Yogi Berra famously observed, while managing the New York Mets, that "it ain't over till it's over." Now I know what he meant.
If you followed the saga of the sale of CitiStorage and my two other companies (see "The Offer: Parts One–11"), you probably figured -- as I did -- that I had wrapped up that particular phase of my business career back on December 21, 2007, when Allied Capital acquired a majority stake in the business and I went from being CEO and principal owner to well-paid adviser. Well, not so fast, Kowalski. For the past six months or so, I have been working to find a new owner for the records-storage, document-destruction, and delivery businesses I spent most of my adult life building. Along the way, I've had a front-row seat to the unfolding financial crisis, and I've seen how and why it has caused the rest of the economy to seize up. I've held off writing about the experience out of fairness to the other parties involved, but we're now at a point where I feel I can share with you some of the lessons I've learned.
By the time we closed the deal, the credit markets were already tightening, and it looked as though difficult times lay ahead. We had no inkling, however, of the problems that the economic downturn would create for our new majority shareholder, which had been around for almost 50 years and had assets of more than $5 billion. Neither, I suspect, did Allied Capital's people. My partner Sam and I were working closely with two of them as we put together our acquisitions team and began looking for other companies to buy. That was the plan, as you may recall. The companies I had founded would serve as the platform on which we would build a nationwide records-storage and document-destruction business, with Allied supplying the capital and Sam and me the industry expertise, while my other partner, Louis, ran the new company that emerged from the sale. In four to six years, we would have a liquidity event of some sort. With that in mind, my CitiStorage partners and I had reinvested about $13 million of the sale proceeds, for which we received about 37 percent of the new company's equity and an identical share of the junior debt portion of the deal (which included junior debt and preferred stock).
The first red flag came in the spring of 2008, although I didn't fully appreciate its significance at the time. Our contacts at Allied Capital told us that they wanted to change the capital structure we had set up for the company. They had purchased our businesses using a combination of equity, junior debt instruments, and senior debt. (Senior debt is senior because it gets paid off first in any liquidation, before junior debt and preferred stock, which in turn get paid off before equity. Because there is less risk involved, the yield on senior debt is lower than the yield on junior debt and preferred stock.) Now Allied wanted to find someone else to supply a portion of the senior debt, presumably because it wanted to invest its capital in higher-yielding investments. Because we had good relationships with several banks, our contacts asked us to see if any of them would be interested in providing the senior debt. We were happy to oblige.
It took only one or two meetings for us to realize how drastically the landscape had changed. A year before, bankers would have fallen over themselves to offer up to five times our EBITDA -- earnings before interest, taxes, depreciation, and amortization -- in senior debt. Knowing credit was tighter, we were now looking for three and a half times EBITDA (or "turns of EBITDA," as the bankers say). We quickly came to understand that two and a half or three turns was the best we could hope for -- and the number went down weekly. It finally hit zero, at which point senior debt simply wasn't available. You couldn't get it, no matter how good your credit was. When we so informed our friends at Allied Capital, they said, "Yes, we know."
Our business was, in fact, the least of their worries. In the fall of 2008, Allied Capital began closing offices and laying off staff, including the two guys who had been working with us and who served on our board. During this same period, the media were filled with stories about how mark-to-market accounting rules -- which required periodic adjustments of the value of assets -- were aggravating the problems of financial-services businesses. It dawned on us that our majority partner was probably Exhibit A. Although it had steered clear of the subprime mortgage market, it couldn't escape the general drop in asset values. With each passing day, its investments in companies were declining in value, as would-be acquirers reduced the multiples of EBITDA they were willing to pay. At the time of the sale, for example, businesses like ours were going for nine to 10 times EBITDA. A year later, the same businesses were being sold for six or seven times EBITDA. Thus, even if a company's EBITDA had increased in the interim, its valuation had declined. As long as the business remained fundamentally sound, its equity would recover sooner or later, but the mark-to-market rules required Allied Capital to reflect the decline in its quarterly financial statements. As a result, Allied was in increasing danger of being found in violation of its bank loan covenants, which stipulated that it must always have twice as much in assets as it does in debt.
By then, we had long since realized that our plan to build a records-storage giant was dead in the water. Allied Capital was in no position to finance acquisitions. Mark-to-market aside, it had companies in its portfolio that were struggling and needed a lot more attention than we did. When we asked its executives what they wanted us to do, they said, "Don't worry. Just run the business. Everything will be fine. There are some problems we're working out. Just keep doing what you're doing."
