MARKET WATCH Turning Ugly Ducklings Into Golden Geese

By Gretchen Morgenson

NEW YORK — While the New Economy continues to rule the hearts, minds and wallets of most investors, there appears to be a stirring among the Old Economy stocks left for dead on Wall Street. Shrewd institutional investors, who know a bargain when they see one, and corporate managements, fed up with problems that depressed share prices present, are taking companies private.

Two deals announced last week characterize the nascent trend. United States Can, a maker of plastic and steel containers, said on Wednesday that an investment group led by the chairman of the company planned to buy it for $282 million. The offer was a 41 percent premium to the stock’s price before the announcement. The shares, which closed Friday at $19.6875, still trade at only 12 times earnings.

A day earlier, senior managers at Cameron Ashley Building Products made a move to take their company private for $328 million. The offer carried a 21 percent premium to an earlier bid. At its closing price Friday of $17.4375, Cameron Ashley is trading at around nine times earnings.

“As everybody knows, there has been a huge flight of capital into dot-coms — technology or biotech,” said Paul L. Schaye, a principal at Chestnut Hill Partners, a firm that advises private equity investors.

“That sucking sound has left everybody else saying ‘What about me?

“The what-about-me’s are legion.” Schaye said, “There were hundreds of publicly traded companies with relatively few shares outstanding, price/earnings ratios of less than 9 and current values of less than $1 billion. Those with solid businesses may become buyout targets, rescuing shareholders and managements from oblivion.”

“Some old economy companies that are trading at 3 to 6 times cash flow were trading at 7 to 12 times 2 years ago,” said Dan O’Connell, chief executive of Vestar Capital Partners, which manages $3.6 billion in private equity investments. “We probably meet with two to three management teams a day that are considering going private.”

Going private appeals to these managers because their depressed stock prices make strategic acquisitions using their own shares prohibitively expensive. Investors like the going-private deals because they can acquire valuable assets at cheap prices. Annual returns of between 20 percent and 30 percent are common. And with stock prices so depressed, even an investor taking on substantial debt for a buyout can still make the numbers work.

Indeed, the premiums to market price that acquirers paid in going-private transactions rose significantly last year. Mergerstat, a supplier of global merger and acquisition data, reports the median premium paid in 1999 was 32.7 percent, up from 20.4 percent the year before.

Adding to the lure of Old Economy buyouts today is the fact that earnings in some beaten-down sectors could soar this year. Steven Weiting of Salomon Smith Barney expects earnings at basic materials companies and energy concerns to grow 41 percent and 50 percent, respectively, in 2000. He also sees strong growth in the capital goods sector.

Investors looking to take companies private have amassed quite a war chest — $350 billion by one estimate. Even if half of this goes into technology companies, that still leaves a good chunk of change for action among the have-nots.

A hybrid formula entices investment funds

Sunday June 3, 2007

In August 2005, Blue Harbour Group, a small fund based in Connecticut, began buying shares in Laidlaw (NYSE:LI), operator of America’s largest fleet of yellow school buses and Greyhound coaches.

The company was weighed down by Greyhound, which was struggling to compete with other forms of transport such as low-cost airlines, but the school bus business was doing well, churning out healthy cash-flow from a series of recurring long-term contracts.

More importantly for Blue Harbour, Laidlaw’s management was receptive to change, including buy-backs and the possible separation of Greyhound.

The fund earned a 40 per cent return on its investment in February 2007, when Britain’s FirstGroup agreed to buy Laidlaw for $35.25 per share – well above the $23 per share Blue Harbour paid for its stake.

The success of that deal highlighted Blue Harbour’s unusual strategy, which combines elements of both private equity investing and shareholder activism, and is becoming increasingly popular on Wall Street.

Sageview Capital, a fund based in Greenwich and Silicon Valley, founded by KKR alumni Scott Stuart and Ned Gilhuly also puts money to work this way.

Loosely called “private equity-style investing in the public markets”, the strategy has been employed by US investors such as Warren Buffett and Eddie Lampert.

But Wall Street investors say it has gained traction thanks to a greater openness to outside ideas in US boardrooms in the wake of the Enron and WorldCom scandals. “There has been a sea change in the attitudes of boards and senior managements,” says Clifton Robbins, chief executive of Blue Harbour. “They are listening to shareholders like never before, particularly shareholders who bring value-enhancing ideas to the table.

“And this isn’t temporary: we won’t go back to a world of poor corporate governance, insular boards and limited transparency.”

Activist investors such as Nelson Peltz, Ralph Whitworth and Carl Icahn have also benefited from this trend. But there is a fundamental difference between their tactics and those of Blue Harbour and Sageview, who exert a level of pressure on managements, but without engaging in proxy fights.

Instead, they look at companies through what they describe as a “private equity lens”, identifying targets that are undervalued and could do with some transformation, whether in the form of balance sheet restructuring, the disposal of certain assets or the sale of the entire company.

“They are applying the same discipline that private equity groups do and are shaking up companies,” says Paul Schaye, managing director of Chestnut Hill Partners, a New York boutique investment bank.

Sageview’s first deal, for example, involved a stake in Guitar Center, and working with management to slow its store expansion, which many felt unnecessary as the company already dominated its music retail niche.

One way in which executives can benefit from bringing in an investor such as Sageview or Blue Harbour is that it can deter the appearance of an activist.

“As an executive, you might want to defuse the criticism that you are underutilising your balance sheet and not making tough decisions,” says Peter Schoenfeld of P Schoenfeld Asset Management, a New York-based hedge fund.

