In the early years of the digital music industry, entrepreneurs were passionate about music but had no understanding of how the music business actually worked.1 The entrepreneurs were, nevertheless, easily able to raise funds from venture capitalists due to the dot-com bubble.2 However, after the dot-com bubble burst, it became very difficult to attract venture…
Tag: Valuation
Getting a Good Deal: Strategies for Entrepreneurs in VC Negotiations
Venture capital is an invaluable resource for the nascent business. Providing much-needed capital, VCs enable a business to fund the future growth that every entrepreneur hopes for. Negotiations between entrepreneurs and VCs frequently allow a company not only to raise funds but also to create long-term value through lasting business relationships. However, these negotiations also…
Twitter’s Bumpy Flight from the Nest: Twitter’s IPO and the JOBS Act
Twitter: An “Emerging Growth Company” On September 12, 2013, Twitter announced its initial public offering (IPO) filing through its own Twitter feed: “We’ve confidentially submitted an S-1 to the SEC for a planned IPO. This Tweet does not constitute an offer of any securities for sale.”1 At the time, this tweet was the “only public…
A Flash of Light in a Dark Holding Environment? Apollo’s Resuscitation of the Quick Flip
The peak purchase prices private equity firms secured immediately prior to the financial crisis have left many firms stuck with poor exit options after portfolio valuations plunged in the aftermath of the crisis. The decrease in portfolio valuations resulted in increased holding times across the private equity industry as profitable exit options disappeared.1 For example,…
Private Equity and the Leveraged Buyout: Taking a Public Company Private
What is a Leveraged buyout?
A leveraged buyout (LBO) is a form of a business acquisition. However, it differs from an ordinary merger and acquisition (M&A) deal in many ways. First, the acquirer in an LBO is not a traditional corporation as in other acquisitions. Instead, the acquirer is a newly formed non-operating company, made up of the private equity firm and often the party who will manage the daily activities of the business.
Additionally, LBO’s are heavily debt financed, often with as little as 10 to 20% of the purchase price coming from equity investment.[1] In order to secure the large amount of debt necessary to complete the deal, the non-operating company is forced to borrow against the physical assets of the acquired business.[2]
Once the terms of the LBO are agreed to, current shareholders will be compensated with an agreed upon per share price and the ownership will be transferred to the non-operating company (the private equity firm and all other investors).
Why take a company private through an LBO?
Private equity firms are motivated to take the targeted company private in order to unlock potential synergy gains[3]. These synergy gains might come from financial restructuring, change in control, or increased coordination in decision-making.[4]
Firms often create synergy gains through financial restructuring. As discussed before, leveraged buyouts involve heavy debt financing. Debt has a tax benefit not available from equity investment, in that the interest owed on current outstanding debt decreases taxable income, resulting in higher cash flow available to all stakeholders.[5] In other words, debt creates a tax-shield equal to current interest expense multiplied by the effective tax rate.[6] Therefore, increasing the amount of debt within the financial structure of the firm can create value.
Additionally, Private equity firms often look to unlock synergy gains by eliminating the waste associated with inefficient management. By taking the company private, the firm no longer has to seek shareholder approval of management, but instead, can self select the new leadership team.[7] The idea is that the new management team will make better business decisions, increasing revenues and decreasing the associated costs.
Moreover, even if current management is efficiently running the company, there are coordination advantages from taking a company private. Public companies face a folly A/folly B problem. The company wants long-term success. In other words, it wants to make investments that result in the greatest net present value in the long run. However, companies have to respond to shareholders, who reward short-term performance, which results in increased stock price, over long term performance.
By taking the company private, management has flexibility in its decision-making and can focus on long-term performance without having to worry about shareholder repercussions. Also, public companies are often slow to act because there is a shareholder coordination problem. The company must provide information on major changes to all shareholders and must convince owners of a majority of the shares to vote collectively. By taking the company private, ownership is concentrated in a few individuals/entities who can act swiftly.
