At HHC, we believe that the likely return on invested capital for a business over the next 5–10 years should drive the type of transaction we engage in rather than arrive to the scene with a prescriptive approach. We recognize this defies industry convention — particularly within the private equity industry. Typically, private equity firms utilize significant leverage to acquire the majority of a company — architecting a “product” onto businesses with vastly different future prospects (return on invested capital). Given the state of the private equity industry — undoubtedly mature — we think it appropriate to critically examine the one-size-fits most approach employed by the industry to understand what drives the strategy of HHC. What is working? What is not? How should young practitioners of investing think about the LBO structure in the future?
First, let’s understand the historical context of our current circumstances. As with everything, private equity started with a good idea to solve a market problem. McLean Industries, Inc. likely completed the first LBO in January 1955. In this transaction, McLean borrowed $42 million and raised an additional $7 million through an issue of preferred stock. A light bulb went off within young, enterprising financial entrepreneurs — “you can lever companies up just like you can with real estate”. The industry germinated in the 1960s within the ranks of Bear Sterns. There Jerome Kohlberg, Henry Kravis, and George Roberts, began acquiring businesses that lacked a viable or attractive exit for their founders or owners — too small to issue public stock and also reluctant to sell to competitors. Thus, the group started acquiring small businesses through the 1960s and 1970s, culminating in the formation of Kohlberg Kravis Roberts in 1976. KKR started with the basic premise that if you acquired a business with stable cash flows for low multiples, you could substantially increase your equity returns through the application of leverage. This simple concept led to substantial success by early entrants operating in a low competition environment.
But, as with every market, competition corrects imbalances. In 2020, the average private equity fund is $1.0 billion. In 2020, average purchase price multiples were 11.4x. Average starting leverage multiples were 6.0x+ heavily adjusted EBITDA. Returns responded by coming down. Bain reported in early 2020, that private equity returns trailed those in the public markets for the first time over a ten-year period in the history of the industry.
One explanation for the decline of private equity returns relies on the concept of supply and demand correcting a market imbalance for the price of companies, which delivered excess returns to early private equity investors. While this explanation partially explains the discrepancy, my view is that the overuse (and increasing — see below from Bain) of leverage drives an underinvestment in private equity backed businesses that ultimately impedes business building, which hurts returns.
The use of leverage sucks nearly all the free cash flow out of private equity owned businesses — leaving very little for reinvestment. Why does this matter? Let me show you.
The typical private equity transaction looks something like this (based on the 2020 Bain PE Report):
On the surface, debt can seem quite cheap relative to the typical costs of equity. The average private equity transaction is typically financed with debt that costs about 8%-9% on any given day. This rate seems cheap relative to the equity returns targeted by most sponsors of 25%+. Aside from the real cash costs of supporting debt, significant opportunity-based costs exist that cause this debt to carry a much greater economic burden on a company. This burden comes in the form of cash interest, mandatory amortization, and a concept called “excess cash flow sweep”. Mandatory amortization repays debt principal and banks set this anywhere from 1%-5% over the term of the loan. Excess cash flow sweep (ECF) acts as a contractual obligation of the borrower to pay out 50%-75% of free cash flow to the debt provider to pay down principal. Amortization and ECF drastically reduce free cash flow (FCF) available for reinvestment by the company. These charges, coupled with normal expenses to operate a business (NWC, capex, and taxes) leads to a low conversion of EBITDA to FCF despite minimal normal expenses, as seen below.
Only 12% of the EBITDA above converts to FCF that investors can use to fund investment or shareholder returns. While some of company EBITDA finances normal expenses, these expenses only represent 15% of EBITDA. Debt absorbs 73% of EBITDA in the typical private equity transaction. The inability to reinvest in future growth represents the opportunity cost of utilizing debt to fund the majority of transactions (pushing the true equity cost into the future). To contextualize the opportunity cost of investing — we must first understand the mechanics of ROIC and its determinant of future business success.
Companies grow by making investments that will pay off in the future through earnings (or earnings potential) growth. Businesses do not grow without investment. After paying all its expenses, companies earn net income, which they retain or pay out through dividends to shareholders. The retained portion of net income forms the traditional “book value of equity” of a business, meaning the cumulative earnings retained for investment. The net income (return) generated by these investments drives the metric return-on-equity (ROE). ROIC normalizes for debt on the balance sheet. But to generalize, assuming no debt, ROE is ratio of earnings to capital required to produce those earnings. The return on invested capital (ROIC) and the amount invested (book value of equity + debt) determines the ultimate size of a company and therefore the returns to the shareholders for investing in that company.
Side note: In high growth businesses, these GAAP financial metrics (net income, book value of equity, ROE, ROIC) generate muddled outputs, so adjusting for investments undertaken through the income statement (sales and marketing) is appropriate.
