Shareholder Value for Beginners

Ever wondered how the private equity industry works? The New York Times has the story for you. (Thanks to a reader for pointing it out to me.) Yves Smith has a summary of the juicy bits.

The game is basically this. Thomas H. Lee Partners bought Simmons in 2003 for $327 million in real money and $745 million in debt. But that’s debt issued by Simmons, not by THL. To buy the company, they needed to pay the previous owners $1.1 billion in real money. The previous owners didn’t care where the money came from, so as long as THL could find banks or bond investors willing to lend $745 million to Simmons, the deal could go through. Since THL put up 100% of the equity in the new version of Simmons, they owned 100% of the company.

In 2004, Simmons borrowed more real money (by issuing new debt) and promptly gave $137 million of that real money to THL as a special dividend. In 2007, Simmons borrowed $300 million more in real money and paid $238 million of it to THL. So THL got $375 million in special dividends in exchange for its $327 million investment (plus an additional $28 million in fees). Simmons is now going into bankruptcy, unable to pay off all that debt, a casualty of the collapse in the housing market (houses => beds).

Now, there’s nothing illegal about this. If I own 100% of the equity in something, I can do whatever I want with it (subject to any covenants imposed by lenders). Since THL was the sole shareholder in Simmons, it was perfectly justified in pulling cash out of the corporate treasury, and I’m sure it told Simmons’s creditors that this is precisely what it was going to do with the 2004 and 2007 bond proceeds. They were just maximizing value to the shareholders — themselves. And they did it using their core competency — at every chance they got, they prettied the company up for the debt markets and convinced investors to lend it even more money.

So why doesn’t all of American capitalism come tumbling down in an orgy of shareholders raiding their own companies’ bank accounts? Two reasons. First, most companies have widely distributed ownership, which means that the managers call the shots, not the shareholders. Managers are unlikely to destroy the companies that pay their salaries, and it’s also harder for managers to raid their own companies’ bank accounts (that’s called executive compensation, which has to be justified to someone). Second, most of the time, a company is worth more as a long-term going concern than as a piggy bank to be broken open. So even if there is only one shareholder, the rational thing is to invest in the company’s long-term health, not to borrow absolutely as much money as possible and stuff it in your pockets. (THL’s returns on the deal, though positive, are far below what they would like to see from an investment.)

But what if there is only one shareholder, and the company is not worth more as a long-term going concern? Let’s say you know the market for your product is going to implode, and you know you can make more money by borrowing money to stuff in your own pockets than by running the company for the next ten years and then selling it. Then the rational, shareholder value-maximizing thing to do is precisely to load up on the debt and pay yourself off.

So, two final points. First, this is one reason why I don’t think all corporate evils can be ascribed to managers not acting in the best interest of the shareholders. Because acting in the best interest of the shareholders, in a time of crisis (or simply given inside information that the bond market doesn’t have), can lead to what Yves Smith, following Akerlof and Romer, calls looting.

Second, the theoretical “solution” to this problem is that the creditors should never have loaned Simmons the extra money in 2007. But it’s possible that they will learn, since it is the creditors who are being taken to the cleaners in bankruptcy. Had Simmons been too big to fail, then this would have simply repeated over and over again.

Update: See this comment for a reasonable counterpoint.

By James Kwak

88 thoughts on “Shareholder Value for Beginners

  1. At some point, banks become less stupid and don’t lend money to those who won’t repay, or they add meaningful covenants or do due diligence to make sure a business is viable after allowed dividends.

  2. At another point, public policy superceeds private greed and societal abuse… and we march the barbarians out behind the gate and shoot them. It has the same affect as cainning does in Singapore of deterring abhorant behavior.

  3. James, could you give us your thoughts on the other constituents who were affected by the new owner’s actions, in particular the employees. And perhaps generally, what is a company’s responsibility toward its employees?

  4. The variable missing from this equation is the part that THL gets ro avoid contributory liability to the creditors. Thru the sham of requiring Simmons to take 1.3 billion in debt in the companies name only. Yes, that is the current “law”. But as you really know, that law is a corporate special interest cram through with only one result intended. To leave (ultimately) taxpayers holding the back. Trace the actual ‘creditors’ back along the sewer pipe and tell me you won’t find securitization — collateralized debt obligations and credit default swaps. The next step would be TARP funds, probably CITI or Goldman and AIG.

    Clawback is a term that comes to mind but I agree with Plebeians, I like a more direct means of recourse. Can we take up a collection for the 1,000 Atlanta families who were terminated?

  5. James — The Simmons/THL story is indeed a sad one, and a cautionary tale for all those who would dally with private equity firms: lenders, bondholders, management teams, and employees. That being said, as you point out, nothing THL did appears to have violated any laws. In the extreme, the person who owns a thing can destroy it. Whether that means we need different laws is a broader question.

