Feast Along With the Buyout Vultures

The vultures are circling over Wall Street. They have been patient for lo these many months. And now they are smiling, smug and voracious as they come in for the kill.

In a set of moves reminiscent of the 1980s, leveraged-buyout (LBO) partnerships are raising record amounts of money to purchase and privatize wounded but salvageable public companies. They're paying prices that would have been considered insulting a few years ago but look like manna from heaven today, bailing out thunderstruck shareholders and demoralized management groups with the expectation that business-plan tweaks, divestitures and patience will turn an investment of a couple of hundred million dollars now into a billion or more in a few years.

Earlier this month, the Blackstone Group announced it had put together a $6.5 billion buyout fund, the largest ever. That gives the firm more than $10 billion in buying power because it generally invests only 35% in any given deal and borrows the rest. Other firms of its kind -- which now refer to their deals as "private equity" rather than LBOs because of the corporate-raider taint of the latter -- also have built big war chests. Thomas H. Lee Partners raised $6.1 billion last year, and Kohlberg Kravis Roberts & Co. has reportedly raised at least $5 billion for a new fund.

The deals are starting to smoke faster than the ash on a fat cigar. Among the deals in the past few weeks:

  • Investors in troubled Morton's Restaurant Group ( MRG) accepted a $71.1 million deal from private equity firm Castle Harlan. Shares in the steakhouse chain were languishing at $10 when the first buyout offer came in at $12.60, but bids were later raised four times -- most notably by a losing group led by buyout veteran Carl Icahn -- until shareholders settled for $17.
  • Dallas-based buyout firm Hicks, Muse, Tate & Furst said it was committed to its plan to partner with Colorado-based Booth Creek Management to buy 54% of ConAgra's ( CAG) beef and pork-processing divisions for $1.4 billion, despite a record recall of contaminated meat that had beaten the fat out of the food giant's shares. Hicks Muse plans to sell $400 million in bonds to finance the deal.
  • Burger King was sold for $2.26 billion to a private buyout team led by Texas Pacific Group and backed by Bain Capital and Goldman Sachs Capital Partners. A deal for the fast-food giant previously had foundered for two years.
  • KKR announced its largest European acquisition ever as it bought seven engineering outfits from embattled German industrial giant Siemens ( SI) for about $1.7 billion.
  • At least two LBO syndicates made final bids this month for the lucrative, stable yellow pages business of Qwest Communications ( Q), whose shares have fallen from $27 to $1.50 in the past year. Qwest was asking for up to $10 billion, which would potentially make the deal the second-largest buyout in history.

    The Market's High-Wire Act

    Private buyout deals such as these have long been considered the safety net for a fallen stock market. The number and value of deals began to decline in the mid- to late 1990s as prices of public companies got out of hand for these consummate value buyers. But now they are stepping up with their baskets of cash. "If the market falls off the trapeze, we are the people who provide a soft landing and a way to bounce back," said Saul A. Fox, chief executive of private equity firm Fox Paine in San Francisco.

    In a deal typical of the kind that may become a mainstay of headlines in coming months, Fox Paine recently completed its purchase of tiny oil-services provider Paradigm Geophysical ( PGEO) for $5.15 per share -- an 85% premium over the prices the shares fetched in February.

    Fox said investors had sold down the shares for four largely emotional reasons: It was perceived as a software company at a time that technology is hated; it's a microcap at a time when small companies are viewed with suspicion; its customers are energy companies, which have fallen into disfavor with the decline in oil prices; and it's based in Israel at a time when the risk of war is high. Fox said he and his partners liked the fast-growing company so much that they're strictly using equity from his fund -- no debt.

    In the 1980s, LBO firms gave greed a bad reputation by selling junk bonds to raise funds necessary to take over public companies, then exploiting corporate cash hoards to pay off the debt by slashing divisions and firing thousands of workers. The era ended in disgrace -- symbolized by the jailing of junk bond privateer Michael Milken of Drexel Burnham Lambert in 1986 -- followed by court time and congressional reform.