The potential downside of an LBO
While there are certainly numerous potential sources of synergy gains associated with an LBO, the form of acquisition is not without its risks. When levering a company to such a high debt to equity (D/E) ratio, the company must be able to produce enough cash flow to make its periodic interest payments on the outstanding debt. As a result, the risk of bankruptcy increases and the possibility of receiving the tax shield decreases. Additionally, banks will require higher returns to compensate for the risk associated with the debt. Therefore, private equity firms partaking in LBOs are continuously confronting the issue of how much leverage to implement in the deal.
Additionally, in an LBO, there is a constant conflict between shareholders and bondholders. Shareholders are incentivized to take risk, whereas bondholders prefer sound investments that will allow the company to pay back its debt. Therefore, when securing debt, private equity firms might lose some financial flexibility due to bank-imposed constraints on spending. If not managed properly this can counteract some of the benefits associated with making the move to a private company.
Lastly, by taking a company private, the investors lose access to a liquid market. As a result, it may take longer to recoup the investment. Research has indicated that the median LBO is still in private equity ownership around 9 years after the initial buyout transaction.[8]
Who is a good LBO target?
Given the potential risks associated with an LBO transaction, private equity firms must be careful when deciding whom to target. Private equity firms should look at targets from a three-value driver perspective: leverage, change in control and private-public.[9] The ideal target should be underlevered, inefficiently managed, and should be incurring large costs from staying public.[10] Additionally, companies with large assets and stable free cash-flows (cash cows) can support more debt, making them an attractive target. At the same time, private equity firms want to avoid using an LBO to purchase companies in highly cyclical industries and industries with rapid product obsolescence.[11] Companies in these industries are prone to periods of low to negative free cash-flows, which in turn increases the probability that they will be unable to meet their debts as they come due.
Summary
LBO’s are a form of private equity acquisition, in which the investors form a non-operating company and purchase a public company by implementing primarily debt financing. Taking a public company private can create gains in a multitude of ways, including increased tax shield free cash flows, elimination of inefficient management, and increased coordination of decision making. At the same time, there are many risks associated with an LBO. The risk of bankruptcy increases immensely, resulting in higher lending rates and loss of some financial flexibility. Consequently, private equity firms must be strategic about when to implement an LBO acquisition and realize that it is not always the proper tool.
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[1] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013); Note on Leveraged Buyouts. Center For Private Equity and Entrepreneurship at 1, available at http://pages.stern.nyu.edu/~igiddy/LBO_Note.pdf.
[2] Steven N. Kaplan & Per Stromberg, Leveraged Buyouts and Private Equity, Journal of Economic Perspectives, American Economic Association 23(1), 2009.
[3] Here, synergy gain is a proxy for a long term financial benefit
[4] See Note on Leveraged Buyouts at 2.
[5] Grant Houston, Tax Advantages of a Leveraged Buyout, Chron, http://smallbusiness.chron.com/tax-advantages-leveraged-buyout-24006.html
[6] See id.
[7] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[8] See Kaplan, supra note 2, at 130.
[9] Amiyatosh Purnanandam, Associate Professor of Finance, Valuation course at the Ross School of Business, University of Michigan (February, 2013).
[10] Id.
[11] Id..
