You seem to imagine that there were creditors who lent money to a “healthy” Simmons under Fenway’s ownership and then woke up to find themselves at the back of the line to the new deal. But that isn’t true. The $1.1bn went to discharge ALL claims against Simmons – both Fenway’s equity and the previous lenders’ debt. The day after the deal, the only claimants on Simmons were people who explicitly agreed to the specific capital structure.

Furthermore, your description of the transaction is incorrect. An acquisition vehicle was formed that bought Fenway’s shares in Simmons. The consideration was fair, as it was the price at which Fenway was willing to sell its shares and THL was willing to buy them, neither being under compulsion to trade. A subsidiary of the acquisition vehicle holding debt and cash then merged with Simmons, since both the debt vehicle and Simmons were subsidiaries under common control (Newco). The cash was used to retire the existing debt on Simmons, and the world was left with THL owning all of the shares in a Simmons that had the acquisition debt.

What causes me the most discomfort is that this pattern of dividend recaps is again on the upswing. With the rate of return on safe bonds at minimal levels (due to government action), pursuit of returns will eventually override concerns about risk (particularly with hedges available) and institutions will once again lend money to these schemes.

While the owners may not want want these companies to fail, if they have recaptured their investment and more, they have less incentive to take additional risks to make them succeed.

One possible solution is for the bankruptcy law to treat these dividends as preferences subject to claw-back. If they aren’t now, they should be. Proposing such legislation would pit the vultures against the parasites. It would be fun to watch the competing lobbyists.

The latest missive continues the trend of large takeovers and blow ups to again portray the industry in poor light. To help, I will refute some of the misunderstandings and bring about the industry in lay terms.

Imagine a house. Now imagine you want to buy that house. If you are unlike Bill Gates, you will more than likely require financing. Now the current owner’s financing may be completely different from your idea of what an ideal capital structure may be. The mortgage may have already been paid off, or they may only own 25% equity if the had recently purchased it. This does not matter because you will pay them the agreed sales price and then can institute your own capital structure. For instance, once the sales agreement is negotiated stating you would pay 100,000 for the house. If it was the latter situation (25% equity), 75,000 would go to pay down the mortgage lender and 25,000 of equity would go to the former owners. Now your financing may be something like 50% cash and 50% mortgage from your local bank. The bank lends you money because it knows if you do not pay than it can reclaim the house from you, that is the mortgage is collateralized.

Most LBOs are like mortgages where the new owners put down 20% equity and borrow the last 80% from banks, or shadow banks (sophisticated debt investors) using the assets of the firm as collateral. After the mortgage is paid down, does not have to be all the way, you can sell it. The purchaser (PE firm) will make money in several ways: the equity appreciation (less debt in the capital structure), multiple expansion ( the next buyer will pay you more than you paid for the home.) That’s basically all there is to private equity. Just like a 68% of Americans have done when purchasing their home, Private equity firms use collateralized loans.

Of course just like Americans found out, PE firms’ portfolio companies can still end up underwater trying to live the American dream.

1st let me flesh out an idea about how the cycle of a portfolio company works. Ever see the movie Ronin. Well, Robert DeNiro’s character never walked into a place he couldn’t get out of. That’s exactly how PE firms think. From day one they are thinking about the exit. (plenty of good work here.) Basically, there are a few ways PE firms will end their involvement with one of their portfolio companies.

* Merger with a public company, including a reverse merger where the public entity merges into the private entity
* Acquisition, this can be from a conglomerate, a competitor, or to another PE firm
* IPO, sell the shares to the public
* private placement, where a few large institutions purchase the company or a portion of it

So instead of this paragraph sounding ominous “… as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money.” You can see that this is just one of the ways that a PE firm exits. It just so happens that each time it was to a financial buyer instead of a strategic purchase from a firm like Sealy or Tempurpedic.

The article then speaks about dividend recapitalization. Here I can agree with the article’s thrust that this action is a very dangerous game to play. However, the General Partner of the PE firm, may be at a time where his investors are looking for a return. What this action does is bring money back immediately to the LPs (investors of the PE firm) but also gives them a call option should the firm continue to shed its debt with its operational cash flow. The new debt though has to be sold to someone and that entity or entities may require some agreements, or covenants, that restrict the flexibility of the firm. This is, as the article insinuates, akin to taking out a second mortgage. Plus, as in the case of Simmons, the company can become over-levered in an economic environment that is unfavorable thus tipping the portfolio company into bankruptcy. With no recourse to follow back up to the PE firm, this leaves a bad taste in the mouths of all the people mentioned in paragraph one.

As always, the financial intermediaries will make money as long as transactions are going on. So of course investment banks made money as underwriters of debt and of IPOs. Articles like these love to point this out when the company fails but the i-banks also make money when these firms succeed as well.

The rest of the article could be about any firm, any where in the current economic environment. The cheap debt era ended, consumers have cut back and employees who were looking for a lifetime commitment are in the best of cases receiving a severance on their way out the door.

From the article, “because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits.”

