Infinite Variations On the Theme Of Financial Buying

To put their vast war chests to work, LBO sponsors are utilizing every conceivable format and approach to compete and win in the hyperactive m&a marketplace. Playing the Angles A deft blend of creativity and caution drives dealmaking by well-established leveraged buyers in the late 1990s. In response to the highly charged competition in the m&a market, sponsors define an edge in bidding situations that gives them a good chance to win or hunt for deals off the beaten path. Industry and market specialization can be big boosts to completing transactions. Strategic plans and cooperation with managements are essential. Pockets of Strength Reputation and experience count for a lot in finding and completing leveraged deals at reasonable prices. They can lead to a variety of formats recapitalizations, minority investments, working with entrepreneurs to add value to a business that appeal to sellers. The willingness to do deals fast and stick with opportunities that may turn off strategic acquirers are often good hole cards. In the Loop Venerable leveraged buyers have spent considerable time building their bench strength and are finding that these efforts are paying off. Solid networks of intermediaries have been formed to source deals, and they are delivering. Incentives such as funds that allow these associates to invest in deals have been established. Industry specialization or expertise telescopes the referral of deals to the right acquirers. Massaging the Growth Good industry consolidation plays are coveted. But not all work, and the established LBO sponsors are careful about picking their spots. The best consolidations and the build-up projects being increasingly emphasized offer built-in organic growth from the start. Add-on acquisitions are being viewed as rather cosmetic if growth cannot be fashioned from within. Public-Company Disenchantment A growing number of public companies are going private through leveraged buyouts shepherded by a well-regarded sponsor. Most are mid-cap to small-cap stocks that have not been well treated by the public market. While no blockbuster going-private transactions have been logged, that may be a matter of time. Playing the Angles M&A: No matter how it’s measured, activity in the m&a market is at an all-time high. Exactly how has this affected your business? Callaghan: The conditions in the marketplace have been favorable for the past three years. Earnings are pretty strong, although there are some clouds on the horizon on that front. Interest rates are low. Financing, through June 1998, has been at an all-time high in terms of availability at all levels of the capital structure. And this has created a great seller’s market. So, those of us with portfolios have been rapidly trying to take advantage of that solid market for the past several years. On the buy side, it means that firms like ours have to figure out a way to compete in a way that plays to our strengths. For Berkshire Partners, that has meant that we have become pretty ruthless about trying to figure out early on whether we have a chance to win something. We will not chase something unless we have what amounts to a strategic advantage in a competitive process. We will chase almost anything if it is not a competitive process. So, we have retained our opportunistic roots but have decided to allocate resources to projects that are highly likely to close. That has meant working with a number of our portfolio companies as they accomplish acquisitions. It has meant focusing on our core areas of transportation, growth manufacturing, wireless services, retailing, and business services. It has meant moving overseas in the past several years to a significant extent and following some of our portfolio companies and various consortia as they buy railroads or tower companies in overseas markets. As much as anything, it has meant focusing on the things we know and the management resources that we have and utilizing those strengths while staying away from things we know little about. Gonyo: If you don’t have an angle or an edge in an auction situation, you might as well not participate, because it is going to go to the highest bidder. Therefore, you must have some sort of proprietary knowledge, perhaps from a prior investment in that industry, an understanding of key customers, or an executive that can assist in due diligence. We often find some good values with companies that are undermanaged, possibly as a result of an absentee owner. It has an attractive competitive position in the market but there is something minor wrong with it yet it is not broken. The other angle that has been popular for some time is an industry consolidation or growth-through-acquisition approach. Once a platform company is established you can average down purchase multiples fairly quickly by adding smaller acquisitions and gaining operating synergies and efficiencies. For example, we have initiated a consolidation in the pest control industry by acquiring mom-and-pop companies with between $1 million and $20 million in revenues. Although this strategy is maturing, fortunately the financing market is becoming more sophisticated and can accommodate a fair amount of debt leverage. Harlan: From our earliest days and we just started our 12th year we have been buying our deals away from Wall Street. I think there is a real discontinuity between values in the public market and values in the private market. What we have attempted to do is to utilize our reputation as a firm that is exclusively in the buyout business. A lot of folks are in a lot of other businesses as well as the buyout business. They get