Private Equity Firms Accused of Misleading Buyer
Japanese beer and beverage maker Asahi Group has filed a lawsuit in Australia against two private equity firms who sold Asahi a liquor company for $1.3 billion USD. The suit claims that Australian-based Pacific Equity Partners and Hong Kong-based Unitas Capital—the previous owners of New Zealand’s Independent Liquor—presented inflated earnings figures during the sales process.[1] As a result of this “misleading and deceptive conduct,” Asahi feels that it grossly overpaid for the premixed cocktail distributor and that it deserves compensation.[2]
At the heart of Asahi’s complaint is the allegation that Independent Liquor’s earnings before interest, tax, depreciation, and amortization (EBITDA) figures were embellished.[3] EBITDA is often used to value a company for purposes of buying it, and has been called the “single most important financial contributor to buyout performance.”[4] The complaint alleges that Independent used creative accounting techniques such as ‘channel stuffing’—“a practice where a supplier forward sells stock on extended terms to retailers in order to account for significant ‘one off’ sales in a particular period”—to wrongfully include income and exclude expenses.[5] Asahi claims that these practices inflated Independent’s EBITDA by $NZ42 million,[6] and made it appear as if Independent was growing at the time of the sale when normalized calculations show that it was actually declining.[7] These inconsistencies likely had a significant impact on the negotiated purchase price, as Asahi claims it “conducted due diligence thoroughly and in good faith and relied on [the EBITDA figures] provided.”[8]
Although this dispute will be resolved in an Australian court, it is factually similar to a case arising out of Delaware a few years ago. In ABRY Partners v. Providence Equity,[9] the buyer, ABRY Partners, accused the private equity seller, Providence Equity Partners, of knowingly presenting a portfolio company’s misstated financials in connection with a sale.[10] The purchase agreement contained provisions designed to insulate Providence from liability for representations made by its portfolio company.[11] Specifically, the warranty that ABRY claimed was breached was “by its plain terms . . . [a warranty] made only by the [portfolio company] and not by [Providence].”[12] The agreement also contained a $20 million indemnification cap.[13] The Delaware Court of Chancery ultimately found that the indemnification cap would be honored if Providence did not lie.[14] However, it found that ABRY could collect damages in excess of the cap if it could prove that Providence knew its portfolio company made false representations or if Providence itself made such representations.[15]
If the Australian court takes a similar approach, the purchase agreement will be crucial in determining the level of culpability Asahi must prove and the amount of damages that they can recover. ABRY suggests that a properly drafted agreement can insulate PE firms from fraud committed by their portfolio companies in connection with the sale as long as the firm was not aware of it. If such a term were contained in this agreement, it would force Asahi to prove that these companies knew Independent was manipulating the EBITDA figures. While this is a seemingly heavy burden, the Asahi complaint suggests that they would be able to prove knowledge through email correspondence they have obtained.
Regardless of the outcome, this case evidences the importance of (1) conducting thorough due diligence; (2) understanding ways in which EBITDA can be manipulated; and (3) thinking carefully about future liability when drafting purchase agreements.
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[1] Neil Gough, Asahi Sues 2 Private Equity Firms Over $1.3 Billion Deal, N.Y. Times (Feb. 14, 2013, 5:13 AM), http://dealbook.nytimes.com/2013/02/14/asahi-sues-2-private-equity-firms-over-1-3-billion-deal/.
[2] Id.
[3] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, The New Zealand Herald (Feb. 18, 2013, 11:45 AM), http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10866101.
[4] Nicolaus Loos, Value Creation in Leveraged Buyouts 229 (2006).
[5] Adele Ferguson, Japanese Brewer Up in Arms Over Purchase Price, Newcastle Herald (Feb. 26, 2013, 5:00 AM), http://www.theherald.com.au/story/1326151/japanese-brewer-up-in-arms-over-purchase-price/?cs=9.
[6] See id.
[7] Asahi Alleges ‘Channel Stuffing’ At Beer Firm, supra note 3.
[8] Gough, supra note 1.
[9] ABRY Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006).
[10] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, Goodwin Proctor LLP (Mar. 14, 2006), http://www.goodwinprocter.com/~/media/Files/Publications/Newsletters/Private%20Equity%20Update/2006/Ruling_in_ABRY_Partners_v_Providence_Equity_Case_Has_Lessons_for_Buyers_and_Sellers.pdf.
[11] See id.
[12] ABRY Partners, 891 A.2d at 1042.
[13] See Ruling in ABRY Partners v. Providence Equity Case Has Lessons for Buyers and Sellers, supra note 10.
[14] See id.
[15] See id.
Is the 2013 Private Equity Boom Sustainable?
