Category Archives: Private equity

raising capital… (II): venture capital

December 8, 2011 By in Industry Analysis, Investment firms, Private equity Tags: , , , , , Leave a comment

Although I’ve observed the venture capital industry at work for most of my career and have invested in lots of companies making their first move away from private equity financing, I’ve never actually worked in the venture capital industry.  So this post will be brief.

venture capital

Venture capital is a form of private equity financing.  VCs support early-stage companies that they think have substantial growth potential, but which are too small, and too risky, to get conventional bank financing.  Their small size and immature businesses also rule out the possibility of a conventional IPO.  Again, the risk it too high.  In addition, if the company wants to raise, say, $10 million, fee income would at most be $1 million–too little to interest most reputable investment banks.  (The only time I can recall seeing brokerage houses reaching down into venture capital territory in a big way was in the latter days of the internet bubble in 1998-99–and we all know how that turned out.)

In the US, venture capital is typically associated with Silicon Valley in California.  In their search for start-ups with explosive growth potential, they have acquired deep knowledge of technology-related industries (where that potential resides) and of skilled entrepreneurs who can turn that potential into a fast-growing firm.  So they feel comfortable there.

VC activity isn’t always in the tech world.  But you won’t see venture capitalists backing firms in, say, furniture retailing, where it’s difficult to see earning several times your initial investment in a reasonable period of time.

funding rounds

Venture capital financing isn’t a one-shot deal.  It typically occurs in a number of stages, or “rounds,”  where a company gets more money, so it can move to a higher level of development.

Stages might correspond to company needs for:

–seed money, where the VC firm supplements funds committed by the entrepreneurs themselves, or their friends and family.

–product development

–manufacturing and marketing

–working capital

–expansion.

If everything is going smoothly, each round of funding will be at a higher stock price.  The funding may be done through convertible securities rather than straight equity.  This gives the venture capitalist some income while he waits for the company to mature.  Convertibles can also give the VC a stronger claim on company assets than ordinary equity holders in the case that things go badly.

exit strategy

The venture capitalist has traditionally expected to cash out of the company he has invested in thorough a conventional IPO–at which time he will have the option of selling some or all of his shares.  In today’s world, however, it’s equally possible that a private sale to a much larger firm in the same industry will happen instead.

pluses

Venture capitalists are willing to invest in companies at a much earlier stage of development than others.

VCs also typically provide organizational help, management and technical expertise that may be sorely needed by a fledgling company but which may not be available any other way.

minuses

If you don’t have stellar growth potential, VCs probably aren’t interested.  Simply getting their money back, with interest, isn’t enough.

At some point, usually very early on, part of the price for additional financing will be that the entrepreneurs cede control of the business to the VCs.  In most cases, this is probably a good thing, since risk-taking visionaries don’t often make great managers (look at the early Steve Jobs).

That’s it for today.  More tomorrow.

what is a roll-up?

September 27, 2011 By in economics, hedge funds, Private equity Tags: , , , , , , Leave a comment

definition

Roll-up is the name commonly used to describe the process of buying up and merging small participants in a highly fragmented industry.

characteristics

The acquirer is most often a financial buyer, typically a private equity firm, rather than the operating management of a company in the industry in question.

The companies acquired are typically relatively small–and of sub-optimal size, in economic terms.

They are most often privately held, and owned by individuals who don’t have a sophisticated awareness of the value of their firms–either as stand-alone entities or as part of a larger combination.  As a result, purchase prices can be small single-digit multiples of yearly sales.

examples

Industries in the US that have been rolled-up include:  radio stations, auto dealerships, funeral homes, independent radio and TV stations, billboards, taxi walkie-talkie radio systems (i.e., Nextel).

why do this?

The two basic aims of a roll-up are to achieve large size relative to other competitors in the industry, and to grow to economically optimal size in absolute terms.  Doing so allows the roll-up to:

–lower administrative overheads,

–cut capital spending by sharing plant and equipment,

–negotiate lower prices and/or better payment terms with suppliers,

–offer a wider array of services to customers,

–create and market a brand name–with the increase in unit profits that this will bring,

–have units mutually support each others’ sales efforts,

–focus competitive activity at firms outside the roll-up.

profit sources

I’ve already mentioned that:

–the target companies can usually be bought very cheaply, and

–economies of scale and simple improvements in general management can boost profitability a lot.

In addition:

–better access to credit can reduce borrowing costs,

–the target firms can be more highly leveraged financially (= more debt) as part of a larger unit, and

–the rolled-up company will likely be IPOed, allowing the private equity company to cash out at least several times its purchase price.

why an IPO?

