BankUnited Shares Rise 5% on First Day

BankUnited’s public offering received a warm reception on Friday morning, as shares rose nearly 5 percent to around $28.25 in the first few hours of trading.

As with other I.P.O.’s this week, BankUnited, a Florida-based lender, priced its offering higher than expected at $27 a share, raising about $780 million. BankUnited previously predicted a range was $23 to $25 a share.

The healthy demand for the bank, which filed for bankruptcy 18 months ago, is yet another encouraging sign for the I.P.O. market.

The sector has enjoyed a string of strong debuts this week, including the online content creator Demand Media and Nielsen, the year’s first billion-dollar-plus offering. Like BankUnited, both Demand Media and Nielsen priced above their anticipated range.

Nielsen, which is owned by a group of private equity firms, priced at $23 a share on Wednesday and raised $1.9 billion. After two days of gains, shares of the consumer ratings company were trading slightly lower on Friday, down about 1.5 percent in morning trading to around $25.

Demand Media, which priced its shares at $17, rose to nearly $24 this week, before settling around $21 on Friday morning.
BankUnited’s owners — a consortium of buyout firms that includes Wilbur L. Ross Jr., the Blackstone Group, the Carlyle Group and Centerbridge Partners — will profit handsomely from the offering. The investors, who injected $900 million into the bank in 2009, sold about 22 million shares as part of the I.P.O. Mr. Ross and the Blackstone Group sold about about 5.1 million shares, putting them in line for a $137.7 million pay day. Each will retain a 15.9 percent stake.

Paul Schaye, a founding partner of advisory firm Chestnut Hill Partners, said the strength in I.P.O. pricing was very encouraging for private equity firms, which have struggled to take companies public in recent years.

“This is a sign that things are coming back, that private equity firms are not just passing off goods in the food chain — I think everyone is breathing a sigh of relief,” he said.

Even so, private equity firms are managing their expectations. While a 40 percent return on investment may have been common in the frothy years preceding the financial crisis, said Mr. Schaye, “the new normal is about 20 percent.”

Carlyle Founders’ Stakes May Be Worth More Than $1 Billion

By Jason Kelly and Devin Banerjee on April 16, 2012
Bloomberg Businessweek
News From Bloomberg

Carlyle Group (CG) (CG)’s co-founders stakes in the firm that are likely to be on par with George Roberts and Henry Kravis’s holdings in KKR & Co. (KKR) (KKR) and worth less than Stephen Schwarzman’s shares in Blackstone Group LP. (BX) (BX)

Carlyle, which updated its initial public offering registration with the U.S. Securities and Exchange Commission today, said it will offer 30.5 million shares at $23 to $25 each. William Conway, Daniel D’Aniello and David Rubenstein’s stakes in the firm they founded in 1987 would be worth $1.13 billion apiece at the midpoint of the expected price range.

The firm, based in Washington, is the world’s second- largest private-equity manager, with $147 billion in assets as of Dec. 31. An IPO is one way founders are cashing out after building firms that control dozens of companies employing hundreds of thousands of people.

“What determines a good private-equity firm is the guys in the corner offices,” said Paul Schaye, managing partner of New York-based Chestnut Hill Partners, which helps private-equity firms evaluate deals. “These are 21st-century conglomerates. They’ve created something in reality with underlying value.”

Schwarzman’s piece of New York-based Blackstone is worth about $3.4 billion at today’s stock price. Schwarzman, who created Blackstone in 1985 with Peter G. Peterson, held 232 million shares of the firm at the end of 2011. The 65-year-old Schwarzman sold a portion of his stake for $684 million when Blackstone went public in June 2007. His remaining stock was valued at more than $8 billion at the peak that year.

Blackstone, which oversees about $166 billion, is the largest private-equity firm by assets.

‘Crystallize the Value’
Peterson, 85, sold the majority of his Blackstone shares in the IPO for $1.92 billion, which he used to fund philanthropic efforts. Blackstone President Tony James has a stake worth about $625 million, according to the firm’s government filings.

“Going public would crystallize the value in our work,” Schwarzman said at a Captains of Industry event last week in New York. “And I would have something to give to my heirs.”

Carlyle’s founders aren’t planning to sell any shares in the offering, a person familiar with the firm said this month. The proceeds of the IPO will go toward paying down debt, according to today’s filing.

