfolio once the investment period has ended. In order to align the interest between

limited partners and the management team, a fee in form of carried interest is paid to

the management team. That fee is based on the performance of the fund and is around

20%. However, as the investors carry more risk than management team, than before

anything else is paid out of the fund, the investors are first compensated with a so-

called hurdle rate, which is between 5 and 15% (Demaria, 2010).

(Source: Figure 3.6 Demaria, 2010, p.55)

Figure 6: Cash flows in private equity investments

3.3.1 Debt forms

The use of debt financing is what most obviously distinguishes buyouts from other

transactions such as venture investments. Buyouts are often structurally very complex,

with many different layers of debt, were often the key buyout skills lay. The buyout is

typically financed with 60-90% debt, which explains the term leveraged buyout

(Kaplan & Strömberg, 2008). One of the key barriers to entry for new buyout firms is

to obtain as good terms from banks as the established players (Fraser-Sampson, 2007).

 17  

     

The typical debt structure almost always includes a portion of senior and secured

loans that are provided by a bank and also layers of junior and mezzanine debt.

(Source: Spliid, 2007, p.31)

Figure 7: Typical capital structure in LBOs

3.3.2 Existing debt

This part is often overlooked when observing PE activities. These are the debts that

are already present in the firm for the working capital purposes. Companies with high

levels of operating debt are less attractive as buyout targets. But on the other hand,

firms with low levels of debt and even a cash stack will be highly attractive. Buyout

firms typically seek to reduce the level of operating debt within a business once they

have acquired it. Operating debt finances the working capital cycle, so lowering the

stock levels can reduce the debt, also fewer debtor days or the opposite, by adding

more creditor days. Firms with a low operating debt might persuade a bank to issue

more debt in the acquisition so that equity can be released back to the buyout fund as

part of recapitalization (Fraser-Sampson, 2007).

3.3.3 Senior debt

Senior debt is a first priority debt in repayment in any liquidation of the company. It

has a greater seniority in the issuer´s capital structure than subordinated debt and is

often secured by collateral (Fraser-Sampson, 2007). Senior debts are issued in various

loan types (tranches) according to risk/return profile, repayments conditions and

maturity. For example as shown in figure 7, tranche A is the safest type of debt,

featuring a fixed amortization plan. Tranche B and C are lower-grade loans, based on

bullet payment structure. Debt tranches with bullet payments allow target companies

to take on higher debt multiples, as the payments will be made at the end of the loan

Financing Senior loans > > Mezzanine loans > > Equity and shareholders loans

Percent of capital structure 45-65 10 to 20 25-40

Expected return Euribor + 1,75-3,25% Euribor + 9-13% 15-30% (IRR)Leverage 4-5 x EBITDA 5-6 x EBITDA > 6 x EBITDA

A: Amortization 7 years Bullet loanB: Bullet loan 8 yearsC: Bullet loan 9 years

Typical capital structure in LBOs

Repayment profile

 18  

     

period, so there is a kind of payment relief in the beginning. But it does not come

without a cost, since the bullet loans carry higher interest rates. (Spliid, 2007)

3.3.4 Mezzanine debt

Mezzanine financing represents capital with a level of risk, which is positioned in the

gap between senior debt and equity. This kind of financing is junior to senior debt and

takes the form of subordinated notes from the private placement market or high yield

bonds from the public market. Due to its popularity, special mezzanine financing

funds have been raised to operate in this space (Fraser-Sampson, 2007).

Mezzanine finance is by nature cash flow lending but sometimes the lenders are

secured with operating assets in case of insolvency. This kind of debt obviously bear

higher interest rate then are paid on senior debt. Often it includes some form of equity

“kicker” in order to allow the mezzanine investor to participate in the upside of the

equity value and to compensate them for the risk taken. The existence of this kind of

financing allows PE firms to secure a gap in the financing of the deal at a price that is

less than pure equity and allows them to keep full majority control of their businesses

(Cendrowski, Martin, Petro, & Wadecki, 2008).

3.4 Types of buyouts

There is a great deal of overlap in the definitions of different buyouts. The discussion

so far has been centered on leveraged buyouts (LBOs) but certainly there are more

types. This section will try to distinguish further between these forms and definitions

of them.

3.4.1 LBO

Leveraged buyout can be defined as an acquisition of a company by an investor or

group of investors with a significant amount of the price paid by borrowed money.

The cash flow generated in the acquired firm or procedures from asset sale is then

used to pay down the massive debt. The assets of the acquired company are though

almost always used as collateral for the debt structure (Demaria, 2010). In the 1980´s

leveraged buyouts first arose as an important phenomenon due to its increased activity.

Famously, Jensen (1989) predicted that the leveraged buyouts would become the

 19  

     

dominant corporate organizational form in the future. He argued that the structure of

the PE firms were superior to those of the typical public corporations because of their

combined form of highly leveraged capital structures, concentrated ownership,

incentive systems and efficient organizations with a low overhead costs (Jensen,

1989). In a sense it can be said that all buyouts are leverage buyouts (LBOs) since all

buyouts involve use of some debt, just at different quantity.

3.4.2 MBO

Management buyout (MBO) in its purest form involves the executive team who are

managing a particular business activity, buying it out from the parent company. This

form of buyouts was especially popular in the early to mid 1990s. This method

requires the management team to put its own money into the deal but with a reward of

an equity stake. With larger funds and bigger deals, this method has become less

common (Fraser-Sampson, 2007).

3.4.3 MBI

Management buy-in developed from the MBO and is similar method apart from the

way in which the deal initially comes together. The key difference is that instead of

the management team of a business getting together to buy it, a team is put together to

buy another company operating in the same sector. Pure MBIs are rare and often fall

into the BIMBO category (Fraser-Sampson, 2007).

3.4.4 BIMBO

Buy-in management buyout occurs where outside executives join the existing

executive team to buyout a company. Much of the buyout activity falls into this

category if one applies the definition strictly. An example of this could be a former

CEO that returns to advice and help in the acquisition process (Fraser-Sampson,

2007).

3.4.5 PIPE

Private investment in public equity is a category of deals that occurs when a particular

investment instrument is created within á public company that may offer a private

equity-type return. Typically, while the company´s equity is quoted the instrument

 20  

     

itself is not. An example of this could be a private investments firm or mutual fund

that purchases firm´s equity at discount to current market value for the purpose of

raising the firm´s capital. This is called traditional PIPE and the stock equity could be

either preferred or common. Structured PIPE refers to the issue of convertible debt for

the same purpose (Fraser-Sampson, 2007).

3.5 Value drivers of PE funds

Demaria (2010) recommends that when value creation in firms is analyzed one should

put emphasis on the structure, execution and the exit of the deal. The reason behind

investments in PE funds it that they are believed to have the X factor to generate value

within their investments beyond others.

This section will discuss the various value generating activities that PE funds

undertake in their investments. Berg & Gottschalg (2005) and Renneboog & Simmons

(2005) made a comprehensive contribution to the literature in this field of PE

investments and this section will depart from their studies.

In order for PE funds to reach their goal they have to exploit the value creation

opportunities laying in their investments. Berg & Gottschalg (2005) introduced three-

dimensional framework to analyse the factors behind value creation in LBOs either

within the portfolio company or through the interaction between the portfolio

company and the PE fund.

In both studies by Berg & Gottschalg (2005) and Renneboog & Simons (2005) a

distinction is made between value capturing and value creation in PTP buyouts. Value

capturing refers to activities that increase the value without changing anything in the

underlying performance of the business e.g. financial arbitrage, breaking up of

companies or improvements in the macroeconomic environment. Value creation on

the other hand takes place in the holding period or during the PE ownership of the

company and refers to the improvement of performance of the portfolio companies.

These improvements can be further divided into primary (direct) value creation, e.g.

the ones that are easy to measure on the portfolio company´s performance or

operations, and secondary (indirect) value creation, which refers to events that are

 21  

     

harder to measure but have an influence on value generation, such as benefits of

reduced agency costs. Figure 8 gives an overview of the various factors behind value

generation in LBOs as discussed by Berg & Gottschalg (2005).

Figure 8: Factors behind value generation in LBOs (own creation)

3.5.1 Value capturing

3.5.1.1 Financial arbitrage

According to the classical world that Modigliani and Miller among others belong to,

arbitrage opportunities should not exist if markets are efficient. However, market

conditions such as information asymmetry distract this picture of the perfect market

(Berk & DeMarzo, 2007). It is therefore possible for PE funds to find an investment

opportunity where value can be generated between the buyout and the divestment

without operational changes within the portfolio company.

