WHARTON PRIVATE EQUITY & VENTURE CAPITAL Volume 1 / Issue 21
IN THIS ISSUE: 1. Manufacturing: Can the U.S. Stay Relevant? 2. Wyndham Sells Its European Rental Business 3. Bain Capital & iHeart Media: The Slippery Slope of LBOs 4. Challenges to the PE Business Model
MANUFACTURING: CAN THE U.S. STAY RELEVANT? There is a lot to be said about the U.S. economy today. Phrases such as “manufacturing is on the decline” and “worker productivity has been slowing down” are all too common now. To address the former, the U.S. economy is often described as having three phases. A booming agricultural U.S. economy lasting through the 1800s was followed by a shift to an industrial and manufacturing economy. Recently, as of the late 1900s, the U.S. seems to have lost its edge in manufacturing and turned to services, an industry portrayed as intangible and possessing low barriers to entry. However, the story is a bit more nuanced. With the onset of the 1800s, both the industrials and services sectors began to grow at similar rates and sizes. The turning point occurred after World War II, when wealth grew in the United States and manufacturing became focused around efficiency. This led demand for services to grow to meet the needs of those wanting to spend their wealth, while reducing the demand for manufacturing workers, given optimization. This funneled much of the workforce into services, slowly making the sector less productive while also decreasing the U.S.’s ability to manufacture. In order to further understand the manufacturing sector of the U.S. today, the sector must be defined. Traditionally, manufacturing is associated with “nondurable” manufacturing, or mass, short-term, often commodity production. We have seen this type of manufacturing shift overseas. Regardless of whether this can be won back or even if we want to win this back, the answer is very likely a resounding no. With a global shift to lower cost nations, it is hard for the U.S, where cheap labor and materials are not as abundant, to also compete in this space. Furthermore, as a forward-looking nation, the U.S. would rather like to compete in R&D, technology, and skilled advancements. Therefore, tax cuts and stricter trade policies are not necessarily the solution to the slowdown in manufacturing and worker productivity.
Author Sadhvi Venkatramani Class of 2019 sadhviv@wharton.upenn.edu
“Durable” or “deep skilled” manufacturing, on the other hand, although also seeming to be on the decline in the United States, can be made a core competency of the country. Why? Manufacturing must occur somewhere, just like agriculture. However, unlike agriculture, which is based on land available in a given nation, manufacturing is mobile and depends on the trained workforce and capital available. Whichever nation is most efficient can become a manufacturing hub. Currently, the Midwest U.S. is one the most competitive areas in this space – through 1) the low cost of real estate, 2) consistent and cheap electricity, and 3) easy accessibility given the network of roads and
seaways, connecting a majority of the U.S. population. Most other nations lack these two components, providing the U.S. with an opportunity to capitalize. Deep skilled or specialized manufacturing includes items of longer lives, such as automobiles, aircrafts, medical equipment, and the precision machinery/tooling needed for production. As deep skilled manufacturing requires more capital expenditures, it would be advantageous for the U.S. to further its involvement in an industry with higher barriers to entry. Higher skilled manufacturing for the world currently takes places in nations such as Japan, Germany, and Switzerland. The question now becomes one of how to attract and increase skilled manufacturing in the United States. In order to expand any industry operating at full efficiency, adding more skilled workers will inherently multiply output. By investing in developing a skilled workforce, the U.S. will not only increase output and have a “durable” output, but also become a nation that can afford to use relatively higher paid labor compared to “non-durable” manufacturers. However, nations around the world are becoming similar in price of labor and availability of resources. Therefore, training the U.S. workforce in specialized manufacturing is key to differentiating. As mentioned earlier, jobs lost to automation and cheap foreign labor cannot come back. Utilizing skilled jobs is the alternative. As opposed to the stigma around manufacturing jobs as low-paid factory jobs, these new specialized manufacturing and engineering jobs are significantly better paid and require further education. Also, these jobs cannot be easily replaced in the next six to ten years, given the high training cost. In fact, companies in this space currently face a dearth in labor supply and are often forced to recruit those in the 50+ demographic or those fresh out of college, given that very few workers in the generation between had entered this sector for reasons mentioned earlier. The need arises now to re-train the 50+ demographic, to accustom them to new technologies, and then having them train those new to the field using both new and existing knowledge. Since many existing training programs do not provide sufficient training for success in the field, the United States needs a revamp in this space. Unlike other nations, where governments sponsor similar programs, we must look to the private sector to make an impact. The Golden Corridor Advanced Manufacturing Partnership works with high school students in Illinois while the City Colleges of Chicago is constructing a manufacturing
