Mar 28

A guest Post -

In an earlier post titled The Domino Effect, Joe describes the buyout of Domino’s Pizza by Bain Capital and their subsequent exit that left Domino’s saddled with debt. Bain made out with a 500% return on their investment. Joe questioned if this transaction, and indeed many other transactions like this, show capitalism in a good light. Thought provoking questions like this seldom have easy answers. But it is also important to realize the important role these transactions play in a well functioning capitalistic economies. These kinds of transactions occur because on average they do create incremental value to the society.

The Force that Drives Capitalism

Capitalist society functions with a single credo: maximize shareholder wealth. Also known as profit. And profits accrue to those who take risks and create value. The risk taking and value creation is what keeps the society moving forward. If the appetite for risk taking or the profit incentive were absent, we will all be content with our lot and there would be no progress.

It is also worth noting that profit at any cost might work in the short run but it seldom does on a sustained basis. Society as a whole must benefit, which means some incremental value must be created, otherwise one or more stakeholders in the endeavor will refuse to participate. In other words, if you have a history of not doing right by the employees of the business you acquire, for example, they will find ways of making sure your agenda is not carried out.

The Role of the Private Equity

Private shareholders such as you and I buy stocks with the belief that the management will continue to execute their business growth strategy and create shareholder value. Private Equity firms on the other hand buy into a company either to turn it around, or to inject fresh management ideas that will generate additional growth. They believe that the opportunity exists to create value on a larger scale than what the current management is capable of doing. This is a much greater risk to bear since more capital is at stake and the PE firms are stepping into a business as outsiders. Consequently, the rewards of a successful execution, if they come, are larger as well.

In the case of this particular example, Bain did lead Domino’s to an unprecedented growth spurt in the 12 years of their ownership. Domino’s added new franchises and expanded internationally. New jobs were created. For their troubles, Bain walked off with a take of $2.3 B after investing $385 million of their own cash and the company at the end was left with a business that was self sustaining. While the $1.5 B in debt for Domino’s after Bain exited could be termed excessive, it is worth noting that the economics of the Pizza business can support this capital structure due to the fact that there is tremendous cash flow and the cash turns over very very fast. For another company in a different industry where there may be a larger lag between initial cash expenditure and the return of cash through sales, this capital structure could indeed be lethal and I have no doubt that the lenders would not have allowed Bain to borrow so heavily.

And while we are used to thinking about debt as something to avoid as much as possible, the fact is that debt remains a cheaper way to finance a business. It is much cheaper to borrow than to issue equity and the companies have a fiduciary duty to their existing shareholders to use debt in the levels that is appropriate for their business. A software/internet company may not want too much debt as technologies change rapidly and the barriers to entry may be quite low. However, a business making a product that is not going to be out of fashion any time soon and where branding and capital investments create barriers to new entry should always use a reasonable amount of debt that their economics can support.

The Rewards are Commensurate with the Risk

It is easy to own businesses these days. You and I can just open up our Zecco Trading accounts and buy and sell stakes in a company as we please. At the slightest possibility of capital loss, we can exit our positions at the click of a button. A Private Equity firm faces a different type of risk. When they purchase a business, their capital is tied up for extended period of time. Many years, maybe even decades, may pass before their investment and any profits can be recouped. There is a significant lack of liquidity and the possibility exists that entire investment might be lost if the transaction does not work out as planned. The rewards need to be sufficient to entice someone to take this level of risk to perform this essential role in a well functioning capital markets.

Ultimately, Private Equity is the garbage collector and the recycler of businesses, taking on the risks that no one else wants to take on. If they did not do what they do, businesses may not get a lifeline to restructure and become profitable, or in other cases they may continue to prod along with unrealized potential. This leaves the society poorer.

About the Author: Shailesh Kumar writes about value stocks at Value Stock Guide, a popular site devoted to value investing.

written by Joe \\ tags: , , , ,

Mar 15

I consider myself a capitalist. As Larry Kudlow states on his CNBC show,”We believe that free market capitalism is the best path to prosperity!” And yet, there are times that I see certain situations that make me wonder if the system isn’t broken. Which leads me to ask the question, if something is legal, does that automatically make it right?