    However, you do the PE industry a disservice and an injustice by implying with your opening statement that the Simmons deal is the model for how *all* PE firms and deals work. Most of them indeed use borrowed money, but not all of them use the dividend recapitalization strategy that proved so disastrous for Simmons and its employees. In fact, that was a largely temporary phenomenon driven by the desperate search for yield by fixed income investors at the height of the credit bubble. In other words, bondholders got (really) stupid, and some PE firms took advantage of them.

    I am no apologist for PE, but I think it does have a limited but important role in our current financial system. Most of the people who work in private equity do really try to build healthy long-term businesses, since that is a far more reliable way to create and harvest value than pure financial engineering. Do (and did) some get greedy, or act recklessly, and make bad mistakes? Of course: they are human, like the rest of us.

  6. You have a flair for writing James. Two recent lines of yours are classics: “Can you feel the testosterone?” talking about bravado from inflation hawks in the recent environment and the above “Had Simmons been too big to fail, then this would have simply repeated over and over again.” Claaaaaasic…………..

    If this blog was a $5 news stand magazine, those two lines would have been worth the price alone.

  7. I agree with Plebeians. One good neck stretching a year for some really corrupt CEO and the whole system would work a lot better for everyone else.

  8. Yes, it is time to reconsider the limited liability status of corporations. Currently states can license corporations while the nation (or more than one nation) bears the cost of that limited liability. A certain amount of it is a good thing. Bankruptcy is better than debtor’s prisons. But things have gone too far.

  9. Ah, the voice of reason prevails!

    Re: employees.

    Believe it or not, except for the most heartless Gordon Gekko types (very, very small group) in PE, no one enjoys raping a company and firing employees. In many PE deals, there may be layoffs since many PE target companies have become bloated by poor management. Even in this case, I doubt ALL the employees will lose their jobs through/after reorginzation.

    There is another way of looking at this, though: When one chooses a firm for which to work, there’s certain considerations like stability, market position, future outlook, etc that can’t be ignored.

    Granted I don’t expect matress-makers to be Finance professionals, but I’d like to think some of them should have been concerned about the future of their company when it was sold to THL.

  10. I am a former employee of a different company subjected to a similar cycle of looting. A large PE firm bought the company at a 40% premium to the market price, and loaded up the company with debt (at 10+% !). Then, when the company could no longer make the bond payments, they jettisoned their most capital-intensive (but highest growth) business, including me and my associates who now make up a sliver of the 9.8% unemployment rate.

    Time will tell if the company will survive, but without the highest potential growth business, it doesn’t look good. In addition, the company is being sued by a group of their bondholders for “restructuring” the debt without obtaining their consent.

  11. so why when this is continually done by the same firm to the same firm isn’t it just treated as a fancy way to defraud banks and stockholders. I have heard of this same thing being done to many companies and their employees.

  12. nonsense, “bloated by poor management”?

    Typical comment by an academic bone head lifting the party line out of a finance text book. If you actually worked for a living, inside of a real manufacturing company, like Simmons, you would realize that poor management, bloated, inefficient, … all those terms are pure cr/ap. Give me one example of a going concern business that has a management structure that illustrates what you claim.

    Do you think that Simmons, with it’s 20 year history of leveraged buyouts adding mile deep layers of debt was suffering from lazy incompetent bloated management? They are buzz words for the rapists to come in and plunder the village. Every one of these equity firms comes in to recapitalize the company, laden it with debt, withdraw cash and sell, offshore or close the “underperforming” divisions. Fire the middle class American workers making $15 an hour plus benefits and replace them with Mexicans or Chinese. Easy to sketch the dramatic cost saving out on a cocktail napkin and get an orgasmic banker to jump on board.

    How well has this strategy worked out for America? Looks pretty tough now that the opportunity to sell houses and stocks to each other to make a living has passed and we probably need to manufacture something in the future to survive.

    Like the VietNam war strategy that we had to burn, destroy and napalm the village and villagers to save them.

  13. Roger Brown cracked it above…the issue is these days the “poor creditors” are ultimately the taxpayer in nearly every substantial (size) bad transaction. The good ones it will generally be Goldman.

  14. Min, I think Brown is questioning the law that permits leveraged buyouts to take place (or at least the way the law permits LBOs to take place). So it’s possible to support the existence of limited liability corporations while at the same time not make it easy for outsiders with a little bit of cash or a friendship with a banker to load conservatively run firms with debt — and argue that by increasing the firm’s ROE (well, duh!) the firm has been made more “efficient”.

    Brown is right: Simply requiring the initiators of the buyout to put their name on the debt too would undoubtedly do a lot to ensure that buyouts create rather than destroy value.

