Bausch & Lomb 'Success' Less Than Meets the Eye

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.

Still, Bausch & Lomb's takeover and sale highlights a unique arbitrage for PE firms where they finance takeovers and then spend a handful of years managing a leveraged balance sheet until a buyer emerges willing to assume the company's debt.

While such a strategy led to a near record number of bankruptcies in the credit crunch of 2009, five consecutive years of zero-interest-rate policies promoted by the Federal Reserve has made such an arbitrage highly profitable.

For instance, in the buyout of HCA ( HCA), a rare mega deal of the buyout boom years that has worked out for the buyers, the company's market capitalization remains far below its initial purchase price. Currently, HCA's market cap of $17.1 billion is about 20% below its $21.3 billion takeover price in 2006.

Thankfully, firms such as Bain Capital, KKR and the PE arm of Merrill Lynch only had to put up about $5.3 billion to buy HCA and financed the rest of the deal, meaning that even if the company is currently valued in stock markets at well below its takeover price, the risky buyout has already been a coup for investors.

PE firms continue to hold sizeable stakes in HCA. However, they've already made their money back from a series of junk debt fueled special dividends and share sales.

Apollo Global Management, another PE giant, has also booked impressive gains from real estate broker Realogy ( RLGY ), although the company's current post-IPO market cap is just marginally higher than its 2007 buyout. Similar trends are likely to hold true for scores of deals such as Intelsat ( I ), Alliance Boots and HD Supply as buyout investments come to market in acquisitions and IPO's.

While firms like Warburg Pincus, KKR, Apollo and Bain may be in the midst of realizing three baggers and beyond, don't get fooled by the headlines.

Unlike ordinary investors or even hedge fund activists as prominent as Carl Icahn and Dan Loeb run Third Point they are not in the business of buying low and selling high. With enough leverage, buying high and selling low for cash can also work.

As long as interest rates remain low, expect the industry's fortunes to continue to rise.

Sard Verbinnen, a PR firm representing Warburg Pincus, did not return a voicemail seeking comment.

-- Written by Antoine Gara