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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.

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