Wiley Private Equity, Transforming Public Stock To Create Value

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or purposes of this book the term private equity refers to the common stock of a corporation where that common stock is held by a relatively few investors and is not traded on any of the conventional stock markets. Normally the senior managers of the firm hold a significant percentage of the firm's stock, and we will assume that is the situation in all the cases discussed in this book. F

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equity Transforming Public Stock to Create Value HAROLD BIERMAN, JR. John Wiley & Sons, Inc.
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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States, With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and fi- nancial instrument analysis, as well as much more, For a list of available titles, please visit our web site at www.Wiley Finance.com,
equity Transforming Public Stock to Create Value HAROLD BIERMAN, JR. John Wiley & Sons, Inc.
Copyright © 2003 by Harold Bierman, Jr. All rights reserved. Published by John Wiley & Sons. Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a. retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act. without either the prior written permission of the Publisher, or authorization through payment or the appropriate per-copy fee to the Copyright Clearance Center. Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, N] 07030, 201-748-6011, fax 201-748-6008. e-mail: permcoordinator@wiley.coni. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate, Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800- 762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Bierman, Harold. Private equity : transforming public stock to create value / Harold Bierman, jr. p. cm. ISBN 0-471-3.9292-8 (cloth : alk. paper) 1. Corporations—Valuation. 2. Private equity. 3. Going private (Securities) 4. Corporations....Finance. 5. Leveraged buyouts. 6. Venture capital. I. Title. HG4028.V3 B445 2003 338.6'041--dc21 2002013636 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1
contents Preface ix Acknowledgments xi CHAPTER 1 The Many Virtues of Private Equity 1 CHAPTER 2 Valuing the Target Firm 7 CHAPTER 3 Structuring and Selling the Deal 25 CHAPTER 4 A Changed Dividend Policy 35 CHAPTER 5 A Changed Capital Structure 47 CHAPTER 6 Merchant Banking 67 CHAPTER 7 Operations: The Other Factor 79 CHAPTER 8 The Many Virtues of Going Public 85 CHAPTER 9 A Partial LBO: Almost Private Equity 91 CHAPTER 10 Metromedia (1984) 101 vii
vii ______________________________________________________ CONTENTS CHAPTER 11 LBO of RJR Nabisco (1988) 107 CHAPTER 12 Marietta Corporation (1994-1996) 115 CHAPTER 13 The Managerial Buyout of United States Can Company (2000) 127 CHAPTER 14 Phillips Petroleum, Mesa, and Icahn (1984-1985) 137 CHAPTER 15 Owens-Corning Fiberglas Corporation (1986) 143 Solutions 155 References 185 Index 189
P ublic corporations have many different types of investors, each type having a different financial objective. The primary objective of private equity is that the stockholders are likely to have similar financial objectives and it is much easier for the corporation's financial strategies to be consistent with these objectives. Private equity frequently is associated with a leveraged buyout. The equity ownership of a public corporation is changed to equity that is not traded in a public market. There are significant financial advantages and there are also operational advantages. For example, management frequently becomes an owner of a significant amount of the equity and thus the interests of management and the owners become more convergent. Most importantly, the common stock- holders can directly and effectively affect the corporate financial de- cisions. The concepts of this book are important to investors interested in increasing their rates of return on their investments, without in- creasing their risk and to management interested in supplementing their wages with a significant share of the firm's profitability. Harold Bierman, Jr. Cornell University Ithaca, NY ix
Bill privateJim Hauslein, and Hallme. practitioners of the art of Kidd, equity, helped educate Wendel, Sy Smidt and Jerry Hass, co-authors in other books, developed many of the ideas contained in this book. I thank Diane Sherman for her typing efforts through many drafts of this book. xi
The Many Virtues of Private Equity For purposes of thisa book the term private equity refers to the common stock of corporation where that common stock is held by a relatively few investors and is not traded on any of the conventional stock markets. Normally the senior managers of the firm hold a significant percentage of the firm's stock, and we will assume that is the situation in all the cases discussed in this book. In practice, the term private equity is used in several different ways. There are private equity investment firms that direct their clients' funds into mutual funds or to other money managers. There are even private equity funds that invest directly into pub- licly owned corporations, usually concentrating the investments into a few corporations. Venture capital is a form of private equity. In this book the use of the term will be restricted to the investment in the equity of corpora- tions that are, or will soon be, not publicly owned. An exception is the case of a partial leveraged buyout (LBO). This is almost private equity but the firm is still publicly traded. Megginson, Nash, and vanRadenborgh (1996) offer a review of the history of privatization. Jensen (1993) covers the general issue of corporate control. Kleiman (1988) studied and reports the gains from LBO types of transactions. What are the advantages of private equity? 1
