Friday, January 11, 2013

The Most Favored Passenger: Private Equity

The Most Favored Passenger: Private Equity

What if you read in a travel brochure about a lovely cruise ship filled with all kinds of wonderful amenities that also had special compensation arrangement with the captain and certain officers that rewards them for getting the privileged few off the boat first.  Although you’d be tempted by the luxuries to be found on the ship, you’d probably decide to sail on another boat, one that treated the passengers equally.

Norwegian Cruise Line (NCL) is going public by selling $370 million in stock.  The company is owned by Genting Hong Kong, a cruise ship and resort company, and funds controlled by Apollo Global Management and TPG.  Apollo acquired 50% of the company in early 2008 for $1 billion and sold one-quarter of its interest to TPG for $250 million.  The proceeds of the IPO are being used to pay down debt.  The company is the process of acquiring several new ships and appears to have reasonable prospects for growth despite considerable financial leverage.
Meeting With the Boss (1997)

Given the capital intense nature of the cruise business, the private equity owners haven’t been able to get any of their cash out of the deal yet.  True, Apollo sold down their initial investment, but Apollo had probably decided to share some of the investment with TPG from the onset.  Given Genting HK’s 50% stake and operating expertise, Apollo hasn’t extracted any consulting fees from NCL.  All I can find in NCL’s securities filings are a marketing agreement between Caesar’s World and NCL, and a contract to use the Sabre reservations system.  Apollo and TPG control Caesar’s World, and TPG controls Sabre.  The documents also shows that Apollo’s broker dealer will act as one of the underwriters, and will also benefit when some of the debt is redeemed.  These financial relationships are modest.  As per usual, Apollo will maintain strict control of the company after the public offering, and retain control over NCL’s major financial decisions. 

It’s been five years since Apollo put its $750 million to work in the business, and they’re probably getting a bit antsy about realizing a return on their investment.  Obviously, Apollo wants the management to work hard in building the company, so the securities filings contain the usual laundry list of financial incentives and perks, including some 15 million shares set aside for stock-related incentives. 

There’s one interesting wrinkle in the compensation arrangement that I’m calling,  “most favored passenger arrangement” or “MFPA.”  It finally surfaces 97 pages into the registration statement with the SEC.  Back in 2009, before NCL decided to go public, the board of directors approved a profit sharing plan for senior management that included an incentive called performance based units (PBUs).  The value of the performance-based units depends on the amount of capital Apollo receives back on its investment.  If Apollo receives recoups its invest 50% of the PBUs will vest, with the remaining units vesting if Apollo receives two times its capital.  If Apollo receives more than 2.25 times its capital, the CEO will get another 100,000 PBUs.  And then, just to make sure he’d gotten the message he was granted 15,000 more units in September of last year.  As long as NCL was a private company, there wasn’t much wrong with this arrangement.  If a private yacht owners wants to have special compensation arrangement with the captain and crew, that’s fine.

However, now that the company is going public, the MFPA is wholly inappropriate. The management of a public company is supposed to act in the best interest of all the company’s shareholders, not just the first class passengers.  The PBUs provide management with a multi-million reason to help Apollo cash out whether by way of a cash dividend or distribution, or proceeds from the sale of part of the company.  In a nutshell, management has a financial incentive to meet the short-term objectives of Apollo at the expense of everyone else.

Apollo already has a first class cabin on this ship, and gets to dine at the captain’s table every night.  They shouldn’t be paying the captain to get them off the ship before the common passengers.

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