Thursday, January 31, 2013

The Annual Meeting: Where You Sit is Where You Stand

The Annual Meeting: Where You Sit is Where You Stand

You have arrived as a money manager when your annual meeting or investor conference is no longer held in your conference room.  There are, however, two caveats to this rule.  If the meeting is held at the Holiday Inn Express conveniently located by the airport, I’m sorry to say you’re still toiling in the backwaters of the industry.  And if you book your annual meeting in Phoenix in the middle of July because you can get a good rate on the meeting space, you’re not going to have investors for very long.

However, if you hold the meeting for your investors in the finest hotel in a world capital or exclusive resort (in season), host the dinner at a five-star restaurant, and hire a public intellectual or famous ex-politician to speak, you’ve made it.  You’ve gotten to the point where you can spend hundreds of thousand of dollars of your investors money on telling your investors as little as possible about how their investment is doing.

Org Structure #3 (2009)

As an institutional investor, I’ve found these meetings to be the biggest waste of time and the most useful opportunity all rolled into one.  It’s a misuse of time because a well-constructed annual meeting sticks to a carefully rehearsed script.  Every presenter, whether he’s the CEO of a portfolio company or a hedge fund manager, has been coached to only reveal information that has already been communicated in the firm’s sanitized newsletter and financial results.  I suppose I might pick up a useful clue from the presenter’s body language, except that media experts have sculpted the performance. It doesn’t help that I’m drawing all over the meeting materials. 

If the performances are canned, perhaps the obligatory Q&A will unearth some nugget.  The annual meeting isn’t designed to allow this to happen.  If your investment performance is good, half the audience will prefer to retire to the salon for coffee and pastries, and the other half will want to know when you’re going to raise your next fund, and if they can get an allocation.  On the other hand, if your performance is bad, you’ll construct the conference so that the time for questions is crowded out by those banal presentations.  Of course, if you’re truly desperate to avoid a nasty interrogation, you can always schedule the annual meeting in Phoenix in July.

 As a money manager, your biggest worries are those breaks in the action when your investors and your team mingle over cucumber sandwiches or bruschetta stuffed mushrooms.  Those informal gatherings were the most useful due diligence opportunity when I trekked to annual meetings.  My goal was to get as far away from the ears of the bosses as possible and engage a portfolio company CFO or obscure portfolio manager in conversation.  This was never an easy exercise, because those folks had been warned about guys like me.

After many hours of speakers and PowerPoints, the next item on the schedule is the gala dinner.  You’d think that an endless supply of fine wines would loosen tongues and provide the intrepid investor with unscripted insights.  If the dinner is held in a museum or old home, the docent’s tour is the highlight of the evening, followed on occasion by a thoughtful speaker.  And those speakers had better talk about something other than investing, or it's better to head back to the hotel early.

Investors aren’t allowed to sit just anywhere at one of these meals.  However, a large investor, or one considering becoming a large investor, needn’t consult the seating plan.  They’re going to be sitting at the main table with you, your most senior colleagues, and the guest speaker.  When I represented a large investor, I automatically sat at that table.   If we invested enough money, I was seated at the right hand of the money manager himself.  If we failed to commit to the manager’s next fund, I was assigned to a table next to the kitchen door.

If you’re planning one of these dinners, you might be a bit more astute about the seating arrangements.  The table by the kitchen door was often the most useful seat in the house, because as an investor, I usually learned something useful from my dinner companions as the doors flapped open and closed.

As you can see, the annual meeting is largely a waste.  However, investors don’t mind being wined and dined or spending an extra day seeing the sights or skiing the slopes.  There is one more opportunity to get something useful out of this extravaganza.  It’s the ride to the airport.  An investor should, if possible, share a taxi with one of the presenters at the annual meeting.  You’d be amazed what you can learn while stuck in traffic on the BQE. 

Wednesday, January 30, 2013

My Own Spin Through the Revolving Door

My Own Spin Through the Revolving Door

Mary Jo White has been nominated to head the Securities and Exchange Commission.  Ms. White, a former prosecutor, is a partner at Debevoise & Plimpton. In her private practice she represented many of the institutions that she will now regulate.  Understandably, the press has raised lots of questions about her ability to switch sides. They’ve also examined the impact of her appointment on the SEC because she will have to recuse herself from a variety of matters that come before the agency.  These are legitimate issues and are ably explored by Andrew Ross Sorkin in the New York Times (“Nominee for ‘Sheriff’ Has Worn Banks’ Hat”).[1]  However, I have some sympathy for Ms. White, recognizing completely that she will be navigating a series of real and apparent conflicts of interest.  I have some experience with this issue on the much smaller stage that is North Carolina.