    I’ve never understood what economic justification there is for the existence of current LBO practice — unless it’s an extremely naive application of the Modigliani-Miller theorem. A bit like a doctor pumping a patient full of steriods and remarking that patient’s physical performance improved dramatically — at least up until the point he died.

  15. As to the fate of employees and owners: I’m reminded here of the 1965 movie “King Rat”, in which an American corporal assumes dominance over his fellow allies in an infamous prisoner-of-war camp in Singapore, during World War II.

    The corporal uses his fellow Allies with cunning, intelligence and hustle in order to live as comfortably as possible in the desperate camp. He is as resourceful as a rat.

    The corporal’s clothes are crisp and clean when his fellow Allies are in rags. Men whose spirits are totally broken wait on him hand and foot. His stash of cigarettes is so plentiful he throws half-smoked lights to the ground, where bedraggled men half crazed with hunger fight tooth and nail for a last drag before death.

    In the end, what does he really have? Dominion over a cesspool of broken men he has led to this state.

  16. James said: “Now, there’s nothing illegal about this.”

    What’s missing from James’ story is who has derivative bets on whether Simmons will go bankrupt.

    Perhaps today we can say, “Now, there’s nothing illegal about this” and it is true. But one day in the future, as the financial services group continues to melt-down the the greater culture, we will return to a proper double-entry book-keeping framework of rules in order to control runaway financial serves.

    Once the method behind the proper framework is understood by the present generation of experts, such as James, there will soon be rules and laws stating for example that whoever has made derivative bets on Simmons going bankrupt has to report such bets.

    Congress, for the benefit of screaming citizens, will also make it mandatory to report who is covering those derivative bets. We The People have a legal right to protect our monetary system. Once a proper double-entry framework is understood. We will do just that.

    Meanwhile, like Madam deFarge in A Tale of Two Cities, we ought to knitting names into the fabric of future justice.

  17. The only problem with what you describe is that he has to see
    these men. If only there were a way to live in the lap of luxury
    cuccooned from all the misery.

  18. Right. Just a few bad apples at the bottom of the barrel ruining it
    for the rest of us honest financiers.

  19. Not only is there nothing illegal about this, there isn’t even anything wrong with it.

    THL bought Simmons for $1.1bn. I’m not sure what your distinction between “real” and “not-real” money might be; it’s not as if the consideration was delivered in ingots. The $1.1bn came from a variety of sources: pension funds via the committed limited partnership managed by THL, THL itself as the general partner of the vehicles, and a consortium of banks. Once the funds flow began at closing, none of this mattered anymore – all of the funds were at Simmons, and corporate limited liability meant that it was all anyone could ask for.

    The subsequent dividend recaps were simply exercises in how to split up the pie that was Simmons beyond the original 745:327 split. The banks took an extra $400mm of risk by giving THL funds the money. It would have been exactly the same had THL drawn $1.5bn at closing and only sent the former owners $1.1bn, except if it had happened in one go the banks might have realized that they were taking virtually all of the economic risk for a capped reward.

    Now it turns out that Simmons isn’t worth the $1.1bn of debt against it. OK. The banks will get whatever value exists. THL will get nothing more. That’s what happens when you take risks.

    What alternate scenario would have been better? Should the banks not have lent the money for the recaps? Sure – but at the time, they wanted the extra credit exposure to the company (and the fees). Should THL have never paid $1.1bn for a business that would not be worth $1.1bn five years later? Sure – but they didn’t know that at the time, and presumably the previous owners would not have sold it for less. Should there be a restriction on limited liability? There already is one for fraudulent conveyance, and in this case, each party seems to have acted in good faith. When you buy a share in a public company, you expect that no matter what happens to it (including paying special dividends), they won’t call you and ask for more money. Why should the rule be different if you buy all the shares?

  20. It’s sad that some people apparently believe that private equity (or any other business owner) would buy a business for the purpose of firing people and/or destroying it. They buy the company with the same intent as anyone who buys a stock; to sell later at a higher price. If a business is strong and profitable, the return to shareholders can be increased by adding more debt. This is the exact same behavior that was encouraged for individuals by Fannie and Freddie’s artificially low mortgage rates. As we have all painfully learned, leverage is great on the way up and not so great on the way down.

    I would also say that when jobs are cut in an LBO, it’s usually jobs that are less productive. The firm is able to produce the same product with the same (or nearly the same) quality using fewer resources. This is called productivity growth. In the long run, productivity growth is the ONLY path to increased standards of living.

    P.S. Please no comments about income inequality. Any reasonable person would agree that the objective living standard of any person (creature comforts etc.) is higher than it was 20, 30, or 50 years ago.

  21. not so sure that managers are that much less likely than the ‘shareholders’ to want to raid the company. after all , we can see how they set their own pay, and all they have to do is convince the pay consultant (who they hired) and the directors (who they chose) to approve their pay plans.