“A change in strategy may raise the stock price and require a significantly higher buy-out price.”

The strategy has potential pitfalls. In spite of the fact that their investment horizon spans several years, a sharp drop in stock market valuations could dramatically hit these funds’ portfolios, while private equity groups are somewhat protected by swings in public company valuations.

In addition, it remains untested across many fund managers: it is unclear what might happen if a company’s management is unable to execute a plan and the sides disagree on future strategy.

But so far the returns look good. Although Blue Harbour declined to comment on its returns, one investor said the firm had posted a 25 per cent gross internal rate of return last year.

Where Has All the Money Gone?

By Jill Andresky Fraser

You’ve built a profitable company on the cusp of expansion. All you need is some capital to fund your growth plans. But if your company isn’t high-tech, getting it will take creativity

After a wild and crazy year in the capital universe, the first E-mail message that I got after New Year’s Day seemed to be, well, just one more sign of the times: “We are in need of anywhere from $30 million to $100 million. … Can you help me with some advice please. This project has been dropped in my lap. That’s OK but I could use some good advice.”

There’s never been a time like this. Forget tulip-bulb mania; no matter how besotted Holland’s investors of the 17th century might have been, there probably weren’t too many burghers of the time who had the audacity to ask for help in finding — and to expect to get — their equivalent of my correspondent’s megamultimillion-dollar goal. Just consider what happened in the financial world in 1999. Some 544 companies raised a record-breaking $65 billion from initial public offerings, thousands of other businesses merged-and-acquired their way through at least $1.4 trillion worth of deals, and the Nasdaq Composite Index rose by more than 85% — the biggest annual gain of any major stock index in the history of the U.S. equity markets.

There has never been a time like this.

Thanks to a remarkable rise in the market trading value of public stocks (and an economy boosted by low inflation and technology-driven productivity gains), we have entered an era in which a huge amount of capital is wending its way through the equity and debt markets. It’s not so surprising, then, that many people, like my correspondent, have concluded that it’s now possible to raise money for just about any and every business venture.

But the sad reality is that they’re wrong.

Despite all that available money, especially in the equity arenas, many entrepreneurs — maybe even most entrepreneurs — still face significant difficulties when it comes to finding outside funds to support their company’s growth strategies.

It’s heartbreaking but true. Investment banks may have raised a near-record $2.1 trillion for deals in 1999, but the vast majority of business owners (especially owners of small companies and low-tech start-ups) didn’t stand a snowball’s chance in hell of getting their hands on any of it. For plenty of good companies that had strong prospects (if they could only raise the capital!), financing options were — as usual — somewhere between limited and nearly nonexistent.

Here’s the straight story behind all those jubilant headlines and dizzying statistics that tend to pervade the media these days. During the past year or so — as tremendous new wealth was being created an entrepreneurship flourished across the nation — two distinct tracks developed in the equity-financing market. And while it may seem simplistic to define them as “the dot-coms” and “everybody else,” those descriptions are not far off.

As Paul Schaye, a managing director at New York City based Chestnut Hill Partners, an investment-banking firm specializing in mergers and acquisitions, puts it, “The markets have become bipolar.”

The most favored child of today’s capital markets is, predictably, a hypergrowth technology company: a kind of business that runs the gamut from online retailer to telecommunications service. So many companies in this category have successfully bucked all the age-old financing rules of thumb that it sometimes feels as if an entirely new world of capital has been created. During 1999 everyone from private-equity firms to day traders seemed to have money to burn when it came to investing in this endlessly proliferating, financially voracious sector. Meanwhile, low-tech companies, even those with well-established niches, healthy cash flow, and vibrant growth potential, were left to fight for the table scraps.

The photograph of iVillage cofounder Nancy Evans smoking a celebratory cigar after her red-ink-trailing company’s $87-million initial public offering seems emblematic of one side of today’s capital markets. The other side might be perfectly encapsulated by Schaye’s description of one of his recent airplane flights.

“I sat next to a guy who had built up a $200-million Main Street, America, type company. Profitable. Very successful. And he was complaining to me that he had absolutely nowhere to go unless he was willing to sell out to a larger company. He couldn’t go public. He couldn’t attract venture capital,”

Schaye says. “Those markets were completely closed off to him and to any other company that wasn’t a dot-com, a real glamour business like Martha Stewart, or a massive leader like UPS.”

The Carlyle swoop

EVER since 2007, when Blackstone became the first private-equity firm to go public, its fellow “barbarians” have been rattling the gates of stock exchanges around the world. The latest is the Carlyle Group, which on September 6th filed a registration statement for an initial public offering (IPO) that will probably happen sometime early next year.

An announcement of this kind had long been expected. The firm has spent the past few years acquiring new units and portfolio companies with the abandon of a compulsive shopaholic. As of June 30th it oversaw $153 billion in assets, up by nearly 43% since 2010, much of this down to its acquisition of AlpInvest, a $43.3 billion Dutch fund of funds, earlier this year. It has branched out of private equity into other businesses, including hedge funds, energy investments and collateralised loan obligations. “Carlyle will probably use the proceeds from an IPO to fund further expansion,” says Paul Schaye of Chestnut Hill Partners, an investment bank. Being a public company also provides a clearer exit for the firm’s three billionaire founders, who are all over 60.

But even those who had predicted Carlyle’s move are flummoxed by the timing of its announcement, given market volatility. In the past three months Blackstone’s shares have fallen by around 20%; those of KKR, Apollo and Fortress are down by at least 30%, compared with a 9% fall for the S&P 500.

