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— Private Equity —
At the height of the buyout boom, his Apollo Management LP eschewed the $10 billion and $20 billion and $30 billion take-privates other private equity firms with $10 billion-plus funds were pursuing. Instead, Apollo was signing $1 billion, $2 billion and, on a big day, $4 billion deals. Apollo then backed those companies as they bought similar sized companies to transform the businesses. By targeting smaller companies, Apollo was able to shun the consortium deal: Fifteen of its 16 most recent deals through the end of last year were done solo.
Diverging from the crowd has produced some eye-popping profits for Apollo's investors. Its $3.7 billion fifth fund, raised in 2001, generated a net unrealized internal rate of return of 54% through Dec. 31, according to Apollo's stock prospectus. The sixth fund, a $10.1 billion pool raised just two years ago, boasts a 42% unrealized IRR after Apollo takes its cut, according to a recent securities filing by the firm.
Even now, when rivals are biding their time, waiting until the markets allow them to exit investments, Apollo has defied the odds, engineering two exits and laying plans for two initial public offerings. But Apollo's alternative path has come with its own problems. Big bets on cyclical industries have left the New York investment firm with big problems in its portfolio. Retailer Linens 'n Things Inc. filed for bankruptcy as sales slowed, and suppliers tightened credit at the same time jewelry retailer Claire's Stores Inc. saw its same-store sales in North America drop 12% in the first quarter. Bets on the biggest residential real estate brokerages in both the U.S. and Britain now look ill-timed. Revenues have plummeted roughly 30% at both Realogy Corp., the U.S. firm, and Countrywide plc, its British counterpart. Even the supposedly recession-proof gambling industry has gone sour. Apollo's biggest deal ever, the $29.9 billion take-private of Harrah's Entertainment Inc. with co-investor TPG Capital, closed this January -- just in time to see Harrah's quarterly net revenue tumble more than 30%, from $2.66 billion last year to $1.84 billion.
"They have a portfolio of distressed investments that weren't distressed when they bought them," complains one of Apollo's limited partners. If that weren't enough, Apollo and its co-founders, Black and Joshua Harris, are now enmeshed in litigation with Huntsman Corp. over Hexion Specialty Chemicals Inc.'s attempt to get out of its $10.6 billion deal to buy Huntsman. The target has sued Black and Harris personally, claiming they misled the chemicals company into canceling a deal with another buyer in order for Apollo portfolio company Hexion to acquire it. Nothing seems to be going right for Apollo this year. The problems come at an awkward time for the firm, which is still raising its seventh fund and has a registration statement pending that would make its stock publicly tradable. As the debt markets supported larger and larger buyouts, Apollo's main rivals aimed higher and higher, making increasingly larger initial investments so they could put their huge new pools of capital to work. If their portfolio companies made add-on acquisitions, they were typically smaller deals to fill in product lines or refocus the company. Apollo chose instead to buy smaller companies and build them by buying equal- or nearly equal-size businesses:
This buy-and-build strategy led Apollo to target much smaller companies than competing buyout firms such as Blackstone Group LP, Carlyle Group, KKR and TPG. Only two of Apollo's 16 most recent deals as of December exceeded $4 billion initially -- Harrah's and Realogy -- and it teamed with TPG Capital on Harrah's. It also allowed Apollo to pay relatively low multiples for many of its deals. When Apollo filed a registration statement for its stock in April, it touted this strategy as a competitive advantage, referring to its "comfort with complexity and use of strategic platforms to create proprietary opportunities." Since the debt markets turned last year, Apollo noted, it has been easier to finance add-ons for a company than de novo buyouts. Perhaps because its targets were smaller, Apollo can also boast that nine of the 16 investments and commitments it made for its sixth fund through Dec. 31 were proprietary, and it describes four as "complex carve-outs." Once it acquired ownership of its companies, Apollo was aggressive about tapping them for dividends in late 2006 and the first half of 2007. Marketing firm Affinion Group Inc. -- like Realogy, a spinout from Cendant Corp. -- paid out $250 million; Verso Paper Corp. also paid $250 million; Metals USA Holdings Corp. threw off $140 million; Hexion generated $500 million (on top of $550 million in 2005); Berry Plastics offered about $400 million; Sourcecorp Inc. paid $125 million; and Noranda Aluminum Holding Corp. rewarded its shareholders with $216.1 million in June 2007 and $102.2 million in June 2008. A small part of this $2 billion in dividends flowed to minority shareholders, but Apollo controls more than 90% of most of these companies.