  22. Who knows the motives of THL in 2003? Perhaps they thought, “New houses means new beds.” OTOH, the special dividend in 2004 raises questions. As for their actions in 2007, it looks like they played a good game of musical chairs, taking advantage of the limited liability of corporations and the presence of Greater Fools.

  23. Yes, and there are no white collar criminals. Just well-intentioned
    business men and women. No one looking to rip anyone else off to get

  24. The banks haven’t caught on during the last 300+ years, so why do you think they’ll figure it out now?

  25. Wow. You are naive! Companies are purchased because managers earn more if they run larger organizations.

  26. James writes:

    Let’s say you know the market for your product is going to implode, and you know you can make more money by borrowing money to stuff in your own pockets than by running the company for the next ten years and then selling it. Then the rational, shareholder value-maximizing thing to do is precisely to load up on the debt and pay yourself off.

    Sounds like how the oligarchs are running the country.

  27. As always, the real transfer of wealth lies in the credit transactions.

    “Second, the theoretical “solution” to this problem is that the creditors should never have loaned Simmons the extra money in 2007.” That’s one half of the equation – and it was repeated many, many times for 25 years as economists, investors, politicians and the media had an orgy of self-congratulation and celebration of the “prosperity” and “growth” represented by LBOs (the stock market in particular goes ballistic about it).

    The other half of the credit equation is that the private equity managers that leverage “their own money” by borrowing for the purchase, don’t actually use any money of “their own” – it has been provided by investors who want in on the rape of the target acquisition.

    Since the whole rip-off depends on a fixed set of credit relationships, it falls apart when the target can’t service the debt it has been loaded with to pay for its own rape, and in a multiple-event credit contraction and liquidity crisis, even the greedy investors who gave money to the private equity guys can lose out. The only guaranteed winners are the private equity managers.

    For those who cheered the sudden stoppage of LBOs during the Great Financial Crisis, you can stop gloating: this racket is too good to give up and there’s always more suckers ready to extend credit for it as soon as they can (thanks to the feds, the LBO game is starting up again – it’s one of the “green shoots” we’re celebrating already).

  28. When I read the description, my thoughts immediately turned to fraudulent misrepresentation of facts. The key questions being, did the managers/owners (at the time of the loan) have access to information on the likely future of the company that they were not sharing?

    Otherwise, the problem was the bank’s willingness to accept a lot of exposure, as you correctly note. James could argue back that this willingness was in turn induced by the fact that banks were in turn borrowing from their own bondholders, who were in turn effectively secured by the federal government (the TBTF argument).

    IMHO, people don’t realize how much marketing is involved in finance. It’s like hackers say – the best system in the world still has the same old weak spot. People.

  29. Clever line, but certainly, management and employees never want their company to be bought out by private equity. There may be individual shareholders that benefit and if they sell their “shares” of the toilet paper roll in the buyout, yes, but ask Mr. Rogers, the featured employee at Simmons if he was a consentual partner in the rape. But be prepared to run the other way and hope that you are faster.

  30. Kind of like the IPO bubble where founders take out IPOs at super inflated prices. That is probably worse though because a lot more retail investors lose money on it.

  31. James Kwak writes “the theoretical “solution” to this problem is that the creditors should never have loaned Simmons the extra money in 2007”

    No that is not the theoretical solution to this problem, that is the only practical solution to this problem, not that it will work all the time, but, if we get our bankers back to being bankers, instead of sitting glued to monitors being credit rating spread arbitragers we have a chance of doing the best we can… and, is there anything more than that?

  32. I think the argument is that the company _would_ have been worth a lot more than $1.1 bln if it had been managed by its owners (THL) as a going concern rather than as a free cash vehicle. As James argues, when the owners have equity at risk in a venture, they have incentives to operate the business in a way that reduces long-term risk. In this case, all the long-term risk had been divested, so the owners had the perverse incentive to bleed the company dry.

    Not illegal (yet), but if everyone did it, what would the world look like?

  33. The NYT article is just doing what the Shiller piece did, but with the opposite bias (this time playing to the anti-finance Zeitgeist) – holding up one example as indicative of an industry. Somehow it was not OK for Shiller, but it is fine when we are discussing the evil that is PE?

    If one subtracts all the sentimental BS that the NYT has added about Simmons being a great American legacy (it is just a company, after all) – which it only added because the only “victims” in this story are the creditors – there is not much here but a PE firm parting fools from their money. And frankly, I do not get very sad about that. At some point, someone who should have known better decided this company was worth the risk.

    As for the employees, their plight is sad, but if it weren’t for the company becoming a PE darling in the 70s, they would be working for a ho-hum subsidiary of a furniture manufacturing conglomerate during a housing bust, and their jobs would probably be just as secure as they are now. It’s not friendly or kind; it is just the way things work.

