Monday, October 5, 2009

Money Under the Mattress?

Diane Urquhart sent me a couple of interesting articles on private equity. First, Craig Karmin and Peter Lattman of the WSJ report that Stanford Puts $1 Billion in Assets on Block:

Stanford University, which lost a quarter of its endowment last year, has put on the block as much as $1 billion of hard-to-sell investments ranging from private equity to real estate to timberland as it seeks to raise cash, according to people familiar with the matter.

The effort by the $12.6 billion endowment, one of the nation's largest, will test the market for some of these illiquid investments, which have battered the nation's most prestigious universities by tying up cash to fund school operations and other needs. This spring Stanford sold $1 billion in taxable debt to raise reserve cash.

The significant size of the sale, along with an innovative approach Stanford is taking toward it -- it hopes to sell just pieces of its stakes rather than entire partnerships -- will make the effort widely watched among both private-equity players and universities anxious to see if demand for these types of assets has rebounded after a near-moribund stretch this past year.

While Stanford is weighing offers on all of its illiquid investments -- about $5 billion, or one-third of the total funds overseen by Stanford Management Co. -- it is only interested in selling partial interests in these partnerships, or about 10% to 20% across its private-equity, venture-capital, oil-and-gas, timber and real-estate holdings, according to people familiar with the matter. It could sell more in various areas depending on demand.

The structure would allow the Northern California school to raise cash while maintaining majority stakes that would provide it with continued exposure in these areas. The $1 billion it aims to raise would include the value of the assets plus Stanford's future capital commitments to the investments. For Stanford's sale, bids are due around the end of the month.

A year ago as the financial markets ravaged endowment portfolios, a number of schools tried to sell their stakes in private investments in the so-called secondary market to free up cash.

But those endowments, including at Harvard, had little luck because there was too wide a spread between what investors were willing to pay and what the endowments were willing to sell for.

A large sale from Stanford could provide some guidance on where these holdings will now trade and in turn may lead to more activity from other cash-strapped universities.

Private-equity funds received an average bid of about 52% of their funds' value in the first half of 2009, according to a report by Dallas-based advisory firm Cogent Partners, which Stanford has hired to organize its sale.

Some are betting the market could soon perk up. Firms that specialize in buying private investments at a discount on the secondary market have raised billions of dollars in new funds over the past couple of years.

Prominent secondary-fund firms include Lexington Partners Inc., Coller Capital and Goldman Sachs Group Inc.

Elite schools over the past decade eagerly moved toward an investing model that favored illiquid investments that theoretically could outperform public equities over the long term and provide diversification.

But these assets fell along with stocks last year and also sucked up liquidity, as they often require investors to inject a steady flow of capital into the deals over time. Many university investors soured on investing aggressively in illiquid holdings, but because their holdings are illiquid, they have had few ways to get out of the approach.

My advice to Standford, Harvard, Yale and anyone else looking to unload stakes in private market funds is to forget going to secondary fund firms like Goldman Sachs, Coller Capital or Lexington Capital. Just come up to Canada and talk to the head honchos at Canada's public pension funds. They will provide you with the liquidity you need at very favorable terms. Trust me, they love private markets and can't get enough of them.

The second article Diane sent me was by Julie Creswell of the NYT who writes Profits for Buyout Firms as Company Debt Soars:

For most of the 133 years since its founding in a small city in Wisconsin, the Simmons Bedding Company enjoyed an illustrious history.

Presidents have slumbered on its mattresses aboard Air Force One. Dignitaries have slept on them in the Lincoln Bedroom. Its advertisements have featured Henry Ford and H. G. Wells. Eleanor Roosevelt extolled the virtues of the Simmons Beautyrest mattress, and the brand was immortalized on Broadway in Cole Porter’s song “Anything Goes.”

Its recent history has been notable, too, but for a different reason.

Simmons says it will soon file for bankruptcy protection, as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money.

For many of the company’s investors, the sale will be a disaster. Its bondholders alone stand to lose more than $575 million. The company’s downfall has also devastated employees like Noble Rogers, who worked for 22 years at Simmons, most of that time at a factory outside Atlanta. He is one of 1,000 employees — more than one-quarter of the work force — laid off last year.

But Thomas H. Lee Partners of Boston has not only escaped unscathed, it has made a profit. The investment firm, which bought Simmons in 2003, has pocketed around $77 million in profit, even as the company’s fortunes have declined. THL collected hundreds of millions of dollars from the company in the form of special dividends. It also paid itself millions more in fees, first for buying the company, then for helping run it. Last year, the firm even gave itself a small raise.

