Major pointers in a Leveraged Buyout/ Recapitalization

What to look out for in a Recap/LBO situation and how to analyze one?

In recapitalizations and Leveraged Buyouts, the theme is often similar in that these companies often trade below their intrinsic value. These are probably the old economy type of stocks versus the new economy type stocks plagued by generally slower growth rates. These old school companies generally grow at slower growth rates as compared to the "googles" and "apple" of today and hence are ignored by the general public at large and hence trade at a discount to intrinsic value. Other reasons as to why these old school companies trade at discount is that these companies generally have so much cash and are in a net cash position that the public is afraid that the company's management will dissipate the cash through inefficient capital allocation reinforcing the fear that when there's cash, it is easily spent. What the public often wants is a redistribution of that wealth to its shareholders and often a reorganisation of the company to allocate capital more efficiently. Now even if the latter is not what the general investing public wants immediately, a recapitalization can help the investing community "see" that it is pursuing appropriate capital allocation which you will see in following paragraphs.

Typical elements of a Recaitalization should include:
1) Non cyclical Industries - When a leveraged recap occurs, it normally occurs in mature industries without cyclicality. Why? Because companies that encounter cyclical downswings that go through a recap or LBO usually have a lot of debt and hence downswings would magnify the losses or reduce earnings drastically due to altered capital structure where higher interest payments need to be forked out. Conversely as well, any form of topline growth assuming all things constant will magnify the bottomline. Hence, companies that are cyclical in nature are inappropriate candiates for a leverage recap or an LBO. But it can also be argued that during a cyclical upswing, a leveraged recap can occur such that bottom line earnings are magnified. My answer to that would be because the economy behaves in a haphazard fashion, predicting a cyclical upswing in the middle of a cyclical downswing would be disastrous for the private equity firm that does so in my opinion.

2)Steady financial profiles- When companies have stable cashflows, an extension of the previous point above are normally suitable for going private transactions. You do not want any form of cyclcality in this business.

3)Competive advantage and dominant market share- The company most preferrably should have some form of "moat" and dominant market share which adds a stability and predictability element.

4)Low debt plus company in a net cash position- You, as an investor would want the company to have a net cash position = cash and cash equivalents - total debt . If the industry leverage ratios are higher compared to the company that you are looking at it is a good sign that this company is a potential recap candidate because chances are that it has unutilised debt capacity which means that it can take on more debt. One point that Ben Graham adds to the process is that a company's capital structure can be optimised when it can serve very comfortably the debt it can put on its balance sheet. Normally, interest coverage ratios are between 3 to 4 times are very comfortable to be serviced by a corporation with a net cash balance, unutilised debt capacity and generate excess and stable operating cash flows.

5)Low Capex- The company preferably should have a low capex requirements such that its free cashflow is enhanced. The good thing about a recap is that valuation metrics are shifted to a cashflow basis instead of an EPS basis due to the need to pay down debt and interest payments after a recap.

Effects of a recap

1) Short term spike in earnings and ROE- This happens due to the tax shield that the larger interest payments has on the bottom line if the top line is stable. This is a catalyst that investors should look out for.

2)Internal Changes- A recap forces the management to be more disciplined in handling its capital allocation. For one, i believe that capital allocation will be handled in a more efficient manner than before the recap as there is a tremendous need to focus on cashflows to pay down debt and interest. There is in a sense fiscal discipline being practised as opposed to lax capital budgeting processes previously.

3)Discipline forces management to think of ways to focus on EBITDA and there is potential for EBITDA to increase in the prcess of a recap due to capital allocation efficiency. The management stops splashing out on corporate jets and tries to reduce unnecessary expenses can help to increase EBITDA

4)A recap often comes with some equity incentive for management. Mangements become incentivised alongside ordinary minority shareholders. This is one that an investor should look out for. In fact, Joel Greenblatt emphasizes this point again and again in his book.

5) A huge payout can be given out in the form of a dividend and this can be 75% of the market capitalisation of the pre recap share price or larger, financed of course by debt mostly. This is the monetising of future cashflows and giving back to sharehlders which make them happy.

6)After the recap, the focus on deleveraging the company causes book value to rise.

So how does one look at such stocks. I reckon that one should look at such companies when the interest rate environment is falling because when rates fall, LBO activity increases due to the cheaper cost of funds. Owning a stock that has the above elements can be candidates for an LBO, going private transaction where premiums are offered.

In the case that an LBO is not offered, if management is astute, they will conduct a recap on their own producing a stub that will rise in value due to short term ROE and earnings growth expansion even though it is a stable industry! The effect of the distribution and stub's rise in price should prove to be quite lucrative.

Best regards,
Lucas Lim

Buy American. I Am.

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Read article here

Buffet speaks on the US economy

Warren Buffet takes on GE Preferred Stock

General Electric Co. got a $3 billion investment from Warren Buffett and said it will sell $12 billion in common stock, gathering more cash to fund operations amid the worst U.S. financial crisis since the Great Depression.

For more read below:

GE Raises $15 Billion; Buffett Gets Preferred Stake

Best regards,
Lucas

The pain and agony of a "social misfit" and why value investing works

On Monday, i was invited to a gathering of private bankers at a club. It was a networking session for private bankers in general to get together and have a good time and it wasn't just exclusive to private bankers , there were investment specialists and research analyst and a couple of investment bankers hanging out there too.

The word that got around most was speculation of which financial companies were going to go next. Some were saying Fortis was going next. In fact half a year back, someone told me that Merril was next to go but Merril was eventually acquired by Bank of America. The general theme of talk among the bankers seem to be that of "fear" and a random poll by me as i spoke about buying stocks from a valuation perspective was scoffed at mostly. And if it wasn't scoffed at, there were some who might agree with me but they will do so on the quiet, not echoing their views out loud.

And as i examined myself in the situation, i found that there there was tremendous group think and pressure to conform and i found myself a social misfit all of a sudden. And i remembered what i had read about psychology. There is a tremendous need to be part of a group and to be like the group. We need social proof to carry on our activities. It is like a cushion and some form of security. We do what other people do and find comfort in that. Because if we are wrong, it's ok because the others are wrong also. It is a very powerful force at work here and you will see it working in nearly every aspect of society. In fact there was an article "Rejection really hurts" Participants that were participating in a virtual ball tossing game who were eventually excluded seemed to experience some form of stress. For more read here:

Rejection really hurts

Value investing will put you in a similar situation. When markets head south, folks will tell you to stay away or sell. Not many will tell you to put a portion of your net worth into equities. In fact, going against the crowd probably means that they might incur some losses intially.Mohnish Pabrai talks about this and says:"When I buy a stock, two things ALWAYS happen: immediately after I buy, the stock tanks and once I sell the stock, it really takes off" Value investor must be able to take this and stomach "social pain" if their reasoning is right.

I have had the pleasure to meet with Professor Sanjay Bakshi recently during his trip to singapore and i would say that i have learnt so much from him both from a practical standpoint as well as an academic's standpoint. I would like to leave you with a quotes and conclusions by him in one of his articles:

"I think value investing is successful precisely because it is difficult to practice. What I have said it is easy for you to understand, but I can tell you that is not easy to practice.
I think it is successful because it's unpopular and because it is based on fundamentals and not stories that read about or hear or see on CNBC.
I think the value of value investing lies in its unpopularity and I think if value investing became popular there won't be any value left in it."

Best regards,
Lucas