Let’s go back to the example we started with — the average private equity transaction of 2020.
We pay 11.4x for a business that generates $70M of EBITDA in our first year of ownership. We invest $334M of equity and leverage the business with $442M of debt. As we can see, only $8M of FCF makes it through the levered income statement becoming available to shareholders to reinvest. As shareholders, we take the $8M of cash available and invest into projects that generate returns from 0% to 25%. Consistently investing FCF over 5 years at varying rates of returns (0% to 25) leads to a 0% to 35% increase in EBITDA. While the high end of this scenario seems represent a great outcome, the high prices paid in the average private equity transaction (11.4x EBITDA), actually leads to a pedestrian investment return for shareholders (16% gross IRR and 2.1x gross MOIC). This shows that private equity “worked” in the early years of the industry by purchasing low ROIC businesses, but at very low multiples. Investors applied significant amounts of leverage, earned minimal amounts of ROIC, but generated substantial shareholder returns through cash flow generation leading to debt paydown or by selling assets for higher multiples to new buyers. Due to the increase in purchase multiples for businesses driven by increased competition from new private equity funds, private equity investors must assume that businesses generate ROICs over >35%, to generate industry standard 25% IRRs and 3.0x MOICs. In other words, private equity investors need to focus on investing in and building high quality businesses to support these high prices.
Businesses that generate ROICs in excess of 35% represent outstanding business models, primarily due to the fact that their value proposition resonates with customers, such that they extract enormous returns on capital invested. To give you a sense, over the last six years, AIG, the large public insurance company, generated on average 3% ROE annually. The obvious question becomes, does the amount of FCF spent servicing debt — 73% of EBITDA — make sense if the average private equity business generates 35% ROICs? Could these high-quality companies deploy this FCF to more high return projects generating 35% returns, thereby becoming much larger companies over long periods of time?
It turns out, that if businesses reinvest consistently at very high rates of return over 5 years, the ability to reinvest more cash flow each year becomes incredibly valuable due to the effects of compounding — creating much larger businesses. Put simply, if you own a business with the potential to generate high ROICs, then forgoing projects that could generate 35%+ ROICs to repay debt that returns ~10% to shareholders does not make a whole lot of sense. A business generating five years of 35% ROICs, unlevered, generates over 5.5x the profitability of the leveraged business — creating 700% more equity value for shareholders over that same period of time.
Clearly a trade-off exists for placing substantial leverage on businesses fund 60% of the purchase price upfront. While businesses “cost” lower amounts of equity upfront, shareholders end up spending an enormous amount of equity through foregone “retained earnings” to support the debt. The buy-now, pay later approach of some within the investing industry perhaps destroys value relative to a less levered approach. If these same businesses generate enormous returns to invested capital, then their shareholders should prefer for these businesses to remain under-levered.
The reality is that the world is messy and the future unpredictable. Companies that enjoyed fantastic periods of returns could encounter difficult periods of time when nothing goes right. Investors at the outset can not predict with perfection the returns on capital a business will generate (although historical returns tend to act as great predictors). We meant this article as thought exercise to challenge the conventional way of thinking within investing.
· Perhaps using significant amounts of leverage only make sense for businesses purchased for very low transaction multiples
· Perhaps private equity firms seeking to maximize leverage at the outset should not acquire growth assets
· Perhaps the phenomenon of high transaction multiples, driving up the demand for leverage, which restricts private equity-backed businesses from investing in growth drives the low returns we observe in private equity
· Perhaps this explains private equity’s obsession with add-on acquisitions as a pathway for growth because firms finance these transactions primarily through more debt (the cash flow statement)
· Perhaps this is all a by-product of GAAP accounting standards, which incentivizes cash flow statement investing, versus investing through the income statement
· Perhaps the underinvestment inherent within the private equity model of investing drove the market demand for larger “growth” oriented investors (Softbank, Sequoia, Tiger Global, etc.) that developed over the past 10 years
· Perhaps companies that operate in increasingly large markets powered by the internet mature later and therefore require growth investing for longer durations than historical peers
At Hudson Hill, we view historical practice as a guide, but not a dogma by which to live or act.
At Hudson Hill, we believe the world needs more investors willing to take a flexible approach to every situation. We do not blindly apply our “product” to situations that require a nuanced approach. HHC benefits from the fact that we do not possess incumbent status within the investment industry, which affords us the ability to look at the world with fresh eyes. We aim to support management teams to build fantastic businesses and recognize the importance of investing in future growth. As a result, we favor a flexible approach towards investing, dictated by the situation at hand, not the “product” we claim to sell. HHC pursues opportunities that we deem “big ideas” — with the goal of applying patient capital to invest to achieve lofty ambitions. At the end of day, HHC focuses on supporting management teams to build great companies that will last — something we feel the market needs perhaps more than it realizes.