    Saving Grace

    These days the takeover guys are seen as saviors of last resort by management teams of companies small and large that are ready to throw in the towel on the once-glamorous, now-dangerous concept of being publicly owned. In addition to seeing their shares sold down to once-unimaginable levels, they can now turn on the television and see peers handcuffed in a made-for-TV spectacle. And they can watch President Bush sign a bill that criminalizes even small errors in financial statements.

    This diminished sense of well-being has provided ripe opportunities for vulture capitalists. Peter M. Schulte, managing partner at CM Equity Partners in New York, said that many of the small-cap companies that he focuses on for buyouts have "given up on being public" as their management teams come to realize that they could succeed with their business model yet never be given the credit they believe they deserve. "Executives always hope that the public market will see value in their firms, but it's not turning out that way," said Schulte, whose firm is backed by the oldest leveraged buyout partnership in the nation, Carl Marks & Co.

    In contrast to the quarter-to-quarter grind for sales and income growth demanded by analysts and mutual funds, private-equity owners say they are more willing to build value over the long term. Management is weary of having two years of good work wiped out by a single quarter's tepid sales are increasingly receptive to Schulte's pitch that with a private entity they will both get a larger equity stake in the company and find themselves ruled by a patient, engaged board of directors with years of experience. The endgame, of course, is eventually either a sale at much higher prices to a larger enterprise or a return to the public market.

    In fact, "There are a huge number of companies today that should not be public," says Jeffrey L. Balash, chairman of investment bank Comstock Partners in Los Angeles and a veteran of the '80s buyout wars at Lehman Brothers and Drexel. And by that he meant almost any company with a market cap of less than $1 billion that is beneath the radar screen of the big financial institutions and brokerage research teams and therefore essentially too illiquid to trade in meaningful size.

    Thus, just as the late '90s bull market was characterized by dozens of iffy little companies with no earnings going public, the next phase of the market may be characterized by dozens of terrific little companies with plenty of income and assets going private.

    Playing With Vultures

    How can you capitalize on this trend?

    Joseph Haviv, a buyout veteran who has just finished raising $300 million for his new Protostar Partners fund based in New York, said that small investors looking for the sort of deals that attract private-equity bids should focus on sturdy, cash flow-positive, small- to medium-size industrial manufacturers or services companies whose depressed shares are largely controlled in a bloc by a single family or organization. Don't look at telecom companies, he notes, as they are already so heavily laden with debt that further leverage is nearly impossible.

    Saul Fox, the Fox Paine executive, said he would zero in on companies with strong regional franchises in niche industries that are selling for less than four times cash flow. One larger company that caught his eye recently is Allied Waste ( AW), the nation's second-largest garbage hauler, which is selling for less than two times cash flow.

    Ironically, it is already controlled by two buyout firms that have been burned so far: Apollo Advisors, run by legendary investor Leon Black, and Blackstone. Allied has fallen on hard times along with the nation's economic prospects, and now rests near a record low of $6. Paine said "a lot of banks would be happy to lend to you at three times cash flow," so it would make sense for the company ultimately to be taken private at a 50% premium, or around $9 -- all other things being equal, which they might not be.

    To help you look for candidates, I created a screen called Buyout Candidates that looks for profitable U.S. companies in the $100 million to $1 billion market-cap range that trade for less than three times cash flow and have debt/equity ratios of less than 1.0. Of the group, Old Dominion Freight Lines ( ODFL), Aaron Rents ( RNT) and Quanta Services ( PWR) match the model best, as single owners control large blocs of shares.

    Buyout Candidates
    Company Market Cap Price/Cash Flow Debt/Equity Return on Equity Industry 12-mo. change
    Old Dominion Freight Line (ODFL) $125 2.9 0.6 10.4 Trucking 35%
    Nabi Biopharmaceuticals (NABI) 159 1.4 0.0 55.1 Biotech -41
    Quanta Services (PWR) 158 1.1 0.4 5.5 Contractors -91
    USG Corp. (USG) 211 1.5 0.0 5.9 Building Materials 1.0
    Veritas DGC (VTS) 297 1.0 0.2 4.4 Oil and gas services -61
    Aaron Rents (RNT) 322 2.3 0.2 5.6 Rental services 8.0
    GenCorp. (GY) 429 2.3 0.8 35.6 Conglomerate -26
    Spherion (SFN) 450 2.5 0.3 18.9 Staffing services -7.9

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