Kravis and Roberts, who founded KKR in 1976 with Jerome Kohlberg, both hold stakes in the New York-based firm worth about $1.23 billion. Kravis and Roberts, who are cousins, haven’t sold any shares in KKR, according to the firm’s filings.

Apollo’s Black
Leon Black’s stock in Apollo Global Management LLC (APO) (APO), the New York-based buyout firm he founded in 1990, is worth about $1.24 billion at today’s share price.

The founders of the largest private-equity firms already are billionaires by virtue of profits from their funds known as carried interest, or carry.

Private-equity funds pool money from so-called limited partners such as pensions, endowments and sovereign wealth funds. The limited partners get 80 percent of the profits, with the remaining 20 percent going to the fund’s managers in the form of carry.

Carlyle returned a record $18.8 billion to its investors last year, more than three times its distribution in 2010, as it reaped profits from taking companies it owned public or selling them to other corporations. The three founders earned a combined $413 million in 2011, mainly from distributions.

To contact the reporters on this story: Jason Kelly in New York at jkelly14@bloomberg.net; Devin Banerjee in New York at dbanerjee2@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

Read the story on Businessweek.com:

Minority Investors Bring Partnership, Cash, Counsel and Growth

When looking for minority investors, company owners and their chief financial officers often fear investors will shake up the management structure and harm long-term client, employee or supplier relationships. Owners considering outside investors often wonder, “Will our business wind up in a chop-shop, or will our legacy live on?”

Chestnut Hill Partners Paul Schaye, Managing Director of Chestnut Hill Partners

The answer comes down to control. Minority investors will typically take 15% to 49% of an enterprise. Today, smaller transactions are on the upswing because of a surplus of investment capital, scarcity of larger opportunities and investor desire to broaden their portfolios.

In the first half of this year, minority private-equity investment accounted for more than 30% of all private equity deals, according to PitchBook Middle Market Report, an industry newsletter. That’s a 25% increase over each of the two prior years.

Minority investors can enable business owners to partially cash out and gain financial diversification. For companies, they can infuse some critical financial and intellectual capital.

But companies looking for a minority investor should consider:

“Prenuptial” Agreements

The relationship between a company and its minority investor is often like a marriage. Unlike a buyout where company owners cash out and leave, a minority investor will be locked arm-in-arm with the current ownership as the company moves forward. This relationship requires special consideration:

Time for “Dating”: When a company considers being bought out, the main objective is to maximize price. However, with a minority partner, both parties are “investing” in a long-term relationship. Before approaching minority investors, consider the optimal profile and ideal partner characteristics. Are you looking for investors familiar with your industry? Do you want investors with a hands-on or hands-off approach?

Ask Direct Questions: Too often transactions sour because straight-forward questions were not asked upfront. Questions like:

What is your vision and investment strategy? How does our company fit into it?
Who are your primary investors? What motivates their investment decisions?
What are your other investments right now? Where in your priority list would our company stand?
If we need more capital down the road, could more be made available for an unexpected opportunity?
Do they foresee any changes to our management team and will they insist on them?

Call References: Bringing on an investor-partner is like hiring an employee. Ask their references specific questions like:

Were there ever any difficult situations in working together? What is their personal demeanor? Did they rush to judgment or run over to help?
If you had trip covenants, how hard did the investor come to enforce them?
Were they heavy handed in pushing for management changes?
What business expertise do they have that will be “value added” to the transaction? How do they help with generating new business or finding key executives?
How did the investor create value that benefited all shareholders?

Preventing Future Problems

While the details of a transaction will vary, here are some general guidelines:

Matching Timelines: Investment capital is a kind of loan. Investors typically want their money back within 5 to 7 years with an internal rate of return above 15% a year. Take a careful and self-effacing look at your business plan and profit projections. Are you being overly optimistic to get their money? If it’s going to take longer to get the investor’s money back, can you legitimately show they will get an even better return if they wait?

Living with Covenants: The agreement will include triggers for the investor to take more control if the company does not meet defined expectations. Take the time to talk through possible scenarios and how those can be arbitrated rather that dictated.

Keeping the Minority Investor Informed: Part of the beauty of a minority investor is that there is less day-to-day activity with operations. Try to decide in advance what corporate decisions should be run past the investors as a matter of courtesy versus a requirement.

Personnel Changes: If, during the evaluation process, it becomes clear that certain personnel changes are needed, address the issue upfront and determine how much time should pass before there are major shifts in management.

In the current market, investors have a lot of capital and many are seeking minority opportunities. But at the end of the day, the question is not about the money, but how strategically the investor and management team work together to build the business.