Fully a third of Apollo's holdings paid dividends in the first year it owned them, according to a report from Moody's Investors Service in January -- a record among big buyout firms matched only by Thomas H. Lee Partners LP. The dividends go a long way toward explaining the IRRs Apollo lists in its stock prospectus. A spokesman for Apollo declined comment, citing regulatory constraints. But just as Apollo was aggressive in taking cash out of its businesses for itself, its portfolio companies are now being aggressive about conserving cash. In a June Standard & Poor's survey of 41 companies with PIK toggle debt -- notes that give a company the option of paying with more debt in lieu of cash -- four were owned by Apollo, and all four plan to switch or have switched to paying in kind: Realogy, Claire's, Berry Plastics and silicon products maker Momentive Performance Materials Inc. Only three companies in the survey not owned by Apollo have exercised the PIK option. Moreover, in two of the Apollo cases -- Noranda Aluminum and Metals USA -- the PIK toggle debt was issued at the same time as the dividend to shareholders, S&P pointed out. In other words, Apollo collected cash for itself by issuing portfolio company debt that it would quickly opt to pay with more debt. Moody's said in its January report that it has compiled information on sponsors who have aggressively recapitalized their holdings and may weigh that when assigning ratings for those sponsors' companies in the future. Creditors ask, "What's the level of responsibility the sponsors feel toward creditors?" says Kingman Penniman of high-yield research firm KDP Investment Advisors. He says Apollo is viewed as being less concerned about creditors than some buyout firms. "But it's not alone," he adds. The companies that paid Apollo the biggest dividends are not the ones in the most trouble now. Which stands to reason, since the recaps required the cooperation of lenders. Still, by this spring the debt of 40% of Apollo's companies was trading at distressed levels, the Distressed Debt Investor newsletter reported in January. Claire's Stores' 9.25% senior notes trade to yield 24%, Penniman notes, compared with an effective yield of just 15% or so on the long-term bonds of General Motors Corp. and Ford Motor Co. Apollo ranked 11th among 14 big buyout firms based on the performance of their portfolio companies' debt in the secondary market. Only Bain Capital LLC, Madison Dearborn Partners LLC and Thomas H. Lee Partners fared worse in the survey. The collapse of Linens 'n Things is the most conspicuous blow. Apollo's fifth fund along with its co-investors, NRDC Real Estate Advisors I LLC and Silver Point Capital Fund Investments LLC, put $648 million of equity into the $1.32 billion take-private of the struggling retailer when the deal closed in February 2006. Apollo's portion has not been disclosed. The buyout had relatively low leverage, and Apollo brought in CEO Robert DiNicola to lead a turnaround of the chain, which had more than 500 stores. Sales had been flat for several years, and the company ran a perennial second to Bed Bath & Beyond Inc. It was vulnerable, too, because more than 110 of its outlets were in Florida and California, where the housing slump hit early and hard. By early this year some suppliers were demanding payment up front. Same-store sales fell a troubling 3.1% in 2007. Linens' net loss deepened, from $154 million in 2006 to $242 million, and Ebitda swung from $61.5 million to negative $26 million. Net sales fell a further 0.8% in the first quarter of 2008, and same-store sales declined 5.7%, sending Ebitda further into negative territory. In April, the company suspended payment on part of its debt and said it was talking with its creditors. On May 2 its parent, Linens Holding Co., filed for Chapter 11. There have been persistent market rumors that Apollo has bought up Linens debt on the secondary market. But Michael Gries, co-founder of Conway Del Genio Gries & Co. LLC, which has been called in as a financial adviser, says Apollo has assured him it has not. Neither Gries nor Scott Hazen, a lawyer for unsecured creditors, would predict how shareholders and creditors will fare in the restructuring, and a lawyer for Linens did not return calls. The company leases all its stores, so it has few hard assets. In late May the bankruptcy court approved the sale of the