The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything (Bloomberg)

by Jason Kelly

  Yet the amount of debt committed to leveraged buyouts during that period left lingering questions about how much debt was too much, and the dangers of leveraging a company just because you could. One complicated lesson of the boom and bust is Freescale Semiconductor, the chipmaker taken private by a group of private-equity firms in 2006 in the biggest LBO of that type of company ever. While the final chapter on the company has yet to be written, its troubled recent history makes a strong case that not every company can bear the burden of heavy borrowings.

  Freescale began as part of Motorola, the legendary Chicago company that effectively invented the modern mobile phone. For decades, the semiconductor division had a captive customer that was helping define the modern electronics industry. Under pressure from its public shareholders who argued the unprofitable chip business was a drag on the broader company, Motorola announced in 2003 it would spin out what became Freescale. The spin was completed in late 2004 and Freescale’s stock performed well. It was trading around $30 a share when word leaked that Freescale was entertaining buyout offers.

  As the LBO boom began to crest in 2006, there was virtually no company that wasn’t a potential target, given the aforementioned glut of both equity and available debt. Semiconductors are a notoriously cyclical industry historically, owing to the huge capital expenditures necessary to build chip factories, known as fabs. Profits ebb and flow dramatically, based on when a company has to shell out for a new fab, as well as the shrinking margins for semiconductors as they give way to the next generation of products.

  To be sure, some of the most successful companies in U.S. history are chip companies, including Intel, Qualcomm, and Texas Instruments. Those companies and others helped define the modern technology industry; Intel was and is a central force in Silicon Valley, widely considered the cradle of American innovation. Semiconductors are the vital brains in electronics. In Freescale’s case, the company’s products were found in the dashboards of cars and video game systems among hundreds of other products.

  Flush with cash and with easy financing offered, a handful of the world’s biggest buyout firms weren’t scared off from Freescale. They saw an underperforming, undermanaged, and overall neglected company that could benefit from a few years outside of the unforgiving public markets. A bidding war erupted and in the end, four firms—Blackstone, Carlyle, TPG, and Permira—agreed to buy Freescale for $17.6 billion, a 30 percent premium from where it was trading when word of a potential deal leaked. As soon as the deal closed, Freescale became the most indebted semiconductor company by a wide margin. Within months, the global economy began to unravel. Freescale watched as Motorola, still among its largest clients, and automakers, another key customer, faced unprecedented declines in their own businesses. That pain hit Freescale hard.

  The private-equity owners scrambled, divvying up work among the parties to focus on the balance sheet, the company’s operations, and its management. Michael Mayer, the CEO who’d overseen the divestiture from Motorola, stepped down in February 2008. The owners recruited Rich Beyer, the CEO of chipmaker Intersil, to run the company. When he told a fellow CEO he was going to run Freescale, the colleague asked, “Why would you join such a crappy company?”5

  Beyer undertook a massive restructuring effort, closing three factories and reducing the number of design centers to 23 from 66. The owners engineered a debt swap to push out the chipmaker’s borrowings, reducing debt by $2 billion. The efforts culminated in a 2011 IPO that was far from a glorious exit for the buy-out firms. All the proceeds went to pay down debt. The valuation for the IPO of $18 a share was 50 percent less than the average price paid by the owners.

  By early 2012, Freescale was stabilized, if barely. Freescale’s market capitalization was $3.7 billion, The company’s debt load, once in excess of $10 billion, had been pared to a still-large $7 billion. The deal stands in part as a cautionary tale for LBOs, especially those negotiated amid frothy equity and debt markets. While Freescale has struggled, its owners are quick to point out that it did not, in fact, default on its obligations and did not file for bankruptcy. They make the case that the exogenous economic forces that crushed the company during the financial crisis might well have overtaken the chipmaker and forced a fire sale, and that its ability to have focused management and ownership ultimately helped it live to fight another day. The lack of clear lesson only serves to underscore the ultimately complexity of these deals, where numerous variables collide to determine the fate of a company.