Paul Schaye is a managing director of Chestnut Hill Partners, a New York-based boutique investment bank specializing in mergers and acquisitions.

Need Cash to Expand? Call Private-Equity Investors

by Galen Gruman

For many small companies outside the high-tech sector, the dot-com IPO boom has dashed hopes of going public.

“It’s the backhand of the dot-com craze: Investors have abandoned brick and mortar for brick and click,” says Paul L. Schaye, managing director of New York City’s Chestnut Hill Partners, a five-year-old M&A advisory firm that specializes in private-equity transactions for small and midsized companies.

“It has forced them to look for alternative exit strategies and seek new sources of expansion capital.”

One overlooked money spigot is the huge private-equity market, according to Schaye. More than 800 private-equity firms nationwide manage funds capitalized at $85 billion for institutional investors. In a recent interview, Schaye, whose firm has helped 40 small companies raise $600 million in private-equity capital, told FSB how such financing works.

How are private equity funds different from venture capital funds?

“They back mature businesses in sectors that VCs typically aren’t interested in — from restaurants to manufacturing — and provide very-late-stage expansion capital. Private-equity funds are also willing to dole out larger sums of capital than their counterparts. The sky is the limit.

In return, they seek annualized investment returns of about 25% to 30%.”

What kinds of businesses are private-equity investors most interested in?

“Those with unique products and services that have a competitive advantage in their industry. The investors look at companies that have a minimum of $15 million in annual revenues, a diversified customer base, and healthy profits.”

When should a CEO consider a private-equity buy-out over a merger or a total sale of his firm?

“It’s an option for anyone who doesn’t want to leave his legacy to a competitor. More often than not, it’s the retiring founder’s archrival who makes a bid to merge or buy the business. Most of my clients don’t want to open their kimonos to their enemies. They are also afraid that such a buyer will dismantle their business after the sale and destroy their legacy.”

How are your buyout deals different?

“We can arrange them in a variety of ways to suit the needs of the entrepreneur. If he wants to sell all of his holdings and retire, we find a private-equity firm willing to buy him outright and continue to run the company. If the CEO still wants to run the business and just get some cash off the table for retirement, we find a firm that will buy either a majority or minority equity stake and let him do just that.”

So how do you find the right private-equity firm?

“It’s tough to do this on your own because these funds are hard to find and each has a different set of investment criteria. The quickest route is to go to a firm like ours. We are called originators, because we are deal matchmakers. We have a database that monitors the portfolios of private-equity funds, so we know what types of deals they are looking for. That facilitates the process and enables us to complete deals in 90 days. Our fee is 1.5% of the amount of money raised.”

TPG Said to Sell Stake to GIC, Kuwait Investment Authority

April 1 (Bloomberg) — TPG Capital, the buyout firm started by David Bonderman and Jim Coulter, sold a minority stake to the Government of Singapore Investment Corp. and the Kuwait Investment Authority, according to a person briefed on the decision.

The firm, which is based in Fort Worth, Texas, told investors it plans to use proceeds from the sale to finance expansion of new and existing lines of business and into emerging markets, said the person, who declined to be identified because the matter is confidential. The proceeds will remain in the firm and won’t be used to buy the stakes of the founders.

TPG joins the largest private-equity firms, including Apollo Global Management LLC, Blackstone Group LP and the Carlyle Group, all of which have sold stakes in their management companies or a planning to. The firms are seeking capital to expand beyond buyouts as private-equity fundraising remains at an eight-year low, even after the financial market rally fueled a rebound in deals. Outside stakeholders also make it easier for the firms’ founders to cash out.

“Going down this path, you don’t have to open up the kimono,” said Paul Schaye, managing partner of New York-based Chestnut Hill Partners, which helps buyout firms evaluate investments. “They can stick to their knitting without a ticker symbol hanging over their head.”

Officials at TPG declined to comment. The Wall Street Journal reported the TPG sale earlier today.

$48 Billion Assets

Bonderman and Coulter, who worked together for Texas billionaire Robert Bass in the 1980s, left that organization to pursue a buyout of Continental Airlines Inc., a deal that led the formation of what was then known as Texas Pacific Group.

The firm now manages about $48 billion in assets and counts among its investments Energy Future Holdings Corp., the Texas power producer whose $43.2 billion leveraged buyout in 2007 was the largest in history.