According to Berg & Gottschalg (2005) the financial arbitrage can be based on four

factors:

Value  genera*on  in  buyouts  

Value  crea*on  

Primary  levers  

Financial  engineering  

Op*mizing  capital  structure  

Reducing  corporate  tax  

Opera*onal  effec*veness  

Cost  cuJng  and  margin  

imporvements  

Reducing  capital  requirements  

Removing  managerial  inefficiencies  

Strategic  dis*nc*veness  

Secondary  levers  

Reducing  agency  costs  

Of  free  cash  flow  

Improving  incen*ve  alignment  

Improving  mentoring  and  controlling  

Mentoring  

Restoring  entrepreneural  

spirit  

Advising  and  enabling  

Value  capturing  

Financial  arbitrage  

Based  on  change  in  market  valua*on  

Based  on  private  info  about  

porOolio  firm  

Through  superior  market  

info  

Through  op*miza*on  of  corporate  scope  

 22  

     

• Changes in market valuation – An example of this is so called “Multiple

riding”, i.e. when investor takes company private because he expects the

valuation based on public multiples to rise.

• Private information - For example information asymmetries in management

buyouts (MBOs).

• Different expectations regarding the future performance of the business or the

industry

• Superior deal making capabilities – For example, clever firms that managed to

limit competition from other firms and are therefore able to get better deal.

Renneboog and Simmons (2005) explained value capturing with the undervaluation

hypothesis, which suggest that value generated in the public to private process is

based on the management ability to use their knowledge to develop alternative higher-

value use for the companies’ asset´s.

3.5.2 Value creation

3.5.2.1 Primary levers

Changes that are made to the capital structure or the organizational structure in the

portfolio company are referred to as value creation activities. The PE firm can

undertake various restructuring activities within the portfolio company in order to

generate value. Berg & Gottschalg (2005) divided the value creation into primary and

secondary levers where the primary refers to activities that can be directly linked to

improvements in financial, operational and strategic performance of the portfolio

company.

The literature in the field of value creation in buyouts has put a great deal of attention

to the financial engineering i.e. the optimization of the capital structure and the

minimization of cost of capital (Berg & Gottschalg, 2005). This section will try to

bring out the aspects that have been considered to influence the improvements in the

bottom line results of the portfolio companies.

 23  

     

Financial engineering

As has been discussed in this thesis, the revolutionary work of Modigliani and Miller

(MM) can be applied to understand the capital structure of PE investments and how

they create value. Their proposition I, in the world of no taxes, states that the capital

structure decision has no effect on the total cash flows that a firm can distribute to its

debt and equity holders. To illustrate this, let’s assume that two firms exist for one

year, produce identical pretax cash flows (X) at the end of that year, and then

liquidate. However, they are financed differently, company U has no debt and is

therefore unlevered, but company L has some debt in its capital structure and is

therefore leveraged. Figure 9 presents the cash flows of the companies U and L, the

split of the cash flow between debt and equity and the present values of the cash flows

(Hillier, Grinblatt, & Titman, 2008).

Company U Company L

Future cash flow Current value Future cash flow Current value

Debt 0 0 (1 + rD)*D D

Equity X VU X - (1-rD) *D EL

Total X VU X VL = D +EL

(Hillier, Grinblatt, & Titman, 2008, p.510)

Figure 9: Cash flows and their market values for two different firms with different

capital structures

If we assume for simplicity that the debt is riskless and rD is the riskless rate,

company L´s debt holders will receive (1+rD)*D at the end of the year and its equity

holders will receive what remains X – (1+rD)*D. The current value of company L is

therefore VL or the current value of its outstanding debt D plus its equity EL. This said,

a conclusion can be drawn from these assumptions under the MM Proposition I:

• Firm´s total cash flow to its debt and equity holders is not affected by how it is

financed,

• There are no transaction costs, and

• No arbitrage opportunities exist in the economy

 24  

     

Then the value of a company is maintained regardless of the nature of the claims

against it. Thus the value is determined on the left side of the balance sheet by real

assets, not by the company´s leverage ratio.

Proposition II states that cost of equity depends on three factors

• The required rate of return on the company´s assets (RA)

• The company´s cost of debt (RD), and

• The company´s debt to equity ratio (D/E)

The 1958 theory as has been discussed was highly hypothetical. But in 1963 they

introduced corporate tax, which moved their theory closer to reality. Cost of debt is

under these circumstances calculated on an after tax basis as interest payments are

now tax deductible.

Hence, under the assumptions behind Proposition I mentioned above plus an extra

assumption that no personal taxes exist, then the value of a levered firm with risk-free

perpetual debt is the value of an otherwise equivalent unlevered firm plus the present

value of the tax shield. Therefore the firm´s optimal capital structure will include

enough debt to completely eliminate the firm´s tax liabilities (Hillier, Grinblatt, &

Titman, 2008).

However, although markets may work semi-efficiently after MM assumptions, they

are certainly not perfect and costs of financial distress exist. Costs of financial distress

depend on the probability of default and the magnitude of the costs. Proposition II

argues that the expected return on equity of a levered firm increases linearly with the

debt to equity ratio, as long as debt is risk-free. Nevertheless, as figure 10 visualizes,

when debt increases so does the risk of financial distress and debt holders demand

higher return for the additional risk that they carry. The more debt present, the less

sensitive equity holders become to further borrowing, hence the slope of RE slows

down as the ratio debt to equity increases (Brealey & Myers, 2003).

 25  

     

(Source: figure 17.2 in Brealey & Myers, 2003, p.474)

Figure 10: Debt to equity and cost of financial distress

This may seem to contradict Proposition I, which argued that the capital

structure is irrelevant. But as can be seen on the figure there is a risk-return

trade-off. Any increase in the expected return is exactly offset by an increase in

risk and therefore in shareholder´s required rate of return. The required return

simply rises to match the increased risk.

The trade-off theory helps to understand the choice of capital structure. It

suggests that the debt to equity decision relies on a balance between the tax

shield and the cost of financial distress. This explains why target debt ratios may

vary from firm to firm as companies with safe, tangible assets and steady cash

flow can better handle higher debt ratios. The theory also helps to explain what

kind of companies’ goes private in LBO´s. Because of the leverage factor in the

LBO´s, the target companies for the takeovers are usually mature with

established markets, strong cash flow and low debt to equity ratio. That makes

sense according to the trade-off theory since they are exactly the kind of

companies that “should” have high debt ratios (Koller, Goedhart, & Wessels,

2010).

Figure 11 shows how the trade-off between the tax-benefits, improved discipline

and the costs of distress are relevant elements when determining the optimal

capital structure. At some point, the risk of financial distress increases rapidly

with additional borrowing and the cost of financial distress begin to take a

 26  

     

substantial bite out of the firm value. Thus, the benefits from debt may be more

than offset by the financial distress cost.

(Source: Exhibit 23.1 Koller, Goedhart, & Wessels, 2010, p.478)

Figure 11: Tax shield and financial distress costs

Berg & Gottschalg (2005) pointed out that PE firms in power of their extensive

knowledge and experience of capital markets are able to help their portfolio

companies to optimize their capital structure, for example by reducing the cost of debt.

PE firm with good track records and reputation usually has better access to capital and

often at better terms than firm that either is unknown or with bad reputation.

Renneboog & Simons (2005) discussed how value could be created for the

stockholders by transferring wealth from the bondholders. From their point of view it

is possible for companies to do so in three ways: by increasing risk in investments, by

increasing the dividend payments and by issuing debt with higher or equal seniority of

the outstanding ones. They also mention that although this wealth expropriation

theory has not gained convincing evidence in the empirical researches so far, then

some studies show that companies, which have gone through public-to-private

transactions, faced substantial debt downgrades by the rating agencies (Renneboog &

Simons, 2005).

Koller et al (2010) indicate that financial engineering can create value in three ways;

• With derivative instruments that transfer company risk to third parties, such as

forwards, swaps and options.

 27  

     

• Off-balance sheet financing that detaches funding from the company´s credit

risk and often exploit tax advantages, for example leases and securitization.

An example of securitization could be of a distressed company in the car

industry that managed to “pack” their receivables and sell to investors at better

terms than otherwise possible if the company either issued bonds or asked for

traditional bank loan.

• Hybrid financing that offers new risk-return financing combinations. For

example convertible debt, this kind of financing might be used when a great

distinction exists between management and lenders about company´s credit

risk. Creditor might be tempted to finance a company at more reasonable

terms because of the warrant included in the structure, so the debt part of the

structure is, for the lender, not the most attractive but rather the warrant

component (Koller, Goedhart, & Wessels, 2010).

Sub-conclusion

As has been discussed above, Modigliani and Miller (MM) assumed that when

corporate taxes are included and the interest on debt is deductible (tax shield), than

firm’s optimal capital structure should be 100% debt. That was built on the idea that

the value of the company increased with the amount of debt because of the

exploitation of the tax shield that improved the cash flow to investors. But as was then

pointed out, the existence of financial distress cost makes this picture biased and a

balance is needed to realize the benefits of the tax shield. According to Kaplan

(1989b) tax benefits play an important role for the value creation in buyouts. He

found that in 76 buyouts completed between 1980 and 1986 the value of the tax

benefits ranged 21% to 143% of the premium paid to shareholders (Kaplan S., 1989b).

