Monday, September 24, 2007

Private Equity: What a Business!



One of the all-time greats in the hedge fund business once told me we were in the wrong business.

It happened during the dot-com/telcom bubble deal-a-day phase, when Cisco announced the purchase of yet another three-month old start-up making V-FLOP CYBERWAP nano-modules for the Fiber-to-the-Sun space—or something like that—for several billion dollars.

I don’t recall the company and my guess is Cisco doesn’t either, but since they paid for it with Cisco stock instead of cash, it didn’t really matter except to the poor shlubs who never sold their newly-minted Cisco shares under the delusion that whatever it was that V-FLOP CYBERWAP nano-modules did, they really were worth several billion dollars.

Still, Cisco paid what was, at the time, a ridiculous amount of money for a company with almost no sales and absolutely no earnings—a “company” that was, in fact, not much more than a Venture Capitalist’s dream of a business.

Yet nobody blinked an eye.

In fact, the only question on Wall Street’s mind was who else Cisco might buy for a ridiculous amount of money.

With that in mind, as soon as the announcement hit the tape, I called Tim McCollum, the aforementioned all-time great, for his take on possible answers to that question.

Tim had been one of the original Microsoft analysts on Wall Street, yet unlike most of his peers, he held the distinction of actually providing useful information on that company to hedge fund types like me.

Indeed, Tim had proved so useful to hedge fund types that he’d been lured to our side of the table and he quickly became one of the best analysts I ever knew in this business.

And for that reason Tim was my first call the morning Cisco announced it was paying billions for a V-FLOP CYBERWAP Fiber-to-the-Sun nano-module play, or whatever it was the thing did.

I was looking for public company stocks that would be affected, either positively or negatively, by the news.

“Tim, what does it mean?” I said, while the headlines were scrolling across the tape.

“It means we’re in the wrong business, Jeff. We should be in venture capital”

And Tim was right—at least for another six months or so. Then the Telcom Bubble ended, and all those Fiber-to-the-Sun V-FLOP CYBERWAP nano-module plays, or whatever they were called, became nothing more than accounting ledger write-offs.

Cisco’s own share price went from $77 to $12, and being in the hedge fund business—what with stocks like Cisco going down more frequently than up—once again became a good business to be in, all things considered.

But I think if Tim was here watching the headlines, he’d once again tell me we’re in the wrong business.

Only this time, he’d tell me we should be in Private Equity.

“Surely you jest,” you’re thinking. “After all, private equity deals are blowing up right and left. Blackstone’s IPO was a bust—a complete, utter, embarrassing, highly public bust. And KKR just blew out of the Harman deal.”

And all that is true.

But how many businesses do you know allow the principal of a major transaction to 1) agree to do something, 2) back out of the deal, and 3) ask their bankers to pay the penalties for them?

I am not making that up: after all, that is precisely what KKR—the grandfather of Private Equity—apparently did in the case of Harman Industries, the electronics company that KKR agreed to acquire earlier this year for $120 per share.

To grasp what happened, let’s go back to the halcyon days of April, when KKR and its Private Equity brethren were cutting deals right and left under the assumption that what was happening in the sub-prime housing business would stay in the sub-prime housing business and never affect their own massively leveraged, sub-prime takeover business.

The following is excerpted from the KKR press release trumpeting the Harman deal:

HARMAN INTERNATIONAL INDUSTRIES TO BE ACQUIRED BY KKR AND GS CAPITAL PARTNERS


Harman Stockholders Can Elect to Receive $120 Per Share In Cash or Shares in Post-Transaction Company

Transaction Valued at Approximately $8 Billion

Henry R. Kravis, Co-Founding Member of KKR, said, “Harman is one of the world’s outstanding providers of audio equipment and infotainment systems with an unparalleled portfolio of legendary brands and strong customer relationships. Since founding Harman more than 50 years ago, Dr. Sidney Harman has brought exceptional vision to the company and we are proud to work with him and the management team to continue building the value of their company.”

—Press Release, April 26, 2007

Now it just so happens that on the very same day of that takeover announcement, Harman conducted an earnings call for Wall Street’s Finest—the third quarter of the company’s fiscal year.

And on that call, the plain-spoken Dr. Harman did not shy away from discussing the downs as well as the ups of running a large-scale supplier of high-end electronics systems to the automobile industry, as follows:

To reach our [earnings] target of $4.35 [per share], we will need a strong fourth quarter…. At our midyear earnings call, I stated we hoped to achieve that target despite the expectation that R&D costs would exceed plan by $30 million.

Our analysis of R&D continues unchanged, but I am less certain that we will be able to absorb it all. It is too early to know with certainty…

—Sidney Harman, CEO Harman Industries, April 26, 2007


Unlike most CEOs who prefer to accentuate the positive, Dr. Harman made no bones about the challenges faced by his company:

Permit me to offer a perspective going forward. Ours is a very healthy business, as we have a special place in both the automotive OEM and the professional sides of our work. But we have no conceit that this is a walk in the park. There are challenges as there are opportunities throughout the markets and throughout the technologies with which we work.

There is no guarantee where new, vigorous competition may or may not arise. But my judgment today is that our role in that firmament remains unique. We are the strongest player in that space and our job is to stay there.

—Sidney Harman, CEO Harman Industries, April 26, 2007



All of that is public information, and was presumably available to Mr. Kravis and his deal-makers who had voluntarily agreed to buy Harman’s less-than-certain $4.35 per share of earnings for the absolutely certain price of $120 per share—a multiple of 28-times earnings for what is essentially an OEM supplier to the automobile industry.