2013 has seen an early resurgence in the volume of mergers and acquisitions conducted globally. Since January, there have been in excess of 1000 deals with an aggregate value of over $160 billion,1 the fastest start since 2005.2 This boom has been anchored by several large, and sometimes unprecedented, buyouts, including the $23 billion takeover of…
Dividend Recapitalization: A Controversial Trend
In a slow economy, with low interest rates, private equity firms are adding debt to the companies they own in order to create returns for investors. This controversial practice is now reaching record pace.[1] The resurgence is due to investors’ desires of achieving high yielding debt at a time of historically low interest rates.[2] Some of the most prominent private equity firms, such as Leonard Green & Partners LP, Bain Capital LLC, and the Carlyle Group LP are a few of the firms using this tactic, which became popular before the financial crisis.[3] Between 2003 and 2008, companies borrowed $69 billion primarily to pay dividends to private-equity owners, according to Standard & Poor’s Corp.[4] That compares with $10 billion in the previous six years.[5]
“In these deals, known as ‘dividend recapitalizations,’ private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.[6] In other words, private equity firms are creating returns for their shareholders by leveraging the companies that they own. This financing method allows the private equity fund to recoup part, if not all, of the fund’s initial investment and leaves open the possibility of benefiting from any future increase in value, since no sale transaction occurs.[7] Despite the creation of high returns for shareholders, this trend of dividend recapitalization may prove to be extremely costly to a recovering economy.
First, many private equity funds, especially the mid-sized and smaller funds, are likely to feel pressure to sell off portfolio companies to create liquidity for their investors and build a track record that will support future fund raising efforts.[8] Although the main goal for private equity firms is to create returns for investors, this is not the way that private equity firms traditionally went about fulfilling that goal. In the traditional sense, multiple parties with diverging interest potentially benefited from private equity firms taking over a struggling company. A struggling company would be made profitable through changes made by the private equity firm, and the private equity firm would sell the company once they thought they could get a return on their investment. With “dividend recapitalization,” the only party that benefits is the stockholders. They are getting paid, but the companies that the private equity firm owns are not any better off. In many cases they are worse off, as private equity firms may be unwisely leveraging the companies they own.
Second, through dividend recapitalizations, private equity funds maintain high leverage on portfolio companies capable of paying down their debt, thereby maintaining risk of insolvency.[9] In times of economic uncertainty, it does not seem like a wise move to create unnecessary debt. One has to wonder what would be the consequence if some of these companies started going bankrupt. It all probably depends on how greedy the private equity firms are. There is one thing that will probably keep them in check, their public image. Leonard Green & Partners LP, Bain Capital LLC, and the Carlyle Group LP do not want to be known as the people who shut down American companies.
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[1] Ryan Dezember & Matt Wirz, Debt Fuels a Dividend Boom, Wall St. J., Oct. 18, 2012, (http://online.wsj.com/article/SB10000872396390444592704578064672995070116.html?mod=WSJ_Markets_LEFTTopStories)
[2] Id.
[3] Id.
[4] Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7
[5] Id.
[6] Dezember & Wirst, supra note 1.
[7] Alan S. Gutterman, et al., Review of Major Developments Affecting Mergers, Acquisitions and Divestitures, 28 No. 12 Corp Acq Ideas 1
[8] Louis S. Freeman, General Overview And Strategies In Representing Sellers, 825 PLI/Tax 7
[9] Id.
