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— Industry Insight —
Leverage has been and always will be a critical component in private equity investments. However, the economic volatility of the current environment has changed the dialogue on leverage, often for the better. It seems more appropriate today to talk about leverage not as categorically higher or lower, nor as a rigid number, but rather in terms of "effective leverage." In 2007, when debt capital supply reached an all-time high -- $535 billion according to Standard & Poor's data -- many deals were leveraged to the hilt. Odds are many investors are paying heavily for that strategy now, as generating returns based on multiple expansion has become much more difficult. At the same time, creating sustainable growth through an active approach to company enhancement is gaining respect among buyers, sellers and even brokers. But it's also clear that these valuable enhancements most often can only be executed in the absence of excessive debt, and that's why the market is finally starting to think about leverage in a more comprehensive way.
For investment bankers and financial intermediaries, finding a capital partner who does not rely excessively on leverage to generate returns not only reduces the chance of an aborted or renegotiated transaction, but addresses many clients' desire to find a qualified steward for the company that will protect its legacy. It is incumbent on intermediaries and company owners alike to find buyers who can supply the right blend of sponsorship and leadership to generate acceptable equity returns through value-enhancing improvements -- without leverage that threatens the success of those initiatives. An approach built around lower leverage that enables investment in high-potential enhancement activities -- what I call effective leverage -- may stand in opposition to the traditional belief that higher leverage leads to higher returns. But more and more, we have seen higher leverage deals -- while more attractive to some investors -- produce lower returns and slower business growth. In contrast, lower leverage investments bolstered by selective strategic enhancements more than compensate for the supposedly higher cost of equity, and create stronger companies that are ultimately more competitive in their markets, and thus more profitable. Standard & Poor's reported an average leverage ratio of 6.2 times for megamarket LBOs and a ratio of 5.6 times for the middle market in 2007. While these figures are a handy reference, they really don't cast light on how effective that leverage is. In most cases, effective leverage is going to be on the low end but on a given deal, but it could fall anywhere. Although some investors may believe only high leverage investments can bring the desired profits or business growth they hope for in their portfolio companies, applying effective leverage can prove more beneficial than relying on financial engineering. Lower leverage gives management the flexibility to invest in promising growth and profit initiatives while giving the investment firm the opportunity to help improve overall operations and add value to the company. Adding value is, essentially, what effective leverage is all about. When leverage is out of proportion, the investor must apply cash to paying interest and principal on loans rather than making needed improvements -- often causing the company's strengths or potential strengths to suffer. As private equity sponsors of the Room Place, Chicagoland's largest and oldest furniture retailer, we turned down the opportunity to place a higher level of debt on the company and spurned a recapitalization offer during the peak of the debt frenzy. Along with management, which had significant ownership, the board chose to pursue a value creation strategy focused on opening new stores outside of Chicago to leverage fixed costs, increase depth of management (which added overhead), implement a strategic marketing program and aggressively pursue an information systems and technology upgrade. When the decline in the retail furniture industry occurred, many competitors went bankrupt or simply closed operations. The Room Place was able to continue its growth strategy throughout while funding select enhancements. With excessive leverage, these initiatives would have ground to a halt. This is what I mean by effective leverage. The combination of lower leverage and strategic guidance accomplished far more than high leverage could have on its own. Although there is no set equation to find the ideal amount of leverage to be effective, our experience has shown that 2.5 times to 3.5 times is a good target. It's high enough, after enhancements, to please both management and shareholders while allowing the business to grow, improve performance and generate strong results over time. As with everything, flexibility is critical, and what works for one company may not work for another. Enhancing companies is not a "one size fits all" proposition either. The strategic application of business enhancements will rely on the discretion of the investment firm. The major enhancement areas where we invest time and money are: strengthening corporate governance through increased oversight, operational initiatives like lean transformation and IT improvement, finance, marketing and branding, and strategic moves such as add-on acquisitions. To execute these types of enhancements, investors must become intimately familiar with the most intricate workings of the portfolio company. Intensive due diligence is absolutely necessary, in order to discern both what the company has done in the past as well as what the company should do in the future to drive growth and increase profitability. Making the right enhancements not only improves operations, it can inspire talented management by setting a higher horizon and refocusing them on more interesting, engaging work that develops their skills. By taking some of the stress of managing the business off of management's shoulders, strategic enhancements make it easier and more enjoyable for management to run the business. In addition to knowing which enhancements to make, one of the most important issues for investors is the discretion to know when to apply enhancements -- and the ability to immediately switch gears when a strategy is not working. This flexibility is especially important during times of economic difficulty, when investors must be quick on their feet as fallout from global economic changes affects portfolio companies. A tough U.S. and global economic climate doesn't mean investors should shy away from leverage. If anything, global shifts have shown us that we should approach each investment with fresh eyes and an open mind. Investment success is not simply about lower or higher leverage or Ebitda. Profitable investments hinge on investors who do their homework and know exactly which adjustments to make to portfolio companies to create value and sustainable growth that benefits both parties. By focusing on effective leverage, investors can prove that the old model is not the only option. In volatile times and tumultuous markets, leverage deserves a comprehensive re-evaluation, because it turns out that less can be more. Everett Cook is a managing director and co-founder of Pouschine Cook Capital Management LLC, a middle market private equity fund with more than $250 million of capital under management. |
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