Just a few days ago, MLB commissioner Bud Selig announced that the league was taking over the control of the Los Angeles Dodgers franchise due to the financial woes the club is in. What happened?
Club owner Frank McCourt obviously ran out of cash, despite taking money out of the Dodgers into his personal accounts. It is rumored that he deviated roughly $100 million over the past few years. Right now it seems like both the club and Mr. McCourt are broke. Selig had seen enough and took control away from McCourt.
What appears like just a poor management of an organization becomes a lot more interesting when looking at how Frank McCourt bought the Dodgers back in early 2004: He took over the franchise from former owners News Corp. for $430 million in a highly leveraged deal. Right now it looks like that leverage, i.e. the debt used to finance the takeover, is too much for team and owner. The Dodgers debt is now at $457 million – more than the price McCourt paid for the club seven years ago.
Obviously, things didn’t quite go as planned. But how were they planned? I don’t know too much about McCourt’s initial business plans, but let me take this opportunity to look at the model of Leveraged Buy-Outs in general. I will try to explain it in a quite simplified way, so to those of you with a lot of knowledge or experience in the area of equity investments: Please excuse my straight-forward approach in advance – or jump straight to the final part of this post (“Now what’s the bottom line?”).
Leveraged buy-out has become some kind of synonym for private equity investments (even though that also consists of e.g. venture capital investments in startups or management buy-outs), which some consider the basis of all evil in modern capitalism. That’s quite surprising, given that according to a host of studies there is scientific evidence private equity investors create value in the companies they take over and don’t generally have a negative effect on the number of people employed by the company. Seems like an interesting field.
-> So how does a leveraged buy-out (LBO) work?
If you disregard the details, it’s quite simple. Basically, it consists of an investor buying a company. However, the investor is not bringing all money required to the table himself, some of the money is borrowed. This can e.g. come from a bank or by setting up an investment fund. The possible ways of financing an LBO with all different options, details and rationales could well fill some books, but I will not dig into it in more detail here. What’s important is that as a result, the investor only brings in a small fraction of the overall buying price in his own money, the other part is borrowed/ loaned.
After taking over the company, the investor tries to improve its performance, earn the profits from the operations and increase the company value. Then the investor sells the company at a higher price, pays back the loans and keeps the difference between buying and selling price.
Time for an example: Just imagine McCourt bought the Dodgers for $430 million out of which only $130 million would have come from his own pocket, while the rest would have been borrowed (I couldn’t find a figure on how much money in that deal actually came from where, but a ca. 70% share of borrowed money as in the example is not unusual for this kind of deals).
The Dodgers performed well in the league since McCourt came in. Let’s assume they would also have performed well in economic terms, and McCourt would have been able to sell the team at a price ca. 50% above what he paid, e.g. at $650 million. If they would have also earned $10 million per year over the seven year period, which sounds quite conservative, McCourt would have received $720 million. After paying back the $300 million of borrowed money, there would still have been $420 million left.
So even though the value of the club would have only been raised by 50%, McCourt would have received 3.23 times the money he brought in – a 223% margin.
For the purpose of illustration, this example is highly simplified, for example by not discounting the payments or taking interest rates for the loans, taxes, etc. into account. However, the basic model of LBO’s is pretty much like this.
-> Why do some many people hate private equity investors?
That’s an interesting question. As stated above, they generally add value to the companies they acquire. They make money available to the market that otherwise would not have been liquid, which is good for the flow of the economy in general. However, their purpose is not very romantic: They try to earn money. It’s actually one of the most candid industries, as they don’t hide the bottom line they’re after.
Yet the model only works if significant improvements can be reached in the acquired companies. This often involves changing the remuneration scheme for management or even change the management, taking control of company decisions and financial engineering, e.g. targeting tax optimizations. All of the above often bring significant changes to the company – something people often (always?) dislike, increases the pressure, takes away control and streamlines. Not much fun for those used to the “good old days”.
Much of the criticism private equity investors receive could as well be used to criticize any management consulting company. The difference is that on the one hand, private equity investors have more power to implement the changes they propose while on the other hand they take over responsibility for their decisions.
That’s where the interesting part begins: Leverage is fun, as long as the result is positive. If it isn’t, the leverage works into the negative direction. That’s what million of homeowners learned two years ago, and it’s what Frank McCourt also realized: if the returns are not coming as expected, the debt wave is rolling over you with all the leveraged power.
-> Now what’s the bottom line?
My bottom-line may sound a bit surprising to you and it broadens the scope of this post significantly:
I don’t see that our markets would lack a lot of additional rules and regimentation to cope with th4e Frank McCourts of this world or with private equity investment companies in general. Yet when looking at the private equity investment industry, one thing became obvious to me: The relationship of risk and reward must be protected!
It’s a basic principle of our economy: Someone who takes a risk does this to have the chance to be rewarded. There’s no reward without risk. The higher the risk, the higher the potential reward.
While this may sound logic, all approaches I have heard from politics looked at how to limit companies, investments, etc. That’s the wrong perspective, as the motivation by reward is the driving force that makes companies and investors aspire to improve and develop. The right perspective would be to close down options to bypass risks while keeping the opportunities.
What I mean by this: There are rare situations, where a risk exists on paper, but will never materialize. If the Dodgers go bankrupt, no one would expect that the franchise and brand would really die. Some way to keep them going would be found, as the takeover of control by MLB last week shows.
And we all learned that if a major bank is threatened to go bankrupt, the government will step in. Or if a country, e.g. Greece or Portugal, is approaching the financial collapse, the community of countries will support them.
Those situations occur when the reward goes to one party, the risk on paper goes to that party, too, but in reality threatens a much broader community. In the end, the community will react. This setup encourages investors to go for extremely high leveraged deals: Their opportunity is great while the risk is limited or not existing at all.
Disallowing leveraged deals doesn’t make sense, but thinking before closing them what would happen in the negative case does. If the potential negative impact for the community would be so huge that the community would have to support and take the risk, why not think about a way to make the community participate in the potential returns as well? Or why not set up a mandatory insurance investors would have to buy in these cases?
These are just two raw ideas, but they came from changing the perspective: If we don’t look at how to best avoid risks, but how to save the relationship of risk and return, we can come up with way more feasible, interesting and productive approaches than anything that has been discussed in politics over the last couple of years.