Wall Street investment banks also cashed in. They collected millions for helping to arrange the takeovers and for selling the bonds that made those deals possible. All told, the various private equity owners have made around $750 million in profits from Simmons over the years.

How so many people could make so much money on a company that has been driven into bankruptcy is a tale of these financial times and an example of a growing phenomenon in corporate America.

Every step along the way, the buyers put Simmons deeper into debt. The financiers borrowed more and more money to pay ever higher prices for the company, enabling each previous owner to cash out profitably.

But the load weighed down an otherwise healthy company. Today, Simmons owes $1.3 billion, compared with just $164 million in 1991, when it began to become a Wall Street version of “Flip This House.”

In many ways, what private equity firms did at Simmons, and scores of other companies like it, mimicked the subprime mortgage boom. Fueled by easy money, not only from banks but also endowments and pension funds, buyout kings like THL upended the old order on Wall Street. It was, they said, the Golden Age of private equity — nothing less than a new era of capitalism.

These private investors were able to buy companies like Simmons with borrowed money and put down relatively little of their own cash. Then, not long after, they often borrowed even more money, using the company’s assets as collateral — just like home buyers who took out home equity loans on top of their first mortgages. For the financiers, the rewards were enormous.

Twice after buying Simmons, THL borrowed more. It used $375 million of that money to pay itself a dividend, thus recouping all of the cash it put down, and then some.

A result: THL was guaranteed a profit regardless of how Simmons performed. It did not matter that the company was left owing far more than it was worth, just as many people profited from the mortgage business while many homeowners found themselves underwater.

Investors who bought that debt are getting virtually nothing in the new deal.

“From my experience, none of the private equity firms were building a brand for the future,” said Robert Hellyer, Simmons’s former president, who worked for several of the private equity buyers before being asked to leave the company in 2005. “Plus, the mind-set was, since the money was practically free, why not leverage the company to the maximum?”

Just as with the housing market, the good times ended when the economy fell into recession and the credit markets froze. Simmons is now groaning under a huge amount of debt at a time when its sales are slowing. And this time there is no escaping by finding yet another buyer willing to shoulder its entire burden.

Simmons is one of hundreds of companies swept up by private equity firms in the early part of this decade, during the greatest burst of corporate takeovers the world has ever seen. Many of these deals, cut in good times, left little or no margin for error — let alone for the Great Recession.

A disproportionate number of the companies that were acquired during that frenzy are now struggling with the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms, according to analysts at Standard & Poor’s. Among them are household names like Harrah’s Entertainment and Six Flags, the theme park operator.

Executives at THL counter that Simmons was the victim of hard economic times, not mismanagement or too much debt. As proof, executives point to Simmons’s 40 percent growth in sales and its 26 percent climb in operating income from 2003 through 2007 as well as its 13 consecutive quarters of market share gains against competitors through March 2009.

Simmons’s woes, said Scott A. Schoen, a co-president of the firm who sat on Simmons’s board, are entirely caused by the “unprecedented and unforeseeable” downturn that has shaken the entire bedding industry.

“We think the work we had done had positioned the company for us to reap the financial rewards that this economic cycle has taken away,” said Mr. Schoen, gazing across a conference table at THL’s headquarters overlooking Boston Harbor.

Still, he acknowledged, “We are clearly disappointed in the outcome of this investment. Make no bones about it.”

Built Over Generations

Like other emerging industrialists of the 19th century, Zalmon G. Simmons, of Kenosha, Wis., had his hand in numerous businesses — the local bank, a telegraph company, a railroad and a cheese-box factory. He was even, for a time, the mayor of Kenosha.

Around 1876, Mr. Simmons came across a new machine that could mass-produce woven wire mattresses. The Simmons bedding company was born.

From its humble beginnings on the banks of Lake Michigan, Simmons grew to become one of the country’s largest manufacturers of mattresses. Along the way, it even sprinkled a little Hollywood pixie dust on the ho-hum mattress business, hiring Dorothy Lamour and Maureen O’Hara to plug its products.

Until the 1970s, Simmons largely prospered. Then the troubles started, and the company was soon buried deep inside two enormous conglomerates, Gulf & Western and the Wickes Corporation, for a number of years.