Two reasons, other than extra profits  …one good reason, one bad:

–the private equity company is likely funding the roll-up with money from institutions or high net worth individuals.  These investors will expect their capital + profits to be returned after, say, five years.

–firms that carry out roll-ups typically have little hands-on experience running businesses, and not much detailed knowledge of the rolled-up industry.  They’re good at basic general management and at creating a capital structure with a lot of debt in it to boost returns on equity.  I think they realize they’re better off exiting the roll-up before some crucial issue arises that requires industry knowledge to solve.

 

question from a reader: the merger of Alpha Natural Resources and Massey Energy

September 26, 2011 By in Current Market Thoughts, Energy, Industry Analysis, Private equity, Stock ideas, Uncategorized Tags: , , , , , , , , , , , Leave a comment

the question
24.149.88.16

I listened to a debate recently on the merits of small commodity companies
acquiring larger ones. The company in question was Alpha Natural Resources purchasing much larger Massie Coal.
Can a smaller commodity company like ANR actually make the investment finacially feasible when they bought a company that was already foundering?
I enjoy your blog greatly!

my thoughts

At the outset, you should be clear that, although I’ve done extensive research in natural resources over the years, I don’t know much about the coal industry. So personally I don’t know enough to want to buy ANR stock.  But I can see several issues a buyer might want to explore.

background

ANR, which has private equity roots, was formed in 2002 to buy assets from Pittston Coal and has since growth by acquisition.  Its largest purchase to date is Massey Coal, a 2000 spinoff from Fluor.  It bought Massey in June 2011 for about $1 billion in cash plus just over 100 million shares of ANR stock, worth $5 billion+ at that time.

By revenues, both are roughly equal in size.  Mine output seems to be similar as well, with 5/6 thermal coal for power generation and 1/6 higher-value coking coal for blast furnace steel making.

Massey is the owner of the Upper Big Branch Mine in West Virgina, which experienced the worst domestic coal mining disaster of the past forty years on April 5, 2010.  A methane gas explosion there killed 29 miners.

Since the Massey takeover, ANR shares have lost about 60% of their value.  Part of this is due to general selloff of commodity stocks on worries about economic slowdown, part to former Massey shareholders cashing in their profits, part to ANR’s announcement in September that sales volumes will be lower than expected.

merger issues

My experience is that there are two types of risk in a merger like this:

–Are Massey’s safety problems confined to this one mine, or has that company been cutting corners to increase profits of other mines as well?  Certainly, industry gossip may provide clues.  But until ANR actually analyzes the Massey properties one by one in detail, it won’t know for sure.  Aside from the human issue, the question is whether ANR will have to make substantial capital investment to get the Massey mines functioning properly.  In other words, are the Massey properties actually less profitable than they appear to outsiders?

–Does ANR have the management depth to run an enterprise twice its former size.  It may be able to rely on the former Massey management.  But suppose they just refuse to do what ANR wants?  Sounds silly, but culture clash is a significant risk.  The risk going in is much higher when there’s evidence of badly-run operations.

In addition, is the ANR management composed of deeply knowledgeable and experienced coal miners?  …or is it basically a financial company doing a “rollup,” that can make generic efficiency improvements but entrusts the actual operation of the business to others?  I don’t know.

–One positive thing.  The combination was done mostly for stock.  So increased financial leverage isn’t a risk.

specific questions

A quick look at Value Line shows that ANR achieves only about half the operating margin of the VL coal industry.  Why?

My guess is that coking coal may be as much as a third of ANR’s profits, although only about 1/6 of volumes shipped.  At least some of that goes to China.  If so, have recent profits been inflated by flooding and transport problems in Australia?  How long will that advantage last?

old soldiers fade away; what about old hotels?–how overcapacity shrinks

August 25, 2011 By in Casinos, economics, Entertainment, Industry Analysis, Lodging, Private equity Tags: , , , , , , , , Leave a comment

supply/demand imbalances…

In many cases, imbalances between supply and demand resolve themselves relatively quickly.

–Fresh produce goes bad.

–Clothing wears out, or is lost or damaged–or fashions shift–constantly creating new demand.

–Workers retrain and change careers.

–Technological change makes production equipment, as well as their output, obsolete.

…are difficult with long-lived assets like real estate

But what happens with real estate?

…where structures can be very expensive, are typically funded with borrowed money, may take years to build, generally can’t be relocated and can last for fifty years or more.  They’re also relatively low tech.

In this post, fresh from my visit to Las Vegas, I’m going to write about what happens with hotels/motels, a special case of this real estate question.

motels

These are easier to analyze than hotels, since they cost less and can be built faster.  Often, they’re designed in modular fashion so they can add extra wings of rooms at relatively low expense, if needed.  They also tend, in the US at least, to draw most of their customers from people who have business within a few miles of the motel.