Carlyle may choose to hold off going public until markets improve. But it had reason to announce its plans this week. Its annual meeting of investors starts on September 11th. That is a useful forum to discuss the IPO, although the founders may not get an easy ride. “We prefer our general partners not to go public,” says an executive at a sovereign-wealth fund that is invested with Carlyle, because of the potential conflict of interest between fund investors and shareholders. Carlyle will “see the pushback” when it raises its next American mega-fund, he predicts.

There are more cynical reasons to explain why Carlyle is pushing ahead with its IPO now. Blackstone went public at the top of the market, only to see its shares languish. Carlyle could go public at a bottom, and claim credit if its shares rebound with the market.

Victor Fleischer, associate professor at the University of Colorado Law School, says Carlyle may also want to go public sooner rather than later before potential changes to the tax treatment of private-equity firms, which would increase taxes on firms’ public shareholders and make it harder to exist as a publicly traded partnership. As the only large buy-out firm to be headquartered in Washington, DC, Carlyle is better than most at keeping its finger on the political pulse.

Private attractions – For many company managements, the allure of becoming owners couldn’t be stronger.

By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) – Somewhere in America right now there’s a CEO staring at the ceiling and dreaming of taking his bat and his ball and heading home.

What is the point, after all, of being a public company anymore? The stock market has not been kind over the past three years and increased regulatory scrutiny has made company heads spend more time bean counting and wading through legal problems than running their companies.

Meanwhile, with research departments getting pulled away from the sheltering wing of investment banking, many Wall Street firms see little point in covering lesser-known names in unsexy industries. Even with the stock market improving, many companies’ shares continue to languish.

“Who cares about a half-billion dollar business? It doesn’t matter,” said Paul Schaye, managing director at investment advisory firm Chestnut Hill Partners.

The appeal of going private is strong, and now the means to do it may be at hand. When company managers look to become owners, they typically turn to the leveraged-buyout — a transaction where they first buy the company and then turn around and finance that transaction by issuing debt. Usually this debt comes in the form of high-yield, or junk, bonds.

Until recently the junk bond market had been in sorry shape, making the cost of doing an LBO prohibitively high. But enthusiasm for junk bonds has been on the rise, with investors putting more money into high-yield funds like never before. As a result, spreads — the difference between Treasury yields and junk bond yields — have contracted sharply. And because Treasury yields have fallen, the absolute yields on junk bonds have fallen sharply as well.

“My gut tells me that spreads and yields are still too high to see a flood of deals,” said Kirlin Securities fixed income and economic strategist Brian Reynolds. “But if the market continues to improve, we will be at a point where a pickup in deals would be feasible.”

Like Schaye, Reynolds thinks the most likely companies to be taken private are the ones that equity investors find among the most boring, like midsize rust-belt manufacturers with steady earnings, but little growth.

If there is a move toward going private, it could be good for the stock market in general. For one thing, it would make investors much less willing to bet on stocks going down — the bear’s greatest fear is being caught short a company that is getting bought. Moreover, if company managements started saying they saw more value in their shares, investors might, too.

“It would boost confidence in the overall equity market,” said Smith Barney equity strategist John Manley. “The best statement a management can make that it believes in itself is for it to take the company away from you.”

— Justin Lahart is a senior writer at CNN/Money covering markets and investing.

Chrysler sold in unprecedented auto deal

By James R. Healey, Sharon Silke Carty, Chris Woodyard and Matt Krantz, USA TODAY

German automaker DaimlerChrysler (DCX), after paying $36 billion for Chrysler in 1998, now is essentially paying a private investment company to take money-losing Chrysler off its hands.

It’s a stunning reversal, just one of several stunners in a deal unprecedented in the modern auto industry.

The sale of Chrysler to Cerberus Capital Management, announced Monday, would result in the first private ownership of a major U.S. auto company since Ford Motor went public in 1956. It marks the first time the United Auto Workers union has signaled its willingness to compromise on previously non-negotiable issues. It’s a bet by a shrewd investment company on what has appeared to be a lame U.S. industry beset by high costs and better, lower-cost competitors.

And it is the chance of a lifetime for a car company to reinvent itself, to out-Toyota Toyota in lean manufacturing and vehicle quality.

“It doesn’t matter who owns it,” says Jack Fitzgerald, a Chrysler dealer since 1966. “It’s what they do with it. I would like to see them copy Toyota” so dealers would have better-quality vehicles that are easy to sell and buyers would develop the kind of loyalty that eventually makes them willing to pay more.

“It’s all about product,” says Fitzgerald, who sells Chrysler’s namesake brand as well as the company’s Dodge and Jeep brands at Fitzgerald Auto Malls in Maryland, Pennsylvania and Florida.

Cerberus, which invests in troubled companies it thinks are undervalued and ripe for turnaround, won’t specify how it would overhaul Chrysler after the deal closes in the third quarter. Nor does it appear eager to micromanage the automaker, despite recent losses and lukewarm products.

“Our plan really is to provide patient capital,” says Cerberus spokesman Peter Duda; to “free management from quarter-to-quarter results and allow them to focus on a long-term recovery and transformation plan.”

Cerberus, founded in 1992, is based in New York and is run by financier Stephen Feinberg. John Snow, Treasury secretary from 2003 to last June and former head of railroad CSX, was appointed chairman of Cerberus in October. Former vice president Dan Quayle is a director.

The company says it manages some $25 billion in assets and owns about 50 companies with combined annual revenue of more than $60 billion.

