From Industry to Alchemy by Max Holland

Author:Max Holland
Language: eng
Format: epub
Publisher: Beard Books

KKR did just that during a lengthy meeting in Fort Lauderdale. The investment bankers began by hastily explaining that they agreed with Saltarelli: so long as a leveraged company had to service its high-interest debt, it operated at extreme risk. An LBO was predicated on a steady, if not expanding, market for a company's products. In a stagnant or down market a leveraged company could quickly go bankrupt. From experience, KKR knew that after a company was leveraged, the loans had to be retired quickly.

There was a second reason for paying off the debt rapidly. For until then, as KKR explained, the "pot of gold" that theoretically lay at the end of every buyout was unattainable. A private, leveraged company could go public and claim the pot of gold only after its debt-to-equity ratio had returned to acceptable proportions. This was the precise juncture, of course, where KKR, holdover management, and other equity partners reaped their huge reward— as much as twenty times their original investment.

Saltarelli was quick to appreciate this kind of thinking, but he was still mystified by one thing. How was Houdaille going to generate all the profits necessary to pay off the high-interest debts so quickly? Here the key phrase to remember, KKR told Saltarelli, was managing for cash flow.

As CEO of a company publicly traded on the stock market, it was only natural for Saltarelli to think in terms of net profits, returns on investment, and other measurements featured in quarterly and annual reports. But a buyout meant Houdaille would have to reorient its corporate mind-set and think more broadly, in terms of cash flow. That would be the secret to removing the shadow of debt over a leveraged Houdaille.

Not that profits ceased to be important, KKR assured Saltarelli. Profits would remain a key element in generating cash flow, so Houdaille still had to be in the black as much as possible. But there was another, more accurate way to think about Houdaille's situation after the buyout. It was here that KKR introduced Saltarelli to the third partner in the proposed deal: Uncle Sam.31

Stripped of all the complicating factors, Uncle Sam's contribution was at the core of an LBO. KKR could offer an unheard-of price for Houdaille stock, leverage the company to the hilt, and then cash in on the pot of gold all because of Uncle Sam's generosity when it came to the depreciation of capital assets and interest write-offs. The new, private Houdaille would hire an appraiser to revalue all assets to their present cost level. Partly because of a decade of inflation, but primarily because the appraiser would be in Houdaille's hip pocket, the assets could be marked up to artificially high values. Even assets that were not being used at all could be assigned a new value. Houdaille would then redepreciate the capital assets according to the federal tax laws. If a leveraged Houdaille remained sufficiently profitable, the annual value of the depreciation allowance, together with the tax write-off for interest payments, would effectively shield Houdaille from the 48 percent corporate tax rate for years.

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