Therefore, new capacity comes in lower increments and is visible to potential new entrants faster than with hotels.  So overcapacity tends to be less severe.

cost pressure points

There are two big costs for a motel operator that I don’t think are readily apparent–the price of affiliation with a national chain, and the need for periodic refurbishment of rooms.  These expenses end up being the big factors in eliminating existing capacity.

Chain affiliation, which may cost 5% or more of revenues, brings two benefits:  a brand image and access to a reservation system to direct potential guests to the motel.

Although guests don’t think about it much, hotels and motels suffer a lot of wear and tear, both in the rooms themselves and in common areas.  So they require a considerable amount of spending on maintenance.  In addition, to keep the rooms new looking in a way that justifies a higher rate, rooms have to be refurbished periodically–say every five years.

The two expense items are interconnected, since maintaining a specified standard of appearance will also be a condition for retaining affiliation with a chain.

When profits are under pressure, in my experience the first area to suffer cutbacks will be maintenance/room refurbishment.  Once these expenditures begin being postponed, it becomes progressively more difficult to catch up, since returning to the former standard is increasingly more expensive.  At the same time, less favorable online user reviews translate into less repeat business.  This compounds the financial problem.

At some point, a motel may fall below the standards necessary to maintain its affiliation with, say, the Marriott chain.  It may, however, still qualify to be a Best Western or Comfort Inn affiliate.   So it “solves” its maintenance/refurbishment problem by switching affiliations.  The motel effectively removes capacity from a higher-price market segment and introduces new capacity to another, lower-price one.

For a given motel, this journey to less expensive market segments may have several steps.  At some point, the building may be sold for alternate use as, for example, a nursing home.  If so, the capacity disappears entirely.

hotels

The same principles apply.  Three differences, however:

–hotels need to achieve a certain amount of occupancy–generally thought of as 30%–regardless of profits, so the building will feel “alive” and safe

–hotels are much larger in scale

–there are no alternate uses.

In Las Vegas, scene of immense overcapacity currently, two additional patterns are evident:

–older and new, but not as conveniently located, properties had been competing on lower price.  Given the new hotels’ need to generate occupancy to create a favorable ambiance, that advantage is diminished.  WYNN, for instance, had been planning to charge $300+/night for its new rooms.  But average room rates are currently around $200, with mid-week rates considerably below that.

–in the case of WYNN, LVS and to a lesser extent MGM,  management fees from Asian operations to the US are supplementing US cash flows, thereby enhancing the location advantage the three have.

signs of strain

You can already see signs of strain–and of capacity leaving the premium segment of the market.  The Wall Street Journal reported yesterday, for example, that Hilton is planning to end its affiliation with the Las Vegas hotel owned by private equity investor Colony Capital.

And MGM is also hoping to be able to blow up its as yet unopened Harmon hotel on the Las Vegas Strip.

LinkedIn IPO: sign of a second internet bubble? three reasons I don’t think so

May 22, 2011 By in Current Market Thoughts, Industry Analysis, internet, Private equity, Recent Market Action Tags: , , , , , , , 2 Comments

the LinkedIn IPO

Class A shares offered

Social networking company LinkedIn (LNKD) went public last Thursday, offering 7.8 million Class A shares.  According to the preliminary prospectus, 4.8 million of them were new shares sold by the company;  the rest were secondary shares sold by existing stockholders.

LinkedIn also has Class B shares, which differ from Class A mostly in that each has 10 votes while Class As have one apiece. This is a standard device used by family-owned or other closely held firms to raise public money and have a listed stock, while retaining complete control over operations.  News Corp., Hershey and Google are other US examples.  In the case of LNKD, the insiders who own Class Bs still muster 99.1% of the corporate votes, making the class As, in my mind, more like preferred shares than common.  For Thursday and Friday, though, no one cared.

pricing and initial trading

Underwriters initially talked of an offering price in the low thirty-dollar range–maybe $32.  But as they saw the strength of investor demand for the issue, the number gradually rose to $45.

The opening trade for LNKD was $83.  The day’s low was $80, the high $122.70.  The stock closed at $94.25, on volume of 30+ million shares–meaning each share changed hands 4x on average during the day.

I was in PA

I was driving to Pennsylvania while this was going on, listening to the Bloomberg Surveillance program on satellite radio.  The reporters on the broadcast commented a number of times that this felt to them like Internet-Bubble activity of late 1999-early 2000.  When I got home, I read similar comments in the Wall Street Journal and the Financial Times.