DaimlerChrysler had been romancing buyers for Chrysler since announcing financial results Feb. 14, a companywide profit of $4.3 billion despite a $1.5 operating loss by Chrysler. As many as five bidders were reported to be interested.

Best bet for Daimler

Cerberus’ winning bid is, rather than the highest price, more like the proposal that will cost Daimler the least. “DaimlerChrysler is paying Cerberus to take Chrysler off its hands,” says David Healy, auto analyst at Burnham Securities.

Highlights announced by the companies Monday:

Cerberus puts up $7.4 billion to get 80.1% of Chrysler. But most of that goes into Chrysler and Chrysler financial. Daimler gets just $1.35 billion.

Cerberus-owned Chrysler still would be responsible for pension and health care liabilities, but the pension plan is $2 billion overfunded, by Daimler’s reckoning, minimizing some of that concern.

Daimler lends $400 million of the $1.35 billion to Chrysler; spends $1.6 billion on the costs of a Chrysler restructuring plan announced Feb. 14; buys back all of Chrysler’s bonds to leave it debt-free, paying a forecast $878 million in prepayment penalties for retiring some bonds early.

Daimler CEO Dieter Zetsche said the all-in cost to dump 80.1% of Chrysler is $500 million.

Daimler books other costs and write-downs, forecast at $4.1 billion to $5.4 billion, more than it made last year, against this year’s earnings. Daimler will provide 2007 earnings guidance today.

“It’s an embarrassment, but it’s getting rid of something that wasn’t producing. You can keep on bleeding, or bite the bullet and say it’s not working,” says Anand Sharma, CEO of TBM Consulting. TBM markets itself as an expert in teaching how to implement Toyota’s high-quality, lean-manufacturing principles.

TBM worked with Chrysler in 1995-98, the years leading up to the acquisition by what was then Daimler-Benz. “Middle management was bloated and overpaid, and they didn’t want to do anything about it; people had retired and didn’t tell anybody. That’s why we walked away” from the Chrysler job, Sharma says.

What Cerberus should do

That’s the first thing Cerberus-owned Chrysler must do, he says: Have the guts to ax anybody more interested in turf that success.

That, he says, will take new management, even though Cerberus says it will leave CEO Tom LaSorda in place. “The first announcement always says you’ll keep it the same, but that never happens.”

Cerberus has auto veterans at hand. Former Chrysler COO Wolfgang Bernhard recently joined Cerberus as a senior executive. David Thursfield, who ran Ford Motor’s operations outside of North and South America, joined Cerberus in April 2004 as a senior member of its automotive team.

Cerberus said Monday that Bernhard would not be involved in Chrysler operations. It wouldn’t comment on any role for Thursfield.

Burnham’s Healy can’t imagine Bernhard on the sidelines. “He’s largely responsible for the fact that Chrysler did better than Ford or GM in the early part (of the merger period). He was responsible for the Chrysler 300,” a profitable sedan, “and he’s very aggressive. He could get a non-operational assignment – board member, for instance – and influence affairs that way.”

What else the industry veterans and observers say Chrysler must do to survive and thrive:

Get tough with the union. That’s where private ownership can make all the difference.

“Shareholders are much more apt to see a strike solely as a negative” while a private owner with deep pockets “has a little stronger stomach in dealing with a strike,” says Kevin Tynan, auto industry analyst at Argus Research.

Private companies “are in business for one objective, to do whatever it takes to make the company successful and profitable,” says David Cole of the Center for Automotive Research. “Not having public shareholders gives them more power, and part of that is the fear they bring to the game.”

The UAW had been lobbying hard for Daimler to keep Chrysler. But when the sale was announced Monday, UAW President Ron Gettelfinger called it “in the best interests of our UAW members.”

“We didn’t get a choice in the selection,” Gettelfinger said at a press conference. “We pushed very hard to stay in the Daimler family. It’s not going to happen.”

Daimler flew Gettelfinger and General Holiefield, UAW vice president in charge of DaimlerChrysler, to Stuttgart, Germany, for a meeting Saturday with Zetsche and LaSorda. That’s when they laid out the deal with Cerberus for Gettelfinger, who is a member of DaimlerChrysler’s supervisory board.

The union decided to support the plan after it saw that Cerberus had promised to pour $1.7 billion into research and development at Chrysler. “Our goal, our objective, is to strengthen the Chrysler Group and maintain job security for our membership,” Gettelfinger said.

Gettelfinger and Holiefield plan to meet with Chrysler executives and Cerberus’ Feinberg, among others, early today. Gettelfinger hopes to hear “a reaffirmation” of the promises made Saturday.

Dump dealers. The fewer there are, the more profitable each one can be. One dealer can own several stores, if need be, to ensure the company’s presence in key markets. When there are too many dealers, they compete against one another instead of against ford and Honda and Hyundai.

Chrysler reported 3,698 U.S. dealers at the end of April. LaSorda said in February he would cut 10% to 15%, but gave no hard target or deadline. “You have to look at a reduced dealer network, and reinvest in your strongest dealers,” says Mike Jackson, CEO of dealership chain AutoNation.

Leverage connections. Cerberus previously bought 51% of GMAC, once the captive finance unit of General Motors.

Part of the fix-it plan is expected to involve cost savings by merging some operations of GMAC and Chrysler Financial, says Roger Aguinaldo, CEO at M&A Advisor newsletter. Cerberus “can make this thing work,” he says.

Cerberus also has learned some automotive ins and outs while bidding for auto suppliers Delphi and Tower.