Optimization of the capital structure and the exploitation of the tax shield do clearly

impact the bottom line results of the portfolio company, but whether these tax benefits

are confined to PE activities is highly questionable. It is very likely that in today’s

competitive environment the former owners have already exploited these tax benefits.

It can therefore be concluded that it is unlikely that PE funds are able to create much

additional value through tax benefits (Renneboog & Simons, 2005). It is more

difficult to conclude something about the wealth transfer hypothesis; the effect of this

value-creating factor is likely to be built on how the covenants behind the bond issues

 28  

     

are made. Renneboog & Simmons indicate that bondholders that suffer losses have

simply not been contractually well protected (Renneboog & Simons, 2005).

Operational effectiveness and strategic distinctiveness

As has been discussed earlier the structure of a PE investment can be split into 2 parts,

the second part can be referred to as the holding period where the PE firm can make

its impact on the portfolio firms operations. The PE firm can initiate dozens of things

that can improve the operational results of the portfolio company. Bull (1989)

conducted a study where he compared different accounting variables of companies

before and after LBO and found that the financial performance improved significantly

after the LBO. Berg & Gottschalg (2005) draw attention to number of activities that

PE firms implement in order to reduce cost and capital requirements, such as

tightened control on corporate spending, reduction in production cost, decreased

corporate overhead cost and improvements in working capital. They also point out

that sometimes during the LBO process, the PE firm use the opportunity to dispose of

incompetent management team to get rid of managerial inefficiency (Berg &

Gottschalg, 2005).

In the last couple of years the importance of strategic distinction has become more

prominent as a part of the value creation instruments for PE firms. Their vision often

leads to a strategic change such as, new market entrance, changes in production or

pricing or asset sales. These activities can help the portfolio company to improve their

focus on the financial performance and increase its value (Berg & Gottschalg, 2005).

3.5.2.2 Secondary levers

Berg & Gottschalg defined the secondary levers as: “levers of value creation (that) do

not have a direct impact on financial performance, but influence value creation

through primary levers” (Berg & Gottschalg, 2005, p.24). In this context, the focus of

this section will be on how the PE firms can use their knowledge and experience to

reduce the agency costs within their portfolio company in order to increase their value.

 29  

     

Agency cost

Many researchers have identified the reduction of agency costs as a key value driver

in buyouts. Agency cost reflects the conflict of interest between management, owners

and other stakeholders in the firm. The cost results in a loss of efficiency that reduces

the advantage of debt (Brigham & Gapenski, 1990). The root of the agency problem

as has been discussed earlier, is the separation of ownership and control, where the

manager becomes an agent for the owner (Shleifer & Vishny, 1997).

Berg & Gottschalg (2005) specify a few factors that LBOs can influence in order to

reduce the agency cost. For example by increasing debt, the waste of free cash flow

can be limited. Jensen (1989) concluded that debt is a powerful tool for change and

can be used to directly force managers to put all their effort in running the company

efficiently in order to reduce debt. Jensen stated that managers tend to spend the

additional cash flow in projects with negative NPV instead of distributing it to the

shareholders. He argues that companies that take on additional debt keep their spirit

going since they need to refocus on their strategy and structure so they can meet the

debt payments (Jensen, Eclipse of the Public Corporation, 1989). But as has been

discussed and Berg & Gottschalg (2005) draw attention to, the existence of financial

distress costs makes things more complex. High leverage can both cause managers to

drop projects with positive NPV because of risk aversion and caused companies to

overlook good investment opportunities because of stretched budget (Berg &

Gottschalg, 2005).

Incentive alignment and mentoring

The alignment between the management and the shareholders (owners) plays a crucial

role in successful buyouts. Jensen (1989) indicates that PE firms are efficient in

linking management bonuses to cash flow and debt retirement. In many buyouts, the

management team is encouraged to take on equity stake in the company in order to

align their interest with the owners. The argument for this method of reducing the

agency cost is to set the management focus on future strategic performance.

Management tolerance for inefficiency within the firm will also be on the bottom of

the scale and they feel that they are fighting for their own benefits (Muscarella &

 30  

     

Vetsuypens, 1990). This is in line with Smith (1990) who conducted a study on 58

Management Buyouts (MBOs) of public companies during the period of 1977 to 1986.

His findings revealed that there exists a positive relationship between management

ownership and the performance of the firm.

Berg & Gottschalg (2005) on the other hand pointed out the contrary, that financial

performance could decline when management ownership soars. This is due to the fact

that increased equity stakes might be of that size that it affected the management’s

personal budget dramatically, which could make them more risk-averse.

One of the characteristics of PE firms is that highly skilled and experienced

professionals with deep knowledge of the financial markets often manage them. How

the PE firm manages to be a mentor for their portfolio companies plays an important

role in whether the buyout will be successful or not. Among the advantages that the

PE firms have are:

• Huge network of financial within the industry and financial institutions that

can be used to get more favorable borrowing terms and also to appoint

experienced board members,

• Experience in running businesses with stretched budget and the awareness of

the importance of selecting top management team to improve the portfolio

companies’ efficiency ((Berg & Gottschalg, 2005) (Jensen, Eclipse of the

Public Corporation, 1989)).

Sub-conclusion

This section has discussed the various factors PE firms can use in order to create

value within the portfolio companies. The debate on private equity has often solely

been about the capital structure changes that are adherent to LBOs. But as has been

reviewed there are other things such as reduction of the agency cost by implementing

incentive systems and strategic changes that have become more and more important

for the value generating process.

 31  

     

4. Case comparison

In order to put the theories and discussions revealed in this thesis into perspective it is

interesting to make a connection to the real world. This section will therefore attempt

to do so by exploring two recent PE investment cases, the EQT Partners and Goldman

Sachs Capital Partners takeover of ISS and Nordic Telephone Company ApS (NTC)

takeover of TDC. The intention is to compare changes in the companies´ capital

structure and operational performance with their peer group.

The construction of this section will follow Koller et al. (2010), Penman (2010) and

Vinten (2007) thoughts on multiple analyses. There are a few things that have to be

kept in mind when a multiple comparison analysis is made. First it is important to

build a peer group of comparable firms that have operations similar to the target firm,

secondly, relevant measures within the companies have to be identified to calculate

the multiples and at last it is recommended, to use an average of the multiples used for

the comparison (Penman, 2010). The focus in this part will be on developments of

different ratios of growth, operational performance and capital structure. The peer

group used to compare with ISS was quite difficult to identify since none of their

competitors operate in more than one of ISS´s business areas. I decided to follow

credit analysis from Standard & Poor’s (2006) that defined Compass Group6 ,

Sodexo7, and Rentokil Initial8, as ISS´s core competitors although they differ in size,

revenue and product offering. It was easier to identify a peer group for TDC A/S as it

was possible to get a list of peers from the Orbus database. I decided to focus on well-

known Nordic/European competitors, Deutsche Telecom, France Telecom, Telecom

Italia, Telenor, Teliasonera, Swisscom and Belgacom.

6 Compass Group is a British catering and support services company with more than 380.000 employees and market share in 50 countries. http://www.compass-group.com/ 7 Sodexo is a French catering, health care and sports & leisure company with 380.000 employees and market share in 80 countries. http://www.sodexo.com/group_en/default2.asp 8 Rentokil Initial is a British service company with over 78.000 employees and market share in 50 countries. http://www.rentokil-initial.com/

 32  

     

Operational performance

The following ratios will be used to observe the changes in operational performance

of the companies:

!"#$%&  !"  !""#$"   !"# =  !"#  !"#$%&!"#$%  !""#$" Equation 1

Return on assets is a profitability ratio that measures the net income generated per

dollar of the company´s assets. The ratio is useful in comparing companies within the

same industry and can give indication of how effectively companies are using their

assets. There are especially two factors that affect ROA, the profit margin (PM) and

asset turnover (ATO) (Penman, 2010).

!"#$%&  !"#$%&  (!") =  !"#  !"#$%&!"#"$%" Equation 2

!""#$  !"#$%&'#  (!"#) =  

!"#  !"#$!  !"#$%  !""#$"

Equation 3

Profit margin (PM) illustrates how much of the income from sales is kept as income

after subtraction of costs and asset turnover (ATO) measures the ability of assets to

generate sales (Penman, 2010). The limitations of these measures are that they do not

separate the effects of operating and investing decisions from the effects of financing

decisions.