How quickly they forget!

Yes, there are some similarities.  Both then and now are periods of very easy money policy, and extra money sloshing around the system invariably gets into speculative mischief.

But the late-1999 Fed had the money taps wide open in spite of economic strength, not like today when the central bank is fighting to reduce sky-high unemployment (how effective today’s Fed policy can be is another question).

Y2K

If you recall, the Fed’s big worry back in 1999 was Y2K–the possibility that every computer in the world would shut down at midnight on 12/31/99, stopping commerce everywhere dead in its tracks (kind of like the Lehman failure did in 2008, only worse).  That would supposedly have left us with blue screens, warm refrigerators, stuck elevators, dead machine tools and ATMs that refused to give out cash.  All our financial information might be wiped out.

In 1999, Amish farmers couldn’t replace worn out horse-drawn plows, because survivalists preparing for this potential Armadeggon bought them all up.  Silver coins were trading at 10x face value, on the idea that paper money would be worthless as developed economies fought to avoid sinking back into pre-industrial chaos.

The Fed injected a lot of extra money into the system to help ease any Y2K damage–none of which occurred.

three big stock market differences:

1.  cult of the internet back then

In late 1999-early 2000, the US stock market was flooded with internet-related IPOs.  Many of these firms had no actual businesses and little more than business plans (sometimes, not even that).  In normal circumstances, they would be looking for venture capital financing.  At investor meetings, which had a cult-like quality to them, company executives focused on concept, not near-term business prospects.

Even a survivor of the subsequent dot.com meltdown like Amazon didn’t make money back then.  The company wouldn’t turn profitable until 2003, and had negative net worth until two years later.  In my opinion, Amazon only made it because it had large follow-on offerings of stock and bonds.  But very many more, like eToys or Boo.com, went out of business as soon as they burned through their IPO proceeds.

It wasn’t just crazy IPOs, either.  At the peak of the frenzy, media conglomerate Time Warner traded half its assets for a near-worthless AOL.

In contrast to the hundreds and hundreds of highly speculative transactions in 1999-2000, in 2011 there have only been two questionable ones that I see:  the first-day price of the LinkedIn IPO, and Microsoft’s purchase of Skype.

2.  wild overvaluation in 2000…

…in the TMT sector…  internet-related stocks as a group were known as Technology-Media-Telecom (TMT) stocks.  They made up a significant chunk of the overall US stock market, even before the buying frenzy began.

As I mentioned above, many e-commerce stocks had no earnings at al–and therefore no meaningful PEs.  More mature companies did have earnings, though.  And they were priced through the roof.  At the peak, Qualcomm was trading at 177x its 2000 profits; smaller chipmakers traded at even higher multiples.  Staid, slow-growing, highly cyclical communications equipment providers, like Ericsson and Alcatel traded at 137x and 110x respectively.  Similar “hot” names like Nortel no longer exist.

Brokerage house analysts like Henry Blodget (since barred from the securities industry and now a blogger) and Mary Meeker (now in vc) whose horribly inaccurate forecasts helped justify the mania, acted like–and were treated like–rock stars.

…and in the stock market as a whole

In March 2000, the S&P 500 peaked at about 28x earnings for 2000.  This compares with a ten-year Treasury yield at that time of about 6%, which would justify a stock market PE of 17.  Relative to bonds, then, stocks were 65% overvalued.

In contrast, the S&P is trading today at under 14x the consensus estimate of 2011 profits.  The ten-year Treasury is trading at a 3% yield, implying a stock market multiple of 33x.  So stocks are 60% below the level implied by bond yields.  Put another way, if stocks are fairly valued, bonds are trading at well more than twice the price history would say they should be.

3.  real rocketship IPOs back then

Yes, LNKD did double from the IPO price on its first day.  So what.  Renren (social networking in China), a first-day star a couple of weeks ago, is now trading $1 below its initial offering price of $14.

If you want to see real IPO action, take a look at UTStarcom (which still exists today).  It debuted in March 2000 at an IPO price of $18.  It closed that day at $68, up 277%, after having reached an intra-day high of $73.  It then proceeded to run up to its all-time high of $93.50–5x the IPO price–before the end of that month.  (It closed last Friday at $2.09–but, hey, it survived, which is more than you can say about most of the dot-com names.)

my thoughts

Yes, there may be overvaluation in today’s financial markets, but I don’t think it’s in publicly traded stocks.  Maybe  privately-traded equities are too expensive.  But that’s a relatively small market whose failure wouldn’t have severe negative consequences for the US economy.  For my money, if you want to see expensive, look at bonds and commodities.


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