  As the global economy, and private equity along with it, recovered in 2010 and 2011, a number of buyout executives were quick to point out the lack of defaults by private-equity-owned companies. An analysis of the biggest deals of the boom shows that largely to be true and while “not going bankrupt” is far from the definition of a successful deal, the doomsday scenarios didn’t play out in spectacular fashion. There were some failures. KKR’s Capmark, a commercial real estate lender, sought bankruptcy protection in 2009. That followed retailer Linens ‘n’ Things, backed by Apollo, which filed in 2008.

  In early 2010, there was a rigorous debate over how defaults by private-equity-backed companies compared with non-LBO backed concerns. Boston Consulting Group helped stir up the discussion, predicting that almost half of the companies bought by private-equity firms would default on their debt within three years.6 Defaults have yet to accelerate. Historically, defaults have actually been lower for companies that have been through a private-equity transaction, according to at least one research paper. The study, by Per Stromberg at the Stockholm School of Economics, found an annual default rate from 1980 to 2002 of 1.2 percent for LBO-involved companies, versus a default rate for U.S. corporate bond issuers of 1.6 percent for the same period.7

  The ambitions of the private equity industry rise and fall largely on the availability of debt, a lesson underscored by the lack of deals in the wake of the credit crisis, when banks weren’t able to lend and the funds that bought the loans backing LBOs largely evaporated.

  In 2007, the notion of a $100 billion leveraged buyout, was kicked about with abandon, and modeled by eager analysts inside every bank and major buyout firm. In 2012, the notion of a deal that size was simply laughable. Since the Hilton deal, announced in mid-2007, the largest buyout announced was a KKR-led consortium’s $7.2 billion takeover of Samson Investment Co., an oil exploration concern, according to Bloomberg data.

  The debt wasn’t there to the extent that it once was. One of the easiest ways to measure it was through the percentage of the price that comprised debt versus equity. This was one of the most fundamental changes from the earliest days of the industry, when a private-equity fund could provide 5 to 10 percent of the purchase price and borrow the rest. Data showed that especially for smaller deals (under $1 billion), debt comprised only 46 percent of the purchase price in 2011 on average, down from 57 percent in 2006, near the peak of the boom, according to researcher Pitchbook. Transactions above $1 billion were able to get 61 percent of the purchase price in debt, down from 67 percent in 2006.8

  Equity, however, was more than available from eager buyout firms. Much was written and discussed about the industry’s “dry powder,” the colloquial term for committed, uninvested money. Firms collectively had around half a trillion dollars of dry powder, according to numerous estimates, having sat on the sidelines for much of 2008 and 2009. The relative scarcity and cost of debt meant the dealmakers couldn’t buy with abandon. One lesson of the boom and bust was clear: Be careful what you buy.

  Notes

  1. Miles Weiss, “Black’s Apollo Strengthens Former Drexel Links with Push into Brokerage,” Bloomberg News, April 12, 2011.

  2. William D. Cohan, “Private Equity’s Public Subsidy Is a Tragedy,” Bloomberg View, January 22, 2012.

  3. Cristina Alesci and Laura Marcinek, “Morgan Stanley Targets Mid-Market Private Equity to Boost Fees,” Bloomberg News, March 18, 2011.

  4. Peter Lattman and Jeffrey McCracken, “Equity Firms Cheer Return of �
�Staple’; Critics Don’t,” Wall Street Journal, March 5, 2010.

  5. Jason Kelly and Ian King, “Freescale Weighs IPO to Ease Chipmaker’s $7.9 Billion in Debt,” Bloomberg News, August 26, 2010.

  6. Heino Meerkatt and Heinrich Liechtenstein, “Get Ready for the Private Equity Shakeout,” The Boston Consulting Group and IESE Business School, Dec. 2008. www.iese.edu/en/files/PrivateEquityWhitePaper.pdf

  7. Steven N. Kaplan and Per Stromberg, “Leveraged Buyouts and Private Equity,” Journal of Economic Perspectives 22, no. 4 (Season 2008). http://faculty.chicagobooth.edu/steven.kaplan/research/ksjep.pdf

  8. PitchBook Annual Private Equity Breakdown 2012. www.pitchbook.com/component/option,com_performs/Itemid,179/formid,70/showthank,1/uid,g2fXicZXffYPSGNFaWcV

  Chapter 4

  “When Was the Last Time You Bought a Toilet Seat?”