into potential conflicts of interest, disclosure issues, competence issues, and such. Another matter is the quality of your potential investment people, or sponsors, or whatever you call them. There are folks in the business who don’t offer a high level of ethics. Before we started the firm, John Castle and I had been in the buyout and investment business, and our reputation was established. People bring us situations as a result of past conduct and our conduct is that we try not to squeeze the last penny out of a deal, either as a buyer or a seller. That leads to a reputation of being treated fairly, that we are not going to take advantage. And we try very hard to focus on creating a partnership between the managements of these companies and ourselves. So, we provide the glue, if you will, to transition from old, retiree management to young folks who are running the business, and we drive the ownership in that business deep into the organization. As a result, there is a payoff for everybody. For instance, when we sold Smarte Carte a year ago, 116 people at world headquarters in White Lake, Minn., got on average $20,000 apiece. de Nicola: On that point about treating people fairly, our firm has a reputation for being responsible and for being a good corporate partner. We create good partnerships with our management teams and employees, and that suits us well when we are competing for businesses, especially in the entrepreneurial world where there is a founder who wants to sell the business and also wants to make sure that the employees and the management team are well taken care of. As for the angle on making deals work, Welsh Carson began in the early 80s to focus its investments in only two industries: health care and information services. That differentiates us in terms of both deal flow and the ability to create value after making an investment. The principals in our firm have spent virtually their entire careers in either of the two industries. So, when we are looking at a new investment opportunity, we very quickly get to the crucial business issues and make fast decisions about whether we want to proceed. We avoid much of the basic industry research, which takes a lot of time, and are then able to concentrate on cultivating the deals we want to do. All of our companies become platforms for acquiring additional businesses. And since we play in only two fields, we see virtually every transaction of scale that gets done in either information technology or health care. By utilizing portfolio companies to help with due diligence and evaluate the opportunity, we typically can make informed decisions very rapidly and create additional value because of that process and the synergies within our portfolio. Finally, with respect to deal structure, we have been very creative over the past two years in making deals that other buyers, especially corporate entities, could not make happen. We have entered into a number of corporate partnership transactions in which we have bought businesses from very large corporate entities which, for a variety of reasons, wanted to monetize an asset and deconsolidate, but also wanted to retain some of the upside potential in the business. We have done deals like this with The Limited, J.C. Penney, SBC Communications, Premier Health, Century Cable, and Dow Jones in the last few years. Max: We are seeing a lot of deal flow. I think the biggest challenge is finding quality businesses among this deal flow and evaluating businesses in this environment. We are seeing a lot of things that look good on the surface, but if you take into account the robust economy, it can be very tough to find quality companies. Judgment gets to be the critical issue. From a marketing and strategic point of view, how do we compete in this environment? Our strategy involves a number of different approaches. One is that we have created a number of baskets for different kinds of deals. People know that if they bring us something they don’t have to spend a lot of time screening as to whether it is a fit for us. With 40 companies in our portfolio, we do a number of strategic deals and we do a lot of heavy shared equity transactions, such as 50-50 recaps with family-owned companies. We also play the auction game. As much as we don’t really enjoy it, the auction process has actually proved to be a pretty successful place for us to source deals. Our approach has been to say that everything is of interest and let us make the decision. That has worked reasonably well The common thread for everybody here is that our groups are probably differentiated from the general buyout community in that all of us have longstanding relationships within the brokerage and investment banking community. We probably have more opportunity than most in a market that is as busy as this one. Pockets of Strength M&A: As for the competitive conditions in the marketplace, are there any particular areas where you believe that financial buyers typically have an edge or can win the bidding, and conversely, where they are invariably bound to lose? Are there any special approaches or techniques that give you an edge in bidding or in finding companies worth negotiating with? Harlan: There are a lot of new people in our business, and I think one of the elements that has been fueling the auction market is that a lot of these new people don’t have the history of long relationships that those of us around this table have. Therefore, they have to go to Wall Street to generate product. So, you get a lot of these folks in just that small arena, and given the supply-and-demand curve, that drives prices up. My observation also is that the marquee names