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Bausch & Lomb 'Success' Less Than Meets the Eye

Stocks in this article: VRX GS HCA APO KKR I

NEW YORK ( TheStreet) -- Warburg Pincus is opening eyes for all the wrong reasons after agreeing to sell Bausch & Lomb to Valeant Pharmaceuticals (VRX ) for $8.7 billion, in a deal that may net the private equity firm a threefold return on its 2007 buyout investment.

Bausch & Lomb's takeover came near the peak of a leveraged buyout boom in May 2007. However, the deal is now being heralded as a classic investment success given Warburg Pincus's threefold gain, or annual internal rates of return of about 20%, in line with private equity industry standards.

If Bausch & Lomb is typical of how private equity firms generate their oft-celebrated investment returns the deal should be viewed as an indictment of the industry.

Buyout firms are often heralded for two-and-three-bagger investments in superficial analysis, but a closer look at the numbers indicates returns are often generated by a unique arbitrage available only to buyout funds who can raise $1 billion loan with a phone call.

Consider that while Warburg Pincus may be tripling its investment on Bausch & Lomb, the company's value has only increased about $830 million, according to terms of its $3.67 billion May 16, 2007 takeover and Monday's sale to Valeant, which will pay Warburg Pincus $4.5 billion for control of the eye care specialist.

Using just the equity value of Bausch & Lomb, Warburg Pincus's over six year investment in the company has yielded about a 22% absolute gain and annual returns of under 4%. While the growth in Bausch & Lomb's equity value slightly exceeds sub 20% gains posted by the S&P 500 over the span of Warburg Pincus's investment, it isn't worthy of a firm that closed a new $11.2 billion buyout fund earlier in May.

So if Bausch & Lomb was taken private by Warburg Pincus for $3.67 billion and is being sold to Valeant Pharmaceuticals for $4.5 billion, how is the PE firm getting it's much hyped three-bagger?

The simple answer is debt, which, gives Monday's deal it's reported $8.7 billion price tag.

A skeptical view of Monday's deal shows the vast majority of Warburg Pincus's investment gains are a result of Valeant Pharmaceuticals giving the private equity firm cash for its takeover financing.

In taking Bausch & Lomb private, Warburg Pincus appears to have to put up just over $1 billion in cash for control of the company, while financing a remaining $2.59 billion, according to Bloomberg data. In 2012, Bausch & Lomb also took $800 million in additional debt to pay a special dividend to Warburg Pincus and co-investor Welsh Carson.

Happily for Warburg Pincus, it is getting paid in cash for debt the PE firm will effectively throw onto Bausch & Lomb's next owner, Valeant Pharmaceuticals.

According to the terms of Monday's deal, Valeant will repay $4.2 billion in Bausch & Lomb's debt through a mixture of an up-to-$2 billion equity raise and nearly $7 billion in new financing, arranged by Goldman Sachs.

Warburg Pincus may deserve some credit for growing earnings before interest, taxes, depreciation and amortization (EBITDA) and operating cash flow at Bausch & Lomb, but numbers clearly show majority of its investment gains come from taking cash for debt financing.

For instance, Bausch & Lomb was a profitable company when it was acquired by Warburg Pincus. However, the company's interest costs now consume over 100% of its operating income, according to 2010, 2011 and 2012 financial statements in a S-1 filing with the Securities and Exchange Commission.

Employment at Bausch & Lomb has fallen by over 15% during the company's time in private hands. The bulk of an impressive-sounding 33% EBITDA growth between 2011 and 2012, meanwhile, is mostly attributable to escalating interest expense and a tax rate that fell by over 60%.

Judging by financial statements, Bausch & Lomb does generate more revenue, and free cash flow than it did prior to its 2007 buyout. That's why the company's equity value has grown slightly and Bausch & Lomb managed to attract some interest both as an IPO and M&A candidate.

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