More recently, TPG paid $3 billion to acquire J. Crew Group Inc., the retailer it first bought in 1997 and then took public in 2006. TPG, which houses most of its top executives in San Francisco, also owns broadcaster Univision Communications Inc. and casino giant Caesars Entertainment Corp.

The largest private-equity firms increasingly are looking beyond buyouts for fees and profits. At Blackstone, the fund of hedge funds business is now the firm’s largest by assets. KKR & Co. recently hired a partner to oversee real estate investments and plans to start its first long-short hedge fund later this year.

Looking Abroad

TPG is looking abroad and in emerging markets for deals, as well as seeking to build expertise in areas such as energy and real estate. Its ranks have swelled to 278 employees in 14 offices.

TPG chose to sell a stake as an alternative to raising money through the public markets, a path that Apollo and Blackstone pursued. Apollo completed its initial public offering this week, selling shares at the top end of the predicted range. The stock has dropped 5 percent since its debut.

Blackstone, which went public in 2007, is trading about 41 percent below its $31-a-share IPO price, even after gaining 46 percent in the past six months. Blackstone founders Stephen Schwarzman and Peter G. Peterson sold shares worth a combined $2.33 billion in the firm’s IPO. Schwarzman still owns about 231 million shares, valued at about $4.2 billion at the current stock price.

KKR, which gained a public listing in New York last year, in September registered the 70 percent interest in the firm that’s still privately held, to allow executives and employees to sell stakes. Henry Kravis and George Roberts, who created the company in 1976 with Jerome Kohlberg, still run the firm and have yet to sell any of their stock.

Carlyle, the Washington-based firm founded in 1987 by William Conway, David Rubenstein and Daniel D’Aniello, is weighing a public offering as soon as this year, people familiar with the firm’s plans have said.

—Editors: Christian Baumgaertel, Steven Crabill

Private Equity Shakeout Looms

As investors turn away from risky debt, conditions for leveraged buyouts get tougher; firms with the sharpest elbows will be left standing.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) — As the benign market conditions that have fueled the buyout boom come under pressure, the swelling ranks of private equity firms are likely to be winnowed, leaving only the strongest and sharpest players.

Private equity is facing headwinds from a variety of fronts. Investors are starting to shy away from risky debt, raising worries that some of the biggest deals will have trouble securing financing. Congress is muscling ahead with tax rules on private equity, and interest rates are ticking higher around the world.

But while market conditions are starting to wobble, activity has not waned. “The bubble isn’t bursting, a little air is just being taken out of an inflated balloon,” said Paul Schaye, founder of Chestnut Hill Partners, a boutique investment bank in New York that works with private equity firms.

Bell Canada said Saturday it was being bought by a group including two private equity firms for $33 billion in cash, which would make it the largest leveraged buyout ever. On Monday nursing home operator Manor Care (Charts) agreed to be taken private for $6.3 billion and there was market talk about a possible private equity bid for Virgin Media (Charts, Fortune 500), whose biggest shareholder is Richard Branson.

As market conditions shift, only the strongest players will survive, according to David Buik of London brokerage BGC Partners. “Credit will not be available at the indiscriminate levels it has been at, and business will focus on the big companies – the Blackstones, CVCs and Bains – companies of that nature,” he said.

Well-known firms Providence Equity Partners and Madison Dearborn Partners are part of the group that has reached a pact with Bell Canada, while powerful Washington buyout shop Carlyle Group is behind the Manor Care deal, and is reportedly the bidder for Virgin Media. The British cable company confirmed Monday that it’s received a takeover offer but declined to name the bidder.

Low interest rates and aggressive lending by banks and other lenders have fueled the surge in take-private deals, in which buyout firms borrow heavily to purchase companies. Private equity deals accounted for about 34 percent of the $1 trillion in U.S. merger activity in the first half, according to deal tracker Dealogic.

Favorable market conditions and hefty returns have attracted several new players into private equity. The number of active buyout firms in the world has climbed to 676, up 55 percent from five years ago, according to London-based research house Private Equity Intelligence.

But too many buyout shops have stretched themselves too far and taken on too much debt, said Rick Rickertsen, managing partner of Washington-based private equity firm Pine Creek Partners.

Now investors in risky debt are pushing back. In a sign of the winds of change in the lending environment, U.S. Foodservice pulled a bond sale last week, and Dollar General (Charts, Fortune 500) tweaked its offering to drop a sale of so-called toggle bonds – which let borrowers pay interest by issuing more bonds instead of cash.