Regulatory Oversight in Private Equity
Late last year, the Securities and Exchange Commission (SEC) announced an informal inquiry [1] into private equity funds. This investigation has at least three goals: (1) understanding alleged systemic risks posed by private equity funds; [2] (2) ascertaining whether valuation, due diligence, and related compliance controls are in place and adequate; [3] and (3) rooting out potential fraud. [4] However, some commentators have expressed the belief that the SEC is concerned with the valuation and compliance processes in place at smaller funds and so called “zombie”[5] funds, as opposed to the major players. [6] Indeed, neither the Blackstone Group nor KKR—both major players and publically traded—received the SEC’s first wave of informal inquiry requests in February, [7] and it is unclear if they have since received a request in a subsequent wave. Comments by the Bruce Karpati of the SEC’s enforcement division confirm this narrow view: “[the agency] is looking at zombielike funds that have potentially stale valuations.” [8]
The SEC’s espoused goals thus seem inconsistent: in contrast to large funds, small funds or zombie funds are unlikely to cause the systemic risks that would warrant investigation. Although valuations for zombie funds might raise concerns of fraud, [9] systemic fraud in private equity valuations seems unlikely due to countervailing incentives: private equity funds might want to overvalue assets to attract new investors, [10] but they want to maximize the difference between purchase and sale price [11] which could incentivize undervaluing assets. Reputation, which directly affects investor confidence, is another check on fraud. [12] Additionally, private equity investments involve sophisticated investors, [13] and as a matter of policy the SEC limits oversight of sophisticated investors. Increased regulatory oversight chips away at the notion that sophisticated investors can and should bear the economic risks of their investments themselves.
Therefore, to even investigate zombie funds is a marked policy shift for the SEC. By subjecting zombie funds to regulatory oversight, as opposed to leaving them to private resolution, the SEC has imposed not-insignificant regulatory compliance costs onto all private equity funds. [14] Simply put, the industry-wide costs imposed by the SEC’s new regulatory scheme could substantially outweigh the costs [15] associated with private resolution of zombie funds. Although investors might face significant losses through private resolution, private equity is a field for sophisticated investors that are capable of bearing investment risk. Consider a hypothetical pension fund that has invested into what has become a zombie fund. The fund must only take steps to leave the investment and absorb the associated losses. [16] In contrast, the SEC must first identify the zombie fund by reviewing valuation and compliance procedures, likely a costly and inefficient endeavor. Every private equity fund subject to SEC oversight must thus bear the cost of regulatory compliance, rather than limiting the costs to investors in zombie funds. A more efficient solution might be to work directly with aggrieved investors to investigate only particular funds. Upon receiving a complaint from an investor, the SEC can launch a targeted investigation that does not impose unnecessary costs onto the industry. The SEC already maintains a complaint reporting system, and expanding that system to include zombie funds is potentially a better use of the Commission’s finite resources.
Further, some commentators also question whether the SEC should devote any resources to valuation methods. [17] Conventional wisdom holds that valuing a private entity is an art, not a science; there is inherent uncertainty in valuation. [18] Industry groups argue that valuations are not as important to private equity funds as they are to other alternative investments. [19] Hedge funds, for example, charge fees based on changes in valuation, whereas the majority of fees due to private equity firms are based on the difference between the entrance and exit prices. [20] Although the SEC contends that smaller private equity funds might be incentivized to overvalue assets to attract greater investment and management fees, [21] they also face the countervailing incentive to minimize their asset valuation to maximize the delta between entrance and exit price. As previously noted, the private equity industry serves sophisticated investors capable of bearing investment risk, and the SEC’s resources might be better used to protect lay investors rather than to regulating an uncertain-by-nature practice.
This is not to suggest that greater regulatory oversight does not lead to benefits for the firms themselves. For example, some small and midmarket funds have retained outside firms to analyze and test their compliance practices, with the goal of understanding vulnerabilities. [22] Funds have already seen benefits from these reviews, by discovering that their internal controls with regard to data security were not up to SEC standards. [23] Nevertheless, these benefits must be weighed against the broad inefficiencies imposed by the regulatory scheme. Small and midmarket funds must already consider how to efficiently use their relatively limited resources. Rather than imposing costs across the industry, a much narrower regulatory scheme implemented through the existing complaint system is more likely to limit costs. Risk aversion will still lead to the creation of elaborate compliance schemes and mock reviews given that many compliance groups have “little or no experience with an SEC inquiry[,]” [24] or may not understand how to handle an SEC investigation. However, because fewer funds will be in the spotlight at any given time through the use of the complaint system—there at least 200 zombie funds, compared to more than 10,000 private equity funds generally— [25] it will be easier to contain industry-wide costs.