As I’ve repeatedly noted in my posts, I was Chief Investment Officer for the State of North Carolina from 2001 to 2004.  However, I had a second stint in 2005 advising the State Treasurer that garnered attention from the press and editorialists.  The coverage wasn’t flattering.  The facts looked bad, and the press jumped on them. 
Org Structure #2 (2009)

After I left my state post in 2004, I started a consulting practice advising money managers on organizational and investment issues.  I set two limitations on the business: first, I would not market or solicit business for any client; and, second, I would disclose to the State Treasurer any prospective client that also worked for the State, and he could veto the prospective relationship.  Among my small group of clients, two turned out to be managers for the pension plan.  As a result, I quickly went through the revolving door.  I sat on investment committees, advised on succession plans, and had nothing to do with the manager’s relationship with North Carolina

None of this would have mattered, but in early 2005 the Treasurer asked me to temporarily come back to help oversee the pension plan.  I terminated all my consulting relationships and went back through the revolving door.  Somewhere along the way, the local newspaper got wind of this story, and by the summer I was reading a critical portrayal of my behavior.  I tried to explain to reporters that my brief sojourn into consulting had no impact on my ability to advise the State Treasurer.  However, I can’t blame the press or the public for their reaction.

However, there was one fact missing from this story, and that was the reason for my return to the pension plan.  My successor had fallen seriously ill immediately after taking the job in late 2004.  The State Treasurer needed someone to help oversee the plan, and work with the new CIO as she received medical treatment.  As a new employee, she didn’t have much sick leave or vacation, so we needed to make sure she could remain involved and work as much as possible over the many months that she received treatment.

I don’t have any doubt about my conduct over the course of my temporary assignment.  I was a zealous advocate for the pension plan and its beneficiaries, notwithstanding the appearances, which brings me back to Ms. White.  Almost anyone who dedicates a part of their career to public service is going to accumulate a series of real and potential conflicts.  In Ms. White’s case, the list is pretty long.  However, Ms. White’s public and private sector experiences are unusually valuable to us if she applies them to the public good.  We have to hope her heart is in the right place.


Tuesday, January 29, 2013

There is No Closing Statement in Private Equity

There is No Closing Statement in Private Equity

If you’ve ever bought a home, you’ve probably received a HUD-1 form at the closing.  The form has two columns of tiny print that detail all of the buyer’s and seller’s fees and expenses in the transaction.  Unfortunately, private equity firms don’t present their investors with itemized statements.  It’s nearly impossible to account for all of the fees because some of them are deducted at the fund level and others are deducted at the company level.  The success of the private equity model depends on the lack of accounting of the fees incurred.  If investors realized that 40% of their equity was paid out in fees in a successful fund, and even 25% in an unsuccessful one, they’d never show up for a closing.

Today we return one more time to the Bain Capital and the Bright Horizon deal.
A few readers have asked me to provide greater detail about my statement yesterday that the banks earned millions in fees for financing the Bright Horizon deal over the past five years.  I’m going to do the best I can to produce a HUD-1 statement for this transaction. 

Org Structure #1 (2008)

Before we dig into the figures, I want to be clear that there’s nothing illegal about the fees that were charged or anything wrong about how Bright Horizon operates as a business.  As far as I can tell, the company has an experienced management and has drawn knowledgeable people to its board.  Bright Horizon is simply an example of how private equity and the banks can sink their teeth into a company and extract fees.  Bright Horizon’s proxy statement when it went private and the recent prospectus are our best sources of data.  However, they are far from comprehensive or transparent when it comes to fees.

We start with the advisory fee paid to bankers by Bright Horizon when the company went public.  Goldman Sachs received about $13.3 million or 1.2% of the sale’s price.  However, because of all the entanglements between Goldman, the company, and Bain, a second banker, EverCore, was hired to also advise the company’s board.  EverCore received at least $3 million, and the board had discretion to pay them another $5 million if they so desired.  We don’t know if EverCore got its bonus.  Presumably, an investment bank represented Bain and its investors, and its fees of perhaps 1% or about  $7 million were charged to Bain Capital Partners X (the fund).  In summary, the advisory fees on the transaction to take Bright Horizon private might be anywhere between $21 million and $28 million.  In exchange for these fees, the parties received guidance on the appropriate price for and structure of the deal.

Next, the deal required debt financing, and, once again, Goldman Sachs stepped up to the plate.  In fact, two affiliates of Goldman Sachs provided all the borrowing.  GS Credit did the senior lending, and GS Mezzanine V did the riskier bits of the subordinated debt.  The two Goldman entities charged a variety of different fees, including a facility fee, an annual administrative fee, and an unused commitment fee.  The components aren’t itemized, but the total came to $27.1 million plus another $2.3 million to finance an acquisition in 2012.  Lawyers, accountants, and printers earned another $2.4 million.  These fees are designed to pay the bank for analyzing, structuring, and administering the loans.

Finally, there’s $15 million in underwriting expenses that will be paid to Goldman and the other underwriters for the IPO.  These fees compensate the banks for underwriting the IPO, paying commissions to brokers, and cover a variety of other expenses.  When we add the three components, investors have incurred between $68 million and $75 million in fees to bankers, lawyers, and accountants.

As I noted yesterday, Bain has earned two fees: one from its investors and the other for advising Bright Horizon.  These two fees come to about $67 million.  This means that Bain’s investors have incurred about $125 million so far on their $640 million investment, or roughly 20% of their capital.  I’m sure my numbers are off a bit since I had to make a bunch of guesses.  But I also know there were a variety of due diligence expenses and other advisory services that I haven’t unearthed.  The table below is a summary of all the estimated fees and expenses associated with Bright Horizon going private in 2008 and public again last week.