But in the mid-1980s, Simmons caught the attention of a new type of investor. The businesses that stormed corporate America in recent years under the banner of private equity were not always called private equity firms. In the 1980s, they were known as leveraged buyout shops. Their strategy is essentially unchanged, however: they try to buy undervalued companies, using mostly borrowed money, fix them up and sell them for a fast profit.

Because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits.

Simmons’s first trip through the revolving door of private equity came in 1986. Like the latest trip, it was not a pleasant one for employees, but the buyers did just fine.

William E. Simon, a private equity pioneer and a Treasury secretary under President Richard M. Nixon, was the man with the golden touch. In 1986, his investment firm, Wesray Capital, and a handful of Simmons’s top managers acquired the company for $120 million, the bulk of which was borrowed. After selling several businesses to pay back some of the money it had borrowed, Wesray cashed out in 1989. It sold Simmons to the company’s employee stock ownership plan for $241 million — twice what it paid just three years earlier.

The deal was a fiasco for the employees. As part of the buyout, Simmons stopped contributing to its pension plan, since the stock ownership plan shares were meant to pay for the employees’ retirements. But then the bottom fell out of the housing market and Simmons, with its large debt, stumbled. Its pensions crumbled as the value of the stock plan shares plunged.

A succession of private equity buyers came and went. Merrill Lynch Capital Partners bought Simmons in 1991 for $32 million for a 60 percent stake in the company and the assumption of its debt. Merrill sold it to Investcorp, an investment group based in Bahrain, for $265 million in 1996. Two years later, Investcorp sold the company to Fenway Partners for $513 million.

During Fenway’s tenure, Simmons released one of the industry’s biggest innovations: the no-flip mattress. Profits soared. But after five years, Fenway executives decided to cash out. By the fall of 2003, Simmons was back on the block.

Teddy Bear at the Gate

A longtime figure in investment circles, Thomas H. Lee vaulted into the big leagues of private equity with what is regarded as one of the legendary deals of all time. After founding Thomas H. Lee Partners in 1974, he grabbed headlines in 1994 when he sold Snapple, the iced tea maker, for $1.7 billion to Quaker Oats. He bought the company two years earlier for around $130 million.

But while other captains of the buyout craze — like Henry Kravis of Kohlberg Kravis & Roberts — chased giant companies in hostile deals, Mr. Lee focused largely on midsize companies and steered clear of deals where he was not welcome. The research firm Hoover’s describes Thomas H. Lee Partners as “the teddy bear at the gate.”

Mr. Lee, scion of the family that founded the Shoe Corporation of America, left his namesake firm in 2006 to start another investment company. During his 30-year tenure at THL, his firm invested in a series of big names: Ghirardelli Chocolate, Petco Animal Supplies and General Nutrition Companies, among others. And by 2003, as the buyout boom began to build, his firm had Simmons in its cross hairs.

The Deal

The fall of 2003 was little more than a blur of meetings and presentations for Robert Hellyer, the former Simmons president who is among the fourth generation of his family involved in the mattress industry. In eight weeks, the company was shown to 20 private equity suitors in the corporate version of speed dating.

The list of potential buyers was quickly whittled to three and finally to THL, whose $1.1 billion bid for the company consisted of $327 million in new equity from the firm and more than $745 million in bonds and bank loans that had to be raised from investors.

“They were good guys; very smart guys,” Mr. Hellyer said. “Their thesis was to buy a good business with good management and let them get better.”

What THL wanted from the deal was a return of two to three times its initial investment.

From the get-go, the lofty price the firm paid for Simmons and the amount of debt raised red flags on Wall Street.

The “higher debt burden will limit the company’s ability to respond to unexpected negative business developments, including economic or competitive threats or internal missteps,” analysts at Moody’s Investors Service warned at the time.

But nobody, it seems, was listening. Six months after acquiring Simmons, THL set in motion plans to take the company public. And by December 2004, THL found a way to get part of its initial investment back. Simmons issued debt that required the company to pay a hefty 10 percent annual interest rate. The proceeds were used to pay THL a dividend of $137 million. With the company’s debt climbing, Simmons executives had to aim high with new products — and pray they were right.

In late 2004, Simmons unveiled the HealthSmart mattress in a blitz of marketing.

It gave away 250 beds to the audience of “The Ellen DeGeneres Show.” It began a $15 million advertising campaign. It put coupons for free HealthSmart beds in celebrity souvenir bags during New York’s Fashion Week.