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[1] Letter from Securities and Exchange Commission to Certain Private Equity Funds (Dec. 8, 2011), available at http://online.wsj.com/public/resources/documents/SECInquiry.pdf.
[2] Shaun Gittleman, U.S. SEC Set to Monitor Private Equity Funds, Official Says, Reuters (May 8, 2012), http://blogs.reuters.com/financial-regulatory-forum/2012/05/08/u-s-sec-set-to-monitor-private-equity-funds-official-says/ (due to new regulations implemented under Dodd-Frank, private fund advisers must report potentially systemic risks through the SEC and Commodity Futures Trading Commission).
[3] Carlo V. di Florio, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Address at the Private Equity International Private Fund Compliance Forum (May 2, 2012), available at http://www.sec.gov/news/speech/2012/spch050212cvd.htm.
[4] Id .
[5] Zombie funds are those where investors must continue to pay management fees, even though the funds are inactive or not actively managed. Often, the zombie fund’s assets are difficult to value or sell. Thus, investors are locked into these funds—which continue to accrue management fees—without the prospect of future payoff. According to one estimate, as much as $100 billion is tied up in zombie funds, and investors stand to lose substantially if they try to sell their stake: private markets value those investments at 30-40% of the stated value. See David P. Abel, Investors Beware of Zombie Funds, Motley Rice Blog (June 7, 2012),http://blog.motleyrice.com/investors-beware-of-zombie-funds/; see also Susan Pulliam and Jean Eaglesham, Investor Hazard: ‘Zombie Funds’, Wall St. J. (May 31, 2012), http://online.wsj.com/article/SB10001424052702304444604577339843949806370.html .
[6] See Dan Loeser, SEC Investigates Private Equity Valuation Methods, Colum. Bus. L. Rev. (Feb. 27, 2012), http://cblr.columbia.edu/archives/11980.
[7] Joshua Gallu and Cristina Alesci, SEC Review of Private Equity Said to Focus on Smaller Firms, Bloomberg Bus. Wk. (Feb. 14, 2012), http://www.businessweek.com/news/2012-02-14/sec-review-of-private-equity-said-to-focus-on-smaller-firms.html .
[8] Pulliam & Eaglesham, supra note 5.
[9] Abel, supra note 5 (there is “concern about the possibility of private equity firms manipulating the value of investments to prop up these zombies.”)
[10] See Gallu & Alesci, supra note 6; see also Jonathan E. Green and Lindsay S. Moilanen, SEC Scrutiny Focuses on Asset Valuation and Private Equity Funds, Inv. Funds Group Newsletter (Kaye Scholer, New York, N.Y.), Summer 2012, at 8, available at http://www.kayescholer.com/news/client_alerts/Investment-Funds-Newsletter-Summer2012/_res/id=sa_File1/Investment-Funds-Group-Newsletter-Summer2012.pdf .
[11] See Loeser, supra note 6.
[12] Id.
[13] See Gallu & Alesci, supra note 7; see also Loeser, supra note 5.
[14] See Loeser, supra note 6.
[15] Which are perhaps more accurately characterized as investment losses.
[16] Private resolution is likely to lead to losses upon exiting the investment. See Abel, supra note 5 for a description of some potential private remedies.
[17] See, e.g. , Loeser, supra note 6 (discussing the inefficiencies arising from greater SEC oversight in the context of the Commission’s already overextended resources).
[18] Id . (citing European Private Equity and Venture Capital Ass’n, Int’l Private Equity and Venture Capital Valuation Guidelines (2006)).
[19] Gregory Zuckerman, How Scared Should Private Equity Be Under SEC Microscope?, Wall St. J. (Feb. 27, 2012), http://blogs.wsj.com/deals/2012/02/27/how-scared-should-private-equity-be-under-sec-microscope/ .
[20] Id . Note, however, that private equity funds do derive some fees from fund valuation (typically 2%) but receive far greater fees from profits or “carry” (typically 20%). This fee arrangement is commonly referred to as “2 and 20.”