This is in so many ways wrong. The PE firms do not hold cash, they hold commitments from their limited partners (LPs/investors.) When they find a firm to purchase they hold a capital call and the LPs are supposed to provide the cash necessary to support the capital structure the GP (general partner) thinks is best suited for the targeted firm given its micro- and macro-economic environment. So never will a PE firm pony up 100% of the cash to buy a firm, just to then lard it down with debt, given the new acquisition its best shot but just playing the coin flip of heads I win, tails you lose. Intense projections, which are corroborated by the retained management, are devised. The capital structure is tested for revenue drops and unexpected shocks. The management is encouraged by the PE firm because they will also have a stake in the new capital structure along with the PE firm. So everyone works together to make the most amount of money for the equity holders of the new firm.

As I stated above there are a few ways in which to make money in the PE process, the two already mentioned because they fell in with the house analogy are debt repayment and multiple expansion. The third however is the generation of cash flow. The PE firm’s staff are highly trained management, process innovators, former industry titans and financiers who know how to change a business model from one that may putter along into a well oiled machine. The business model has to be that way to ensure enough leeway to make bond coupon payments from the debt the company has taken on.

Any cash taken out of the portfolio company is returned to the partners of the PE firm, either the General or the Limited Partners according to their agreement and how far along they are in the agreement. If this is the first cash generating investment it would more than likely all be going to the LPs. If it was the last 80% would go to the LPs and 20% to the GP. None of this money is used to make new investments.

The remaining piece of the article tends to hone on the two points, the dividend recapitalization and the fall of Simmons market & thus the company. I would point out one more thing, the dividend recap was oversubscribed. The investors buying this “home equity loan” knew what it was being used for and thought with all the cheap debt and the solid business model that Simmons could handle it and be able to pay them back. Unfortunately they were wrong. The human interest portion of the article while touching and sad as Schumpterian creative destruction takes hold, shows how the executives were trying to save the company. Whereas the employee remarks there were no more Christmas parties, I say, well that means that the factory can make payroll for the next week instead.

Did THL error, yes. Did employees suffer, yes. Is this what THL predicted or wanted as an outcome? No. That they may have gleaned their principal back is not what their LPs want. In fact when they raise their next fund the LPs will remember that in this investment they were returned their principal and not a return on the principal. The fact is at the end of the day the bondholders (including the ones who lent the “second mortgage,”) will try to make a new go of it. The only thing changing will be the owners of the company. I predict that consumers will still be enjoying Simmons mattresses years from now.

If you want to follow the links my post is here:

http://serialcorrelation.blogspot.com/2009/10/private-equity-my-version-of.html

I think it is hard to gain that much knowledge about any particular subject. I’m old enough to know how to avoid most disasters in my particular area of expertise, but that area is not finance. (That’s why I read the expert comments in this blog, and now hire financial talent when I need it.) Years ago, I watched as the technology company I founded was taken over by investors after we got our first million-dollar order and was run straight into the ground by them. Did they make out OK? Some did, some didn’t. I lost my entire investment and 12 years of my life. Should I have known better than to give them control of the company in exchange for their investment? In retrospect, yes, but in the heat of the moment, and in my ignorance, I did what I thought I had to do, and it wrecked the company.

I’ve been told that a handshake is more than sufficient to cement a deal with an honest man, but all the contracts in the world won’t protect you from thieves. Mark Twain might add fools to that list.

I say this so you won’t misinterpret my attitudes toward workers, or capitalism in general. I don’t think (most) workers have a right to their jobs. But I do think that grazing the prairie without restraint will starve all the cattle, and allowing corporate profit levels to be set by financiers will drive real investment activity into looting, if there are no laws to prevent it. These things may be self-correcting in the long run, but in the long run, we are all dead.

I agree with you when you say that laws can’t change morality. But they can certainly change culture.
When I was a boy, my father was in the military. I’d watch the men as they interacted, to learn how to be a man myself. One thing I noticed amidst the soldier’s camaraderie, between men who depended on each other for their lives, was that after a white man would shake the hand of a black man, he’d wipe his hand on his pants. I’m pretty sure they weren’t conscious of doing it. That is culture.

In the sixties, the liberal Supreme Court took a leap of faith, and on the advice of sociologists, who said that simply associating with people makes you like them better, instituted school bussing. The government-forced equal opportunity employment laws were initially a business disaster, but eventually elevated us above South Africa, and now a U.S. business can actually benefit from the best talent wherever it arises. We even have a half-black President. I’d be honored if he were to shake my hand, and so would many of the people I know. That is the effect that laws can have on culture.

I completely agree with you when you say that any changes that are made to the economic system will probably have unforeseen consequences. Life is very far from Statistical Mechanics. However, I think the danger of missteps can be minimized by looking at who accurately predicted, years ago, where we would be today (because they will be using the most accurate models) and taking their advice. Two people who, I think, seem to have a fairly good understanding of things are Simon Johnson and Thomas Palley. I’m paying attention to them because I still want to be rich (and good models contribute to that), but even more, I want to live in a society of friends and equals, and it will take some work (and the proper direction) to get from here to there.

Or are we too greedy to think in these terms?

Maye we all need a new photograph of a starving or dead child emailed to us daily to encourage more thought about this.