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On November 17, 2010, I was walking past the Empire Room on 33rd Street in New York City, when I noticed something going on. What looked like a Wall Street job fair turned out to actually be an intense discussion between suited financial professionals listening to their host, Josh Kosman, investigative reporter, author, and financial journalist for the NY Post.
Josh Kosman was hosting a small gathering of industry insiders to launch the follow-up paperback version to his investigative research book The Buyout of America, which was released November 30, 2010.
The timing of Mr. Kosman’s event was somewhat coincidental to the events that recently unfolded in the world of Private Equity. Ironically the largest taxpayer funded bailout of Wall Street ripened the same low interest rate lending environment to kick start a wave of “junk bond” refinancing and a rising tide of “debt for dividend” payments to the same fee-chasing Buyout Barrons that leveraged America into the greatest credit collapse in history.
Bain Makes Fortunes by Hobbling Companies
Referencing page 107 in The Buyout of America, Josh Kosman hones in on a study of seven leveraged buyouts, led by Bain Capital Partners between 1988 and 2000, where Bain Capital had made total capital investments of $223.5 million and generated total cash returns of $876 million. During the 12-year period, Bain Capital’s seven fund investments generated $4 (4x multiple) for every dollar invested by the fund’s investors/shareholders.
A four-time multiple is an impressive return for any asset manager. However the returns generated by Bain Capital Partners do not mean the portfolio companies created value or benefited from any “perceived” superior asset management skills during Bain Capital’s investment holding period.
Three of the seven companies accounted for $205 million of the $876 million total return. To exit, Bain Capital either sold the company outright or issued a public stock offering. Two of the three companies filed for bankruptcy shortly after going public. The third company wound up in litigation with Bain in which Bain Capital had pleaded guilty to allegations of designing a scheme to defraud and overbill the Medicare system. The company, Damon Corporation, paid $119 million in penalties. The other four companies issued additional debt to fund the remaining $671 million in shareholder dividends that were realized for their fund investors. However all four companies filed for bankruptcy after Bain Capital Partners walked away with four times the amount of cash they had initially invested.
Josh Kosman emphasized the following concerns and outright conflicts of interest with Private Equity’s (PE) motivation to buyout the homegrown economies of Small Business, USA:
Dunkin’ Donuts Was Leveraged Well before Private Equity’s Leveraged Buyout
Franchise attorney Paul Steinberg rose to the occasion. He took center stage, shedding light on the issues emerging from the mixology between Private Equity and franchising. Mr. Steinberg addressed the meaning and the importance of "leverage" in the world of franchising, and how it relates to a franchise system such as Dunkin’ Donuts, given its 2006 DB Master Finance, LLC 144a Private Placement levered financing scheme.
“The basic premise of franchising,” Mr. Steinberg said, “is to grow a franchise brand by leveraging other people’s money [franchisee capital]” He continued, “The importance here is that both franchisees and Wall Street need to understand what assets are being leveraged by Private Equity when they acquire a franchise system that is already highly leveraged with franchisee capital.”
Paul covered a wide spectrum of issues. Finessing it with lawyer speak, he explained how various federal and state court matters have evolved the franchise industry to where it is today. Given the breadth of Mr. Steinberg’s discussion, one can conclude that franchising is not a function of regulation, but rather a function of procedural precedence that has regulated the evolution of the franchise industry for the past 35-40 years.
Traditionally, the franchise relationship has been between two legally distinct parties – 1) Franchisor, and 2) Franchisee – both parties maintained significant skin-in-the-game. Additionally, both parties shared the common goal of maintaining and building the value of the Franchise IP – The Brand™. By focusing on the Brand™, both parties achieved their mutual goals – 1) Franchisor – goal is focused on maximizing revenues, and 2) Franchisee – goal is focused on maximizing bottom line profitability. The grayish area between the two parties is control over the supply chain where the franchisor can build incremental sources of revenues by controlling the supplier approval rights. Great franchise systems sort through these issues by “collaborating” and “sharing” the benefits and rewards of the franchise system’s “bulk” purchasing power.
When private equity steps into the picture the franchise relationship is distorted by increasing the number of parties involved within the franchise system. To fund a franchise acquisition, private equity uses a financing technique known as whole business securitization. In doing so, private equity multiplies the total number of parties contractually involved in the entire scheme of contractual arrangements with each having their own distinct sets of goals and risks.
The Dunkin’ securitization increased the number of related parties from two to five – 1) Private Equity Sponsors – [Bain Capital, Carlyle Group, and THL Partners], 2) Master Servicer – [Dunkin’ Brands, Inc.], 3) Master Issuer Control Party/Trustee – [Ambac Assurance Corp and Citibank Trustee], 4) Bondholders/Investors – [Pension and Hedge Funds], and 5) Franchisee Owners – [Individual Small Business Owners and Operators].
In the post securitization environment, the Private Equity Sponsors and the Master Servicer are outside of the securitized special purpose entity (SPE) because they "sold" the entire business to the Master Issuer SPE – DB Master Finance, LLC. Hence, the two groups became third parties but remain contractually affiliated. The Master Issuer Control Party/Trustee and the Bondholder/Investors are related inside the securitized SPE and are considered to be the “successor” Franchisor, in aggregate. The "existing" Franchisee Owners, in aggregate, are the collateral guarantors and the securitization co-issuers since the franchisee, by virtue of the franchise agreement, personally guarantees the financial obligations and performance related to each and every individual franchise agreement underlying the pool of collateralized franchised assets.
Within the securitization, control of the franchised brand is now outside of both franchisor and franchisee control and in the hands of a self-interested third party asset manager (a/k/a Master Servicer) whose goals are no longer aligned between the franchisor and the franchisee. The Master Servicer's sole motivation is to regain control of the "entire" franchise system which they had sold to the special purpose entity. Conceptually, the securitization can be viewed as a classic real estate sale leaseback transaction that functions as a Mortgage-Backed Security.
Mr. Steinberg argued when a PE company targets a franchise system in a leveraged buyout, and then uses securitization proceeds to finance the acquisition, the process delinks the sacred franchisor / franchisee relationship by putting a third party asset manager [Master Servicer] between the core “relational” element that the franchise system was built upon. The Master Servicer has the luxury of reaping the benefits of ownership without the risk. The third party master servicer has the perverse incentive to act in self-interest when there is no ‘skin-in-the-game.’ The third party has nothing to lose, and yet, everything to gain.
This is part one of a three-part series.