Service Master (Charts), which originally was slated for an all-toggle bond sale, postponed its offering last week and has restructured the deal, according to a market source. The company, which runs lawn care services firm TruGreen and the Terminix pest-control business, has reduced the amount of toggle bonds in the sale and is now due to price its offering on Monday.

Some expect the turbulence in the credit market to be short lived. “There’s growing risk aversion and the market is going through a reality check. But there don’t seem to be any major cracks in the system and the markets aren’t dramatically different than they were a few weeks ago,” said Sabur Moini, head of credit strategy at investment management firm Payden & Rygel.

He said a confluence of factors have created choppiness in the market: many big deals are trying to get done ahead of the July 4 holiday, creating a flood of supply; subprime problems at Bear Stearns (Charts, Fortune 500) brought risk back into focus for many investors; and mixed economic data further fueled uncertainty.

Going forward, market watchers expect a decline in “covenant-lite deals” – which give borrowers more leeway when they run into trouble – and fewer toggle deals. That means only the companies capable of putting up more equity are likely to pull off big deals.

No wonder many industry watchers said they expect at least three or four big private equity names to be public this time next year. KKR announced its plans to go public late Tuesday, and Carlyle Group and Apollo Management have long been considered prime candidates for the public markets.

Going public gives private equity firms access to huge amounts of capital. It also increases the ability of these firms to attract and keep the best talent, according to Timothy Spangler, a partner at law firm Kaye Scholer’s London office.

Blackstone (up $0.45 to $29.72, Charts) made a splashy debut with a $4 billion initial public offering. Shares have dipped about 3 percent from their $31 a share offering price, but the stock has only been trading a little more than a week.

“There are concerns about whether the buyout market is going to turn, but the success of the Blackstone IPO is validation of the fact that there is still a tremendous amount of money to be made in the buyout space,” Spangler said.

When a Minority Investor Makes Sense

The role of the board in negotiating a minority investment.

By Paul L. Schaye

There are two extremes with outside money: Either it’s from a bank that has no involvement in business operations, or the cash comes from a majority investor or buyout that takes away control from the current ownership.

However, there is a powerful middle ground boards can consider: minority investors. This option can allow a company to maintain control while securing the cash to move the company forward.

Last year Forbes Inc. became its own business news story when, for the first time in its 90-year privately owned history, the company sold a significant stake to an outside private equity investor. As Steve Forbes said, the partnership gives us a chance to move faster than we would have been able to do otherwise, both in the United States and overseas.

What Drives the Decision

When the board is given the option to consider outside funding from a minority investor, five key factors can drive the decision:

Strong upside for expansion, liquidity, and diversification: shareholders want to retain control while taking the next step to grow the business. A minority investor allows the owners to maintain their vision and reap more rewards in the future.
Need for business counsel: management and board members sometimes must acknowledge that their skill sets could limit the growth of the business. While minority investors do not take over the business, they can provide expert counsel to fill voids.
Transformation in the marketplace requires expertise: with globalization and the emergence of new markets, expansion will require both money and expertise. A minority investor can provide the resources needed to build relationships internationally.
Making more aggressive business decisions: when current owners have the option of taking some of their money out and still maintaining control, they can embark on new ventures they would otherwise avoid.
Maintaining or attracting better talent: often a company wants to keep its star people or draw leaders in the industry who want to see a fresh dynamic in the company. That new energy can be infused by a minority investor.
Even if the minority investor is brought to the Board by management with a potential arrangement in place, due diligence by the board is still necessary. Although a minority investor would have less control than a majority investor, the board members must assure the shareholders that they are getting the best possible transaction. The transaction must address both the financial arrangement and cultures of the company and the investor.

Questions to the investor

When the board conducts an evaluation, here are some key questions the prospective minority investor must answer:

How does our company fit into your investment strategy?
What motivates your decisions?
Even with a minority stake, do you want to pursue changes in how the company is run?
If our company needs more capital down the road, would it be available?

Questions about the investor

The board should also ask the following questions when checking the minority investor’s references:

Were there any difficult situations in working together?
Did the investor’s attitude become less enthusiastic after the transaction was completed?
If you had tripped covenants, how strictly did the investor enforce them?
Was the investor heavy-handed in pushing for management changes?
How did the minority investor create value that benefited all shareholders?

A question for the board

Finally, the board must ask itself, are we ready to have someone else at the table with money at risk who will add another layer of accountability? The Answer will help determine whether the minority Investor is an asset or a liability.