The last profitability measure that will be reviewed is the EBITDA margin. Since

EBITDA excludes non-cash flow items such as depreciation, it removes the effect of

financial structuring and can therefore be defined as a pure cash flow measure. It is

stated that the buyout industry invented this measure in the late 1980s as they were

looking for a measure that could specifically indicate the ability of a company to

service certain level of debt (Fraser-Sampson, 2007).

!"#$%&  !"#$%& =  

!"#$%&!"#$%  !"#"$%"

Equation 4

 33  

     

Growth ratios

Company´s ability to deliver growth is critical in relation to value creation. But

growth can only create value when a company´s new projects or acquisitions generate

returns that are above the cost of capital. The main components of growth can be split

into overall market expansion in the market segments, market share performance9 and

mergers & acquisitions10 (Koller, Goedhart, & Wessels, 2010). The following ratios

will be observed to understand development in the companies’ growth.

!"#$%  !"#$%ℎ =  !ℎ!"#$  !"  !"#$!

!"#$"  !"#$%&´!  !"#$!   Equation 5

!""#$"  !"#$%ℎ =  

!ℎ!"#$  !"  !""#$"!"#$"  !"#$%&´!  !""#$"

Equation 6

Capital structure

The analysis of a company´s capital structure is different from both the profitability

and growth analysis in a way that the focus is now on ratios that indicate the

likelihood of default. As has been discussed, the main characteristic of LBOs is the

extensive use of debt. It is therefore informative to look at different ratios that can

give an insight into the companies´ situation.

!"#$  !"  !"#$%&  !"#$%   =  !"#$%  !"#$

!"#$ + !"#$%& Equation 7

Debt to equity ratio (D/E) gives an indication of company´s financial leverage and it

shows how the company has financed its assets in the past (Penman, 2010).

!"#  !"#$  !"  !"#$%&   =  !"#$%  !"#$!"#$%& Equation 8

As stated by Axelson et al. (2007) practitioners like to focus on multiples that indicate

debt relative to cash flow. The net debt to EBITDA ratio shows approximately how

long a time it would take to pay down all debt overlooking interest payments, taxes,

depreciation and amortization.

9 Refers to changes in company´s market share 10 Refers to revenue growth that has been bought externally

 34  

     

!"#$%$&#  !"#$%&'$  !"#$%   =  !"#$!"

!"#$%$&#  !"#!$%! Equation 9

In order to understand the company´s ability to meet interest payments the interest

coverage (solvency) ratio is calculated. It measures the number of times operating

earnings cover the interest requirements (Koller, Goedhart, & Wessels, 2010).

Company´s value

!"  !"  !"#$ ! !   =  !"#$%&%'($  !"#$%

!"#$ ! ! Equation 10

Enterprise value to EBIT(D)A is a good ratio measure of a company´s value. Koller et

al. (2010) argue that the enterprise value should be divided by EBITA instead of

EBITDA. From their point of view most companies cannot compete effectively unless

they set aside capital to replace worn assets (depreciation). Despite that, EV/EBITDA

is commonly used among practitioners so both multiples are calculated for the

comparison.

4.1 EQT Partners & Goldman Sachs Capital Partners takeover of ISS

In 2005 PurusCo, a holding company controlled by EQT Partners (EQT) and

Goldman Sachs Capital Partners (GS Capital Partners), acquired ISS A/S. EQT and

GS Capital Partners are the principal shareholders and hold 54% and 44% of ISS A/S

share capital respectively. The remaining approximately 2% of the share capital is

held by certain members of the Board of Directors, the Executive Group Management

and a number of senior officers of the Group through director and management

investment programs (ISS A/S, 2010).

EQT is a leading private equity group in Northern Europe and together with a network

of industrial advisers EQT implements its business concept by acquiring or financing

good medium-sized to large companies in Northern and Eastern Europe, Asia and the

United States. EQT´s strategy is to develop their portfolio companies by applying an

industrial strategy with focus on growth. EQT has invested in more than 85

 35  

     

companies and exited around 40. The Goldman, Sachs Group, leading global

investment banking, securities and investment management firm manages GS Capital

Partners (ISS A/S, 2010).

ISS is one of the largest Facility Service Providers in the world and employs more

than 520.000 people in over 50 countries across the world. The company´s strategy is

to offer facility services on an international scale to meet customers’ needs. Their core

business is cleaning services, security services and facility management services.

PurusCo offered the shareholders of ISS A/S a price of 465 DKK11 for each share that

was at that time 31% premium over the share price at the announcement date. The

deal was finished on the 26th of July and the shares were then delisted from the

Copenhagen Stock Exchange. In the legal papers that were issued along with the offer,

the consortium claimed that their objective was to make ISS the world leading

provider of services, cleaning, catering, office support and property services, through

both organic growth and acquisitions. Further they insisted that they believed that ISS

was best positioned as an unlisted private company to achieve this goal (PurusCo A/S,

2005). Ole Andersen, who was the director of EQT Copenhagen office, said that they

were interested in ISS A/S because they believed in the strategy that had been

initiated by the company and they also thought that they would be able to increase

their organic growth (Spliid, 2007).

The bond market reaction to the takeover announcement was not surprising. It was

expected that the company’s debt would soar and the outstanding bonds were

punished with a steep decline in ISS bonds value. ISS Global, the parent company of

ISS A/S that issued the bonds, had 7,1b DKK in equity and 1,8b DKK in cash flow at

the time of the takeover. In the transactions associated with the buyout, the

consortium set up a holding company (PurusCo), which acted as the bidder in the deal

and all financing flew through it in the beginning. The capital structure of PurusCo

was 7,7b DKK paid in equity from the consortium and 15,3b DKK in new loans.

Further, PurusCo received 7b DKK from ISS Global A/S in the form of dividend

payment, at the same time the name of the holding company was changed to ISS

11 The original offer was 470DKK but with a notice that if dividends would be paid the tender offer would be lowered. In the meantime, the board of ISS A/S decided to pay divdend of 5DKK which resulted in final offer of 465DKK (PurusCo A/S, 2005).

 36  

     

Funding A/S and it also took over the ISS Global A/S obligations, consequently the

outstanding bonds. So all of the sudden the company that guaranteed the bond issue in

the beginning became heavily indebted. The results of these practices were that

Standard & Poor’s (S&P) downgraded the bonds to junk due to the increased risk of

the borrowings, leading to even more reduction in value for the bondholders. As can

be understood, the bondholders were furious. In 2004 when the bonds were issued,

ISS stated that it was their intention to keep the company´s investment grade from

S&P and the bondholders argued that this behavior of the new owners in the process

was nothing but a fraud. The former CEO of ISS later said that when new owners take

over the company their rules apply and there is nothing that the CEO can do about it.

What the bondholders could have done in order to protect themselves is actually just a

matter of a more detailed reading over the covenants of the bond issue. At this time in

Europe, corporate bonds contracts nearly never contained a so-called “Change-of-

Control (CoC)” clause. It was though a rather well known clause in the US. If the ISS

bond issue had had this kind of clause, the bondholders would have been able to react

to the actions of the new owners by insisting repayment of the bonds on the grounds

of changes in the ownership of the company. The bondholders had to pay greatly for

this experience but this event also changed the scope of the corporate bond issues in

Europe. The use of this CoC clause increased from being used in 7% of the issues in

Europe at the time of the ISS takeover, to 32% within next 14 months (Spliid, 2007).

If we look further at the changes that have happened in the management of ISS since

the buyout and start by exploring changes in the capital structure, then we can see

from figure 12 that the debt played critical role in the deal and has done since in the

company´s financing.

 37  

     

Figure 12: Debt to equity ratio of ISS and its peers

At the time of the takeover, subordinated bonds were issued, a senior loan of 6.3b

DKK and another high yield loan of 3.4b DKK, both with maturity in 2016. These

loans were taken in addition to the outstanding bond and amounted to a total of 10b

DKK with maturity in 2010 and 2014 (Spliid, 2007). As can be seen from figure 12

ISS debt to equity was similar to the peer group until 2005 when it soars dramatically,

and it has been on this level ever since. Due to Rentokil´s negative equity for the last

few years they were cut out in the comparison here. When companies are so heavily

financed with debt as ISS, it is appropriate to look at other ratios such as the solvency

ratio, or the interest coverage ratio.

Figure 13: ISS and peers interest coverage ratio

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 38  

     

It can be seen in figure 13 that the increase in debt has not been followed by the same

growth in operating income. In the year before the takeover the EBITDA covered the

interest payments nearly 6 times, which was at that time better solvency ratio than the

peer group had. But after the ownership changes, the ratio have declined and the

interest coverage is now just below 2 times the EBITDA. This means that ISS have to

rely a lot on robust cash flow in order to avoid financial distress, a solvency ratio

below 1 means that the company is not capable of serving the interest payments from

its cash flow.

