The recent somewhat rapid demise of Dick Smith Holdings, resulting in its entry into voluntary receivership, is a stark reminder of the risks of investing in companies listed by private equity firms without doing careful research. Another example from the recent past is Myer, which has also never recovered anywhere near its original listing price.
Some commentators have blamed the demise on poor strategy, circumstances in the retail sector, or poor inventory management. But while investors in Dick Smith Holdings shares could end up with nothing, the private equity firm that acquired Dick Smith from Woolworths in 2012 has already recouped its cash investment several times.
How is this possible?
How did Anchorage Capital Partners manage to acquire Dick Smith from Woolworths in 2012 in a deal worth $115 million and list it in the market for an equivalent total market value of $520 million?
Private equity 101
Private equity firms typically represent informed investors such as high net worth individuals, or fund managers looking for higher returns through leveraged investments.
Typically a private equity firm will undertake a portfolio of highly leveraged investments in different sectors achieving a level of diversity but at a high risk the longer they stay in.
The firms have a very clear objective: identify businesses with potential for high returns based on their balance sheet, operating potential or capacity for leverage and for tax benefits but to exit as soon as objectives are achieved.
The objective is not to acquire a business with the objective of investing for the longer term, but purely with a view to exiting at a point where the return for risk relation is maximised.
This means that an exit is planned from day one to the extent return is not compromised. The long-term prospects for the business are only of interest to the private equity firm to the extent that it helps dress the business for the market to help with the private equity firm’s exit. In the case of exit by listing this will typically involve changing and packaging the business so it is perceived as a more valuable investment by future investors. The packaging will typically involve all essential market positive aspects of the business, the balance sheet, capital structure and management.
If an acquired business is already listed, often they will de-list the firm, restructure and repackage it and then place in on the market through a stock exchange or sell it as going concern in part or whole in a sale. Often they will acquire divisions or segments of businesses within larger enterprises as was the case for Dick Smith.
Typically private equity deals are highly leveraged, namely there is much more debt than equity used to fund the acquisition, but once interest and debt is covered all returns go to shareholders, and initially this is the private equity firm. When a business is acquired by a private equity company, it is done through an entity or holding company (let's call it Newco). Newco under private equity control, typically buys itself, in the sense that Newco will own the acquired business but private equity controls Newco.
Private equity will fund the acquisition of the business by a majority of debt within Newco and not the private equity firm. The private equity firm and management will contribute the minimum equity required; this will depend on the financing arrangements which will be governed by Newco’s balance sheet, the reputation of the private equity firm and management, and the appetite of the financial institutions for Newco debt. Tax benefits will also be maximised to the extent that interest is tax deductible, a huge benefit given the degree of debt. Furthermore the tax paid on such gains is capital gain, taxed at a lower rate. Private equity firms will use very smart tax lawyers and accountants to structure the deal so that taxes paid will be well minimised.
The private equity firm and management will hold all the equity in Newco, but with restrictions on managers in terms of selling their equity. Private equity firms will only accept restrictions on their selling down shares to the extent that it is a condition precedent for debt financing and they believe it maximises the price they can receive on exit so it doesn’t create the wrong impression.
Private equity firms will also earn returns by charging the acquired firm sometimes exorbitant management fees as well as by extracting returns from sale of the business in part or whole, and may even extract dividends, depending on financial covenants from lenders that are put in place at time of acquisition.
Private equity may plan to maintain a stake in the longer term, past their initial exit, to the extent it helps maximise the value received for their sold down stake and will be prepared to write off that continuing stake having already achieved their desired return.
This is what I suggest has already happened in the case of Dick Smith. Anchorage received a price of more than A$2 a share, liquidating the majority of its holding and in the process is also likely to have raised new equity to retire some of the debt, depending on the covenants in place. Regardless Anchorage will have made many times its initial investment at the listing of Dick Smith Holdings even after paying the upside to Woolworths if any requirement as part of the deal.
The losers will be those who are committed, management, shareholders, particularly those who held on since the Dick Smith Holdings listing and unsecured creditors with skin in the game vs Anchorage which is simply involved. It’s like bacon and eggs, the hen is involved but the pig’s committed.