In some cases, if management is pushing for a Minority investor transaction, what management sees As a benefit to the company could be seen as a Detriment by the board.

For example, if a minority investor is going to put in $150 million, that money could be as preferred equity or subordinate equity. While it might help grow the company in the near future, it could push back the shareholders in the capital structure.

All about the relationship

Ultimately, board members must decide what is in the long-term interest of the company and the Shareholders. It could be a matter of opinion how this new capital will be spent. For example, the Management team might want to use the money to pay down debt, while the shareholders would rather pay out dividends.

The good news is that today investors have a lot Of capital and are seeking out companies. Many are willing to take a smaller portion of businesses they participate in. Boards do not have to be as concerned about whether or not the money is out There; rather, the board can focus on whether the Potential transaction will lead to a mutually beneficial relationship.

The VIP Ticket to a Buyout Deal

Tom Taulli May 30, 2007

Fidelity Investments, the California Public Employees’ Retirement System, and other major institutional shareholders have resisted the leveraged buyouts (LBOs) of companies like Clear Channel (NYSE: CCU), OSI Restaurant Partners (NYSE: OSI), and Herbalife (NYSE: HLF). To compensate, private equity firms have begun offering “equity stubs,“allowing existing shareholders to participate in the post-LBO entity. What does this really mean for Foolish investors?

To better understand equity stubs, let’s study an example. In late April, KKR and Goldman Sachs’ (NYSE: GS) private equity arm agreed to shell out $8 billion to acquire Harman International Industries (NYSE: HAR). Current shareholders have the option of getting $120 in cash per share or equityin the new, private company holding the assets of Harman. As much as $1 billion will be available for the equity stub.

“An equity stub is really a win-win for private equity firms and current shareholders,” said Paul Schaye, a managing director at Chestnut Hill Partners, in a Fool interview. “The private equity firms do not have to invest as much, which is important as deals get much bigger. Current shareholders also get to keep a toe in the water and that can be very helpful in getting shareholder approval on a buyout deal.”

There’s even a tax benefit. Because of IRS Section 351, investors should get tax-free treatment when rolling over shares into the private entity.

What’s the catch? Despite the advantages, investors need to realize that equity stubs are fairly rare for public shareholders. If you’ve ever seen a shareholder agreement for an LBO, you’ll definitely see the complexities.

Keep in mind that private equity firms have the resources to hire top Wall Street law firms to draft airtight agreements. These often include board seats, veto rights, shareholder repurchase rights, liquidation preferences, restrictions on the transfer of shares, and so on.

“Investors need to realize that the private equity firms will have 100% control over the direction of the company,” said Julie Corelli, a partner in Pepper Hamilton, to me in an interview. “So you are relying on the expertise of the private equity firms, as well as the management team, on these deals.”

Because retail investors will be holding shares, the SEC will require the privately held company to continue reporting its 10-Qs, 10-Ks, and 8-Ks. There’s also a good chance that the shares won’t trade on an exchange like the Nasdaq or theNYSE. Instead, there will probably be illiquid marketplaces like the Pink Sheets or the Bulletin Board.

Investors also need to understand that private equity firms will probably spend two to five years working on a deal. This usually involves outsourcing operations, cutting jobs, changing management, and divesting non-core businesses, all of which lead to the “J-curve” effect.

Confused? The “J-curve” means that an LBO probably will have negative returns in the first couple of years because of the restructuring. But if the company does improve its operations, it could fetch a healthy valuation in a sale or an IPO. So if an LBO trades on the Pink Sheets, the stock price could be quite volatile.

The debt conundrum An LBO will also have a large amount of debt on its balance sheet, which means that an investment can actually increase in value even if there’s no growth. How? Suppose XYZ does an LBO for $1 billion and borrows $800 million for the purchase. This means the private equity investor will write a check for $200 million.

Let’s say that the company continues to generate its current cash flows of $200 million per year and pays down $400 million of the debt. Now shareholders own $600 million in equity. That’s a nice return on a $200 million investment.

But problems arise if XYZ cannot pay the debt. In this case, the equity-stub holders are last in line to get any proceeds if there’s a liquidation, which could ultimately result in a worthless investment.

To deal with this problem, private equity firms perform extensive due diligence and invest in a portfolio of companies. While some deals may go bad, others will have high returns.