really drive prices up. Certain folks in our business like to be able to say that we own a marquee name, and “isn’t that terrific” for a variety of reasons. They may think it is appealing to their investment partners or that it puts them on the map. For example, why do people buy an airline, or a restaurant, or a hotel? In the old days, if you bought a prestigious hotel, you could say, “That’s my hotel.” I think that there is a certain element of that and, again, that drives prices up. By contrast, there may be good products and good companies that are not marquee names so people don’t instantly recognize them but they may be good values. Max: People are expecting to pay significant multiples in the auction market and they need to see the growth in the business to justify these prices. But lately, a number of mature businesses are getting auctioned. These mature companies don’t provide the kinds of growth that people need and they don’t get the kinds of multiples or the buyers’ attention that one might expect. Sometimes, no one shows up for the final bid. It doesn’t happen all the time, but our group has found a few we can buy this way. If we can get one or two of those a year, it supplements some of the other things that we do. Gonyo: As part of our strategy, we believe that recapitalizations are an area where a financial buyer has an advantage over a strategic buyer. A strategic buyer in most cases is able to pay more for a company than a financial buyer, especially if the business is combined with another company in the same field. For example, consider a family business in which the owner holds 100% of the stock and he wants to diversify his wealth today. The capital gains tax cut has just gone into effect and he wants to take some chips off of the table yet still maintain significant upside and operating control. That is a perfect marriage between a good financial partner and the owner. We can add some value in assisting with financing, expansions, or an IPO. We also can help in recruiting rounding out his management team if he wants to slow down. We may perhaps hire a president to run the business day to day. That is a terrific advantage. In approaching entrepreneurs, we have found that they may value a transaction at a 10% to 15% discount to what they could sell the company for potentially in a broad auction. They just want to go through a very quiet process. It is not like putting a piece of artwork up at an auction. They want to be discreet within the community, particularly with respect to their employees or customers. Max: We often do recapitalizations in which we share the equity 50-50 with the current owners and will even consider taking a minority position. If that is what the owner of the business is interested in doing, there is really not much discussion on a strategic deal. It seems that one of the nice things about recapitalizations is that you don’t have to sell them. It tends to be what the owner is looking for, and he or she will quickly be on the same side of the transaction with you trying to make it work. But I think it is also interesting that the strategic buyers tend to show up among the high-profile transactions. Those do not represent most of the transactions we do. A strategic buyer can become very picky and selective about what it wants. Just because something is for sale doesn’t mean it is going to attract a strategic buyer. So, you tend to hear a lot about strategic acquisitions, but I don’t think that strategic deals are as common as you might think. Once a strategic buyer wants something, the financial buyer might as well pack up its bags and go home. But it is often worth getting into a deal because I am not sure that the strategic buyer will show up. In the Loop M&A: What are your principal sources of deal flow today? Where are you accessing most of your deals your own search-and-screen programs, intermediaries, sellers coming to you, etc.? Callaghan: We see a lot of things, about 1,000 transactions a year. A lot of those are very quick kills and not suited for us. But of the transactions that we have done in the past four or five years, we first heard about almost all of them through either a limited partner, a long-time friend of the firm, a portfolio company, or a former manager that we’ve done deals with. Occasionally, those were transactions that were in competitive processes. For example, the privatizations that we’ve been involved with overseas were situations we first heard about through our portfolio companies, but they were typically flat-out auctions. Even though the business was to be sold at the highest price, we believed that we had the most relevant knowledge of, say, the British rail freight operations, so we pursued it. So, the vast majority of things that we do these days we hear about through that tight group of friends and associates. A lot of the stuff that comes to us from Wall Street is something we could have an interest in, but we haven’t developed a compelling angle on it and we just pass. Harlan: We have tried to institutionalize the process. We have created an affiliates fund which operates side-by-side with our other funds. We have taken several of our good friends who are well positioned and who have wanted to invest in our fund. We would not normally take individuals of that size, so we created a separate fund for them. Gonyo: We have established an Executive Advisor Partners Fund which is comprised of current and former executives of medium- to large-sized companies. It has worked extremely well because these folks have a vested interest and they are out there kind of looking around for situations within their respective industries. Max: We