  Dollar General

  Richard Dreiling stepped onto the balcony outside the bar of the Dream Hotel in New York on the evening of November 13, 2009, and took a deep breath. As a light rain began to fall, exhaustion overcame him. He went back inside with his wife Ellen, told his colleagues good night, and went back to his hotel to sleep.

  It was the end of a long day. That morning Dreiling had stood on the balcony of the New York Stock Exchange and rung the opening bell in honor of Dollar General’s return to the Big Board via a public offering. It capped two weeks of pitching institutional investors on the story, repeating an hour-long presentation 9 or 10 times a day over breakfast, lunch, and dinner and everything in between in almost a dozen cities, from New York to Denver to Los Angeles, sometimes circling back to the same place for more meetings. It also capped a two-and-a-half-year reinvention of a discount retailer that had lost its way, floundered for a plan, and eventually succumbed to a rich takeover by KKR at the height of the LBO boom.

  Dreiling, who started his career in retail as a stock boy in Kansas City, was the primary architect of the reinvention, charged by KKR with burnishing a chain that dated back to the 1930s in Kentucky and had once operated under the motto “The Town’s Most Unusual Store.” For a massive chain (10,000 stores in 39 states), the company retains more than a whiff of eccentricity. I had been told that to really understand Dollar General, I had to go there, to the company’s headquarters in the northern suburbs of Nashville, in an enclave called Goodlettesville. There, perched on a hill is a two-building, four-story complex. Their addresses are One Integrity Place and Turner One, a nod to the company’s founding family.

  The first thing you notice is the bears, massive metal statues of bears climbing over the fountain in front of the headquarters, one lying lazily on a nearby stone bench. Just inside the door is another bear (he was wearing a Santa hat on this particular December day). The bears were put there by one of Dreiling’s predecessors, Cal Turner Jr., the son and grandson of Dollar General’s two founders and its CEO for more than 20 years.

  Off to one side of the atrium inside the front door is the “Hall of Values,” a mini-museum of Dollar General’s history, complete with a Southern baritone voice-over with a banjo and fiddle as background music. Walking counterclockwise through the room, the story of the company unfolds. Cal Turner Sr. and his dad, J. L. Turner, opened in 1939, a single location in Scottsville, Kentucky, under the name J. L. Turner & Son Wholesale. The elder Turner had dropped out of school when he was 11 years old; much of the company’s philanthropic efforts centers on education and literacy.

  By 1955, the Turners had decided to sell directly to consumers, intrigued by the allure of “dollar days” at department stores. What if, they wondered, there was a store where that was true every day? A big part of the initial strategy was to buy huge amounts of unwanted goods at a low price and then resell them. Cal Turner at one point negotiated with a vendor to buy reams of pink corduroy he made into pants and then successfully sold for $1 a pair.1 The company expanded and was generating more than $1 million in annual net income by 1967, and a year later Dollar General went public. Cal Turner Jr. took over from his father as CEO in 1977 and the company kept growing by opening new stores and eventually making acquisitions. In 1983 and 1985, the company bought almost 500 additional stores and then struggled to integrate them into the existing company. With sales growth at a near-standstill, the company stopped advertising altogether in 1985 to regroup and focus on the brand, a fact noted in the Hall of Values.

  One part of more recent history that goes unmentioned in the museum is the company’s settlement in 2004 with the U.S. Securities and Exchange Commission after an investigation over accounting irregularities. The company never admitted wrongdoing, eventually agreeing to pay $10 million to settle the probe. Turner resigned as CEO in 2002 and chairman in 2003 after repaying $6.8 million he received in bonuses and through exercising stock options in 1999 and 2000.2

  Armed with funds from limited partners and with access to debt from Wall Street, private-equity firms are rarely interested in companies firing on all cylinders. Healthy firms can’t usually provide the potential for returns that buyout managers have guaranteed their investors, and which will deliver the rich profits they’re after. In an era where huge amounts of leverage are no longer available, the combination of cash and debt has to be aimed at companies where something dramatic can happen to the company, usually by making radical changes to the way the target operates. That often starts with who runs it.