And though it appears to be getting a good deal, the fact that Cerberus would agree to buy Chrysler “with its current pension/health care liabilities but without an apparent new labor contract in place” is “a positive sign for the Big Three’s labor restructuring efforts,” notes JPMorgan Securities analyst Himanshu Patel in a note to clients.

Focus the product line. Echoing remarks of analysts and consultants, Healy says: “I don’t think (Chrysler) can afford to cover the whole spectrum from big SUVs to compact cars with the volume they have in the U.S. they have to find some way to be a niche player where the profits are.”

Can it be done?

Yes, say most observers, including Paul Schaye of Chestnut Hill Partners. Chrysler under Cerberus will have the independence to close plants, eliminate unprofitable operations and take other steps difficult or impossible as a public company. But, “This is easily a two-year work in process,” Schaye says. Others foresee a three- to five-year turnaround. All figure Cerberus will take Chrysler public again once it’s repaired.

Healy says it could take longer than expected and cost Cerberus more than $7.4 billion, because “the company’s in chaos.

“All I know is that I’m glad I don’t have this thing dumped in my lap.”

Specialists Offer a Second Chance for the Wilted Buyout

Buyers and Consultants Create Niches to Revive Leveraged Underachievers

By Martin Sikora

As analytical and careful with a buck as they are, financial buyers still have their share of stumbles.

Chicago-based turnaround expert Lawrence M. Adelman estimates that one-third of leveraged buyouts are “home runs,” another third are average performers, and the final third are underperformers that “may lose all or part of the money” put up by investors. “Even in a good year, those numbers tend to hold true,” he said.

Until recently, the failure rate had been a little-noticed sidelight of the LBO wave that sprang to prominence in the 1980s and established an important base in the M&A market.

But as private equity firms proliferate, amass more money from investors, and commit funds to more deals, their troubles have not escaped the watchful eyes of a growing number of professionals who sense opportunity in rescue missions. As a result, a small army of specialists has emerged to handle a variety of roles in fixing the troubled highly leveraged company.

Paul Schaye, managing director of Chestnut Hill Partners in New York who specializes in handling acquisitions for financial buyers, says that, “his clients are increasingly willing to take on another private equity firm’s bad apples and turn them around.” He said he is scouting hard for such opportunities.

One of Schaye’s clients is Sun Capital Partners Inc., a Boca Raton, Fla.-based LBO and venture capital firm which has taken at least three troubled businesses off the hands of financial buyers and seeks more of their distressed properties.

Adelman, together with attorney David L. Eaton and former Heller Financial Inc. executive Michael Goldsmith, recently formed AEG Partners LLC specifically to handle turnaround management assignments at the underperformers in private equity portfolios.

And there has been expansion in the ranks of individual interim managers who have the Know-how to shape up the lagging leveraged company before handing the reins to a more permanent executive corps and moving on to another assignment.

“Given the upsurge in leveraged dealmaking and the expanding holdings of LBO funds. It’s inevitable. Schaye said, that some portfolio companies will go south. When that happens, the sponsor may pay less attention to the laggard while committing more time and funds to the sure winners where the returns promise to be greatest, thus accelerating the downward spiral. The subset of buyers who will take over and resuscitate the business offers an “escape valve” for the private equity owners to exit without scuttling the company or losing their entire investment,” he said.

Poor performance, Schaye added, does not mean a hopeless case. “Some of them are basically good companies that have suffered from lack of attention,” he said. “A new owner that focuses on the business can restructure the finances, improve the operations, and create value in a previously distressed situation.”

A key factor, he noted, is that the new owner knows that it is tackling a troubled situation from the start and is able to identify and work on the pressure points that can turn things around.

Rodger R. Krouse, managing director at Sun Capital, says that his firm is seeking “orphan companies” in private equity portfolios that have unrealized potential. “We look for great franchises that are undermanaged,” he said. If that seems like an unrealizable ideal, Krouse said those kinds of hidden gems abound because there are portfolio companies that don’t receive the right attention, care, and feeding. “We can get value out of them because we have more professionals focused on the operations rather than the deal side,” he noted. “We can improve the company dramatically. The lenders are happy and the former owners are not distracted.”

In the latest rescue mission, Sun Capital last February acquired control of JTECH Communications, a producer of on-premise paging systems, from Bain Capital Inc. JTECH was a disappointment despite a 90% share of paging systems in restaurants and strong penetration of other service markets, such as hospitals, offices, churches, and nurseries. “We put in a new CEO and made personnel changes,” Krouse said. “We are working on growing revenues. And Bain’s return is better than if it had retained full ownership.”

While it’s too early to judge results at JTECH, Krouse claims success at two other turnarounds with longer track records. Nailite Inc., a Miami-Fla. based producer of specialty siding panels, was acquired from Kleinwort Benson after a 10-year down spin in which “the equity had gone to zero.” “In the third year, we doubled sales and tripled profitability,” Krouse said. “We introduced new products and improved customer service. We did the blocking and tackling types of things to make it work.”

Labtec Inc., a manufacturer of computer peripherals including speaker headsets, in which it has a 50% market share, was acquired from Stephens Inc. and Northern Group. While Nailite was an internal regeneration, Vancouver, Wash. -based Labtec also has benefited from two add-on acquisitions – Connector Resources Unlimited, a computer data storage products concern, and Spacetec IMC Corp., in 3-D controllers. “Sales have doubled and profits have more than doubled,” Krouse stated.