inventory and fixtures of 120 weaker stores -- more than one-fifth of Linens' outlets -- to two liquidators for $121.6 million. "It's hard to see how there would be anything left for the equity," Penniman says. While Linens drew attention because of the long lead-up to its Chapter 11 filing, Apollo has more at risk with Realogy, which at $8.3 billion was its second-largest investment behind the $29.9 billion Harrah's deal. Realogy franchises the Century 21, Coldwell Banker, ERA, Sotheby's International Realty and Coldwell Banker Commercial brokerage brands and claims that its franchisees and company-owned offices captured 24% of all home real estate commissions in the U.S. last year. Of course, that may be just the problem. The take-private agreement was struck in December 2006, just months after Realogy's former parent, Cendant, had spun off the business, at a point when the weakness of the housing market was only emerging. Apollo and AP Alternative Assets, an Amsterdam-traded public fund sponsored by Apollo that co-invests in Apollo's LBOs, forked out more than $1 billion to close the deal in April 2007. When homes stopped selling and prices started falling in many states, Realogy's results nose-dived. Revenue in 2007 fell 8%, and Ebitda swung from $775 million to a deficit of $239 million. It only got worse in the first quarter of 2008, when Realogy's franchisees closed 25% fewer sales than they had a year earlier at an average price that was 7% lower. That lopped 30% off the top line for those three months compared with 2007, and Ebitda fell from $59 million to negative $216 million. The Realogy investment would have been a bitter enough pill. But Apollo had also bet on Countrywide, just as Britain's housing market was following America's downhill. After shareholders had rejected an earlier take-private bid by 3i Group plc, Apollo stepped in with a $1.88 billion offer in March 2007. Apollo has less at risk in Countrywide because some hedge funds that had held shares pushed to roll over their equity in the buyout. Apollo and AP Alternative Assets put up $292 million of equity when the deal closed in May 2007. But the two real estate investments account for approximately 10% of Fund VI's capital. The trends for British real estate turned out to be depressingly similar to those in the U.S. Mortgage approvals in the U.K. were down 43% in the first quarter of this year, and Countrywide booked an Ebitda loss of £12.5 million ($24.7 million) in the first quarter as revenue fell 32%, according to a May 2 Moody's report. Its cash position also deteriorated badly. After reporting in late March that the company had £73 million on hand, Moody's issued a new report six weeks later disclosing the company had drawn down £90 million of its £100 million line of credit but had a cash balance of just £137 million. That is more than enough to cover its £60 million in annual interest costs, Moody's said in the May 2 report, but the ratings agency still whacked several notches off the company's debt ratings. For the moment, neither Countrywide nor Realogy is in danger of default, the ratings agencies say. Realogy has little debt due before 2013, and it has opted to pay its PIK notes with more paper. But there are few predicting that home prices or sales are going to rebound anytime soon, so it may be a while before Apollo has any hope of exiting these investments. "I don't know anybody who thinks [Realogy is] going to be a good business next year," remarks one of Apollo's investors. "They may not get back to 2006 [levels] ever." If a company bought in an LBO falls behind projections for several years in growth and debt repayment, this LP says, it is very hard to make up the gains later and earn the return originally hoped for. Harrah's, too, has suffered from the changing economy. When results were tallied at the end of the quarter, net revenue was down 30%, a function of reduced consumer spending, higher gas prices, renovations and flooding in the Midwest. Ebitda fell 46%, from $662 million to $357 million, excluding a one-time insurance settlement over casinos damaged in Hurricane Katrina, net of taxes. The early IRR on Fund VI, pumped up by early dividends, would likely fall over time, anyway. But if Realogy, Countrywide and Harrah's ultimately do not rebound strongly, the huge bets on those three companies could depress the longer-term return rates on