A mattress line aimed at combating dust mites, mold and germs, the HealthSmart featured a zip-off top that could be washed or dry cleaned. But in the rush to get the product to market, Simmons did not go through its normal research and testings, Mr. Hellyer says.

HealthSmart was a flop. Consumers did not like the mattress — they thought the zip-on cover was troublesome. Sales at the company slid nearly 8 percent in the first quarter from the previous year.

“Panic ensued. Thomas H. Lee came in and pulled the national advertising right away,” said a former Simmons employee involved with HealthSmart who declined to be named because he is still involved with the mattress industry.

THL shelved its plans to take Simmons public, and the company shook up its sales division. By the third quarter of 2005, Simmons had “one of the best quarters in the company’s entire history up to that point,” a spokesman for THL said in an e-mail message. The numbers tell a slightly different story: Net sales declined 4.8 percent in that quarter from a year earlier, and operating income fell to $25.1 million, from $25.5 million in the third quarter of 2004. Later, spokesmen for THL and Simmons clarified the statement by saying that after excluding a one-time reorganization expense, an adjusted earnings figure for the quarter was the 10th best in the company’s history.

Executives at THL say they moved quickly to put Simmons back on track.

“More than a dozen THL professionals have devoted literally thousands of man-hours to Simmons, including making over 115 visits to company headquarters and site facilities around the country,” the firm said in a statement.

The results, it argued, speak for themselves. In the following years, Simmons’s sales and profits climbed, and the company introduced several new products, including the successful premium-price Beautyrest Black line of mattresses.

By early 2007, at the very top of the credit market bubble, THL took a bit more out of Simmons. It created a holding company that it used to issue $300 million more in debt, which paid an additional $238 million dividend to the private equity firm. With that, THL had recouped its entire $327 million equity investment in Simmons and booked a profit of around $48 million. (It made an additional $28.5 million in various fees over the years.)

THL was hardly alone in undertaking this sort of financial engineering, known as a dividend recapitalization. From 2003 to 2007, 188 companies controlled by private equity firms issued more than $75 billion in debt that was used to pay dividends to the buyout firms.

Asked whether the 2007 dividend was too much for Simmons, Mr. Schoen of THL defended the deal.

“That debt financing, which clearly spelled out to the market the use of the proceeds, was extremely well received. The securities were heavily oversubscribed,” Mr. Schoen said. “Not only did we think it was appropriate, but the market did as well,” he added.

As the economy soured in late 2007, so did Simmons’s sales. The company slashed costs and cut jobs throughout 2008. But last fall, unable to meet the terms of its bank loans and debt dating back to the 2003 acquisition itself, Simmons stopped making interest payments to its bondholders. THL began talking to the banks and bondholders about how to lighten Simmons’s debt load, and put the company up for sale.

The Impact on Employees

From the start, Noble Rogers loved working at Simmons.

“There were picnics, March of Dimes walks, Christmas parties, and we always had Halloween parties. It was a really family-oriented company,” Mr. Rogers, 50, recalled. “I told my wife that this was a great place for me to work. A great place for me to retire, to make a living at.”

For a long time, it was. For 22 years, Mr. Rogers worked at Simmons, the bulk of those years at a factory in Mableton, outside Atlanta. After operating the coiler machine for the company’s Beautyrest mattress, he moved into maintenance and kept all of the plant’s machinery humming.

Over the years, as Simmons passed from one private equity firm to another, and as Mr. Rogers became president of the local union at the plant, he saw little difference on the plant floor. Then, in the spring of 2008, when the slowing economy had begun to hurt sales, Simmons laid off the night shift at the Mableton plant. And on Sept. 18 that year, it gathered employees in the cafeteria to say that the plant was closing.

“So many people were hurt because they thought this was a great company to work for and they planned on spending the rest of their lives here. Their families were here. They bought houses and cars here,” Mr. Rogers recalled. “After this happened, people were really struggling.”

Between the closings and other cuts, Simmons let go of more than a quarter of its work force last year, said its chief financial officer, William S. Creekmuir.

Mr. Rogers, who received his union-negotiated severance package of two months’ pay, said he and other union representatives had tried to get a little more for workers, particularly those who would have been eligible for retirement. Simmons had a long history of giving retiring employees a bonus of $20 for each year worked and a free mattress set, Mr. Rogers said.

“They wouldn’t give us anything,” he said.