2 __________________________________________________ PRIVATE EQUITY SIMPLICITY_______________________________ Because there are no public equity investors the private equity firm's financial reporting requirements to all the relevant governmental en- tities are reduced. This simplifies management's responsibilities and results in transaction cost savings for the firm. With private equity there are no requirements that management keep Wall Street informed of the firm's expected earnings and then provide an explanation of the actual earnings and why they differ from the expected earnings. Decisions are not affected by short term earnings and the anticipated stock market's reactions to the earn- ings; thus the firm's decision making may be improved. The firm's board of directors can be chosen for effectiveness rather than appearances or public relations. ALIGNMENT OF MANAGEMENT AND OWNERSHIP With the average publicly held firm the interests of management and the firm's ownership are not always perfectly aligned. An entire area of study called agency theory has been created with the objectives of studying and reducing the conflicts between a firm's management and its owners. The classic papers on agency theory are Jensen and Mecking (1976) and Jensen (1986). We assume the common stock of the private equity firm dis- cussed in this book is to a significant extent owned by management. Management has an incentive to act in a manner consistent with maximizing the well-being of the equity owners. DIVIDEND POLICY OF A PRIVATE EQUITY FIRM The owners of a private equity firm tend to be paid for their services as members of management, consultants, or members of the firm's board of directors. They also hope for a value accretion to their stock holdings. If the owners are also employees of the firm, the incomes earned for services will be taxed at ordinary income tax rates. But there is
The Many Virtues of Private Equity 3 only one level of tax since the corporation gets a tax deduction for the amounts paid for service. This is the first tax advantage. The gain from the value accretion of the stock will be taxed in the future at a capital gains rate when the gain is realized for tax purposes. Thus there are two tax advantages from value accretion and the use of private equity; one is tax deferral and the second is the lower capital gains tax rate compared to the tax rate on ordi- nary income. The private equity firm has little or no incentive to pay cash div- idends on the common stock. The investors would rather be paid as employees or have their equity investment gains be converted into capital gains and have these gains taxed at the lower capital gains tax rate in the future. CAPITAL STRUCTURE _____________________ The normal public corporation has managers and owners. While the managers may also be stockholders, the total value of their stock in- vestment in the corporation tends to be much less than the present value of their salaries and bonuses. The senior managers of public corporations have a significant incentive to act in such a way as to not jeopardize the stream of salaries that will be earned if the man- agers are not dislodged from their jobs. With a private equity firm the relative values of salaries and ownership are changed. Now the owners have an incentive to sub- stitute debt for equity both to gain (or maintain) control and to add value. The use of debt becomes a much more important tool for adding value with a private equity firm than with a public firm. VENTURE CAPITAL _______________________ This is not a book on venture capital though many of the conclu- sions of this book apply equally to venture capital activities, since venture capital is a form of private equity. It is assumed in this book that the firm being taken private has a track record and its value can be estimated based on objective
4 __________________________________________________ PRIVATE EQUITY financial measures of the results of operations. Frequently, a ven- ture capitalist is evaluating the story told by an entrepreneur. While there may be projected financial results, they frequently are not backed up by actual results. The valuation of such a firm is more an art than a science. MBOs_______________________________ DeAngelo and DeAngelo (1987) review the early history of manage- rial buyouts (MBOs). From 1973-1982 they identify 64 buyout proposals made by managers of New York and American Stock Ex- change listed firms. They identify eight factors that are important in the decision to effect a management buyout. These are: 1. Potential improvement in managerial incentives 2. Save costs of disseminating information to stockholders 3. Company secrets are better protected 4. Tax savings of interest tax shields and other tax savings 5. Avoidance of hostile takeovers 6. Difficulty to raise capital 7. Illiquid stock (leading to greater difficulty attracting managers) 8. Disagreements among stockholders (because of illiquid in vestments) Diamond (1985) put together a team of practitioners of the LBO art to construct a book that explores the legal, tax, account- ing, operational, and financial considerations of an LBO transac- tion. It is a handy reference book regarding the practical aspects of the LBO deal. THE J.P. MORGAN CHASE FUND ____________ In February 2001 J.P. Morgan Chase announced that its J.P. Mor- gan Partners unit was raising $13 billion for a private equity fund (see the Wall Street Journal of February 6, 2001). While $8 billion was to be the bank's own funds, $5 billion was to be raised from