the fund. After disappointing returns on its third and fourth funds, Apollo can ill afford to have another one perform at subpar levels. Even the good news at Apollo came with a qualification, it seems. Apollo was able to take Verso Paper public in May, but that was tempered by the issue having come off at just $12 a share, far below the $16 to $18 range projected. Apollo, which had recouped most of its original equity investment via the $250 million dividend at the beginning of last year, was not able to sell shares in the IPO because the overallotment option was not exercised. It watched as the stock -- and its stake -- fell in value by more than a third over the next two months. The shares were trading at $6.25 by July 10. The dismal showing could make it harder for Apollo to pull off the IPOs of Metals USA and Noranda Aluminum, which were also announced in May. Likewise, what promised to be the biggest add-on ever for an Apollo portfolio company, Hexion's $10.6 million purchase of Huntsman, instead turned into a pissing match between Huntsman's founders and Apollo. The two chemicals companies each suffer from higher energy and feedstock prices, Huntsman somewhat more so. Hexion alleges that Huntsman's business has deteriorated enough to constitute a material adverse change under the merger agreement and that lenders are not likely to fund the deal now, allowing Hexion to walk away. Huntsman's first-quarter net income plunged to $7.3 million, from $46.6 million in the same period in 2007, and Ebitda fell from $242 million, to $169.5 million. Debt also rose substantially. Moody's seemed to side with Apollo and Hexion in a June report, saying the combined Hexion-Huntsman would likely be out of compliance with its debt covenants the moment it was formed. Apollo must make its best efforts to find alternative financing if its banks pull out, but it seems unlikely it can find other lenders to back the deal on workable terms. In essence, the merger would more than double the debt on the companies with no additional equity. The combined company would replace $6.6 billion of Huntsman equity with an equal amount of new debt, on top of the roughly $3.6 billion of long-term debt that Hexion carries and the $2.3 billion Huntsman was showing on March 31. All this has occurred as both companies' cash flows have fallen since the deal was signed last July. (The agreement specifically provided that Apollo was not required to invest additional equity.) In Huntsman's suit in Texas, it claims that Black and Harris misled Huntsman into calling off a $9.6 billion deal for Basell Holdings NV to acquire it. Chairman Jon Huntsman and his son, CEO Peter Huntsman, have gone on TV to attack the financiers from New York, who they claim tried to take advantage of them. There are bright spots in Apollo's portfolio. Ceva and Affinion appear to be doing well. Ebitda more than doubled at machinery maker Rexnord in the year ended March 31. Even the wipeout at Linens is unlikely to put a big dent in the returns for Fund V, whose investments were valued at $13.4 billion as of Dec. 31. Assuming Apollo put up just half the equity for the deal, the loss would likely shave just a few points off the fund's ultimate realizations. So far, Realogy and Countrywide look like they can ride out a trough in the residential real estate market for several years without defaulting. Moreover, Funds VI and VII may ultimately turn a profit on the distress of others. Apollo's buyout funds have unusual flexibility to deploy capital in debt, and those pools and debt funds Apollo manages have invested several billion dollars this year to buy huge packages of unwanted LBO bank debt at a big discount from Citigroup Inc. and Deutsche Bank AG. Since the banks offered 75% financing, those investments could produce huge gains if the debt markets recover. Apollo made its reputation buying a massive portfolio of distressed junk bonds from Executive Life Insurance Co. at the bottom of the market in the early '90s and is plainly hoping for a repeat of the outsize gains it made on that investment. Apollo likes to tout its bottom fishing and turnaround expertise. At the moment, it looks like it will need to tap that for at least the next year or two. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
When his competitors zigged, Leon Black zagged.
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