Let’s look at one deal that deserves a bit of discussion. The takeover of Domino’s pizza chain by Bain Capital. Here is the timeline for this series of events:

  • 1998 – Bain Capital buys Domino’s for $1.1 billion. $725 million is borrowed against the company, with Bain investing $385 million of their own cash.
  • 2003 – Bain refinances the debt, pulling out an additional $188 million to pay out to its investors. Domino’s debt is now nearly $1 billion.
  • 2004 – Domino’s is taken public by Bain. Bain retains 79% of the company,  and receives $108 million for the 21% sold to the public
  • 2010 – Bain sells out and over a 12 year period makes over 500% on their investment. Domino’s is saddled with a debt load with interest equal to half the company’s income.

I bring this up as an example of what seems to be a typical leveraged buy out. There’s always more to the story, but the common theme among the leveraged buyout I’ve studied are twofold, a lot of money is made in comparison to the amount invested, and the newly public company is left with a debt load that puts it at risk for bankruptcy for years to come.

In the end, the Domino’s franchises have increased and more people employed over the period, so on a positive note it wasn’t case of firing people and reorganizing. Nonetheless, I’m hard pressed to understand how these deals are shining examples of capitalism.

 

written by Joe \\ tags: ,

Sep 22

The recession lasted 18 months and just as we didn’t know there was a recession until we were well into it, we are now told it ended in June 2009.

I was thinking back to my post last July, Dennis Kneale Recovery in which I remarked that he had declared the bottom was behind us, and it would just take time before it was declared. As you can see, the recession lasted longer the the prior three, and it will take somemore time before we feel that we are in a vibrant recovery. a bit of patience.

written by Joe \\ tags: ,

Dec 07

In another guest post on Good Financial Cents, today I offer the first of a two part article on Estate Planning. In today’s installment, I discuss Wills, Beneficiaries, and Probate. Whatever your age, good estate planning is something you shouldn’t avoid, it’s the right thing to do to protect your family as well as the assets you’ve worked so hard to accumulate over your lifetime.

Joe

written by Joe \\ tags: , ,

Oct 07

A few weeks ago Mrs. Micah published a post discussing the financial list that you should create for those who leave behind, titled How to Save and Store Critical Financial Information For Your Family. Ever since I read that I’ve been thinking about her post as well as my own On my death, please take a breath. It occurred to me that the financial list Mrs. Mike created would be an excellent place to leave some further instructions to your beneficiaries regarding their inheritance, with an emphasis on the tax aspects of IRAs. This would be a good way to avoid the tragic mistake that I referenced in my earlier post.

Here is an example of what I had in mind;

Dear Rich,
Some of the money that I left you is in an IRA account. Please understand something about this account. When I left it to you there were no taxes due, but because this IRA was funded with pre-tax money, you owe taxes at your marginal rate as you withdraw it. Fortunately, withdrawals can be made based on your current life expectancy, so you can withdraw this money a little bit at a time over the years and hopefully pay very little in taxes along the way. The way the money is currently invested, even though right for me, may not fit with your investing style or needs. If you wish to reduce the stock portion and keep it all and CDs that choice is yours. You can sell the stock and reinvest the money into CDs or even place it a money-market fund and this transaction will not be taxable. It’s only when you withdraw the money from the IRA that you’ll be required to pay taxes. The required minimum distributions that you must take are just that, minimum numbers, if you need to take a bit more it’s your choice to do that as well. Just keep one thing in mind, if you take out too much money in one year you may jump into a higher tax bracket and pay more tax than is necessary. Lastly, the one thing I ask you not to overlook is to include a new beneficiary should something happen to you. Again this is your decision, a child, a friend, a family member, a charity, the choice is yours.
Use it in good health,

Obviously, you can fine tune this to your own style. The message here is that years of your planning can be undone by one mistake your beneficiary makes. Here’s a way to help avoid that.
Joe

written by Joe \\ tags: , , ,