Believe it or not, investors aren’t done paying fees, because their profit in Bright Horizon is still unrealized.  Bain will continue to charge them a management fee, and the banks will charge a hefty fee to sell the shares at some point.  Not all deals are as successful as Bright Horizon, and thus the burden of fees, both seen and unseen, sink most private equity funds.  As long as investors tolerate this investment model, private equity partners and investment bankers will continue to live large on their fees.

Monday, January 28, 2013

Shuffling Paper to Generate Fees: The Case of Bain and Bright Horizon

Shuffling Paper to Generate Fees: The Case of Bain and Bright Horizon

After I posted about Bright Horizon’s recent IPO, I began to realize that this deal is one of the premier cases of paper shuffling.  Bain is going to receive kudos for doubling its investors’ money, but when you step back from this deal, it’s apparent that the transaction was a net drain on investors.

Let’s begin with a bit of background.  This past Friday, Bright Horizons completed its initial public offering.  Governor Romney’s former firm, Bain Capital, controls the day care company.  The stock was offered at $22 and quickly climbed to $28.32.   Over the weekend, I wrote a brief note about Bain’s $7.5 million payout based upon the termination of its consulting contract with the company.  In total, Bain has received about $18 million in the past several years for advising the company.  I also noted the curious use of proceeds from the IPO.  The lead underwriter, Goldman Sachs, is also one of the company’s main creditors.  In fact, the vast majority of the proceeds from the IPO will be used to retire debt held by Goldman.

Music Matters (2009)

It turns out that at the IPO price, Bright Horizons’ market capitalization is about the same level as when it went private in May 2008.  Two things changed in the meantime.  First, the public shareholders were paid about $1.3 billion, and Bain’s investors became owners by investing $640 million.  Second, to make up the difference Bright Horizon borrowed $650 million because Bain didn’t want to put in as much equity as the public shareholders were paid.  The company has borrowed more money in the intervening years for acquisitions and expansion, and debt stood at over $900 million before the recent IPO.

With the completion of the IPO, Bain’s investors now have a stake worth just over $1 billion, so there’s a tidy profit.  There’s just one small catch.  Bain didn’t sell any stock, and its investors still own 51.6 million shares.  For the next six months, Bain has agreed not to sell any shares.  As a result, the entire profit on this deal exists only on paper.  Institutional investors eagerly purchased 10.1 million shares in the IPO and are bidding the shares higher.  However, before Bain’s investors can actually enjoy their profit, Bain and Bright Horizons will have to find investors willing to purchase the remaining stake some time in the next year or so.

Now imagine there’d been no buyout in the first place.  Bright Horizon’s stock would have swooned in 2009 and then recovered along with the rest of the market.  Since Bright Horizon had very little debt and a steady business, the market’s decline wouldn’t have posed any threat to the company’s well-being.  Bain would, of course, argue that they sheltered Bright Horizon from the bear market.  According to Bain’s logic, Bright Horizon, as a private company, didn’t have to respond to skittish public investors, and could go about building its business under Bain’s guidance. 

This rationale for private equity doesn’t amount to a very compelling case.  The stock market consists of thousands of companies that did just fine as public companies during the recession and are thriving today.  Bright Horizon would most certainly have been one of them.  The price of Bain’s ownership was huge since Bright Horizon was saddled with a pile of debt, interest payments, and all sorts of fees.

Who were the winners and losers?  The biggest losers were the old public shareholders.  They would have been better off voting against the Bain takeover and keeping the company.  They owned a solid company and gavermir it away far too cheaply.  Of course, we have to remember that the hedge funds and mutual funds that owned Bright Horizon couldn’t resist a short-term profit.  Bright Horizon’s management couldn’t refuse Bain’s enticement either.

The Bain investors will do okay.  At the moment, they’ve probably doubled their money before fees, which would equate to about a 16% annual return.  By the time all the fees and expenses are paid, the net return might be anywhere from 11% to 14% per year, depending on whether the fund earns carried interest.

Of course, Bain has done well earning its annual management fee on the $640 million of equity.  If the fee is 1.5%, Bain has made about $40 million to this point.  Of course, there’s also the $2.5 million per year in consulting fees from Bright Horizon, which as I’ve noted amounts to $18 million, including the termination charge.  Bain may share some of that largesse with their investors.  On top of all of that, Bain may also garner carried interest if the overall fund does well. 

The investment banks like Goldman have made tens of million of dollars.  They got their first payday advising Bain and Bright Horizon on the original deal.  The banks then earned another series of fees for arranging the debt financing, and adjusting the debt package over the last several years.  And now there’s another bonanza, as the banks get paid for underwriting the IPO.

Bright Horizon continues its steady growth just as it did when Bain took it public the first time in 1997.  The only thing that has changed is that Bain and Wall Street have done a bunch of financial engineering that rejiggered the equity and debt in the company in order to produce multiple opportunities to generate fees for themselves.