[21] See supra note 10.
[22] Laura Kreutzer, PE Firms Learn to Live with Dodd-Frank, Dow Jones Private Equity Analyst (Aug. 27, 2012), available at http://pevc.dowjones.com/article?an=DJFPEA0020120827e88refmxe&from=alert&pid=22
[23] Id .
[24] Id.
[25] Pulliam & Eaglesham, supra note 5.
The National Hockey League and Private Equity
For the second time in seven years, there is a real possibility that an ongoing labor dispute will prevent the puck from ever being dropped on the National Hockey League season. Hockey has become an afterthought, a professional sport that is lucky to receive a minute of airtime on the nightly Sportscenter broadcast. While reports have estimated that the NHL has lost as much as $240 million in the last two seasons,1 diehard hockey fans do still exist. And while they would probably rather spend their time smuggling octopi into Joe Louis Arena, they may find hope in reading a recently published piece by Bloomberg Businessweek that asks, “Could Private Equity Solve Pro Hockey’s Problems?”
The article lays out a number of qualities that would make the NHL attractive to private equity firms. Among the qualities listed are:
• “Weak management
• Underachieving revenue
• Opportunities to expand while taking on debt
• Problems that are driving down value, but could be solved by a fresh set of outside managers.”2
These undesirable characteristics have plagued the NHL for years, and PE firms have taken notice. In 2005, Bain Capital surprised many with an offer to buy the entire league for $3.5 billion.3 Bain’s proposal reflected the classic PE business-model: by combining all 30 teams into a single business entity, it would be possible to streamline operations, boost TV revenue, and slash player salary from a position of absolute leverage.4 This single ownership strategy is the model that Major League Soccer, a league that started as an afterthought in the crowded American sports market, has employed (to at least limited success).5
As a dispassionate third party, Bain would focus solely on making money—it would not be blindsided by the emotions that undoubtedly come with owning a pro sports team. Yet those emotions are what ultimately doomed the deal, as Bain failed to muster the required majority approval from team owners.6 Given that most of these owners are independently wealthy and are not in the business for the money, it is unlikely that this type of transaction would ever be agreed upon.
Even if a firm like Bain were somehow able to overcome this hurdle, they would still be faced with an even larger issue: the players themselves. During a PE takeover, labor is often one of the first areas in which costs are cut. Technological improvements or cheaper workers typically replace longtime employees. However, sports are unique in that the laborers are the products. The NHL could recruit inexpensive, second-rate talent, but it certainly would not improve economic conditions considering that the league currently employs the top players in the world and still struggles to make a profit. The alternative—convincing the current players to take a significant pay cut—is extremely unrealistic given the lucrative contracts that foreign franchises would assuredly offer the NHL’s stars.
At first glance, the NHL and PE may seem like a perfect match. However, a closer look reveals that some major issues would have to be resolved in order for the relationship to be profitable. But still, if an entire season is lost and teams continue to operate in the red, the league would be wise to at least reconsider a PE model that has helped save so many similarly distressed companies in the past.
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1 Dirk Hoag, NHL CBA 2012: How can the league, as a whole, be losing money?, ON THE FORECHECK (Sept. 4, 2012, 4:55 PM), http://www.ontheforecheck.com/2012/9/4/3292168/nhl-cba-2012-league-losing-money-ha-ha-ha.
2 Nick Summers, Could Private Equity Solve Pro Hockey’s Problems?, BLOOMBERG BUSINESSWEEK (Sept. 11, 2012), http://www.businessweek.com/articles/2012-09-11/could-private-equity-solve-pro-hockey-s-problems.
3 Id.
4 Id.
5 See http://majorleaguesoccertalk.com/2009/11/27/mls-and-its-players-third-party-ownership-player-and-club-rights-non-existent/; see also, Fraser v. Major League Soccer, 284 F.3d 47 (1st Cir. 2002) (MLS central-ownership structure not an anti-trust violation).
6 Id.