The Domino Effect – Why Private Equity Does What it Does?

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.