teaching center. Companies have begun to take charge, and we need to expand upon this to grow our skilled manufacturing base. If the government could offer subsidies to companies hiring interns for a duration of 3+ years, companies would be incentivized to simultaneously increase output and train new workers, while also capturing the “tribal knowledge” of older, experienced people and bridging the education gap. Another aspect is investment in deep skilled manufacturing in the United States, as investment is an additional driver of output. The private equity industry traditionally seeks out faster returns, with an investment time horizon of typically three to five years, based on short term turnarounds or improvements. With these expectations, private equity does not see manufacturing as a very attractive investment sector. However, deep skilled manufacturing can offer the same returns of ~20% annually, but consistently and over the long term. How can we funnel investment to manufacturing and give this advanced sector a much-needed boost? A difficult but eventual route is to convince investors to believe in the value of sustainable, long-term, and higher overall returns, which the innovative technology of manufacturing in the U.S. can boast – banking on, again, developing a stronger, specialized workforce. Some investors have already begun paving the way. In early 2013, Warren Buffet’s Berkshire Hathaway bought out Iscar, a producer of metal cutting tools based in Israel. Buffet had described Iscar as one of its five most profitable portfolio companies, outside its insurance holdings. In 2011, Buffet acquired Lubrizol, a specialty chemicals provider. Other Buffet industrial holdings are included with the International Metalworking Companies. Announced late 2017, China Investment Corp and Goldman Sachs have partnered to invest in manufacturing, industrial, consumer, healthcare, and other U.S. industries. Lynn Tilton, founder of Patriarch Partners, has made various investments across the manufacturing space. Tesla, as another example, has been investing in unique projects in the space, relying on specialized manufacturing. The United States has a long way to go but is positioned well to reverse the manufacturing slump and take on a leading role in the deep skilled manufacturing space. Reshoring focuses on training our human capital not only through education, but also, more specifically, through the pass-down of veteran knowledge.
WYNDHAM SELLS ITS GROWING EUROPEAN RENTAL BUSINESS TO PLATINUM EQUITY Wyndham Worldwide Corporation recently announced an agreement to sell its European vacation rental business to Platinum Equity, LLC for approximately $1.3 billion, or 9.2x EBITDA. Under the deal terms, Platinum Equity will acquire the target through its Platinum Equity Capital Partners IV, L.P. fund in the second quarter of 2018. The deal is subject to approval of the European Commission and includes a $55 million termination fee from Wyndham Worldwide.
Co-Authors Kevin Byun and Jason Cohen Class of 2020 byuny@wharton.upenn.edu cohenjas@wharton.upenn.edu
Wyndham’s European vacation rental business controls a number of holiday rental brands, notably James Villa Holidays, Landal Greenparks, and Novasol. The acquired business has more than 110,000 units in more than 25 countries. As of 2017 year end, it generated approximately $745 million in revenue and $141 million in adjusted EBITDA. The sale terms include a 20-year agreement, under which the newly acquired business will pay a 1% royalty fee of net revenue to Wyndham Worldwide for brand rights. Wyndham has recently announced an agreement to acquire La Quinta Holdings’ franchising and management businesses. This transaction was pursued in accordance with Wyndham’s strategy of pursuing growth opportunities, as well as expanding its presence in the upper-midscale hospitality segment. Wyndham agreed to purchase 100% stake of La Quinta for a consideration of $1.7 billion. Although the La Quinta deal reflects general trends in the hospitality market, the sale of a European business appears to be on the contrary. After recent high profile deals such as Marriott International and Starwood Hotels or AccorHotels and Fairmont Hotels, the hospitality industry has been marked by consolidation. Growth by acquiring brands has been led by the key players’ desire to expand scale and market share. Despite such trends, Wyndham Worldwide had expressed interest in selling the European business since August 2017. The Company had separated its vacation rental business and hotel business, and launched an auction process for the sale. A significant level of competitive tension was generated, including the participation of major financial investors such as Bain Capital, KKR, Blackstone, and CVC. After completion of the deal, Wyndham expects tax obligations arising from the sale to be kept under 15% of net proceeds. Furthermore, it plans on using the sale proceeds to finance the recent acquisition of La Quinta Holdings and to fund other business operations. Platinum Equity is a private equity firm founded in 1995, currently with $13 billion assets under management and