The last capital structure multiple that will be reviewed in relation to the buyout of

ISS is net debt to EBITDA. It measures how long a time (in years) it will take to pay

down all debt and is an indication of the company´s ability to serve its debt with its

cash flow.

Figure 14: Net debt to EBITDA ISS v/s Peers

As can be seen in figure 14, while its peers have had quite stable debt to EBITDA

ratio, then ISS went from being able to pay down all debt in less than 3 years to

needing nearly one decade to pay down all debt. That is without putting aside

amounts for depreciation, interest payments etc. But it is also important so look at the

development in EBITDA after the takeover. We can see that they have managed to

moderately increase the cash flow so this ratio has improved for the last years.

The year of 2009 proved to be a huge test for ISS capital strength, as they needed to

secure refinancing of the 2010 debt issue that they took over at the time of the LBO.

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 39  

     

In a normal situation this would probably not have been of any concern at all, but due

to the effects of the financial crisis that started in the autumn of 2007 it was clear that

a hard work was needed to convince investors that ISS was in good shape. It was

decided by the board of ISS to issue new senior debt that amounted 525m EUR in

order to settle the outstanding debt issue with maturity in September 2010. But that

was not enough since the outstanding amount was 850m EUR. To fill the gap it was

decided to use a so-called off-balance sheet financing by carrying out an asset

securitization of its receivables (ISS A/S, 2009, p.9). The purpose was to “pack” ISS

receivables in different countries and sell them to investors. Koller et al. (2010)

discuss that this method is primarily used by companies to get better loan terms than

otherwise be able to get via the traditional methods such as bank loans and more debt

issue. In the mid year of 2009, ISS announced that they had successfully issued the

new senior debt with maturity in 2014 and that the first part of the receivables-backed

program had immediately been sold, that amounted to 150m out of the 350m EUR

needed to fill the gap. (ISS A/S, 2009, p.14).

Development in ISS operational performance

As has been discussed earlier in this thesis, a couple of studies have argued that the

financial performance of the portfolio firms improves considerably after the LBO.

Bull (1989) for example compared different accounting variables of portfolio

companies and found positive effects after the LBO.

This part will observe some multiples that can give more insight into the development

of ISS operational performance pre and post the LBO. Figure 15 presents the progress

in ISS return on assets (ROA) compared with its peers. ROA is a measurement of how

efficiently company´s assets are used.

 40  

     

Figure 15: Return on assets

We can see that following the takeover ISS had problems in keeping the same growth

in profit as in assets. Appendix 1 illustrates that the ISS asset base has been growing

steadily since 2003 and if we look at the development in asset turnover ratio (ATO)

and the profit margin in figure 16 it can be seen that it is not likely that slowdown in

sales is an influential factor. It is more likely that the decrease in the company´s profit

is the reason behind the poor ROA.

Figure 16: Asset turnover (ATO) and Profit margin (PM)

It is therefore interesting to look at the operating margin and the profit margin to

understand this development of ISS operational ratios. Figure 17 is a good example of

how extensive use of debt can harm the company´s bottom line results. It is quite

obvious that the heavy financial expenses have made it difficult for ISS management

to generate satisfactory returns. Earnings before interest and taxes (EBIT) have been

solid and in line with the increase in revenue, while the bottom line (profit) has had

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 41  

     

tougher times, with an average decline in profit of nearly 9% since the LBO compared

with a average increase of more than 10% in revenue12.

Figure 17: ISS operating margin v/s profit margin

In ISS´s 2007 annual report it is stated that the plan is to reduce the company´s

financial leverage on a multiple basis through growth in the operating profit and

improvements in cash flow, operating margin, organic growth and acquisitions (ISS

A/S, 2007, p.16). The financial crisis that began in 2007 has probably played a role in

the owners’ plans for the operational performance of ISS as was expected that they

would exit at least part of the investment by listing it on the Danish stock exchange in

2007. Nevertheless, the IPO was at that time postponed, probably due to the

turbulence in the financial markets (Ibison, 2007). But earlier this year the CEO of

ISS, Jeff Gravenhorst announced that the board was considering an IPO13 in order to

reduce the company´s financial leverage. It is expected that they will be able to get

close to 13.3b DKK from the IPO, which would be used to reduce the company´s

30.6b net debt (Wienberg, 2011). Given the current conditions this would mean that

net debt to EBITDA would become close to its rival or 3.5 approximately14 as was

visualized in figure 14 above.

After reviewing these multiples it is interesting to see that the new owners managed to

increase the company´s cash flow robustly since the LBO despite quite hostile

12 See appendix 3 for more details 13 On the 17th of march 2011 they announched further delay on their IPO plans due to market conditions. (Nordea , 2011) 14 See calculations and figure in appendix 4

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 42  

     

financial environment during the credit crisis. But more notably to see the effects of

the high leverage ratio on the company´s bottom line. Due to the industry´s fairly low

EBITDA margins15, slowdown in sales growth quickly distorts the bottom line

results.16

4.2 Nordic Telephone Company ApS (NTC) takeover of TDC

TDC is a Danish provider of communication and entertainment solutions such as

fixed telecommunication, mobiles, Internet, mobile data and digital-TV. The company

operates in all of the Nordic countries (except from Iceland) with over 10.000

employees. When it comes to the history of TDC and its formers it can be concluded

that they are keen on big activities. In 1994 a TDC former, state-owned Tele Danmark

went for the largest share issue ever to take place outside a home country. In 1997 the

company went into a strategic partnership with American company, Telco Ameritech,

simultaneously the company was fully privatized. Telco Ameritech later joined forces

with an even larger American Company, SBC. In 2000 the name was changed to TDC

and in 2004 SBC sold its shares that meant that the company no longer had one

controlling shareholder (TDC, 2011). In 2005 TDC went through the biggest

European LBO ever (Spliid, 2007).

After an informal hint from the board in 2005 that the company might be for sale,

numerous private equity funds immediately showed an interest in acquiring TDC. It

was clear that the race was going to be interesting. The market expected a rival

between the funds, which was reflected in the share price. In late November it was

announced that the board of TDC would recommend an offer from the Nordic

Telephone Company (NTC) of 382 DKK or enterprise value of 97b DKK. NTC is a

holding company controlled by a consortium of numerous private equity funds, Apax

Partners Worldwide LLP, Blackstone Group, Kohlberg Kravis Roberts & Co. (KKR)

L.P., Permira Advisers and Providence Equity Partners Limited. To be able to delist

the company from the stock exchange it was necessary for the consortium to get more

than 90% of the shareholders to agree on the offer. But due to the resistance of one

big shareholder ATP, (Danish pension fund) simply 88,2% of the shareholders agreed

15 See EBITDA margin calculations and figure in appendix 5 16 See appendix 6 for figure and calculations on profit margin v/s sales growth

 43  

     

to the offer, which led to the strange situation of an LBO company that still had to be

listed (Spliid, 2007).

In order for NTC to finish the takeover they needed to get financing of 95b DKK. As

was discussed in the case of ISS A/S, bondholders are quite vulnerable for leverage

buyouts unless they are protected via the CoC clause or other similar clauses. In light

of the heavy criticism that the takeover of ISS received because of the handling of the

bondholders, it was decided that NTC would secure that TDC bondholders would not

suffer any losses in the process. So out of the 95b DKK, 12,9b DKK were used to pay

down outstanding bonds that would have due date in 2006. The financing structure

can be seen in figure 18.

(Source: Figure 38 p. 336 in Spliid (2007)

Figure 18: Financing and use in TDC takeover

The structure of this takeover is similar to the case of ISS apart from the treatment of

the bondholders. A special dividend amounted 43.5b DKK is paid from TDC to the

shareholders. What is different in this case is that due to NTC failure to get total

control of the company the minority shareholders receive 5.1b DKK so NTC will end

up with 38.4b DKK in special dividend. So the holding company receives total 80.9b

DKK through an equity injection from the private equity funds and new loans (Spliid,

2007).

The capital structure will now be explored in order to understand the development in

several ratios. The main characteristic of LBOs is the massive increase in debt and by

looking at figure 19 it can be seen how the debt to equity ratio has evolved since the

takeover.

Financing B.DKK Use of financing B.DKKPaid-in Equity 16,4 Paid to shareholders 67,1Long-term financing 48,5 Refinancing of outstanding loans 18,3Mezzanine loan 15,2 Cost due to the takeover 3,9Execution of employee options 0,8 Dividend to minority shareholders 5,1Company´s own funds 14,1 Accrued interest 0,6Total 95 Total 95

 44  

     

Figure 19: TDC debt to equity ratio v/s peers

This figure shows how TDC debt ratio increased dramatically following the takeover.