“We just have a different focus from other private equity buyers,” Krouse said. “Forty-nine out of 50 deals they do may be terrific,” he said. “But they are largely deal people. We are largely operating people. We bring our own management to the game.”

Guessing wrong on company managers

How do these companies get into trouble in the first place? The consensus is bad management. “The primary reason is poor management,” Adelman said. “Everything else is a distant second to poor decision making by management.”

Erwin A. Marks, an operations and turnaround veteran who has served as interim CEO at several leveraged firms in trouble, agrees, saying that many managements can’t handle the challenges of running a business in the increasingly complex economy of the 21st Century. The old strategy of focusing on cash and stability no longer works as well as growing the business, and some executives can’t do both at the same time. “If it goes sideways, you can run out of money awfully quick,” Marks asserts.

Although LBO sponsors pride themselves on judiciously sizing up the managements they want to invest in, “they are not always right in what they believe is good management,” Adelman said.

The reasons for analytical miscues are varied, ranging from overestimation of talent to psychological problems not apparent when the deal closes. “For example, if you are buying a divested business’ the management may not know how to run a business in totality,” Adelman said. “They may not know how to run it on a cash basis. The private equity firms may be fairly knowledgeable about managers, but people change. A gov may develop ego problems. He may want to grow too fast. Or he may not impart all the information he has to the owner.”

Even historically good managers may face problems navigating the current complexities and turmoil in the economy, Adelman added. “The bar has been raised the last few years,” he said. “Management needs to apply new technology. There is competition from the Internet. Unless you are really good in a sector or have a new paradigm, you are going to have a problem. By just being marginal it is harder to get by now. Every sector sees companies that run into problems by not being aggressive.”

Marks, head of Northbrook, IL based Marks Consulting, sees a plethora of pressures on business that can be aggravated in a highly leveraged situation where a primary focus is working off the debt overhang. He also notes that several roll-up plays executed at whopping multiples, are becoming frayed because their industries are showing a much more concentrated level of competition. “Bigger companies are being created in areas where there used to be fragmentation,” Marks said. “Pricing has not kept up with volume because of fiercer competition.” Meanwhile, said Marks, Costs have increased and the “rise in SGA has been dramatic.”

“In some cases,” he added, “the buyers didn’t understand the amount of capital investment needed to make these companies viable.”

And across the board, Marks said, there is the ever-present problem of overpaying for deals without a reasonable prospect of recouping the investment. “They are still looking to leverage overhead and back- office costs,” he said, “and they are willing to pay higher multiples to put themselves on the same level as the strategic buyer.”

Ominous signs from the junk market

Both Adelman and Marks think that a lot more problem situations are in the offing. “The default rate on public debt is rising,” said Adelman. “There is a 4.2 % default rate on junk bonds. That means there are many problems out there. If you combine the normal percentages of deals that perform and those that don’t, that means there are a lot more problems out there.” When the junk market is in trouble, he said, “it means that it can’t support asset-based financing.”

That, he said, means a lot of work for a firm like AEG that assumes the managerial headaches. “Problem deals take a huge amount of time, which draws the sponsors away from their focus,” Adelman points out. “We’re really focusing on managing investments for them that reach a good conclusion for everybody.”

Marks, who has been in the LBO turnaround game for more than a decade, says that his consulting assignments are mounting and notes an interesting shift in the trend that suggests that financial buyers are spotting trouble more quickly and moving to fix it before things get too far out of hand. Ten years ago, in the midst of a recession, most work came from lenders that had over-advanced and were eager to salvage their investments. “The market has heated up substantially for this kind of work, and most of my clients now are coming from the buyout group side,” he said.

Staying Private Instead of Rushing into an IPO

by Bronwyn Fryer

Roger Greene, the president, CEO, and founder of Ipswitch, a nine-year-old company in Boston that makes Internet network-management software, wears the shadow of an “I told you so” smile these days. While publicly traded companies such as Dr.Koop.com and Pets.com are writhing under single-digit stock prices, Greene’s very private company has snubbed the notion of an IPO and is ticking along successfully, with profits of 29% annually. It’s a goal that even Amazon.com is still far from attaining. That’s because Greene has found plenty of expansion capital outside the public markets to help his business grow. This is a strategy more CEOs are adopting.

What a difference a stock market correction makes. Last year, it seemed that every dot-com on the planet (including those with the most vaporous business plans and mediocre revenue and earnings prospects) was going public. But when the Nasdaq took its April nosedive, it was like turning a searchlight on an orgy. Of the 73 companies that went public in the first quarter of 2000, 43 slipped below their offering prices.

“Currently, there are 9,600 public companies out there trading at less than 15,000 shares — that’s nothing — a day,” says Paul Schaye, a partner with private-equity firm Chestnut Capital Partners of New York City.

“One main reason for this phenomenon is that many of these companies went public too soon. They should have waited until they shored up their balance sheets and had at least a year’s history of profitability.”

Since then, getting a ticker symbol attached to one’s company name is no longer de rigueur. According to Venture Economics, 47 companies withdrew or postponed their IPOs between January 1 and April 25 of this year. Instead, these companies are focusing on business fundamentals and using a host of other means to raise expansion capital until they are ready for the public arena. These means include securing late-stage angel financing or venture capital, and getting cash from corporate strategic partners. A few are also funding their operations the old-fashioned way — by earning it and reinvesting cash flow into the business.

For companies that are not capital-intensive businesses, such as software maker Ipswitch, going it alone and bootstrapping makes a lot of sense. Greene has slowly built his software —development company by funding everything — from R&D to new hires — with cash generated by profits. For the first four years, he didn’t take a salary, reinvesting 100% of the profits in the business. Even his software developer worked on spec and with the promise of royalties on later sales.

