Private Equity-Stupid Money Chasing Stupid Deals?
April 12th, 2007Just to clarify. Yes, I believe that private equity funds serve an important purpose in well-functioning, efficient capital markets (see The Role of Private Equity explaining why). However, this is not to say that I believe that all private equity deals are destined for success. In fact, my hunch (although I have no hard data on this, and hard data is difficult to obtain for privately held companies) is that LBO’s do not fare much better than the average acquisition. That is, most likely fail. So it came as a surprise to me that one of my students suggested that since I extolled the virtues of private equity, I must surely believe that the volume of private equity deals over the past several years are rational, sound, and bound to succeed.
This is not the case. In fact, if anything, I believe the opposite. Again, so that there is no confusion about this, I absolutely believe that private equity funds serve a purpose in healthy, well-functioning equity markets. However, I do believe that the increasing number of private equity deals of late is an exemplar of excess. Over the past few years, excess liquidity in global capital markets has been driving such deals. I refer to this as the phenomenon of stupid money chasing stupid deals. But I don’t necessarily blame the private equity firms for this. Rather, the blame falls squarely on the beast that feeds the machine. For example, if I’m a private equity manager and institutions are throwing money at me (whether the source of that money is domestic institutions, recycled petrodollars, or foreign central banks), I’m going to make deals. As a private equity manager, that’s what I’m in business to do, and with cash on hand, that’s exactly what I will do. Not only that, but besides the cash infusions that I’m getting on a regular basis, I have banks that are willing to lend me $10 or more for every $1 that I pony up. Crazy! Well if that’s the case, then heck, why not, I can buy firms with little cash, lever the heck out of them and pay myself a nice dividend in the process. Given the sheer amount of global liquidity, it’s only rationale to expect this outcome – increased private equity activity.
Now, will all these ventures be successful? Likely not. With most private equity firms flush with cash as a result of the global liquidity glut (caused by historically low interest rates and a change in attitudes toward risk) and with only a finite number of targets to buy, increased competition among LBO funds (and industry acquirers) for the same handful of firms has led many buyers to overpay. Moreover, with creditors offering enough debt to hang oneself with, many targets will become overextended. And if you buy into the arguments of Edward Altman and Nouriel Roubini (as I do), as credit contracts due to central banks tightening the screws on lending, as the housing market slows in the US, and as consumers buckle under the weight of their own personal debt, we should expect businesses to falter. That is, we should see corporate default rates rise from about the 0.6% observed in 2006 to its historical average of around 3%.
Unfortunately, if such defaults do occur – that is, if the highly levered firms that the LBO funds have taken private cannot meet there debt obligations – it will not be the private equity firms left holding the bag. Rather, it will be the investors in those funds (whose returns will be diminished) and the holders of the corporate debt that will bear the brunt of the costs.
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April 23rd, 2007 at 8:06 am
Here’s a real mystery to figure out in terms of strategy, from “The Onion”:
Even CEO Can’t Figure Out How RadioShack Still In Business
April 23, 2007 | Issue 43•17
FORT WORTH, TX—Despite having been on the job for nine months, RadioShack CEO Julian Day said Monday that he still has “no idea” how the home electronics store manages to stay open.
“There must be some sort of business model that enables this company to make money, but I’ll be damned if I know what it is,” Day said. “You wouldn’t think that people still buy enough strobe lights and extension cords to support an entire nationwide chain, but I guess they must, or I wouldn’t have this desk to sit behind all day.”
The retail outlet boasts more than 6,000 locations in the United States, and is known best for its wall-sized displays of obscure-looking analog electronics components and its notoriously desperate, high-pressure sales staff. Nevertheless, it ranks as a Fortune 500 company, with gross revenues of over $4.5 billion and fiscal quarter earnings averaging tens of millions of dollars.
“Have you even been inside of a RadioShack recently?” Day asked. “Just walking into the place makes you feel vaguely depressed and alienated. Maybe our customers are at the mall anyway and don’t feel like driving to Best Buy? I suppose that’s possible, but still, it’s just…weird.”
After taking over as CEO, Day ordered a comprehensive, top-down review of RadioShack’s administrative operations, inventory and purchasing, suppliers, demographics, and marketing strategies. He has also diligently pored over weekly budget reports, met with investors, taken numerous conference calls with regional managers about “circulars or flyers or something,” and even spent hours playing with the company’s “baffling” 200-In-One electronics kit. Yet so far none of these things have helped Day understand the moribund company’s apparent allure.
“Even the name ‘RadioShack’—can you imagine two less appealing appealing placed next to one another?” Day said. “What is that, some kind of World War II terminology? Are ham radio operators still around, even? Aren’t we in the digital age?”
“Well, our customers are out there somewhere, and thank God they are,” Day added.
One of Day’s theories about RadioShack’s continued solvency involves wedding DJs, emergency cord replacement, and off-brand wireless telephones. Another theory entails countless RadioShack gift cards that sit unredeemed in their recipients’ wallets. Day has even conjectured that the store is “still coasting on” an enormous fortune made from remote-control toy cars in the mid-1970s.
Day admitted, however, that none of these theories seems particularly plausible.
“I once went into a RadioShack location incognito in order to gauge customer service,” Day said. “It was about as inviting as a visit to the DMV. For the life of me, I couldn’t see anything I wanted to buy. Finally, I figured I’d pick up some Enercell AA batteries, though truthfully they’re not appreciably cheaper than the name brands.”
“I know one thing,” Day continued. “If Sony and JVC start including gold-tipped cable cords with their products, we’re screwed.”
In the cover letter to his December 2006 report to investors, “Radio Shack: Still Here In The 21st Century,” Day wrote that he had no reason to believe that the coming year would not be every bit as good as years past, provided that people kept on doing things much the same way they always had.
Despite this cheerful boosterism, Day admitted that nothing has changed during his tenure and he doesn’t exactly know what he can do to improve the chain.
“I’d like to capitalize on the store’s strong points, but I honestly don’t know what they are,” Day said. “Every location is full of bizarre adapters, random chargers, and old boom boxes, and some sales guy is constantly hovering over you. It’s like walking into your grandpa’s basement. You always expect to see something cool, but it never delivers.”
Added Day: “I may never know the answer. No matter how many times I punch the sales figures into this crappy Tandy desk calculator, it just doesn’t add up.”