  34. “It’s not friendly or kind; it is just the way things work.”

    It is not the way things have to work.

    Thomas Paine said, “A long habit of not thinking a thing wrong gives it a superficial appearance of being right.”

    The laws that govern us determine the kind of society we live in. They have been changed before. They can be changed again.

  35. I strongly doubt THL had access to any material information that the banks did not; if they really thought the business was going to fail, they would have SOLD the company to another sponsor that would have been able to avail itself of the full $1.1bn of debt financing available for Simmons at the time (indeed, almost certainly more, since the people at the banks like to give better terms to “new” money, even though there is no economic difference).

    The criticism of TBTF – and I am on the extreme end of opposition to the concept – does not hold, because in 2004 or 2007 not a soul in leveraged finance thought that his bank would be so crippled that the marginal loss from a bad loan would be eaten by bondholders or the feds.

    I am certain that not two months passed between 2004 and 2007 when a banker did not call THL and pitch doing another dividend recap. This was ground zero of the leveraged finance world: an ostensibly stable, free cash generative business with a blue-chip sponsor. The two recaps threw off the better part of $30mm in fees and the banks didn’t even have to find a new transaction.

    The banks were big boys and made their bets. They are taking their losses.

  36. I am not sure I agree with the entire premise of equity at risk.

    Suppose I start a software company. I put in $1,000 of cash, buy a computer, and write a software program. It’s a great program. I show it to people and they think it’s pretty incredible. They believe my company will generate millions in profits.

    Before I ship the software, I borrow $1,000 against the company and pay myself a $1,000 dividend.

    Do I still have equity at risk?

    Of course I do. I am the sole owner of a company that generates millions of dollars in profits. I have many millions of dollars of equity (and $1,000 in debt). Every day that I don’t sell the business, I put the money I COULD have had by selling on the line.

    Suppose you buy the business from me for many millions of dollars in cash. Do you have any different incentives from me? No. Now you’re the one will millions riding on the company.

    The book accounting is irrelevant. That’s like saying that it’s different to bet $10,000 that you take out of your wallet as opposed to $10,000 that you won from a slot machine. It’s $10,000, it’s yours, you’re free to walk away – you’re betting $10,000 of your money, however you rationalize it.

    As for the private equity broadly, Fenway is also a Boston-based sponsor and they invested enough in the business that THL bought it for more than double the enterprise value. I’m sure THL would prefer Fenway’s result.

  37. I think the way these stories are written affects the way people think about them. I have seen this kind of thing with the NYT many times before. The article begins with some History Channel version of how the company came into existence – a model of entrepreneurial spirit and innovation, etc. The company becomes an American Institution and creates countless respectable jobs. The company plateaus (we are talking about mattresses here, right?), and then the greedy, ruthless, pragmatic capitalist vultures swoop in, and in a moment of weakness, gut this American Institution of all value, enriching themselves and sending hardworking Americans (some of the few remaining Americans gainfully employed in the manufacturing sector) packing. I could write these stories for the NYT on my lunch break.

    Companies are created because someone invested money toward a purpose. They are generally not charitable enterprises; such investors seek a return. Investors continue to invest in companies because they seek a return on their money. The investors that participated in this arrangement were likely not taken – money was just that easy then, and their attitudes toward risk/return were distorted.

    I would like for people to be different, for our culture to be different. But that is not something that can be legislated and it is not something to expect from business. If you think it is a good idea to use the legal system to protect investors from their own bad decisions and make it so people are entitled to jobs, that’s fine. It probably will not turn out the way you think….

    There are plenty of things to be upset about with respect to the trajectory of our country’s financial system and our culture. Save the Thomas Paine quotes for those. This story is nothing.

  38. There is a lesson. It’s that once a company goes public, it inevitably gets looted. The last people you want with a say in running a company as a going concern is a bunch of finance people. When companies stay closely held, they tend to do much better; why mess with something that makes money?

    As usual though, the New York Times gets everything wrong. There’s no news there.

  39. I too am completely sick of the NYT trying to make people feel weepy about the wallets of rich creditors. If I had a time for every “poor stupid rich people” story in the NYT, I could join the ranks of the poor stupid rich people.

  40. Banks don’t loan money; bank lending officers do.

    They get sizable bonuses when they do enough of it, and their bosses get to parade large fee income, quarterly.