As might have been expected these changes concerned the credit rating agencies that

reacted quite rapidly and the credit ratings of TDC fell below investment grade. The

external debt that was used in the takeover was more expensive than the TDC´s

current loans so its interest burden went from 5,7% to 6,6% (Spliid, 2007). Figure 20

shows how the company´s coverage ratio evolved after the buyout compared with its

peers.

Figure 20: TDC Interest coverage ratio v/s Peers

The figure shows both the original peer group but also the peer group average when

Belgacom has been excluded. Due to their remarkably different ratio for some of the

years it was decided to show also the peer group without their effect. In such a limited

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 45  

     

group as this is, with just 7 companies, the abnormal behavior of just one firm has so

much weight. It is clear that when the owners are making a plan for their LBO

investments they look deeply to the company´s cash flow ability to serve debt. In case

of the NTC takeover they were obviously right in the way that they have managed to

increase the cash flow that has then been used to pay down debt so they have been

able to keep the interest coverage ratio from the risky area. In light of this it is

interesting to look at figure 21 that shows net debt to EBITDA along with the

development of the company´s EBITDA margin.

Figure 21: TDC v/s peers net debt to EBITDA and TDC´s EBITDA margin

As can be seen, in 2006, the year following the takeover the net debt to EBITDA ratio

increased significantly. That is a pretty normal behavior in LBOs as has been

discussed before but what is more interesting to see here is the EBITDA margin. Ever

since NTC took over they have managed to improve the EBITDA margin. The factor

behind this improvement at TDC is their focus on reducing cost, for example by

reducing employee cost. Full time employees have been reduced from 15.422 in 2005

to 10.423 at the end of 2010 (TDC A/S, 2010, p.20). The management has also been

focused on lowering debt by selling units that do not fall under the criteria of being

core assets. Since 2003 the asset base of the peer group measured in the companies´

home currency has increased on average by 4,5% while TDC´s asset base has

decreased by 3,4%17. In 2010 net interest bearing debt were lowered by 1/3 or 10.9b

DKK that was paid out of the positive cash flow and proceeds from divestment of one

17 See appendix 7

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 46  

     

of their subsidiaries. The managements effort of reducing the company´s debt has

been well rewarded as the company received a credit rating upgrade from the rating

agencies and now again hold an investment grade rating (TDC A/S, 2010, p.5). It

looks like the pressure from the additional debt has encouraged the management team

to do better in terms of efficiency of the cash flow, which has made the fight with the

increased interest payments look quite easy.

In light of the discussion above about the TDC management team´s ability to improve

efficiency of the cash flow it is interesting to look further at numerous operational

measures. Figure 22 shows how TDC´s revenue has evolved over time along with its

revenue growth against its peers.

Figure 22: TDC revenue and revenue growth

Revenue growth was quite stable until NTC´s takeover, but the reason for the

reduction since is primarily related to the management strategy of sharpening the

company´s focus by selling assets that do not belong to their core operations (TDC

A/S, 2010). The next figure shows TDC´s return on assets (ROA) or the ratio of net

revenue generated with the company´s assets compared with its peers.

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 47  

     

Figure 23: Return on assets (ROA) – TDC v/s Peers

By looking at the development of the ROA it is noticeable that some of the underlying

factors tend to be quite volatile. It is therefore helpful to look at the asset turnover

ratio (ATO) and the profit margin (PM) below. While TDC´s ATO ratio is rather

stable over time, although slightly under the peer group average, its profit has

fluctuated a lot and is the main explanation for the volatility in ROA. In 2004, the

year before the takeover the company announced a decent drop in its operating

expenses that led to the jump in profit and in 2007 TDC sold one of its subsidiaries

(asset sale), so the jump in operating income that year is based on one off profit from

that sale.

Figure 24: TDC´s asset turnover and profit margin

But what is most interesting is to look at the development of TDC EBITDA margin

compared with revenue. As can be seen in figure 25 the management team in TDC

has done an excellent job in maintaining a robust growth in the EBITDA margin

despite the decrease in revenue. This is even more remarkable when the evolvement

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 48  

     

of the peer group margin is considered along with TDC. We can see that at the same

time as TDC is admirably increasing their margin from the takeover; the peer group´s

margins have decreased.

Figure 25: TDC revenue and EBITDA margin v/s peers

In the context of the stable improvements of the cash flow for the last few years it is

not so surprising that NTC announced in 2010 that they were going to undertake a

market sale of a part of their holdings in TDC. They managed to sell 210m shares for

the price of 10.7b. DKK, approximately 29% of their ownership and they now hold a

stake of 59.1%. This is an important milestone both for TDC and NTC as this at least

marks a beginning of a change in the company´s ownership and for the shareholders

of NTC, as they will now start to realize the profits of their investment. At this turning

point it is interesting to look at the historical valuation multiple of enterprise value to

EBITDA (EV/EBITDA) for TDC. The EV/EBITDA multiple takes into account the

total value of the firm, not just the equity value and is therefore irrelevant to the

capital structure of the companies and is useful in this context. Figure 26 shows how

TDC´s EV/EBITDA was relatively low compared to its peers in the year before the

buyout, which might explain the NTC´s interest in taking it over at that time.

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 49  

     

Figure 26: Enterprise value and EV/EBITDA for TDC and peers

Today is seems like TDC is slightly more expensive than its peers, which might

illuminate why NTC decided to start decreasing their holdings in the company. Given

the price of the shares they sold in 2010 it can be concluded that the investment has

been successful. The original equity contribution from NTC was 16.4b DKK, the

market cap of the sold shares in last December was 10.7b DKK and that was only

29.1% of their ownership in TDC. Given that they would get the same price for the

remainder of their shares, they then would have more than doubled their original

equity contribution in the beginning.

After reviewing these multiples it is obvious that the change in the capital structure of

TDC by taking on extensive debt in the buyout did encouraged the management team

to be more focused and efficient in running the company. As has been discussed the

company´s revenue has declined because of NTC´s strategy of selling assets that do

not fulfill the criteria of being part of core operation. The results of these strategic

changes have proved to be right when looking at the improvements in the company´s

cash flow margin, not least when looking at the development in the peer group

performance and that the world has been suffering from a financial crisis at the same

time.

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 50  

     

5. Exit strategies for PE investments

“To understand KKR, I always like to say, don't congratulate us when we

buy a company. Any fool can buy a company. Congratulate us when we

sell it and when we've done something with it and created real value.”

Henry Kravis, Co-Chairman and Co-CEO of KKR & Co

A harvest or exit is an event where the investors and management of a company sell at

least a portion of their shares to public or corporate buyers. This provides an

opportunity for PE funds to realize returns from their investments and is therefore an

important aspect of the private equity process. Figure 27 is based on a study by

Kaplan & Strömberg (2008) where they studied exit strategies of buyout companies,

their results shows that the most common way today is to exit via sale to a strategic

nonfinancial buyer, then sale to another private equity fund and third is initial public

offering (IPO) (Kaplan & Strömberg, Leverage buyouts and private equity, 2008).

Figure 27: Exit strategies of leveraged buyouts 2000-200518

Sales refer to exit activities that can further be divided into trade sales, secondary

sales and buybacks (Schmidt, Steffen, & Szabó, 2007). When the PE fund decides to

sell an asset to a strategic investor, it is called trade sale. The strategic buyer is often

interested in the synergies that can be realized in and after the takeover. These

18 The time period refers to the year of orginal LBO, i.e how LBO investments made in the years 2000-2005 have been exited.

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 51  

     

synergies can come from additional market share gains or market access that would

otherwise take many years to obtain (Pindur, 2007). Secondary sale is when a PE firm

decides to sell their portfolio company to another PE firm. This has become more and

more popular for the last two decades. Among the reasons for its increased popularity

can be difficulties in exiting through an IPO and the PE firm´s need to liquidate assets

because of its contractual life span (Renneboog, Wright, Simons, & Scholes, 2007). In

a recent survey among PE executives in UK, four out of five or 80% expected to sell

their portfolio companies via trade sale this year (Javed, 2011). The advantage of

sales against an IPO is that it offers fast exit opportunities and is usually made in

private so the firms are able to get rid of the external pressure that follows the stock

market flotation ((Pindur, 2007) (Schmidt, Steffen, & Szabó, 2007)).

But as was pointed out by Renneboog et.al (2006), the most popular way of selling

large portfolio companies is through an IPO. This is consistent with results from

Harford & Kolasinski (2010) that investigated a large sample of US private equity

exits from 1993-2001 and found that 90% of the portfolio companies were exited

through an IPO.

5.1 Initial public offering (IPO)

The decision to go for an IPO is seen by many private-firm managers and

entrepreneurs as a milestone for their company and for their career. There is a sense of

prestige and pride that comes from taking a company public, as it signifies that a firm

has achieved a high level of historical growth. First and foremost, the IPO process

gives companies way to raise large amount of capital rather quickly. On top of that,

by going public, the company will generally be able to obtain better terms in their

financing since rating agencies will normally accord higher ratings to firms with

publicly traded stock (Cendrowski, Martin, Petro, & Wadecki, 2008). But going

public is also a step towards the separation of ownership and control that might lead

to an agency problem as described by Jensen & Meckling (1976).