In the months after he lost his job, Mr. Rogers nearly lost his home to foreclosure and struggled to pay his family’s bills. Mr. Rogers, who eventually landed a job at an air filter company and picked up part-time work doing maintenance at an apartment complex, said Simmons bore little resemblance to the company he once loved.

“They stopped the picnics. They stopped the Christmas parties. They stopped the retirement parties,” he recalled. “That showed you the type of people I was working for. I just didn’t realize it until the hard times came like they did.”

For now, the Golden Age of private equity is over, the financiers say. In a speech to an industry gathering last spring. Mr. Schoen said that bankers and bondholders were reluctant to lend more money to the buyout kings.

“We’re in a brave new world,” he said. “We can’t go back to where we were, at least not in this investment cycle, and probably not in my career.”

But some private equity investors are searching for profits in the detritus of the buyout bust. Simmons hopes to emerge from bankruptcy in the hands of two new private equity firms. One is Ares Management, which owns the mattress giant Serta. Under the plan, Simmons’s debt would be more than halved, to $450 million, in part reflecting the losses suffered by its existing bondholders.

Simmons and its remaining employees face an uncertain future. Some in the industry predict Ares will eventually merge at least part of Simmons with Serta, jeopardizing more jobs.

“Simmons has been a cash cow. It’s made a lot of people a lot of money,” said David Perry, executive editor of Furniture/Today. “But there’s a growing question in the industry of how many more times can this be repeated. How much more juice can be squeezed out of the orange?”

And guess who just acquired Simmons? The Globe and Mail reported last week that Ontario Teachers' Pension Plan just bought Simmons:

Two of the world's largest mattress makers are jumping into bed together, with Simmons Co. and its iconic Beautyrest products joining Serta Mattresses in the Ontario Teachers' Pension Plan portfolio.

By taking the mattress maker out of bankruptcy protection, Teachers and its partner Ares Management LLC will become the largest player in a traditionally recession-proof industry, which has been ravaged by the credit crunch. Each company has about a 15-per-cent share of the American market.

People tend to finance mattresses, and when credit dried up they couldn't afford to go shopping any more," said Jerry Epperson, a mattress and furniture industry analyst at investment bank Mann Armistead & Epperson Ltd. in Richmond, Va. "This is an industry that never saw a real slump, and it's been shocking to see sales drop as far as they have."

Since record-keeping began in the early 1970s, mattress sales have only decreased on a yearly basis twice - 1982 and 2001. And even then, sales were only down 1.9 per cent. This recession has been brutal for the companies - with sales down as much as 15 per cent in the past year.

In Simmons, the pension fund is buying a 139-year-old company that has now seen six private equity owners since being taken private 20 years ago. Its Beautyrest mattresses were brought to market in 1925 with advertisements showing how even an elephant could get a good night's sleep on its patented coil system while more recent television spots show peaceful partners sleeping soundly as bowling balls were dropped on the other side of the bed.

The mattress maker began seeking a way to restructure its $1-billion (U.S.) debt earlier this year, as sales skidded 19 per cent. The prepackaged bankruptcy restructuring plan announced yesterday will cut debt to $450-million, with Teachers and its partner paying $760-million for Simmons Bedding Co., its U.S. subsidiaries and parent company Bedding Holdco Inc. Simmons Co.

Simmons Bedding subsidiaries in Canada are not part of the deal, although the company said in regulatory filings they'll likely be included once the bankruptcy is finalized.

Simmons will continue to operate with its current management, and will be kept separate from Serta - a point the companies were careful to underscore as they noted that the U.S. government would be reviewing the transaction.

The funds are convinced that as credit markets thaw, consumers will once again turn toward mattresses - which sell for an average nearing $1,500 in the United States, although some of Simmons' top models approach $6,000. A Teachers representative said "the industry fundamentals are attractive - demographics and housing trends, the replacement nature of the products and the industry's history of generating cash flow."

Ontario Teachers better be right because it could be a very long time before sales of mattresses pick up. In recession, you tighten your belt, cut frivolous spending, wear the same clothes for as long as you can and sleep on the same mattress for a few extra years (even if it means waking up with a sore back!).

But unlike those employees at Simmons who lost their jobs, private equity pension fund managers and the GPs they invest and co-invest with are sleeping easy, counting the millions they collect in bonuses and fees as they profit by loading up the debt of companies they acquire.

It's too bad the stakeholders at these large Canadian public pension funds are also sound asleep. If they only knew the real story behind private equity, they wouldn't be so hands off with their pension funds.

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