a portfolio that includes more than 30 companies globally. Lately, Platinum Equity has been actively investing in the European market, employing more than 16,000 people through its portfolio companies. Prior to the Wyndham deal, the Company acquired UK aerospace and defense supply chain provider Pattonair for an undisclosed consideration in the fourth quarter of 2017. On a broader scope, Platinum Equity invests in various industries including telecommunications, manufacturing, metals services, and logistics. The Company has closed more than 200 acquisition deals throughout the span of two decades. Platinum plans to drive growth in their new venture through future add-on acquisitions, as well as through organic growth and the streamlining of business operations. This is nothing new; the private equity industry as a
whole has shown interest in European hospitality recently. With the European economy rebounding from its crisis lows (the Eurozone economy grew 2.5% in 2017, the highest rate of growth since 2007), firms like Platinum have targeted industries that swell when people get wealthier (primarily hospitality). In December of 2016, Onex Corp. deployed the same strategy when acquiring Parkdean Resorts, a large resort operator in the U.K., for nearly $2 billion. Based on industry research published by Technavio, the European vacation rentals market is expected to achieve a CAGR of 8% or above by 2022. As tourism is a major contributor to the gross national product and employment of the European Union, the expected increase of tourists is a key driver of the vacation rental market’s growth. Another significant driver of the market has been the emergence of instant booking functions for vacation rentals. Even before the advent of Airbnb, the size of the vacation rental industry has exploded. This growth is driven by an estimated 44 million users by 2022, each contributing nearly $350 in revenue. By
comparison, the United States’ vacation rental industry generates nearly $18 billion in revenue each year, largely due to Airbnb making renting easier for the average consumer. Darren Huston, CEO of hotel group Priceline, noted that the vacation rental market is growing faster than Priceline’s core business and that the transaction value of the short-term rental market grew more than 200% between 2015 and 2016. This growth is likely a result in more investment in luxury holiday rental which has made it a better and more affordable experience for increasingly wealthy consumers. Platinum clearly sees vacation rentals as the future of hospitality, and Wyndham’s business model has shown that it can be done successfully. In Wyndham’s own 2017 investor presentation, they noted that nearly 1 in 3 U.S. travelers in 2015 used private accommodations. Wyndham’s rental business is more than twice the size of Marriott’s, their next-closest hospitality competitor. In the future, it would be safe to assume that Platinum’s capital investments will only strengthen this lead and transform the hospitality industry as a whole.
BAIN CAPITAL & IHEART MEDIA: THE SLIPPERY SLOPE OF LBOS
Author Sonali Dane Class of 2019 sdane@wharton.upenn.edu
An important player in the private equity market, Bain Capital, is increasingly under public scrutiny for its failed LBO deals. Since 2000, there have been 5 key LBO deals that generated poor returns for Bain Capital: Gymboree Corp, Toys ‘R’ Us, Guitar Center, TOMS Shoes, and iHeart Media. The fund nonetheless still has sound finances due to management fees and purchasing senior debt at significant discounts. Thus, close examination of these failed LBO deals, especially iHeart Media, will reveal whether Bain Capital is on the slippery slope of LBOs and the impact of this trend on the private equity industry. iHeart Media was the USA’s largest radio broadcaster, formerly referred to as Clear Channel Communications. The firm had 855 radio stations, including New York’s Z100 and 103.5 KTU. In 2008, Bain Capital and Thomas H. Lee Partners raised $24 billion for iHeart Media for an LBO, and assumed the company’s $8 billion in existing debt. Buying iHeart Media’s shares at $36/share, both funds held a combined 72% stake and $2 billion in equity. The outstanding transaction, financed by LBO, had a debt value of approximately 9 times iHeart Media’s pre-tax cash flow. Not only did this exceed the 6 times leverage limit set by Obama on LBOs in 2013, but also this deal unfortunately added $13.5 billion in new debt to iHeart Media’s balance sheet. In 2016, iHeart Media had a net loss of $300 million after making $1.8 billion in debt repayments. By 2017, its annual interest payments were $1.4 billion. In conjunction with iHeart Media’s shrinking top line, high debt meant that the firm lacked cash for retained investment to remain competitive against streaming services like Spotify. On February 1, 2018, the media firm missed its $106 million interest payment and began a 30-day period to reach a deal with creditors. Seizing this opportunity, Liberty Media, owner of Sirius XM, offered $1.16 billion to buy a 40% stake of the restructured firm, on the condition that 4 out of 9 board members would be from Liberty Media. Whether it was due to culture clashes or pressure from investors, iHeart Media declined the offer. By March 2018, the firm had over $20 billion in debt and had defaulted $9.4 billion in junk bonds and $6.3 billion in loans.