have invested a lot of time and money in building up a private business broker network. That has been a real franchise and resource for Jordan. But over time, we have had to change how we use this network. What is tending to happen now is that deals aren’t simply bought as much as they are sold. Somebody has put a package together. In the old days the business broker would bring in something that was fresh and new and you would have the opportunity to introduce the business owner to the whole idea of selling. Today, we are getting word from business brokers that something that might be for sale, but even if we get in early, the investment bankers have already put a package together to sell the businesses. We get a lot of value from our intermediary network because we have very longstanding relationships. We’ve closed deals with these bankers and brokers. We’ve been calling on them for 10 or 15 years. That has helped. Business brokers also have been very effective in doing strategic add-ons to platform businesses, where we are going down market to smaller-sized deals. They still have a very good relationship in that market and will bring us new properties all the time. Looking at the auction side of the business, we’ve differentiated between what I would call the major bulge-bracket firms that run pure auction processes at the top level and more regionally-based or smaller investment banks. In the latter case, we have an opportunity to have a relationship that seems to cover more than one transaction. We have probably done better at the regional level than we have on the national level in terms of auctions. de Nicola: It is interesting to listen to everyone here discuss how they differentiate themselves and attempt to generate proprietary deal flow, and I imagine that over time more and more firms will allow for some of these strategies that we are discussing. As others mentioned, Welsh Carson also cultivates its focus industries through business brokers, consultants, and investment banks. In addition, our firm has put together two side-by-side investment partnerships Information Partners and Healthcare Partners. We bring in former executives, current executives, business brokers, and the like so they have an incentive to show us transactions. We have also engaged consultants, former executives of portfolio companies, on a full-time basis to work with us exclusively. They sit on our boards, they source deals for us, and they help us with due diligence and in monitoring transactions post-closing. We use business brokers exhaustively, especially in platform acquisitions where we essentially assign a business broker to a CEO and tell the CEO, “This is your resource to utilize to go out and grow the business through acquisitions.” Finally, and most importantly, our position in health care and information technology gives us a unique franchise. Corporations often call us first to discuss potential deals, and certainly when an investment bank gets involved we are going to get a call. We may not always get the only call from a banker, but we will get a call very early. And being able to speak for both the equity and the sub-debt in the transactions allows us to move quickly, giving sellers more certainty and potentially allowing them to avoid what might otherwise be a protracted process. First to the Table M&A: Are there other factors that may favor a financial buyer? Why would the seller or its intermediary come to a financial buyer first? Or in what situations might the financial buyer have an edge in competitive bidding? Harlan: At least in our situation, if the company has a little hair on it, it does not lend itself to the auction market. All of us here are very well equipped to deal with what might be some unusual elements in a company. It might be an environmental problem. It might be a management succession problem. It might be a variety of issues that require working with the company, with the seller, and with the management to clear up whatever those issues are. We have been willing to take some of these risks. For example, in 1988 we bought a money management company, Delaware Management, at a time when nobody was buying money management companies. In fact, we had trouble finding senior financing because the popular lender responses were that the assets go down in the elevator every night. But look where that industry is today. It was a very successful transaction, and we later sold the company to Lincoln National. We have taken those kinds of unusual and/or pioneering routes before and we will continue to do so. de Nicola: At virtually every company we own, the primary assets we buy are human and intellectual property. That is a unique aspect of all of our transactions. Our track record and experience make us particularly well suited to working quickly with sellers who face the risk that when they put the property on the market, the mere “for-sale” sign could do substantial harm to the business either in terms of employee turnover and low morale or loss of customer relationships. A corporate buyer might be threatening to the key employees, a risk to key customers, or have an internal approval process that is not able to move expeditiously. We realize that the key assets we buy are the physicians, surgeons, nurses, or the computer programmers or engineers of the companies that we acquire. We have to be especially prudent about how we go about doing diligence and structuring transactions in acquiring those businesses. Callaghan: For an entrepreneur seller, the other advantage of working with a financial buyer, other than getting a “second bite of the apple” from the equity standpoint, is the control