  41. This (and other such immoral unethical situations) is the reason why the Harvard Business School pledge for its MBA candidates was signed by less than half of the class. Why sign a pledge involving the public and morality if you have no intention of following standards of moral action. It has been said more than once that morality/ethics can’t be legislated (at least to any major extent). Why do you think that the CFR, Federal and state regulations, tax laws, etc. are so complex? Easy. Not only are the “Haves” benefitted, but the legal profession (which drafts much of this material is well supported by finding loopholes, workarounds, and evasions which line the pockets of the (non-signing) MBA’s. The major problem is that this has become the business standard in our great country of laws. Sure, Bernie Madoff was sentenced to what amounts to life for his crimes and misdemeanors, but probably would still be mimicking Ponzi if our economy hadn’t headed south at the wrong time.

    Sooner or later, this will implode and have disasterous effects on the ability of viable, morally centered businesses to borrow and expand at a reasonable cost. As always, those who obey the law AND act in moral ways, will end up paying for the crooks. Kind of like all of the people who get cheated on health care, and all of the small banks that have been severely stressed in an economy which was seriously violated (carnally) by the big boys with full Congressional protection.

    The result is a country of laws that looks alot like Russia. Don’t kid yourself, the apparachiks are vibrant in our society. We just like to call it democracy. It’s a free country for those with mega bucks and the right connections.

  42. From what I see, you’re argument Mr Kwak is fundamentally flawed on these grounds. “Managers are unlikely to destroy the companies that pay their salaries, and it’s also harder for managers to raid their own companies’ bank accounts (that’s called executive compensation, which has to be justified to someone” This is an entirely FALSE and misleading suggestion. In fact managers will f**k over anyone for money and profit. Hense the peoples great dismay.

    Managers, like their corporate oligarch overlords worship the godmoney and the godprofit! Managers will sell their mothers and daughters for money and profit if the price is right. Managers have no standards, they hold to no code, or bond of ethics, and sadly MONEY alone and PROFIT alone compells the tiny cold hearts of the predatorclass, and the managers that feed the predatorclass.

    Shareholders are predatorclass and so, arch enemies and dire threats to the best interests of poor and middleclass Americans.

  43. Most regrettably, everyone seems to have missed the point that this structure is actionable and thus subject to being unwound as a fraud on creditors. Indeed, there is well established and generally ignored case law that holds that leveraged buy-outs (“LBOs”), as typified by the Simmons case, are per se fraudulent transfers. Let me set out a “Readers’ Digest” version of the Uniform Fraudulent Transfer law and how it relates to LBOs.

    A transfer is fraudulent as to creditors if (a)the transferring debtor (in this case, Simmons) received less than fair value for that which it transferred and (b) the transfer left the debtor with insufficient assets to continue the conduct of its business or to pay its debts as they became due.

    The second part, “(b),” is usually easy to prove as with 20/20 hindsight creditors would not be making a claim unless the transferring debtor had become insolvent and gone out of business, as occurred with Simmons. It is thus usually only with the first requirement, “(a),” that creditors get stuck. However if one stands back and looks at the forest rather than the trees, one can easily see how such a transaction was for zero consideration to the debtor.

    In this case, Simmons was essentially debt free before the sale to THL. Simmons then incurred new debt in the amount of $745MM to the new bondholders, and likely also granted these bondholders first lien rights as against Simmons’ assets to secure this new obligation. But what did Simmons get in return for this transfer? Zero. The $745MM did not go to the transferror, namely Simmons, but rather went to the retiring former owners, a third party. And after the retiring owners had gone their merry way, the continuing creditors of Simmons had as their obligor a once-solvent company that was now saddled with an additional three quarters of a billion dollars in debt but with no corresponding asset to show for this expenditure.

    Clearly, from Simmons’ standpoint there was no legitimate business purpose to this LBO as Simmons received no benefit from the transaction. It would be no different in effect if Simmons merely issued a $745MM dividend to its former owners or redeemed their stock.

    What creditors lose sight of is that all they see is that the bond holders paid $745MM for their rights. They never look at it from the perspective of Simmons itself, which was “Belgium” in this creditor war.

    Richard L Wise

  44. What an interesting comment. Is there a trustee for the Simmons of this world? Could the laid off workers use this argument? Would then the workers who still have their jobs countersue? What a growth market for lawyers!

  45. 1,000 workers lose their jobs + bondholders lose $575 million + Simmons goes bankrupt = $750 million profit to a series of private equity owners.

    So where is the utility in this kind of financial activity?

  46. The Banks are not the lenders here, or if they are they are lending against specific assets and are protected in a bankruptcy/liquidation scenario. The bondholders might include pension funds etc. looking for large returns. I would be shocked if a bank purchased a bond of this nature even 5 years ago. No – they would have bought Fannie and Freddie just to be safe!

  47. This episode perhaps illustrates the Minsky theory (Financial Instability Hypothesis c. 1960) that “Modern finance was far from the stabilizing force…that created the illusion of stability while…creating the conditions for an inevitable collapse.” See Boston Globe 9/13/09 “Why Capitalism Fails”.