With firms like Blackstone and Fortress Investment Group (NYSE: FIG) raking in big bucks, I think we’ll see more equity-stub deals. Public shareholders certainly don’t want to leave money on the table.

But as with any investment, you need to make sure you do your homework. Since this is new territory, it will take even more intensive analysis compared to picking a publicly traded stock. So for Foolish investors, it’s a good idea to be highly selective when dealing with equity stubs, if at all.

Further Foolishness:

Fool contributor Tom Taulli, author of The Complete M&A Handbook, does not own shares mentioned in this article. He is currently ranked 2,817 out of 29,306 in Motley Fool CAPS.

Borders’ Sickly Stock Price Shows – Why LBOs May Be Retailers’ Next Fad

By Katherine Hobson, Staff Reporter

What does a retailer like Borders have to do to catch a break on Wall Street these days?

Delivering good earnings growth won’t cut the mustard. Neither will steady revenue gains. Nor will setting up the all-important Internet unit. For all its efforts in those areas, Borders stock trades at about 15, just about 11 times next year’s earnings and 60% off its 1998 high. Borders threw up its hands last week, saying it hired Merrill Lynch to explore those ever-popular “strategic alternatives,” including a leveraged buyout. And if Borders goes the LBO route, it’s not likely to be alone among retailers, say observers. Cash Is King

“It’s highly possible,” says Amy Ryan, a retail analyst with Prudential Securities. “Some of these companies are at historically low levels, and they have the cash flow to support it.”

Wall Street hasn’t been the happiest place on earth for retailers lately. In part, it’s because investors have yanked their money from steady-as-she-goes sectors like banking and consumer products and poured it into the sexier tech and Internet companies. That’s left retailers feeling a lot like Bill Bradley, sitting on the sidelines watching John McCain reap all the media love.

Also weighing on retail stocks: Internet companies have been perceived as a massive threat to bricks-and-mortar players, particularly ones selling commodity products like books and CDs. “There’s a perception that online players are taking share,” says Derek Leckow, an analyst at Barrington Research who rates Borders a long-term buy, his second-highest rating. (His firm hasn’t done banking for Borders).

While Amazon.com is certainly becoming the bookseller of choice for a lot of people, Borders still managed to eke out $2.6 billion in sales last year, compared to Amazon’s $609 million. And this holiday season proved that even online, consumers like familiar brand names. Borders is still going to sell plenty of books and music. Investors are also scared that higher interest rates will eventually choke off consumer spending. And all this has combined to beat retailers to a pulp. The S&P Retail Index has fallen 18% so far this year. Even industry stars such as Wal-Mart have been hit. Battered stock makes for bad currency. It’s hard to make acquisitions and even harder to attract top executives without the lure of lucrative options.

The Power of Leverage

Under these circumstances, an LBO — that 1980s throwback — can sound pretty appealing. Freedom to spend for the long term. No more conference calls with analysts demanding guidance for the next quarter. No more watching the stock plummet if same-store sales miss by a percentage point. No more explaining your online strategy to some 12-year-old punk of an Internet analyst.

“You don’t have to open the kimono anymore,” says Paul Schaye, managing director at Chestnut Hill Partners, which advises LBO firms.

That’s why a lot of analysts expect Borders to seriously consider an LBO. “We think a leveraged recapitalization or buyout would be most likely,” wrote Danielle Fox, analyst with J.P. Morgan, in a research report Monday. (She rates Borders a market perform, and her firm hasn’t done recent underwriting for the company.) Borders wouldn’t comment further on its alternatives.

Moreover, others may follow Borders’ example. “We’re sure many out-of-favor retailers with good cash flows but not a lot of institutional interest in their stocks will be watching how Borders’ pursuit of strategic options unfolds, particularly Barnes & Noble,” wrote Fox. (A Barnes & Noble spokeswoman had no comment.) “There are a lot of undervalued, strong, sound companies out there,” says David Strasser, an analyst with Salomon Smith Barney. Some have already chosen the LBO route. TCBY Enterprises last month said it agreed to a $140 million buyout by Capricorn Investors III. Vestar Capital took apparel maker and retailer St. John’s Knits private last summer.

One money manager who wanted to remain anonymous says two of his holdings, Ames and ShopKo , could be LBOcandidates. “We didn’t buy these with the idea of them being takeouts, but at these levels, they make sense,” says the money manager. (Ames and ShopKo officials weren’t immediately available to comment.) Who’s in the Game

Most analysts declined to name other specific LBO candidates but said any beaten-up but profitable retailers with a solid business model, good cash flow and not a lot of debt may consider the option. Companies not relying on one season for all their sales are also more likely to consider an LBO, since their cash flow is spread out more evenly during the year. Management frustrated with languishing holdings may also be looking for an exit, so retailers with high insider ownership are more likely to choose an LBO.