advantage. Most of us here are not staffed to operate companies. We have people who might have operating experience, but with 20-plus portfolio companies you can’t be making those day-to-day decisions. So, we truly invest in companies where we believe in management and depend on them to make the right operating decisions. If the seller does its homework about who it is going to take on as a partner, it will see that in Berkshire companies, management changes rarely occur because we’ve done our homework about the management team before investing in the company. de Nicola: Although we acknowledge that good management is a key ingredient to success in our private-equity investing, we don’t necessarily always require having the right management up front. Because of our expertise in our two industries, we will buy a business that we believe is a good business with potential although it doesn’t have the proper management in place. We recognize that at the beginning of a project and we proceed to buy the business with the intent of putting top-notch management in place post-closing. An example of that is the businesses that we acquired from The Limited and J.C. Penney, who are our corporate partners in Alliance Data Systems. We bought in-house data processing and credit-card processing capabilities from those two companies and we merged them together. We knew that the management teams in place had developed a good business serving an in-house client base but probably would not adjust well to competing with the industry leader in credit-card processing. We knew that up front and at closing, so we went out and retooled the entire senior management team. We recruited executives from the leading transaction processing companies in the country to create an exciting new player in the industry, Alliance Data, which has in excess of $400 million in revenue. We were probably the only financial buyer that would execute that transaction because the operational and management risk was so great. The risk involved in taking on an operation that had internal data processing capability and making it a market-driven company by recruiting a whole new management team was so great. Tax-Cut Impact M&A: Since most of your deals are for cash, has the capital gains tax cut been much of a factor in completing deals, helping to get the type of companies you want, or in any other respect? Gonyo: I have heard from some sellers, particularly privately held family businesses, for the last five years that they were thinking of selling business but were just waiting for that capital gains tax cut to go through. I think the overhang is gone, and thus there has been a positive impact. Max: I think that the capital gains tax issue as well as the economy and low interest rates, which have an impact on financing, all have contributed to the healthy deal market. What is most important is not the absolute tax rate, or the status of the economy, but the direction of the trends. If sellers believe that lower rates are ahead or that the economy will get better, they might hesitate to sell. On the other hand, once they reach the point where they don’t have expectations for further reduction in rates or an improved economy, more properties are freed up for the deal flow. I think we are at such a point. Search and Surf M&A: Intermediaries are telling us about all kinds of new tactics for finding deals, such as covering a wider geographic area, using the Internet, more sophisticated use of data bases, using competitive intelligence people, and a lot more cold calling. Are these perceptions correct? And just what are you doing to drum up deals with all of this vast equity that has been raised? Max: We are probably sticking with an old concept, which is that we treat the intermediary as our customer. That is probably the primary driver in how we approach the market. We try to make it as easy as possible for someone to bring us deals because we are going to get the deal done and they are going to get paid. That is probably the biggest thing. The only thing that I would add to the concept is the issue of selectively retaining individuals for focused searches. I think that has been a more effective strategy for us lately than maybe in the past. Harlan: What we have done, and what has been very successful for us, is that when we are growing a company organically, we are also looking for add-on acquisitions. We get the management of the business to focus on searching its arena for add-ons, rather than having us do that. A very good example of that is MAG Aerospace, which manufactures about 70% to 80% of all the aircraft toilets in the world. The CEO is a dynamite manager, but he was totally focused on operating the business. What we did was tell him to raise his eyes over the dashboard, look out the window, and find something that fits. He found the only manufacturer of trash compactors for aircraft in the world, and it was a dynamite acquisition. It is in the same business waste disposal and it has the same customer base. The whole thing just fit. Our experience with add-ons is that nobody knows the industry better than the guy who is running your own business for you. Gonyo: I think that the Internet is a helpful tool, particularly when you are looking at a relatively new industry like the competitive local exchange carrier business, in which we recently have made three investments. It is a relatively new industry that emerged as a result of regulatory changes in the last several years. It makes sense for us to take a rifle-shot approach in that area, get to know as many companies in that industry as possible, and dedicate the professional resources to making the