Engineering the exit

To say that exits are difficult to achieve in the current climate is an understatement. For general partners with some strong investments on their books, this can be frustrating, particularly if they want to evidence some good performance prior to raising a new fund.

To deal with the problem, many GPs have recently enlisted the help of their bankers to restructure and increase the banking facilities arranged at the time when the investments were made. Provided an individual deal shows strong EBITDA growth, such a recapitalisation exercise permits the manager to return the majority of the capital invested at an above cost yield, even though there is no change in ownership. Not only will this manoeuvre significantly boost the performance numbers of the manager's fund, but all the potential upside from a future exit is retained as well.

Too good to be true? On the contrary: transactions fitting this description are becoming far more common, as a look at some recent examples demonstrates.

Cantrell & Cochrane is a leading Irish manufacturer and distributor of alcoholic and non-alcoholic drinks. France-based Elis Group is a worldwide leader in providing rental and cleaning services for uniforms, linens and sanitary equipment. What these two very different businesses have in common is that they are both currently owned by funds controlled by BC Partners, and both have undergone leveraged recapitalisations ? the process described above.

In each case, BC Partners managed not only to return the original capital, but also to recognise an actual gain for investors. This was achieved primarily because of the high quality and rapid growth of the businesses. However the capital structure employed by BC Partners, which indeed is one that most members of the private equity community will use where the jurisdiction permits it, was chiefly responsible for returning significant amounts of capital without affecting actual ownership and control and hence without relinquishing any potential upside going forward.

One relevant characteristic of this structure is to do with the equity portion of a transaction. As is widely known, equity contributions as a proportion of the overall funding of deals are on the increase. What is less widely discussed, though common knowledge for those involved in executing deals, is that the majority of such equity funding is generally not provided in the form of share capital at all, but as loans. These loans have long maturities (10-12 years is common), are deeply subordinated to keep the banks happy, and usually do not pay any cash interest; but loans they are nevertheless. Given their lowly position in the repayment rankings they can, and do quite justifiably, carry high interest rates ? up to 12 per cent fixed is fairly common. The interest charge, often referred to as ?PIK? or ?payment-in-kind?, is accrued and hence earns interest at the same rate. This means that, as long as the banks are amenable and of course the profitability of the company supports it, such ?shareholder loans? can be refinanced with bank debt.

This can result in a return of capital that effectively cashes out the original investment potentially way ahead of any actual exit from the business. This has indeed proved to be the case for Elis, which was refinanced in this way in early 2000 even though an exit is yet to be achieved. Meanwhile Cantrell & Cochrane, which was sold by Allied Domecq after it failed to achieve an IPO for the business in late 1998, is expected to be floated by the middle of this year. However, even if it isn't, BC Partners and its investors will in all probability still be looking at a very good return, as opposed to an exceptional one ? thanks to leveraged refinancing.

It is true that a number of stars need to be in alignment for such an outcome to be achieved, and of course there's nothing wrong with managing capital in this more aggressive manner. But for all buysiders out there considering their next investment in a buyout fund, it is worth asking whether a manager's divestment track record is based on real exits or on such engineered transactions as the above.