When somebody tells me not to worry, that's when I start worrying, and the steady drop in Allied Capital's stock price did nothing to reassure me. From $22 at the time of the sale, it fell to about $1.80 just one year later and showed no signs of rebounding anytime soon. There wasn't anything we could do about it, however, so we followed the advice we had been given and minded our own business. Weeks went by in which we had little or no contact with Allied Capital. Although a new person was assigned to us, he and his bosses left Louis and his management team to run the company. Meanwhile, Sam and I kept ourselves busy with other projects and speculated about what the future might hold.
Mainly, we wondered what would happen if Allied Capital did wind up violating its bank covenants, as seemed almost inevitable, or even if -- God forbid -- it filed for bankruptcy. Either way, we figured, there was a good chance that we would be sold. So we weren't surprised when the executives of Allied Capital came to us and asked for our help in checking out the market. "We might not sell the business if the price isn't right," they said, "but we would like to know what it's worth. What do you think we can get for it?"
"I have no idea," I said, "but I can investigate."
Sam and I had been following developments in the industry closely and knew the various players who, like us, wanted to build the next big, national records-storage and document-destruction business. We decided to meet with the three most likely candidates and give them a chance to make an offer. The number we got back was $65 million, down from the $87 million Allied had paid. (The $110 million figure I've mentioned before included an interest in the real estate.) When we told the Allied Capital people what we had found out, they said, "No, we won't sell at that price. We don't need to."
But Allied's position was continuing to deteriorate. On January 28, 2009, it announced that it was close to being in default on its loan agreements as a result of the decline in the value of its investments. It was opening talks with its lenders to see if they would agree to a waiver allowing the company's assets to fall below two times its debt, as its covenants required. Without such a waiver, it wouldn't be able to pay dividends -- a key reason investors bought its stock -- or borrow money. Whatever the lenders decided, the firm was obviously under pressure to deleverage -- that is, raise cash and unload debt. That meant selling some of its portfolio companies. Unfortunately, the companies most likely to attract buyers, and thus allow Allied Capital to raise the cash it needed, were precisely those that, under other circumstances, it would be most reluctant to part with -- namely, the most solid, best-performing businesses it owned, including ours.
Sure enough, the Allied Capital executives soon came back to us. "We have to sell some companies," they said. "We have a couple of big deals pending, but we may have to sell yours, too. It depends on the price we can get. We want to hire an investment banking firm to handle it." That was fine with Sam and me. Working with Allied's people, we looked at a couple of investment banks and settled on Harris Williams & Co., based in Richmond, Virginia.
At that point, the major question in my mind and Sam's was, What price, if any, would Allied Capital accept for our business? We could only guess the answer. Allied's people weren't talking, as well they shouldn't have been. Their fiduciary responsibilities to their own shareholders required them to keep us in the dark. What we did know was that, if Allied Capital went through with a sale in the present environment, my partners and I stood to lose our entire equity investment. It was a matter of simple math. Given our own soundings of the market, we could be pretty sure that the bids would be from $65 million to $75 million. Whatever the final offer, it would, if accepted, have to cover, first, the expenses of selling the business, which could amount to a few million dollars. Then the senior debt, about $52 million, would be paid off.
The junior debt and preferred stock totaled $16 million, including accrued interest and dividends, of which we owned $6 million, and we could probably count on getting at least part of that money back. But after paying off the debt and preferred stock, there would be little, if anything, left for common stockholders, and we had $8.5 million of our money invested in common stock.
Allied Capital probably didn't have much choice. But I wasn't happy about this turn of events. After all, we had fulfilled our responsibilities. The problems Allied Capital faced were none of our doing. Under the terms of our deal, it had so-called drag-along rights, meaning that as the majority shareholder, it could force us to join in the sale provided we got the same price, terms, and conditions as Allied did. But I felt strongly that we deserved better. Fortunately, we had an ace in the hole. Any new tenant would have to be approved by the landlord -- and we were the landlord.
Then again, that was not a card I intended to play at the last minute. We had been doing business with Allied Capital for 30 years, and we had always treated each other fairly. I did not want to get into a fight with Allied Capital. I said to Sam, "We need to tell Allied up front what we want and see what we can work out." He agreed.
And so we set in motion a chain of events that would determine our fate.
Next: Let's make a deal.
Norm Brodsky is a veteran entrepreneur. His co-author is editor-at-large Bo Burlingham. Their book The Knack: How Street-Smart Entrepreneurs Learn to Handle Whatever Comes Up was named the best book on entrepreneurship of 2008 by 800-CEO-READ.