project a success. We become much more efficient to go direct with research and prospecting tools like the Internet. Massaging the Growth M&A: There are more levels, more types, and more formats of consolidation than we can count, including the build-up plays. Are there any new trends in this area, any new drivers, or any new techniques that make it conducive for financial buyers to undertake these consolidation plays, including possibly the financing situations? de Nicola: Since Welsh Carson was founded in 1979, our firm has focused on this strategy. Virtually every company that we have acquired had both an organic growth and acquisition strategy built into it. Usually an investment has organic growth of 10% to 15%, and we build acquisition-related growth on top of that. This build-up strategy is a primary reason that we have been able to generate strong returns over a long period of time. If you look back at some of our early portfolio companies, like FIserv, Quorum, American Oncology, and SunGard, we started with a platform company and we grew it with acquisitions. Today, one of our biggest investments is Bridge Information Systems, which supplies financial market data. We’ve acquired businesses from Dow Jones and Knight-Ridder, among others, and created a $1 billion-in-revenue company out of what was a $100 million business. It is now a global, full-service provider with the second-largest position in its industry. With respect to new trends in these buildups, I don’t know if there are any, but I would caution folks who are looking at doing these consolidation plays that they involve more than simply financial arbitrage. There is a potential that financial buyers can lose sight of the operational issues required to successfully execute the strategy. Our firm has focused on operational execution because of the background of our general partners. We really press the management team to carefully develop, as part of evaluating the acquisition, the postacquisition integration plans and the operational consolidation and integrations that are going to occur, so that the acquisition is not just a financial arbitrage play. We very much recognize that capturing the operating synergies in a merger is as important to creating a good, well-run company as it is to making a good deal financially. Max: It is hard to argue when someone uses the term financial arbitrage because it has a certain sense to it. But the reality is that financial buyers in general and this goes back to the strategic issue are able to compete traditionally with strategic buyers because they are willing to make the deal for a platform, which can be the basis for either an operating consolidation or a financial consolidation. We have had a lot of success working with people who are growth-minded and who weren’t looking to see their operation pulled into a formal strategic integration. Instead, they were looking to be brought under an umbrella that would give them access to the capital markets or to corporate resources that would otherwise be out of reach. For the last five years it has certainly been an opportunity that has worked well for us. Callaghan: It is amazing to us how many of these small industries, which none of us may have even thought of as industries at one point, have suddenly become categories of build-up. We will stumble on an industry and all of a sudden will realize that most of the targets are being talked to by somebody who had this vision to consolidate the industry, whether the industry is ripe for build-up or whether there is anything really synergistic in it. It reminds me of the old “give a man a hammer and everything becomes a nail” analogy. There are people locked onto this idea of fragmented industry as a build-up opportunity and are launching off on that path, whether or not the industry is appropriate. The other interesting aspect is that the sophistication of the sellers of some of these $2 million to $3 million revenue businesses is extraordinary, relative to where they would have been 10 or 15 years ago, even five years ago. One thing that we have been hearing pretty consistently for the five or six build-ups the wireless tower business, auto body repair business, litigation services, etc. that we are in is that internal growth, or organic growth, has to be there. It is not a sustainable enterprise if it is just pegged to acquisition growth. So, we have been trying to apply a pretty tight screen to the underlying industry characteristics and underlying business characteristics versus just sort of pulling off the multiple expansion game. Without some real strong industry trends, even if you are predicated on doing more deals, at some point it just doesn’t sustain itself unless the internal growth is present. de Nicola: In addition to the internal growth there must also be an integration plan and operating philosophy in place. I worry that at some point some of these companies run the risk that they are not really operating companies but just holding companies that are not fully integrated. There have been a number of troubling instances of highly publicized deals lately where there were acquisition strategies that were, let’s say, far afield. Not only were the operations not integrated but the financial controls weren’t in place either. None of us wants to be in that position. Sorting Out the Trends M&A: Many corporate divestitures and other selling companies are answering to different trends or drivers. How close do you monitor these forces to figure out what may be available for sale? de Nicola: In 1995 we made our initial investment in Bridge. At that time we analyzed the landscape and figured the competitive