THE LONG RUN

Compare and contrast, if you will, the tales of two portfolio companies – Simmons, the mattress maker, and Koppers Incorporated, a Pittsburgh maker of railroad products. Analysing their respective treatments at the hands of private equity sponsors makes for a good illustration of why investors are reevaluating conventional notions of the almighty exit.

Simmons, based in Atlanta and currently owned by Thomas H. Lee Partners, brings to mind a line from the Eagles' “Hotel California”: “You can check out any time you like, but you can never leave”. The company has been owned by five private equity firms since 1986 – Wesray Capital, Merrill Lynch Capital Partners, Investcorp, Fenway Partners and, since last year, Thomas H. Lee, which bought Simmons for $1.1 billion.

Along the way, each private equity owner has profited from a Simmons exit, as have the limited partners, unless, of course, they happened to have commitments to both buyer and seller funds. CalPERS, for example, is an LP to both Fenway and Thomas H. Lee. I'd love to see the matching distribution and capital-call notices on that one: “Congratulations, you just sold a mattress company – here's your cheque”; “Congratulations, you just bought a mattress company – we'll need a cheque for…”

Now consider the story of Koppers, owned by New York private equity firm Saratoga Partners. Like Simmons, the company has a strong franchise and a robust cash flow, but isn't viewed as having blockbuster IPO potential, and does not have that many obvious strategic acquirers. But Saratoga's LPs have now seen seven liquidity events from Koppers in the form of dividends. The most recent, and largest, dividend was announced last month – a $95 million distribution on the back of a $203 million high-yield offering.

Saratoga bought Koppers in 1997 with $30 million in equity and to date has returned roughly $140 million to LPs, and it still owns a 70 percent stake in the company. Investors have checked out and they can eventually leave.

Christian Oberbeck, a managing director at Saratoga, says his firm could have sold Koppers, but opted instead to return value to LPs in a less conventional way. “Koppers is in a unique period where there have been a series of profit improvements, and simultaneously a very hot highyield bond market,” he says. “We made the judgment to take advantage of the debt market, as opposed to entering a sale process.”

The objective of a successful private equity programme is profits, not exits. Full exits are usually the best way to achieve IRR, but the US and the global economies may evolve in such a way that dividend distributions become more important components of buyout fund performance.

While there are very good arguments in favour of LBO-to-LBO transactions, there exists among many LPs a cynicism that these deals do not reflect the healthiest state of affairs in the buyout market.

It can be said that firm-to-firm sales are actually good because as the portfolio company in question changes hands, it moves onward and upward in sophistication, guided by financial sponsors best attuned to each stage of development. “The idea that a company has all its juice squeezed out of it in a single private equity deal is ludicrous,” a general partner said at a recent industry event.

But skeptics see other factors at play as well, primarily a weak IPO market, weak interest from strategic buyers and GPs needing to return capital in advance of fundraisings. And, in truth, pressure from LPs who would rather see a sale – any sale – than hear yet another lecture about investing for the long term. Luckily, buyout firms, flush with cash and eager to invest, are eager buyers as well as sellers.

But in an evolving market, very long-term holds may have much to offer. In the US, tax on dividends has been lowered to the same level as that of capital gains, changing the exit game entirely. Buyout firms remain the primary buyers of low-growth, strong cash-flow assets like power plants, food companies, consumer product makers – the list goes on. Even the technology sector is filled with companies that will see slower growth but more predictable revenue. The right portfolio company, subject to the right financial engineering, may well yield higher returns through years of dividends than through a standard five-to-seven year exit.

There are signs that buyout firms are pondering a drawn-out strategy given the above scenario. The head of one middle-market firm says his team has evaluated the purchase of assets to be used primarily as dividend vehicles. It wouldn't be surprising if private equity firms sought to raise subsequent partnerships with 15-year terms (most US partnerships have 10- to 12- year expectancies) specifically to avoid the exit pressure associated with standard private equity funds.

The Eagles wrote a song about this as well: “Take it to the limit”.