An IPO brings liquidity in for the PE funds as they can sell their shares to other

investors, though in some instances, the funds are required to hold at least some of

their position in so called “lock-up” period. This is done both to keep the knowledge

on board and also to maintain stability in the stock price. The IPO creates an

 52  

     

opportunity for the company to induce top talents to join their forces with employee

stock options or other incentive programs. The stock options can be used to align the

interest of executives with the company as they may benefit greatly from the

appreciation of an equity stake (Cendrowski, Martin, Petro, & Wadecki, 2008).

But the benefits of an IPO do not come without a cost. In today’s markets it is

expected that the monetary cost can be around 10% of the overall IPO offering

amount. The costs contain compensation fees to the underwriters and legal costs

regarding the paperwork. And another major change is that the company now has to

disclose its accounts and be prepared to answer demanded analysts about the

company´s performance (Cendrowski, Martin, Petro, & Wadecki, 2008).

In my conversation with Ballegaard (2011) he mentioned that from his point of view

the main benefits of exiting thru an IPO is that value immediately comes visible and

cashable, but the major drawbacks is the massive amount of time that the management

have to spend to live up to the stock market´s requirements. He also said that stock

market volatility could shift the management focus and caused frustration within the

company (Sørensen, 2011).

The role of the underwriter in the process aside from marketing the IPO is that they

are responsible for conducting due diligence on the private firm, assisting lawyers

with regulatory filings and determining the size of the IPO offering. In addition to this,

the underwriter generally attempts to ensure stock price stability in the days following

the offering, with special emphasis on protection against stock price deterioration.

In order to ensure stock price stability in the days following the IPO, underwriters

frequently use a strategy informally called the “Green shoe” option or the “over-

allotment” option as legally stated. It is a call option where the underwriter is allowed

to buy additional shares from the issuing company at the offering price. If there is a

strong demand for the shares at the time of the IPO, the underwriter can increase the

supply by selling up to 15% of the offering size in the IPO, thus creating a short

position. If prices in the after-market stay above the offering price then the

underwriter exercise the over-allotment option in order to avoid loss. The other way

of the option is to reduce downward pressure on prices in the aftermarket. If the stock

begins to trade below the offering price, the offering is said to have a “broke issue”,

then because of the short selling in the IPO, the underwriter can now step in and

 53  

     

support the stock by partially or fully covering the short position. Since the

underwriter only buys shares at or below the offering price, covering the short

position in this way can be profitable (Aggarwal, 2000, Cendrowski, Martin, Petro, &

Wadecki, 2008).

Draho (2004) splits the IPO mechanism into three categories; book-building, auctions

and fixed-price offerings. The book-building process main characteristic is that

discretion is given to the underwriter and the issuer to price and allocate the shares. In

order to get a feeling for investors’ interest in the IPO, the underwriter sets up a road

show were the issuing firm´s executives introduce the company and the underwriter

presents the details regarding the offers size and preliminary offer price range.

Afterwards, the underwriter starts to collect orders and “build the book”. The

company´s executives and the underwriter then set the final offer price and number of

shares to be sold, which is based on the results of the book building. Fixed price

mechanism differs from the book-building process in the way that the price is set

beforehand and the underwriter in this case is more of an advisory partner than

actually being the seller of the IPO. Auction is the form which the issuer and the

underwriter have the least knowledge on the results of the IPO. Investors make an

offer by stating how many shares they want to buy and a limit price. The offer price is

then decided by the intersection of the demand curve and the fixed supply, so all

investors that submit an offer above the offer price have their orders filled, and the

ones that were at the offer price will receive shares up to their limits (Draho, 2004).

Timing is an important element in an IPO, consequently on value realization of PE

investments. In a rather famous article, Myers & Majluf (1984) argued that

information asymmetry between firm insiders and investors affected timing of a

company´s share issue. They claimed that firm´s managers tended to know more

about the company´s value than the investors and the firm´s will to sell equity was

perceived by investors to be overvalued. At some point the managers might

experience situation where they had the opportunity to invest in projects with positive

NPV but which would be offset by the “old” shareholders loss. Then under certain

circumstances the managers would refuse to issue shares for the positive investment

opportunity, just to protect the “old” shareholder and simultaneously, reduce the

firm´s value (Myers & Majluf, 1984).

 54  

     

Companies that are going for an IPO also need to consider a numerous other things

such as market conditions. The IPO volume has fluctuated a lot over the last decades

with either a massive volume at one time versus times with minimum scale activity19.

Lowry & Schwert (2002) studied IPOs and found that similar types of firms are likely

to choose a similar time to go public and that previous successful IPOs are a

motivation for others to make a decision to go public, which might explain partly the

fluctuations in volume. Draho (2004) argues that this pattern can either be explained

with general macroeconomic trends or a company´s increased demand for capital.

Factors such as strong economic growth and rising stock markets indicate investors´

interest to provide capital to fund risky businesses, and firms should at these times

take the advantage to seek capital for coming investments. Renneboog & Simons

(2005) point to a research that showed PE funds disbeliefs in managing to exit their

investment through a sale or an IPO in times of turbulent markets.

With this in mind I will now shift to a discussion about a recent example of Pandora´s

A/S IPO that took place in the autumn of 2010. I will go through their process of

going public by exploring the Prospectus issued in relation to the IPO along with the

company´s annual reports. As previously discussed, Torben Ballegaard Sørensen20

former chairman and now deputy chairman of the board also inspired this discussion.

I attended a seminar where he went through the story of Pandora and afterwards he

cordially answered questions regarding Pandora´s IPO.

5.2 The case of Pandora

The beginning of Pandora can be tracked down to 1982 when its founders, Per and

Winnie Enevoldsen opened jewelry shop in Copenhagen. Only few years later they

employed their first designer and started to create their own products. In March 2008

the company had a breakthrough in its operations when they completed the

acquisition of Pilisar ApS and Populair ApS. After the completion of the merger, a

private equity fund, Prometheus, controlled by Axcel Management A/S, became the

biggest shareholder in the company. They took over control of close to 60% in the

fund while the Pandora´s founders and other old shareholder held the rest. Following

the merger, Axcel and the other shareholders made a new structural plan for the 19 See appendix 8 for an overview of the IPO volume between 2000 and 2010 20 See appendix 10 for transcript of Q&As

 55  

     

company, which included an ambitious growth strategy for the future. Since the new

plan was set they have managed to increase the production capacity, extend their

product offering and increase their market presence. At the same time they have

managed to strengthen their financial performance both in terms of revenue and

profitability, EBITDA increased by more than 50% between 2009 and 2010.

Appendix 9 illustrates further Pandora´s operational improvements since 2009,

although not fully comparable due to the structural changes that have taken place

within the company for the last years.

The offering

The IPO was the second biggest in Western Europe in 2010. During the year of 2010

close to 100 companies worldwide had postponed or withdrawn its scheduled IPOs

because of the market circumstances and the fear that the effects of the financial crisis

still would exist (Zijing & Gammeltoft, 2010). The growth in Pandora’s operations

was both noticed by the financial community and the media and in the beginning of

2010 it was a strong rumor that the company was considering going public. One of

Axcel´s managing partners commented on that rumor by saying that selling stake in

the company through an IPO might be a preferred exit for the private equity firm

(Bloomberg L.P., 2010). In my conversation with Mr. Ballegaard he pointed out that

the board of Pandora did consider alternative ways in seeking capital, such as selling a

stake to another industrial buyer but as he said: “we saw IPO as the most obvious and

best-valued route” (Sørensen, 2011).

The offering price was determined through book-building process. The underwriters

collected expressions of interest from institutional investors before deciding the price

range. After they had scrutinized the interest, the indicating offering price range was

set to be between 175 DKK to 225 DKK per share. Following the book-building

process, the offering attracted strong interest from investors and offer price was set to

be 210DKK (Pandora A/S, 2010). According to Ballegaard they decided to go for an

IPO at this time as they thought that the worst effects of the financial crises were over

and the sentiment was improving (Sørensen, 2011). That turned out to be a successful

decision as the shares soared by more than 25% on the first day of trading. Proceeds

from the offering can be seen in figure 28.

 56  

     

Figure 28: Proceeds from Pandora´s IPO

More than 5000 new shareholders joined the shareholder´s group at this time but

Prometheus, the selling shareholder still holds 57.4% of the company´s shares after

the IPO, so they are still hold a leading position within the company. Following the

IPO they agreed not to reduce their ownership for 360 days afterwards (lock-up

period). As is discussed in the Prospectus the company relies upon certain key

personnel and in order to encourage them to put all their effort and ability into

developing its operations, Pandora has implemented a long-term incentives program,

which is the reason for them buying back shares in the IPO.