Indeed, so happy was Mr. Kravis in the afterglow of the Harman deal that he could not contain his delight with the state of the world a couple of weeks later, when he made headlines with the following statement:

“The private equity world is in its golden era right now…the stars are aligned.”

—Henry Kravis, Banking Conference, May 2007


As market-topping headline go, Mr. Kravis’ “Golden Era” headline will likely go down in business history right alongside economist Irving Fisher’s famous “Permanently Higher Plateau” whopper about stock prices, made just days before The Crash of 1929.

Indeed, even as Kravis spoke the words “Golden Era,” what was happening in sub-prime had already begun spreading quickly and widely, and by late last week the Wall Street Journal was reporting the Harman buyout was in trouble:

Amid a credit crunch and lackluster financial results from Harman, Mr. Kravis and other investors in the deal have soured on the transaction, say people familiar with the matter…. Should KKR and Goldman choose to break the deal, they would have to pay a $225 million termination fee….

—“Harman's Suitors Sour on Buyout,” Wall Street Journal, September 21, 2007

Now, you might think that someone of Mr. Kravis’ stature in the Private Equity business would recognize a bad decision when he saw it, honor his commitments and move on.

But no, the Journal reported: KKR not only wanted to break the Harman deal, but they apparently wanted help from the bankers in paying the termination fee:


KKR has solicited some of the lending banks to help pay part of that fee, said one person familiar with the matter, but the banks have resisted the effort.

—“Harman's Suitors Sour on Buyout,” Wall Street Journal, September 21, 2007

Which is why I say Tim, who unfortunately—for he was not just a great stock picker but a great human being—did not live to see the Housing Bubble, the China Bubble or the Private Equity Bubble of 2007, would no doubt be telling me we are indeed in the wrong business.

Where else can you ask your bankers to help pay mutually-agreed-upon, clearly spelled out penalties, for your mistakes?

Not in my small corner of Wall Street.

And certainly not on Main Street.

I’d like to see Joe Shmo, who took his mortgage broker’s advice and signed on the dotted line for a no doc, interest-only sub-prime mortgage on his tract house in Sacramento, California, go to the bank that owns the loan and ask them to help pay the cost of refinancing his mortgage to something affordable.

They’d laugh him out of the room.

As, you would hope, the bankers did to Henry.


Jeff Matthews
I Am Not Making This Up


© 2007 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

7 comments:

sdieter01 said...

I'd have to disagree with the last paragraph about Joe Schmo. He actually will be going to his bank and his bank actually will be eating some of the cost of refinancing his mortgage, because it will be a lot better for the bank to do that than to end up owning Joe's $400k mortgage on a house that now sells for $300k.
Sean

CurmudgeonlyTroll said...

But isn't KKR doing the banks a huge favor by not holding them to underwater loan commitments? You expect them to do that for free?

(After they first take a stab at a material adverse change argument, the wise Mr. Harman's comments notwithstanding -- you might almost think he foresaw just such an eventuality)

Care to venture a guess how Congresswoman Jane Harman will vote with respect to 15% income taxes on private equity partners' carried interest?

whydibuy said...

Well, actually I did read a comment on The Housing Bubble blog from a home seller in early '06. He claims he recently received a letter requesting a refund of 50 k for the house he sold in '06 because the buyers felt they overpaid. After laughing his *ss off, he thought, yeah, sure, I'll bet you would send me 50 k if the house appreciated that much and I requested post transaction an extra 50 k. So, yes, there are some schmos who try to do the KKR move. But isn't that just par for the KKR course? Were'nt they the ones that in a recent buyout propose getting covanent free terms on their financing? I think they wanted the debt buyers to give them money without strict debt to equity terms or even what a default event would be. What nerve these guys got.

tylerh said...

"I’d like to see Joe Shmo, ...go to the bank that owns the loan and ask them to help pay the cost of refinancing his mortgage to something affordable."

Jeff, you're on the wrong coast. Something like this happens regularly here California: it's called a "short sale," and it's been a regular feature of the landscape since the last big real estate bust in the early 90s.


I am not making this up.

Sam E. Antar said...

Henry R. Kravis, Co-Founding Member of KKR, said, “Harman is one of the world’s outstanding providers of audio equipment and infotainment systems with an unparalleled portfolio of legendary brands and strong customer relationships.

Well, at least Crazy Eddie Antar is not kicking around Harman Kardon any more. Our sales people were instructed to refer to Harman Kardon as "Harman Card Board."

95% per cent of customers that went to Crazy Edddie to buy Harman Kardon ended up being SW'd (Crazy Eddie code word for switched or switch the customer) to a more profitable product.

Respectfully,

Sam E. Anta (former Crazy Eddie CFO & convicted felon)

tomob said...

Great post - and perhaps the seed of another classic KKR movie. Is James Garner available for "Weasels at the Gate"?

(I've had to sell to automotive OEM's; not a pretty business - especially right now!)

Tom O'B

Richard said...

You forgot the sanctimonious comment:

Meanwhile, one of the buyout industry's leading deal makers tried to temper concerns. "We made commitments to the boards of directors...and we expect those transactions to close," George Roberts, a co-founder of Kohlberg Kravis Roberts, said Wednesday. KKR has more such deals than any other buyout firm, with more than $80 billion worth scheduled to close in the second half of the year.