environment and determined that there was an opportunity to create a leading global provider of financial market data. At that time, we did not know for certain which businesses would ultimately be divested by corporations with different strategic directions, but we figured the industry was ripe for consolidation. So, we acquired a $100 million business with the intention that, as other assets became available, we would supplement the core business, which is providing equity data to institutions. Bridge had a fabulous reputation and position that could be strengthened with acquisitions to add additional product lines and content. The acquisitions of Knight-Ridder Financial and Dow Jones Telerate completely reshaped Bridge. We consolidated the data centers, eliminated duplicate data sources, reduced distribution costs, and consolidated back-office operations. Because Bridge had invested heavily in a state-of-the-art TCP/IP distribution network, that allowed us to take the products that came with Telerate and Knight-Ridder Financial and push them through our existing network to the customer base. Bridge achieved huge economies of scale and has been able to revive what one could classify as a very troubled property. Welsh Carson was able to generate significant value because we had the platform to work with. Harlan: That is the ultimate in being an entrepreneur and breathing life into a business. M&A: Leonard, MAG was one of several consolidators in the aircraft components industry. Did you watch those trends and figure it was good for consolidation because there are fewer airlines around the world, fewer manufacturers, and those kinds of things? Harlan: We simply bought a company that was in the toilet business. “Our interest was in the bottom line.” We bought MAG at the bottom of the cycle and our focus was to keep it at the cutting edge of technology and to diversify its customer base. As a result, all of the new trains that are being built in China and the United States and certain other parts of the world are now using this company’s vacuum toilet systems. We determined that as growth occurs in the aircraft business, MAG could ride that as well, having diversified into these other areas using the same technology. In the midst of all of that, we encouraged the company to find an acquisition, and it was an absolute bull’s-eye. We didn’t go into this saying this is an industry to consolidate. Gonyo: When reviewing industry consolidation opportunities, we spend a tremendous amount of time on understanding the business fundamentals. We want to acquire businesses that have great franchise value and funeral homes would be a classic one that are nice businesses to own by themselves. When you combine them under the right executive talent, you are building a stronger entity. If you are buying dry cleaners or something similar that has lower barriers to entry and is a bit more fragile more of a weed than an oak tree, for illustration that is where you can hurt yourself. We have seen a number of what I would call poof companies that have effectively gone public and merged several businesses together at the same time. I think it will be interesting to see how they withstand the test of time over the next five to 10 years and see whether all these small businesses do become effectively integrated. Max: When you do a build-up, do you do your research first and decide you want to be in the industry or do you find an opportunity in the industry and back it up with research? Gonyo: It is a combination of both. Clearly, there was a lot more research in the old days than today. You don’t have to do much research now because there is probably already a role model out there, such as a public company that you can easily study. Public-Company Disenchantment M&A: We seem to have a rising incidence of going-private deals. These are mostly mid-sized companies. What accounts for this rising incidence? There don’t seem to be any RJRs on the horizon, but will there be? Harlan: If you look at the Russell 2000, which is an index of small-cap stocks, it is down for the year. And if you go behind that you will see that there has been a substantial decline in the public values of the small caps. That just opens up the arbitrage to reflect the differences in the values defined by EBITDA and operating income versus the values as defined by the public market, which uses earnings per share. As stock market values decline, it will lead to an increase in going-private deals. Yes, the stock market has been booming, but there is really a dichotomy going on. Callaghan: The large stocks are safe, but the small-cap stocks are having problems. A large percentage of them are down, well in excess of 30% to 40% for the year, and their businesses haven’t changed that much. A lot of them haven’t changed much in terms of their earnings outlook. What has happened is that momentum investors have just deserted them and withdrawn support. Given how thinly traded some of these $250 million to $300 million market-cap stocks are, when they lose a big investor, they are sort of dead in the water. The management teams know that. They are not going to get analysts calling. They are not going to have the ability to do a secondary. A lot of those management teams that own meaningful positions in their companies are driving the transactions as much as folks like us who can get by the six-month or one-year drop in whatever is going on in our business or industries. I think it is a classic case of investors with different time horizons. The management teams and private-equity investment firms have much longer time horizons. The public market wants performance in six