Despite bankruptcy proceedings, iHeart Media will continue its operations. Both funds retain 10% ownership in iHeart and a significant stake in the company’s out-door advertising brand, Clear Channel Outdoor Holdings. More specifically, Bain Capital still has $1.2 billion of iHeart senior debt. Under 2018 restructuring, senior creditors will be awarded 94% of iHeart’s equity & 100% ownership of Clear Channel Outdoor, while common shareholders retain only 1% equity. Undoubtedly, iHeart Media is an interesting case study for the private equity community. Had the LBO amount been lower, the media firm might have avoided bankruptcy altogether. If iHeart Media accepted Liberty Media’s offer, would they regain a foothold in the disruptive media industry? What are the managerial implications of senior creditors having almost 100% equity in iHeart Media? Most importantly, if a $20 billion LBO deal failed (the biggest in years), what does this imply for the future of Private Equity’s LBOs? In failed LBO deals, funds still gain from the annual management fees that investors pay before the bankruptcy. Hence, should PE Funds be mandated to pay fees for failed LBOs as an incentive to be more prudent in these deals? Bain Capital’s failed LBOs have mostly been in the retail and media industries. Will PE firms therefore start to transition away from these industries for their LBOs? It is crucial that before conducting an LBO, PE funds must anticipate the disruptive changes in their pipeline’s industries and whether these companies are agile enough to adapt to these changes and repay their debt. Without this careful consideration, PE firms will inevitably head towards the slippery slope of LBOs.
CHALLENGES TO THE PRIVATE EQUITY BUSINESS MODEL
Author Miriam Finnemore Class of 2020 miriamfc@wharton.upenn.edu
The basic business model of a private equity firm is to purchase businesses which they perceive to be operating sub-optimally, alter the capital structure, enact changes which will increase the profitability of the companies, and then sell them off for a profit. In theory, this process should revitalize the economy and transform companies for the better. However, in practice, being backed by private equity can sometimes produce negative effects for a company, especially in cases where excessive amounts of leverage are involved or when the private equity firm is overly focused on the short-term growth of the company (so that they can maximize their own profits when they exit the deal) and neglect to consider long-term strategies. Recently, the news has been flooded by stories regarding two large companies which are now failing due to the poor management and decision making of private equity firms: Toys R Us and iHeart Media. Toys R Us is an American retailer, selling toys and other children products. In September 2017, the firm filed for Chapter 11 bankruptcy, telling the court that it would liquidate its operations. While there are other factors that negatively impacted the company’s financials, such as declining sales due to price competition from other mass retailers and the general fall in popularity of brick-and-mortar stores, experts claim that the burden of responsibility falls on the shoulders of the company’s management. For the past decade, Toys R Us has relied on the same sales methods and has failed to innovate to reflect new technology or changing consumer preferences. During this period, Toys R Us was under the control of Bain Capital Partners, Kohlberg Kravis Roberts, and Vornado Realty Trust, a consortium of private equity firms that had purchased the retailer for $7.5 billion in 2005. The trio increased the company’s leverage so much that its cash flow was insufficient to service the debt payments, making it an unattractive acquisition to potential buyers. iHeart Media, the US’s largest radio station company, faced similar problems which ultimately led it to file for Chapter 11 bankruptcy in March 2018. Bain Capital Partners and Thomas H. Lee Partners completed their leveraged buyout of iHeart Media in 2008 for $25.7 billion. This deal was the 8th most expensive private equity deal to have ever taken place at that point in time. However, in a similar predicament to Toys R Us, iHeart Media found itself crippled by debt as being part of a declining industry meant that its revenue was unable to cover the capital required for the debt repayments. Streaming services, such as Spotify and Pandora, have been stealing customers who were once loyal to radio services, reducing the cash flow to the company. Such instances have created poor public perceptions of the industry. Perhaps it is for this reason that private equity firms have started to look for investment opportunities other than corporate equity. Blackstone, for example, only has around a third of its assets invested in corporate equity, with $103 billion invested in property, $100 billion in private equity, and $112 billion in hedge funds and credit. Similarly, less than half of Carlyle, KKR, and Apollo’s assets are invested in corporate equity. A key reason behind this shift is the growing competition for deals. The number of private equity firms has grown from 24 in 1980 to 6,628 in 2015. Other entities with assets, such as Chinese multinational state-owned companies, sovereign-wealth funds and pension funds are also vying for the same opportunities.
In the face of heated competition and increasing numbers of deals going south (as in the case of Toys R Us and iHeart Media), it is likely that the business model of private equity firms will change. It appears that the diversification of asset classes will be simply the first in a slew of adjustments.
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