PE and Balance Sheet Heavy Businesses
WSO - I often hear a lot of PE shops explicitly state that they don’t like or generally avoid balance sheet businesses but it’s not clear to my why that is the case. Can anyone help me understand?
Thanks!
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More cash being tied up in WC and Capex = less cash to pay down debt
Second the above, and I'd also add that it creates volatility and default risk. If you have heavy recurring capex expenditures year-on-year (which is usually associated with asset-heavy businesses), then in tough years the core operating business just might not generate the cash flow to meet interest payments. They also tend to (though it isn't always a rule) have higher fixed costs, which again can make things difficult in tough years.
Thanks, that is helpful. It makes sense, but you could also theoretically just price in that risk, no? My intuition was that it actually has more to do with upside potential given that hard assets (could means a balance sheet of loans that looks like a bank or a bunch of brick and mortar toy stores a la Toys R Us) are simply lower multiple and IRR and that PE is just the wrong home for them. Thoughts?
That's an intelligent response. Let me add a few comments.
1) Yes you can price in that risk, but that then means lower multiples and lower equity cushions, and less leverage. Can't you get comfortable with more leverage given those hard assets? Yes you can, but that's usually more vanilla assets like hospital homes, retail outlets, and restaurants (which are actually very popular PE targets)
2) Low multiple does have something to do with it, but typically when we calculate LBO returns we don't price in a re-rating anyway (unless your IC is more cowboy than most). It has a lot to do with ability to leverage and volatility of cash flows. IRR is a function of multiple re-rating, ability to improve EBITDA, and leverage. Assuming no multiple re-rating, then it really is leverage and EBITDA improvement. You can speculate that EBITDA improvement has something to do with it - heavy asset industries are harder to scale (require capex and building stuff takes time) than, say, SAAS or business services.
3) Let's not write off heavy asset industries. A lot of PEs like or even specialise in this (e.g. hospital homes, holiday parks, restaurants, retail). These are more predictable cash flow businesses with a more vanilla growth story than, say, a fisheries fleet or mining company.
All makes sense. Just to clarify, however, when I say low multiple I mean MOIC. Think of it this way: sum of the parts / returns attribution analysis would tell you that all of the hard assets owned by a portco (take the toy stores once owned by Toys R Us) are actually low-teens IRR / 1.5x MOIC assets; the LBO math might be 25% / 2.5x MOIC but I’d argue it’s really a higher return on the operating assets (ex hard assets) and lower return on the heavy/hard assets (you could take this example further to say not many banks create 25% ROEs but Stone Point still does the deals and it’s because they’re creating platform value over and above the value of the assets). Anyway, the point here isn’t to be a pedant but rather to say everything you’re telling me makes sense but that I suspect at least from an academic sense what I’m laying out here also is a factor.
There are clearly a lot of firms that do specialize in those spaces (industrials, etc) and generate great returns. But firms/partners specialize, and rarely do they specialize in both services and balance sheet businesses. There is almost no overlap because they are very different from an operational perspective. And you are just hearing the services partners use common parlance to define what they do by stating what they don’t do.
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