  48. This is what the Mafia calls “busting out” a place. The mob gets control of your bar/restaurant. They start ordering liquor and supplies well beyond what they need. The supplies go in the front door and out the back door to be resold. Eventually the concern’s credit collapses but the Mob made a tidy profit in the interim. I have more respect for the Mob guys. At least they are what they are without any excuses or pretensions.

  49. One important point that hasn’t been raised above: the entire PE business model is built on the favorable tax treatment of debt. PE firms deduct interest costs from the profits of portfolio companies, reducing their taxable income. Public companies are unable to do so to the same extent because shareholders rightly oppose getting in line behind lots and lots of new creditors. It’s no wonder PE firms often bid more aggressively for assets given this tax advantage.

    The carried interest of PE fund managers is also taxed as long-term capital gains instead of ordinary income, a fact that has generated some recent controversy, but this is a different point.

    Because of these two points, especially the first, I’ve always questioned whether PE firms were really creating value or just taking advantage of features of the tax code.

  50. Why don’t you read the convenants/indentures to see if the Simmons lenders permitted such dividends. If they did, they got what they deserved. Upstreaming has been long been tried and most often prevented. It could be that Lee got the lenders to bend on Simmons in exchange for other business. You should be able to find out rather than just speculate.

  51. I have two responses to Mr Kneser’s comment:

    As I do have a real life as well as a demanding practice, I cannot take the time to dig up and parse through what are likely to be volumes of documentation that were generated to document this transaction, unless someone is willing to pay me to do so. I encourage Mr Kneser to engage in that exercise however if he has the time.

    More importantly, however, the victims in this scheme were not so much the Bondholders, but all the other creditors of and stakeholders in Simmons. Indeed, any fraudulent transfer claim likely would include the bondholders as defendants.

    Kind regards,
    Richard L Wise

  52. Unfortunately, this is only half of the story. The Simmons bondholders and lenders have hedged their positions with CDS transactions which are counter-partied by various financial institutions with either insurance coverage (AIG, etc) or federal implicit or explicit guarantees or support. When you complete the flow of funds, it is the usually the government that winds up funding the credit holders 100% on the $. This is why re-org is no longer as viable. The credit holders in large deals always have the option to get more from the hedged position than from the underlying investment and to pass the loss along to society at large. A structural flaw in a system that has as a core belief that investors are being paid for the risks they can get stuck with. The major macro-risk now is sovereign risk.

  53. Taunter: “Once the funds flow began at closing, none of this mattered anymore – all of the funds were at Simmons, and corporate limited liability meant that it was all anyone could ask for.”

    Emphasis mine. :)

  54. Bond Girl: “It’s not friendly or kind; it is just the way things work.”

    That is how externalities are swept under the rug in public economic discourse: “That’s Just How It Is.”

    As I said elsewhere, I was surprised to discover that economists know about externalities. ;)

    Double entry bookkeeping guy, where are you when we need you?

  55. Thanks James for the CDS reference. Ergo the taxpayers are left with the exposure. Not the bond holders.

  56. Sure…but would you propose the opposite? End limited liability, so that if you are, say, a GM shareholder when the company files, you get a bill from the UAW?

  57. That was funny Brian….

    Look, if ANYBODY out there within the sound of my voice still thinks banks, or for that matter the American government or president has the slightest iota of your best interest at heart, will you please step to the front of the line so I can hit you over the head with a 2×4.

  58. This story is not about the company, it’s about the process – of rent-seeking (the PE “special dividends”, fees, and other extractions) through the destruction of a target institution using other people’s money. That makes it one part of the picture of what has been going on for years that resulted in a debt-GDP ratio of 360% and an eventual financial crisis. It is not “nothing”, it is relevant insofar as examining processes that contributed to the biggest financial crash and recession of most people’s lifetime can be utilized to try to prevent a repeat. I personally believe the only useful lesson from this particular process is that lenders need to get back to risk reality or suffer the consequences, but the eagerly-anticipated return of the LBO process is again demonstrating that suckers seldom learn.

  59. Bond Girl: “I would like for people to be different, for our culture to be different. But that is not something that can be legislated and it is not something to expect from business.”

    It is true that legislation alone is sufficient to make essential cultural change. Legislation is more follower than leader. OTOH, legislation matters. Our business culture rests upon legislation going back at least to the 19th century, and much of that legislation needs review and change. And changing legislation does change the culture.

    You and I may agree in this case that the people who made bad decisions got what they deserved. But there are other stakeholders who did not get what they deserved. And, as others have pointed out, there are systemic issues, as well. Only legislation can address the systemic issues.

