Category Archives: Private equity

“the emerging equity gap”: McKinsey (II)

December 21, 2011 By in Asian economic development, China, economics, emerging markets, Private equity, Strategy Tags: , , , , , , , , , , , , Leave a comment

Yesterday I outlined the McKinsey argument that a substantial “equity gap” will emerge in developing economies between the demand for stock financing for capital expansion and the money that investors are willing to make available to the firms that need it.

I believe the qualitative story

To recap:  The qualitative argument the consultant makes starts with the idea (which I think is correct) that stock markets in almost all emerging nations are hazardous to investors’ wealth.  The companies listed may be the politically connected dregs of the local economy, not the stars.  Financial statements may not be reliable.  Corporate management may not have shareholder welfare as a primary goal.  The regulatory playing field is probably heavily tilted toward insiders.  It’s ugly out there.

Firms may not find it easy to raise money under these conditions.  Foreigners are unlikely to help, either, since in the developed world an aging investor base isn’t likely to have risk assets to spare.

Therefore, emerging economies will only fill the potential we all believe they have if their governments make substantial changes in their stock markets.  Otherwise, companies in these countries will come up $12.3 trillion short of their equity funding needs by 2020.

This is a problem, not only for these countries but also for any investors who have bought emerging markets index funds or ETFs banking on emerging economies to flower fully.

I agree.

…the quantitative?

It’s the quantitative stuff that I have problems with.  Specifically,

1.  starting with a quibble…

McKinsey projects that global financial assets will be worth $371 trillion in 2020.  It’s not $370 trillion.  It isn’t $372 trillion, either.  The precision of the figures implies that McKinsey can forecast the state of financial markets almost a decade ahead with an accuracy of +/- .25%.  All the empirical evidence is that no one can forecast with this degree of accuracy even one year ahead.  Stock market participants know the limitations of forecasts, because the real world beats them over the head with their misses every day.  Why isn’t McKinsey aware?

…or maybe not

The “equity gap” McKinsey forecasts amounts to $12.3 trillion (not $12.2 trillion…).  That’s 3.3% of projected financial assets in 2020.  How much of the “gap” would remain if McKinsey didn’t stick with overly precise point forecasts?

2. using local GDP to forecast corporate profits

McKinsey assumes that the profits of publicly listed companies in a given country will rise in line with nominal GDP.  Three reasons why I think this is a mistake:

–many parts of the local economy may not be represented in the stock market.  On Wall Street, for example, autos, housing and real estate–all pretty sick sectors at the moment–have virtually no stock market representation

–in the US and UK, at least, publicly listed firms tend to represent the best and the brightest of the local economy.  Private equity and trade acquisitions winnow the elderly and the infirm from the herd.

–in the developed world, foreign sales and profits make up a considerable portion of the stock market’s total.  In the UK, for instance, maybe 75% of the earnings of the FTSE 100 come from outside that country–explaining its dominant stock market size in the EU, despite not being the largest economy.  In the US, the best guess of S&P is that foreign earnings make up about half the total.  The figure is rising.

My conclusion(s):  the method McKinsey uses will understate corporate profits, and thereby the size of future equity market.  This is not new news.  Wall Street has been actively discussing the increasingly non-US nature of S&P profits for the past two decades.  In other markets, it’s been a key subject for much longer.

3.  we live in a post-internet world

It isn’t just the internet, either.  Other key factors as well have conspired over the past couple of decades to substantially decrease the capital intensity of business. 

–development of sophisticated supply chain control software, combined with internet communication and the rise of specialized logistics/transport firms, means everyone holds smaller inventories

—for many industries, today’s capital spending = servers and software, not machine tools and buildings.  The rise of technology rental, software-as-a-service, for example, means decreasing capital intensity

—e-commerce has vastly decreased the requirement for repeated expensive advertising campaigns and ownership of physical retail outlets as tools to make potential customers aware of a product or service. 

—the separation of design and manufacture that the internet allows means that companies use less capital intensive processes to make products in low labor-cost countries

in developing economies, too

There’s no doubt that emerging nations will still need a lot of development in capital intensive areas, like power generation, chemicals, water, roads, ports and related infrastructure.  But there’s no reason to believe that these economies won’t also avail themselves of the same capital-saving devices in other areas that developed nations now do.  For instance, eastern China is already outsourcing some manufacturing operations to lower labor-cost countries.

My point:  in projecting the future capital needs of publicly trade firms the McKinsey assumption that companies will be as capital intensive as they have been in the past is the simplest one.   I don’t think it’s right, though.  In fact, the more I think about it, the odder it sounds.

A final thought on this subject:  as prices change, behavior adjusts.  If the cost of equity capital were to begin to rise, companies will rethink their spending plans and economize/substitute.


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.