Ipswitch’s products start at $49 and sell to a broad audience. Although the company won’t disclose revenues, its monthly profit margin can be as high as 25%. Greene has chosen to stay private even though VCs come courting all the time. He never wants to give up equity and do an IPO. “When you’re a public company, you lose your focus on the business because you’re tracking the stock price,” he says. “I like the freedom to grow the business and invest where I see fit.”

Over the years, his independent-funding tactic has worked splendidly. During Ipswitch’s first four years in operation, it broke even despite the fact it reinvested its earnings in R&D, marketing, e-commerce infrastructure, and customer service. Investing in all these programs, however, has paid off handsomely: During the past five years, it has seen an astounding 916% growth rate.

Of course, not all companies are software developers with overhead consisting of intellectual capital. Some companies, particularly ventures that need to grow quickly or expand resources to handle large projects, are much more capital — intensive and need outside infusions of cash. That’s where angel investors — wealthy individuals who typically contribute thousands, even millions, to private companies — come in. Although in the past such financial patrons were interested only in backing startups, recently many are willing to band together to form an entrepreneur’s idea of late-stage financial heaven.

Consider the case of Dave Berkus, managing partner of Berkus Technology Ventures in Arcadia, Calif. The company manages several angel investment funds that make seed-capital and late-stage venture investments in Internet and software businesses in Southern California. A former entrepreneur who ran a software company called Computer Lodging Systems, Berkus understands the needs of private companies with potential.

In 1999, Berkus and a group of seven high-net-worth individuals banded together to offer $230,000 in equity capital to EPC International, an 18-year-old, debt-laden software company whose president and CEO had died suddenly at the age of 32. To save the CEO’s heirs from bankruptcy, Berkus gathered his angels together for the late-stage investment. The money has helped recharge EPC, whose sales have jumped from a faltering $250,000 annually to an estimated $5 million in 2000. The investor group’s projected return: 100%.

Securing venture capital is, of course, the preferred option for companies that see themselves on the IPO or acquisition track and that need larger amounts of money to get there. Right now there is lots of venture capital available. Last year, the industry raised more than $43 billion.

Companies with solid business plans and exciting prospects for growth — which have already secured first and second rounds of venture capital — can pursue subsequent rounds of financing, called mezzanine financing. If your initial offering was in the works and is now on hold, mezzanine financing will pull you through until the market gods smile again, says venture capitalist Ann Martin of Rosewood Partners, in San Francisco.

Contrary to popular belief, not all VCs want a quick exit, nor do they make demands that a portfolio company go public too soon. Jon West, CEO of Cimlinc Inc., a 19-year-old software maker in Chicago, can attest to that. Kleiner Perkins Caufield & Byers has helped him raise $24 million in exchange for 70% equity in five rounds of financing. Now it’s helping him do yet another mezzanine finance to raise $15 million by year’s end. The goal is to help fund development of Cimlinc’s software used by factory workers in the airline industry.

How did West keep his VCs so patient? By working with them to develop a long-term strategy to grow and build. “They realize we can’t go public until we have a long profit record,” he says. With $18 million in sales, West expects that goal will be met soon.

Along the way, West has bumped into another financing source often overlooked by entrepreneurs: corporate VC investors. Many Fortune 500 corporations are eager to fund entrepreneurs to get access to their know-how and technology, or to secure a profitable business relationship. Over the years, West, for instance, has attracted $3 million from his reseller in Japan, Nisho Electronics. What was great was the fact that the deal was structured as a convertible debenture, so West was able to get his stock back and not give up any equity.

The flexible financing terms that can be arranged with corporate strategic partners are the attraction for entrepreneurs. That’s why Elliot Cooperstone, the 38-year-old CEO of EmployeeMatters (www.employeematters.com), is trying to forge an alliance with MasterCard’s small business portal. Under the agreement, Cooperstone would provide his payroll/benefits solution in exchange for MasterCard’s participation in a $30 million mezzanine financing now being arranged by his VC firm, Frontline Capital. “Besides getting money, I’d be getting one of the best customers I could ever have,” says Cooperstone, who is excited by the prospect. “Staying private has its rewards.”

Cash and Control: Bringing in Private Equity Minority Investors

by Paul Schaye

A lifetime of building a business can be shattered when the union between the business owner and an outside investor goes from a match made in heaven to a relationship formed in hell. Private companies and family-owned businesses that have more than just capital invested are especially concerned with the souring of this relationship. Business owners looking for outside investors question, “Will our business wind up in a chop-shop or will our legacy live on?”

A solution to this quandary is working with minority investors who will exert less control. Minority investors typically control 30-49%. Clearly, smaller transactions are on the upswing. According to Dealogic, private-equity investment deals of less than $100 million jumped to almost $9 billion in 2005, up 66% from $5.4 billion in 2003. In continuing the upward trend, in 2006, deals of less than $100 million totaled nearly $10.5 billion.

The advantage of working with a minority investor is that company owners can cash out part of their equity to attain liquidity and diversification, and get a second bite of the apple on future profits. This is accomplished while keeping control of the business.

