Seize The Time
For the next nine months or so, there will be lots of investment money out there looking for solid companies
When Sanford Ziff decided to sell his company, his demands were simple enough. All he wanted was to cash out of his chain of 100 sunglasses stores. And give his 27-year-old son a stake in the business. And get money to expand. Oh, yes, and he wanted to stay in charge.
Now Ziff is not a greedy man, but that was a tall order. Yet his story has not one but two happy endings, and they say more about raising capital in 1989 than any financial forecast. We'll get to Ziff's tale in a moment. First, its message: buyers of companies are in a bit of a panic. Thanks to a huge influx of foreign companies and well-heeled investment groups, demand for companies is at an all-time high and is driving prices into the stratosphere.
But what if you don't have any intention of handing over your company to someone else? What you really need is some financial clout to acquire competitors, say, or to build another plant. Here lies the beauty of this particular sellers' market. With some $25 billion to spend, the investment groups that are hunting for companies are so hungry that they're accommodating all kinds of special requests. They're often willing to share ownership and finance expansion. They're not dazzled by glamour, either. Since these investors are essentially financial engineers who construct deals around a reliable cash flow, they much prefer slow but steadily growing operations to shooting stars.
Consider the rest of Ziff's tale. He wanted to continue to build and run his Miami-based Sunglass Hut of America Inc., but he wanted to cash in his sweat equity. He wanted his son, Dean, to have a piece of the business, but he also wanted more capital to expand. By late 1986, when the former optometrist was grappling with these contradictory desires, his company had sales of about $27 million and earned some $3.3 million before taxes and generous officers' salaries. After sorting through a handful of offers, he nailed down all of the terms he wanted in a deal that was scheduled to close at the end of the year. Then at the last minute, the buyer wanted to pay Ziff with less cash and a bigger IOU than they had originally agreed on. Ziff said forget it.
The scotched deal led Ziff and his adviser, Alan K. Wells, of Bollinger, Wells, Lett & Co., to six new investment groups. Of those, Ziff picked the Greenwich, Conn., investment firm Kidd, Kamm & Co. because its bid was nearly all cash, with only a small portion to be paid to Ziff in the form of a note. Kidd, Kamm also promised to let Ziff retain his current management team, shift some of the ownership to his son, and provide more capital for Ziff's ambitious expansion plans. "They had it all," Ziff recalls.
The price itself was compelling enough, however. Kidd, Kamm paid more than $35 million -- roughly twice as much as the previous buyer had offered only four months earlier. And here's a tantalizing postscript that shows why today's merger-and-acquisition game might just as well be called Name Your Price: when Wells strolled into his New York City office the morning after Ziff had signed on the dotted line, he found a telex from one of the other bidders offering $5 million more.
Think of this type of deal as a camouflaged sale, because most of what changes is invisible to the naked eyes of customers, suppliers, and employees. All the action is on the right side of the balance sheet. Let's say that a business owner agrees to sell for $25 million -- $20 million in cash and $5 million in the form of a note. To come up with the $20 million, the financial engineers contribute a tiny $1 million in equity and borrow the rest. They arrange for bank loans of $15 million, secured by the company's assets and cash flow. This loan is top dog, getting first priority in repayment if times get tough. They get a subordinated lender to put in $5 million of mezzanine debt, so called because on the balance sheet it's sandwiched between the bank loan and the equity. That comes to $21 million -- the extra million covers closing costs and fees.
If the owner wants to retain a 20% stake in the company -- or wants another family member to -- his cost is based on the new, shrunken equity value of $1 million. So 20% of the company costs him $200,000, and the financial engineers get 80% for $800,000. Thus, after the deal is done, the owner has $19.8 million in cash, another $5 million that's owed to him, and a fifth of the company. He's captured virtually all of the market value of the company and bought back into it at a bargain price. Call it having your cake and eating it, too.
The main drawback in these wonderful arrangements is easy enough to spot. Look at what they're called: leveraged recapitalizations, leveraged buyouts, or leveraged buyins. Debt -- a lot of it -- is the sleight of hand that allows an owner to cash out almost completely while retaining a significant stake. In a recap, debt typically goes from zero to six or seven times equity -- or more. That could quickly push a company under if business sours or the economy falters. The owner of a recapped company may have his cash safely parked in Treasury bills, but that would be no protection from the emotional turmoil of watching the company become crushed by towering interest payments.
If it works, however, a recap can do much more than reshuffle a company's capital structure. With the help of Kidd, Kamm's hefty revolving credit line, Ziff's company has added more than 100 stores. The firm has also helped guide Sunglass Hut in upgrading its computer system, including point-of-sale terminals in each store. "There's a lot less pressure for me," says Ziff. "Basically, you know that you have good financing behind you and that you personally are financially set." He's still president; his wife, Helene, is still director of personnel; and Dean is still vice-president and director of acquisitions and expansion -- and has a new 25% stake in the company to boot. While two Kidd, Kamm partners sit on Ziff's seven-person board, they stay out of day-to-day operations. "Firms like mine don't want to run a business," explains Bill Kidd.
As anxious as investment groups are to strike a deal, they do have some criteria that are carved in stone. Since leverage is the key new ingredient of a recap, companies that have little or no debt are the most appealing candidates. They must also have plentiful and reliable cash flow -- a guarantee that all that recap debt is supportable. These requirements typically lead financial engineers to industries that have rarely been objects of desire. Lately the hotly sought have included metal finishers, wholesale distributors, food processors, and equipment renters.
Such companies aren't exactly the type that could expect a warm embrace from the stock market, even a bullish one, if their owners wanted to go public. But then, as Ziff might ask, who needs the stock market when you've got a population boom among company buyers?
LOOK BEFORE YOU LEAP
How to choose the right investors
Veterans of recapitalizations like to say that hooking up with an investment group is like getting married -- that's how intimately your futures are linked. The trouble is that this marriage usually follows what is effectively a blind date. So, in the time you have, find out all you can.
* What's behind the good looks? All kinds of groups have jumped into financial engineering -- private investment groups, banks, venture capitalists, insurance companies, even consulting firms. Many have no experience. You don't want to be their guinea pig.
* Is he/she rich? The number-one deal killer is lack of financing. Experienced investment groups are more likely to have existing relationships with the various lenders required for a recap. Best of all are partners whose lenders have already committed funds for deals, especially for the more difficult to find mezzanine debt.
* What do past partners say? Talk to managers who have already done a recap with your potential investment partner to see if the deal lived up to its promises.
* What's the prenuptial agreement say? Investment groups want to be married only five to seven years before they cash out. They usually get to say when and how they'll sell their stake. Make sure that your own stake and your job will be protected when that happens.
* What's the romance potential? You should like your partner, even if you don't plan to see much of each other. If things don't go according to plan, you'll be spending a lot of time together.
Finally, don't forget timing. The demand for companies could continue to accelerate. But some observers predict that acquisition activity -- and escalating prices -- will slow beginning this October, when interest rates rise and the economy softens.