Author Josh Kosman took on the private equity industry in 2009, releasing his book, "The Buyout of America." In it, he warns that buyout firms like KKR & Co. (NYSE:KKR) and Blackstone Group (NYSE:BX) have become the nation's largest employers while adding over $1 trillion in new debt to an already overburdened economy. Kosman's prediction that two million jobs will be destroyed when these debts go unpaid is not far fetched. Piecing together the financial statements of private equity-owned companies before their purchase and today, we'll use the Z-Score to illustrate how private equity is killing balance sheets. (For more, see Z Marks The Spot.)
|Company||Z-Score Prior To Buyout||Z-Score (12 Trailing Months)|
|Dollar General (NYSE:DG)||7.21||3.10|
|KAR Auction Services (NYSE:KAR)||N/A||0.93|
|Insurance Auto Auctions Inc.||1.36||N/A|
KKR bought the discount general merchandiser in July 2007 for $7.2 billion, using $4.7 billion in debt to pay for the deal. It then hired Rick Dreiling, a veteran grocery and drug store executive, to take the Nashville-based company to the next level. Whether KKR's acquisition was good for Dollar General is certainly questionable. What isn't questionable is the fact Dreiling did very well from the takeover, hauling in over $20 million in compensation since his hiring. I doubt he has anything bad to say about KKR.
Dollar General investors can point to the increase in both revenue and earnings since KKR's involvement as proof it has added value. However, in 2006, Dollar General's cash flow from operations was $555 million, just $121 million less than the latest trailing twelve-months, on $4 billion less in revenue. Further, my estimate pegs its Z-Score in 2007 at 7.2, more than double today's number. No wonder Morningstar gives it a fair value of $20, 50% below where it's currently trading.
KAR Auction Services
Applying a Z-Score prior to this particular deal is difficult because it involved two parts. First, there was the purchase of Adesa Inc., the country's largest publicly traded provider of wholesale vehicle auctions, for $27.85 a share and the assumption of $700 million in debt. Kelso and Co. along with an affiliate of Goldman Sachs (NYSE:GS) and other private equity firms bought Adesa and then merged Insurance Auto Auctions Inc. (their own company) with it, creating KAR Auction Services Inc. This was in April 2007. It then went public in December 2009 at $12 a share.
To calculate the Z-Score prior to the private equity buyout, I need to know the market cap for both companies prior to the merger. At the time of the deal, Adesa had slightly fewer than 90 million shares outstanding giving it a market cap of $2.5 billion. Subtract $2.5 billion and $700 million (the assumed debt) from $3.7 billion (the total value of the two deals) and you arrive at a ballpark market cap of $450 million (after fees) for Insurance Auto Auctions. The rest of the Z-Score can be found in the prospectus (again, these are my own calculations). When you take two companies that are profitable with little debt and add an additional $1.9 billion in financing, it's not surprising the Z-Score took a significant hit. Adesa shareholders are fortunate they were paid in cash.
I frequently come across private equity deals that make absolutely no sense financially, yet banks continue to provide financing for leveraged buyouts. As Kosman states in his book, nothing good will come of it. (For more, see Learn The Lingo Of Private Equity Investing.)
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