  Dreiling has a shock of white hair that gives him a passing resemblance to the late comedian Leslie Nielsen. Belying his long career in retail, he’s engaging but efficient. In a store, he’s taking everything in. Around a table, he’s sizing people up. He’s quick with a compliment. Analyst queries on calls are often met with “That’s a great question” before he launches into an answer.

  It was just outside the Hall of Values where Dreiling first met the company’s corporate staff, in January 2008. He walked into the atrium and stood on a small stage—set up in front of a bear—facing a banner that said, “Welcome Rick Dreiling.” He took one look at that and thought to himself, “I hope like hell they’re still saying that in 90 days.”

  There was reason for apprehension. Several months before Dreiling’s appearance, they’d met their new owner, represented by a fellow named Michael Calbert, a former grocery store executive who’d spent the past seven years at KKR buying companies like Toys “R” Us. Calbert and Raj Agrawal, another KKR partner, along with Dollar General chief financial officer David Tehle and interim CEO David Bere, had spent the past nine months mapping out Dollar General’s strategy. Part of the process had been picking someone to run the company. Now here was the guy they’d chosen.

  While KKR was convinced it had made a winning deal, it was nonetheless a massive bet, especially in the face of an economy that was wilting and on the verge of cratering. KKR and its banks had barely been able to secure the financing needed to close the deal the previous July as the credit markets that had fueled enthusiastic deals earlier in the year locked up.

  That day in January, Dreiling knew he had to be reassuring. He broke the ice by referencing a story in the local paper that had referred to KKR bringing in its “turnaround expert.”

  “I don’t know who this turnaround expert is, but it’s not me,” he told the employees gathered around him and peering down from the three balconies overlooking the atrium. “This is your company and I have to earn your respect.”

  Despite working for decades in California and then New York, Dreiling maintains his Midwestern charm, which played well in the South. He got a taste of Southern manners a early on in an elevator, when an employee recognized him and said, “It’s nice to meet you, Mr. Dreiling.” Dreiling said, “I’m not Mr. Dreiling. My name’s Rick.” The response: “Well, it’s nice to meet you, Mr. Rick.”

  On another elevator ride, when two employees didn’t recognize him, he overheard a conversation that worried him, and underscored the lack of direction at the company. One turned to the other and said, “What do you think the program of the week
is this time?”

  That sort of confusion is where private-equity firms say they thrive.

  Owning a company is where the rubber meets the road for private equity, and in the journey that the money takes from those pensions and endowments, this is the stop that has the broadest implications for the most people. Investors, workers, executives, customers, and the private-equity guys all have something on the line here. The conversation in the elevator, and looking up at the expectant faces looking down into the atrium, reminded Dreiling this wasn’t an academic exercise. This was the sort of deal that KKR should excel at, the sort of deal it had sold itself to its investors on for going on three decades.

  The years 2006 and 2007 were the headiest of times for private equity, and KKR was the busiest of any firm by most measures. The firm had made its name by making deals, and the opportunities to buy things had never been better.

  KKR went on a buying binge. In late 2006, they topped the long-standing record for the industry’s largest deal (set with its own RJR takeover almost two decades earlier) with the purchase of hospital chain HCA. After Blackstone topped that record months later with Equity Office Properties, KKR came back with TXU, the $43.2 billion deal that stands as the biggest ever.

  Among the busiest deal guys was Calbert. He’d arrived at KKR in 2000 after another KKR company, Safeway, had bought a Houston grocery chain called Randalls where he was the chief financial officer. KKR has an affinity for retail, and specifically supermarkets. The firm has owned at least five supermarket chains since its creation, most notably Safeway, which it bought in 1986. Over the following 13 years, KKR turned its $129 million stake into $7.2 billion (making about 56 times its money); it’s one of the most successful deals in the firm’s history.