  60. I am not sure what the “it” is that you are referring to. Could you explain that a bit? Thanks. :)

  61. The deal was even dumber than you think.

    I am an attorney. At one time, I represented a large mattress retailer. As a result of that representation, I learned the following:

    1. Mattresses are mainly air. As a consequence, they cannot be shipped economically long distances. This means that (i) a manufacturer has to have a number of plants around the country, and (ii) most mattresses are sold in geographic areas in which there are a large number of people moving in to live (the DC Metropolitan area, for instance), because people often don’t take their mattresses from their old residences.

    2. Most standard mattresses are pretty much alike. That is, they are commodities.

    3. No one goes into a mattress store to window shop. This means that one has to have or be associated with a very aggressive retail sales force.

    4. By and large the “standard” mattress business is mature. That is, one can only increase sales by cutting into the market of a competitor and there is little growth potential in the business.

    Given the above, why would anyone pay a large goodwill premium for a mattress manufacturer? The same goes for a mattress retailer. (Mitt Romney’s company took a $100M hit on a LBO of a mattress retailer.)

  62. This is a long-standing debate (see Aristotle). IMO, if legislation restricting the behavior of financial firms actually passes… if anything, that will indicate that there has been a major cultural shift.

    Getting any reform legislation passed is against the odds. But even if it does, it will be within the natural course of things for the financial industry to adapt to the new restrictions and find new ways to push the limits. Limits can be good, but new legislation will not improve the intentions of market participants.

  63. When you make an investment in a company, you are taking the risk that the structure of the company will change over time. That is not a spillover effect per se; it is something an investor is compensated for. This company has been passed around by various PE interests since the 70s. Anyone who has been involved with the company since then should have had a clue that is was an investment vehicle that happened to make mattresses.

    But as others have pointed out, the risk here in talking about legislation, etc. is that this is not representative of PE generally.

  64. As I suspected, we were not talking about the same thing. I meant the costs to the workers and the community, and the systemic costs. :)

  65. If all the corporations were nationalized, we could avoid this whole dilemma.

    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.

  66. the previous owners earned $ 1.1 b as payoff for building the company. opportunity for all entrepreneurs to exit at attractive valuations thanks to lenders and PE funds..

  67. I think I see what you are saying. Anyone who was knowledgeable and who looked at what was happening to this company should have known what its likely future would be.

    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.

  68. Nobody likes Private Equity, never have and never will. The hedge funds hate them because they make similar amounts but their structure prevents investor runs on the funds, unlike the ones that occur to a hedge fund. The i-bankers hate them because they have more freedom and make more money than they do. The regulators hate them because they operate outside their grasp. People hate them because the tippy-top make more money than Peru in a given year and almost everyone in the industry, at minimum, makes more than 3x what a median American household makes. For these reasons, and many, many more PE tries to keep a low profile. However, if you want to do the research you can find out about them their deal history, their portfolio companies, and anything else you might ponder. Dartmouth’s Tuck School of Business has a dedicated unit writing up case studies and training talent for these firms. Of course, Harvard, Stanford and Chicago train plenty of MBAs who end up in PE, either by starting a firm or joining one. Still, the only thing that ends up in main stream media are the giant takeovers and the blow ups, which represent a very small and an even smaller proportion of the deals done.

    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:

  69. As James noted, we are the ones who will likely be left holding the bag. But the Simmons story, like so many from the LBO period of the late ’80s and early 90’s, is hardly new; it is just the latest variation on an old theme.

    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.

  70. PE sounds like such a happy and honorable way to _earn_ a living. I am off to Tuck to become a part of this wonderful skys-the-limit career.

  71. There would have been nothing wrong with Simmons borrowing $745mm and paying it out as a special dividend to Fenway. In the US there is no maximum dividend or prohibition against negative book equity.

    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.

  72. If you read the book, you would see that he convinced himself that he actually saved many of the other prisoners. True, he let some die, but he determined that was necessary so he could help the others. Of cours, he deserved to eat better and be clothed better because it was his ability to deal with the corrupt Japanese that enabled him, an only him, to be in a position to save some. He needed to be in better physical condition else the Japanese guards wouldn’t respect him. And seeing the suffering of his fellow-prisoners gave him a chance to feel compassionate. Great book. I put it up there with “What Makes Sammy Run?”

  73. strange I am just reading “what makes Sammy run?” and being more than half way through am most impressed with Al Manheim – he seems very familiar like when he discovers beyond doubt Sammy’s plagiarism and doesn’t blow the guy’s cover but lets him go on using a very lame excuse
    If there weren’t so many conflicted refusing to get their hands dirty Al Manheims around, the Sammys of this world probably would have a much harder time.

  74. “First, this is one reason why I don’t think all corporate evils can be ascribed to managers not acting in the best interest of the shareholders. ”
    Yep, far from it. In fact, it is the opposite, many corporate evils can be traced to the idea of “maximizing shareholder value”.

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