The timing right now is also good for retail LBOs. “You never like to LBO into the Christmas season,” with the uncertainty surrounding all-important holiday sales, says Susan Jansen, an analyst in Lehman Brothers’ high-yield department.

To be sure, conditions aren’t entirely ideal for a LBO boom. The high-yield debt market — which is how LBOs are typically financed — isn’t as friendly these days. It will be more expensive to go private. “That’s a concern, but not a deal-stopper,” says Peter Wexler, an investment banker and managing director at Lehman Brothers. While the high-yield market isn’t great now, things change quickly in the debt world. And Wexler expects more deals to use bank debt or mezzanine financing, which is similar to high-yield debt but often involves equity. Still, things may not really pick up until the high-yield market improves.

There’s a big note of caution to all of this: Buying cheap stocks in the hopes that they’ll be bought out is never the safest investment strategy. And, as the raft of 1980s retail LBOs showed, it’s hard to take a company private, cut costs and still grow the business enough to please its new investors. But if Borders goes the LBO route and all ends well for it, current investors in some ailing but profitable retail stocks may finally get a tiny bit of relief this year. And the companies themselves get a much-needed respite from the Wall Street treadmill.

Neglected Firms Get Their Chance to Grow

LBO Firms Are Taking Companies Private And Breathing New Life Into Them
By Joan Harrison

Investor fixation on dot-coin and other hot technology stocks has left many solid small and mid-cap industrial companies out in the cold. With their stock prices trading at all-time lows and with no capital for acquisitions, many find themselves stagnating, even as their sales and earnings rise.

Faced with few, if any, options for growth, these companies increasingly are teaming up with buyout firms in what seem to be win-win deals for both parties. The LBO firms get strong companies at incredible prices while the once-public companies gain access to capital to expand their businesses, and to return, perhaps, to public ownership at some point.

“Wall Street is the herd mentality, and right now the herd is running to technology plays. That has abandoned the clomp-clomp, rusting companies out there,” says Paul Schaye, managing director of Chestnut Hill Partners, an advisory firm to buyout companies. The situation also creates new opportunities for both neglected companies and investment firms that can allow them to get back on the growth track, he adds.

Even though buyout firms are dabbling in Internet and related investments, traditionally, mid-size manufacturing companies have been the bread and butter of their investments. And backed by about $350 billion of private equity waiting to be invested, they’re having a field day snatching up manufacturing companies with pummeled stocks.

“A lot of LBO firms have started to look at e-commerce and Internet businesses, but as the funds have been set up, they are traditionalists in some respects because the metric for how e-commerce will pay off is still unproven,“says Schaye. “So, where can they put their money to work? in good, solid manufacturing companies.”

By taking these companies private, the LBO community provides them with the capital they need to grow and an exit strategy, such as selling to a large conglomerate or another strategic acquirer, or building up the company to a point where it can be public again, Schaye remarks. “One thing that a privatization allows you to do is to take a public company private, roll things into it, then take it public again.”

For shareholders that are frustrated with the stock price and managers who have their net worth tied up in these companies and see the value of their stock options evaporating, they get a nice premium out of the deal. “For us, we consider it to be good timing. It’s a fair price in light of the circumstances,” asserts Norm Alpert, managing director of Vestar Capital Partners a New York private equity firm.

Two or three years ago, valuations of small companies were very high, says Alpert, and firms like his saw no value in those companies. “Everybody in our business was taking medium-sized companies public, because that was the best value. Now the opposite is the case. These companies are very undervalued and so they make for a terrific buying opportunity, but it will not remain that way forever,” he cautions. The last four investments that Vestar has made, Alpert notes, have been either going-private deals or transactions created by the inability of a company to raise public money.

Schaye agrees that eventually there will be a creeping up of prices for these moderate-sized industrial concerns, once they start gaining the attention of Wall Street and investors, but he doesn’t think their stock prices will return to their pre e-commerce levels, or make them comparable to investment opportunities people are seeking in other stocks.

Alpert says that public-stock money-managers are now starting to reallocate some assets to smaller-cap companies, which will increase demand for those sorts of stocks, but will make them much less attractive to private investment firms.

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