Strike While the Iron is Hot

While the owners of any company first have to come to agreement on looking for outside equity and capital, there are a few instances where business conditions are ripe to seek out a minority investor:

Strong upside and shareholders want expansion, liquidity and diversification. Owners often do not want to invite a majority investor in just when years of hard work are about to pay off in a big way. A minority investor can provide the cash that allows the owners to realize their dream and stay around to reap more rewards.
Changes in marketplace that require capital and expertise. With the globalization of so many industries and the emergence of new markets, now may be the ideal time to expand. Building international relationships takes additional capital and resources, and a minority investor can help you be one of the first in your industry to tap into these opportunities.
Strong need for outside business counsel. A time comes when current owners and management acknowledge that their skill sets limit the potential growth of the business. The beauty of minority investors is that while they will have limited control, a company can still use their expert counsel as much or as little as needed.

Get Your “Prenuptial” Agreement in Order

The relationship between a company and its minority investor is more like a marriage, so the process requires special consideration:

Allow time for “dating.” When a company considers being acquired, the main objective is to get the most money out of the deal. However, with a minority investor, both parties are “investing” in a long-term relationship. So, before you approach minority investors, think about the optimal profile or ideal characteristics.
Ask direct questions. Too often a transaction sours because straightforward questions like the following were not asked beforehand:

• What is your vision and investment strategy, and how does our company fit into it?

• Who are your primary investors?

• What motivates your investment decisions?

• What are your other investments right now?

• Where in your priority list would our company stand?

Call references. Bringing investors on as partners is like hiring employees. Ask their references specific questions such as:
Were there ever any difficult situations in working together? What was their attitude? Did they rush to judgment or run over to help?
If you had trip covenants, how hard did the investors work to enforce them?
Were they heavy handed in pushing for management changes?

Avoid the Problems Before They Start

While the details of a transaction vary, there are some general guidelines to help prepare for a positive working relationship:

Matching timelines. Investment capital is something a company leases, not owns. Investors typically want their investment back within five to seven years with an internal rate of return of about 15-20% a year.
Living with covenants. The agreement will include triggers for the investor to take more control in the event the company does not meet agreed-upon expectations. Take the time to talk through some possible scenarios to see how those can be arbitrated rather that dictated.
Personnel changes. If, during the evaluation process, it becomes clear that certain personnel changes must take place after the transaction, address the issue upfront and determine how much time should pass before there are major shifts in management.

Today, investors have a lot of capital and are looking for companies. Many are willing to take a smaller piece of companies they pursue. However, at the end of the day, the question is not about the money, but how the investor works to build a mutually beneficial relationship.

With minority investors, owners can get an additional payout. It is very attractive for owners to have the ability to take cash off the table now with the incentive that they could take more out later.

The benefit of gaining cash and maintaining control can be realized with minority investors. Company owners who spent their lifetime building their businesses can achieve greater profits to better preserve their legacies.

Sun Capital targets Private Equity Rejects

by Josh Kosman, reporters@thedailydeal.com

Last month, Boca Raton, Fla.-based Sun acquired JTech Communications from Bain Capital, one of the buyout industry’s biggest firms. Bain had acquired JTech in 1995 but struggled to make a profit with the company, which manufactures on-site paging systems for restaurants.

For Sun, JTech represents just the type of company it is looking for: a niche-industry leader owned by a private equity firm but grappling with operational problems.

“There are many companies with strong franchise names that have the wrong management in place and are not performing particularly well,” said Rodger Krouse, a managing director at the firm.

With that in mind, Sun Capital plans to launch its first buyout fund later this year to snap up more companies like JTech, which is also based in Boca Raton. The group, which previously invested its own money or raised funds on an ad hoc basis, will set a target of $200 million, Krouse said.

The JTech deal will serve as a blueprint for other acquisitions. Sun Capital acquired a 26% stake from Bain Capital and a controlling interest in the company. It will install a new management team and work at taking operational costs out of the businesses it acquires.

As it did with JTech, the firm plans to leave the seller with a stake so it can profit, in part, from any turnaround. The group expects to typically pay between a five and six times Ebitda multiple for its investments, though Krouse declined to disclose the numbers for JTech.

Sun Capital believes more opportunities will soon present themselves, as firms that made roll-up investments in the mid-‘90s encounter problems as they execute consolidation strategies.

“In roll-ups, we often find there is too much overhead and significant management issues.” Krouse said. “We are looking for strong franchises that are undermanaged.”

Groups typically raise partnerships in which they have five years to manage companies before selling and returning capital to their limited partners. So many buyout firms now need to find exit strategies for some of the investments made in the mid ’90s roll-up boom, Krouse said.

Sun Capital has retained Chestnut Hill Partners to help develop contacts in the buyout community and to negotiate quiet deals. Chestnut Hill, based in New York, helps firms find deal flow but in this assignment is arranging exits.

“Partners at Chestnut Hill said 15 firms it works with have expressed interest in selling companies to Sun Capital, including BancBoston Capital, Jordan Cos., Madison Dearborn Partners and Sauders Karp & Megrue”, said Paul Schaye, a managing director at Chestnut Hill.

“It’s a natural progression of the food chain that this will happen,” he said.

To fund its turnaround investments, Sun Capital will present the case of Nailite International to potential investors. The firm bought the manufacturer of replica siding from Kleinwort Benson three years ago and has doubled sales, Krouse said.

To smooth operations, Sun Capital improved the delivery of products and responded more directly with customers. Nailite, based in Miami, then introduced a new product line, and customers reciprocated in kind.

Sun Capital, though, has made four turnaround investments so it has only a limited track record.

Two partners at Lehman Brothers Inc.-Marc Leder and Krouse-formed the group in 1995 with a strategy at the time of being a typical buyout investor.

“We got involved in situations that were more and more troublesome,” Krouse said, explaining the change in approach.

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