Hybrid Security Promises Cash To Dress Up Ugly Ducklings: LBO firms flock to new instruments as exit devices but they can be hard to structure and customize

Private equity firms are hoping that cash talks loud enough to get them out of portfolio companies that are hard to sell to both strategic buyers and public investors. Several of the most prominent are betting the exit door is a new form of hybrid security that promises hefty cash payouts to yield-hungry investors willing to buy into companies that lack the growth, size, or unblemished history to cut it in a standard IPO. If they fly, they could be used in many other applications, including sell-offs by restructuring companies. Going by such names as income deposit securities (IDS), enhanced income securities (EIS), or income participation securities (IPS), the instrument bundles stock and subordinated debt strips together and churns out both interest and dividend streams to holders. Tax shields are prominent parts of the equation. Investors pay capital gains taxes on interest and only a 15% bite on dividends. On the opposite side, interest payments, at least for now, are tax deductible – encouraging the company to distribute the bulk of its earnings and literally wipe out taxable income. “It’s trying to give you the effect of a REIT in an operating business,” says Robert Willens, a Managing Director at Lehman Brothers, in noting how real estate investment trusts (REITs) escape federal taxes for paying out at least 90% of income. “Overall, the yield is high and they are tax-efficient,” says Greg Peterson, a private equity expert at PricewaterhouseCoopers. “They commit the company’s free cash flow and there are people out there who will buy it.” In the view of Gil Marnin, head of the private equity unit at Deloitte & Touche, “It’s an attractive exit for a company with low growth and high cash flow that otherwise might be tough to IPO.” Despite the heavy buzz in capital markets, a lot more players have, as of mid-May, gone up to bat than stroked hits. Only one concern, Volume Services America Holdings Inc., a catering and arena management operation owned by Blackstone Group, actually made it to public ownership, in December 2003 at $15 an IDS unit. More than a dozen others have issues in registration (see table). If they prove out, the income securities could be extend beyond financial buyer exits. Some prospects include off-loading of tough-sell divisions and subsidiaries by restructuring companies and even offering a going-public mechanism for private companies with modest growth opportunities but large cash throw-offs and low capital spending requirements. Laura Hodges Taylor, a Partner in the private equity practice at Boston-based law firm Goodwin Procter, says income securities in the U.S. evolved from similarly structured Canadian income trusts (CIT) and were brought here by CIBC Securities, which was the lead underwriter on the Volume Services transaction. In the U.S., she notes, private equity sellers were “the first guys out of the box” because they had the smarts to see the utility of the hybrid instrument and because they were the easiest group for investment bankers and lawyers to pitch. However, Taylor points out that CITs have, in their two decades of existence, been used for a lot more than private equity exits. “When they get better established, more people will start thinking of them as a financing tool,” she states. “The push for yield-oriented products is a big factor. There is an enormous appetite for that, certainly at the retail level and even at the institutional level.” Although the income securities appear simple in concept, the warning is they are hard to structure and customize. Moreover, the issuing company faces a number of crucial tax and accounting issues that may not be answerable for years while there is concern the IDS movement is living on borrowed time before the IRS counterattacks. Technically, there doesn’t appear to be anything to prevent income securities from being used as acquisition currency or to stop a company with an IDS-based capitalization from being acquired. Their presence on either side of a deal, however, may pose some brain-busting problems. This matter may prove difficult since survival of these companies may depend on building scale in their low-growth markets or becoming targets of consolidators in those industries. Willens says that on the buy side the instrument will have to be broken apart and a value computed for each strip. Only the part related to stock would be tax-free and taxes would be levied on the debt portion. William Whitledge, a Partner in the tax practice of Goodwin Procter, who sees a similar outcome says, however, that he expects most of the acquisitions to be financed by cash harvested from the sale of additional units. “In most of the offerings in the pipeline, the people have contemplated follow-on offerings to raise cash for acquisitions.” There is also a question of whether – or when – the tax shields will draw an attack from the IRS. That could be triggered by an upsurge in the popularity of IDS offerings and a fast-paced expansion beyond private equity exits. Peterson points out that there is no guidance from the FASB on accounting treatment for income securities, and figures that IRS action is three to five years off, although government intrusion may be inevitable. “As a public policy matter, the Treasury is not going to let a lot of these things go,” he says. “They will find some way to attack it on its merits if the federal government is getting no money.” Willens suggests that a weak spot is the question of whether the debt portion is truly debt or “disguised equity” that is not entitled to a tax deduction on the payout. Operationally, the success of these companies valued on their ability to pump out cash will depend on the ability of management to keep it going, Taylor points out. She thinks there is a corps of skilled managers who are able to do it. “You have an entire generation of experienced managers who had felt left behind for few years because of the focus on tech companies,” she says. “They are really excellent managers and now they have the opportunity to manage at a public company. They are plain-vanilla companies but so are the vast majority of companies.” One outcome that the experts found difficult to project was what will happen to the debt within the income security. The company will emerge as a highly leveraged, publicly traded firm. Most public companies don’t like to truck forever with that large a debt load, yet much of the financial engineering is based on tax breaks from the interest payments. The notes in the debt strip can be extended for as long as 20 years but there was no way of forecasting if that was financially feasible. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com