The total cost of the offering process was thought to be around 500m DKK. The

company intends to use their proceeds, approx. 600m DKK to acquire its distribution

subsidiaries in Australia and Germany. The Australian investment was expected to

amount to around 210m DKK and to acquire the majority of the German distribution

channel they expected to spend over 300m DKK. In addition to this they have an

option to acquire the remaining shares in the operation in 2015. The company entered

into a PUT option contract with the owner of the remaining shares that is categorized

as financial liability with carrying amount of 435m DKK today, calculated as the

present value of the estimated cash flow if the option will be exercised. The total

investment in this operation is therefore expected to end up being close to 900m DKK.

The calculation of the net equity value of the remainder of the shares in this German

operation is based on method described in the company´s Prospectus p.143 and is

following:

Adjusted EBITDA (x 3)

- Interest bearing debt at 31.december 2014

= Net equity value

(Pandora A/S, 2010, p.143)

Shares sold ( exl. overallotment option) 47.409.927 9.956.084.670 DKKCompany 2.857.142 599.999.820

Selling shareholder (Prometheus) 44.552.785 9.356.084.850 Over-allotment Option granted 6.682.917 1.403.412.570 DKKTotal shares offered with overallotment option exercicsed 54.092.844 11.359.497.240 DKK

Proceeds from the IPO

*In addition Pandora bought shares for their long-term incentive program

190.476 39.999.960 DKK

 57  

     

Torben Ballegaard Sørensen (2011) used similar method when he illustrated with a

simple example how private equity funds calculate value of their investments. By

using a mix of imagination and facts we can try to calculate the net equity value

increase in the Pandora investment from 2008 when Axcel joined as a shareholder

until before the IPO.

Figure 29: Artificial net equity value changes in Pandora

Based on this method mentioned in the company´s prospectus for the IPO and Mr.

Ballegaards´ explication it can be seen how dramatically the net equity value could

have increased during this short period of time because of the increased EBITDA.

This is obviously heavily based on the multiple choices, but seven times EBITDA is

thought to be a fair estimation.21

Sub conclusion

This chapter has focused on the exit routes that PE firms tend to use when harvesting

from their investments. Sale to another PE firm or to an industrial buyer is the most

common way but an IPO is the most popular for big exits. The IPO of Pandora is a

clear example of this. The purpose of the equity sale was in this instance not to pay

down debt as so often in PE investments, but to seek capital for expansion and to

acquire important units that were not under control of the parent company. In the

conversation with Ballegaard, it was clear that it was their opinion that they would get

the best price by going for an IPO. It turned out to be a successful floatation for the

company and the PE fund, Axcel.

21 Mr.Ballegaard mention this was a fair multiple in his speech at IFMA meeting with him on 17.may 2011. ABG Sundall estimate this multiple at 8.7 times EBITDA in their valuation (ABG Sundall Collier, 2011)

Year 2008 2010 GrowthRevenue 1.904 5.162 271%EBITDA 778 2.040 262%

Multiple 7 7

Enterprise value 5.446 14.280 262%Net interest bearing debt 2.688 2.413 -10%Net equity value 2.758 11.867 430%

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6. Conclusion

As discussed in the introduction the aim of this study was to explore how private

equity works, how PE firms manage to create value within their portfolio companies

and to investigate if there is a connection between the theories and reality. The

discussion regarding Private equity is most often surrounded and limited to the

importance of debt in the process. But this asset class has more aspects than just debt.

I have tried in this thesis to throw light upon the actions of the PE firms and how they

use existing theories in corporate finance to exploit the value creating opportunities

lying in their investments.

Modigliani and Miller (MM) capital structure irrelevance theory was an important

contribution to the field of corporate finance, although some of their conditions are

quite unrealistic in today´s environment. Before they came up with their theory it was

widespread understanding that debt above certain limits would reduce the firms value,

but as MM exposed, that is not the case. In my opinion it can be concluded that this

contribution to the corporate finance literature has been one of the most influential

theories of the ideology behind private equity.

The purpose of the extensive use of debt in PE investments has been widely discussed

among academics and different views have been brought up. MM for example, later

suggested that in a world with corporate taxes, companies could be able to increase

their value by utilizing fully the tax deduction of the interest paid. In today’s´

informative and competitive environment it is my belief that this is not a key subject

for the value creation within firms. It is at least not isolated to PE firms and their

portfolio companies but rather what every firm must strive for to be able to compete.

However as Renneboog & Simons (2005) pointed out, value can be created for the

stockholders by transferring wealth from the bondholders, for example by increasing

risk in investments, by increasing the dividend payments and by issuing debt with

higher or equal seniority of the outstanding ones. This is exactly what happened in the

ISS takeover when the additional debt used in the process was combined with the one

that had been issued, which led to a downgrade from the rating agencies and caused

the bondholders a great damage.

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By exploring the development and key ratios in ISS and TDC capital structure, it is

obvious that the strategy behind the investments and implemented by the PE funds,

differed a lot. The emphasis in the ISS operations has been on growth in revenue,

assets and employees while on the other hand the new owners of TDC decided to

narrow the company´s focus to the Nordic region as their core operational area. They

have regularly sold assets that do not belong to their core operations and used the

proceeds from the asset sale to pay down debt, which has led to reduced revenue and

asset base. ISS debt to equity ratio is still at the same high level as after the takeover

but TDC´s has managed to decrease its ratio significantly and is now on similar level

as before the takeover, which has resulted in a credit rating upgrade from the rating

agencies. The consequences of these differences will most likely result in different

access to new capital for the companies´. TDC is more likely under these

circumstances to get better terms and probably easier access to capital than ISS due to

its distinctions in leverage ratios.

Another theory that was discussed in this thesis and has made a substantial

contribution to the evolution of private equity investments is Jensen & Mackling´s

(1976) theory of the problem of separating ownership and control. The theory states

that the success of a company is based on its ability to align the management and

owners interest. Many have mentioned this theory as the core reason for LBOs. In

relation to this, Jensen (1986) put forward an assumption, which I agree with, that

debt is used as a governance tool in order to reduce a company´s agency costs and

creates more efficiency. By studying the cases of ISS and TDC it can be seen that in

both instances the EBITDA cash flow has been increased after the LBO, although the

improvement in ISS´s cash flow is more likely due to its acquisition driven growth. It

is especially interesting to see the development in TDC´s EBITDA margin that has

been constantly improving since 2005 while its peer group´s margins have been

declining. From my point of view this shows that additional debt along with a clear

and focused strategy can help management to be concentrated, which leads to more

efficient operations in the company.

After working on this subject for last few months it is my conclusion that private

equity as a phenomenon has been important to the evolution of corporate finance. The

structure and ideology behind the investments made by the PE firms are often quite

radical and some might even say that the firms live on the edge when looking at the

 60  

     

extensive use of debt in their investments. But due to the PE funds limited life span

they are required to be focused and deliver outstanding operating results relatively

quickly. In order to encourage the management team to follow the same path, the

funds implement incentive systems where the employees are rewarded for improved

operational performance. So debt is used as a governance tool to prevent waste of the

company´s cash flow. This is in line with my conversation with Ballegaard (2011)

about PE firms main competences in generating value, he said: “… they make a clear

strategic due diligence and potential analysis, they zoom on the critical value

drivers…, they put (in) the best people in board and management, and drive

EXECUTION rigorously - the owner, board and management is fully aligned to

realize the strategic plan

When it comes to the exit of their investment it is important to choose the right time.

The case of Pandora showed how successful an IPO could be, and on the other hand it

was interesting to see how quickly things can change. Just a few months later the

board of ISS A/S were forced to withdraw its IPO plan due to changed market

conditions. This can have vital effects on the private equity funds performance.

That said it is my conclusion that the private equity firms are today able to create

value within their portfolio companies by using their expertise in applying debt as a

governance tool and implement clear and focused strategy. And with hands-on

management style, they are able to decrease the agency cost and parallel increase the

unity between owners and employees that results in improved efficiency.

I think it is appropriate to end this thesis of private equity with a quotation from

Johannes Huts, head of European operations at KKR (Kohlberg Kravis Roberts), one

of the world largest PE firms.

“In 1980s private equity firms generated value simply by being able to buy companies relatively cheaply and later selling them at a better price. In the 1990s a lot of value was generated through what you could broadly call financial engineering. Today the markets are fairly efficiently priced, and financial engineering is no longer a differentiating factor. Everyone can do it and everyone has the same tools. So the way the private equity creates value today is by fundamentally changing businesses and driving growth.”

(McKinsey & Company, 2006, p.2)

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