months, and we all feel that if we get it within the next three or four years, we are pretty happy. For all these reasons, I expect that we’ll see a lot more going-private transactions in the next several years versus the last several. Max: We have taken a number of companies public out of our portfolio and it has been an interesting experience. Some examples are American Safety Razor, Custom Chrome, which has changed its name to Global Motorsport Group and which was just taken private again, and RockShox. Basically, going public has been a very good strategy in terms of accessing inexpensive capital, if we’re looking to de-lever or if money is needed to finance growth. It has been a terrible strategy in terms of an exit, both for ourselves and management. de Nicola: I think the trend is going to accelerate over the coming years. There may be a situation in which a company, for whatever reason, disappoints in the short term. There is very often an opportunity for a financial buyer, who can understand both the long-term story and factors causing near-term miss, to come in. The financial buyer can see the long-term value proposition and take a company private that maybe shouldn’t have been a public company because it is a model that is not quite developed. We announced a deal where we are taking MedCath, a cardiac hospital company, private. It is a very capital-intensive business with a number of different joint-venture deals with hospitals and physicians which in the early stages of development are tough to project. We think that in the longer term it will turn out to be a much better company than the public market gave it credit for. A financial buyer who understands the full story can create a transaction that provides the current shareholders with a fair premium yet allows it to finance a deal that gives it returns that are acceptable to its limited partners. In the present financing environment, with the debt financing where it is, with very attractive rates, and with the advent of the new tranches with longer amortization schedules, it is a very attractive time to take some of these companies private. Max: It is very tough for us to buy a public company. One of the questions you need to ask is, “Where do you go with it if the market didn’t understand it the first time?” How are you going to change the story and how is management going to make changes so that it becomes more interesting to the public? That has always been a problem for us in terms of the other side of the equation. Harlan: We are not afraid of buying in the public market. In fact, we have done that. I think that there are some wonderful potential values out there. We spend a lot of time working with the management to develop a strategy and to pursue it, and we find that management not only welcomes it but encourages it. I think the problem with some of these small-cap public companies is that the guys at the top have nobody to talk to. Their boards are a bunch of functionaries who really don’t wrestle with critical strategic questions and all the things that we do on a monthly basis. There isn’t really an opportunity to take what seems to be a company that is just floating in the water and reenergize it. One of the big roles that we play is being cheerlead-ers. We say, “Let’s get a strategy, let’s get a vision, and let’s go!” There are always a lot of companies that can respond to that. Max: We have done that in the private market but we have not found that many opportunities to bring value and reenergize companies in the public market. Look at some of the companies that have gone public and then maybe stalled out. I think the biggest problem is that many businesses that we look at don’t organically have 20% growth rates. That is a that you are competing against in the rest of the market. We may be very satisfied with a company growing 10% a year without acquisitions. But they just don’t play well in the public-market environment. Harlan: I would just like to add one thought. Underlying a lot of this is the fact that there is a huge amount of new money that is coming into the private-equity market. I think the amount of money that is there is somewhere around $100 billion. That is not a huge amount relative to the total value of all the marketable securities that exist on the New York Stock Exchange, Nasdaq, and the other stock exchanges, which amounts to about $9 trillion. It may seem larger than it is because a lot of attention is focused on the auction process coming out of Wall Street. That really grabs the headlines, which say the multiples are now eight to 10, seven to nine, or whatever. In fact, I think that all of us here are probably buying at multiples that are less than that. Max: In terms of the funds raised, the amount compared with the total market cap hasn’t changed a lot. But the level of inefficiency that used to exist in the private market has probably changed. That is just the reality. You can still do well in the market but it is not quite as glaringly an inefficient market as it used to be. Callaghan: If you look at the $100 billion of private equity more narrowly as a percentage of the middle-market m&a activity or all buyouts rather than of the total public-market capitalization, it is still a pretty large number. We should remember that a lot of the capitalization of the market in general is skewed toward the largest 50 to 100 stocks, which aren’t buyout targets at all. It’s tough not to make the case that a lot of private-equity money is looking for a home. The hope of this group here is that groups with strong relationships and reputations, pursuing disciplined strategies, will find a way to continue to outperform.