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Private Equity Investment And The Dividend Recapitalization Value In Or Value Out?

2 |Page Daniel Reddy Indep endent Study A Brief History of Private Equity: Investors have been acquiring businesses and making minority investments in privately held companies since the dawn of the industrial revolution. Merchant bankers in London and Paris financed industrial concerns in the 1850s; most notably Credit Mobiler, founded in 1854 by Jacob and Isaac Pereire, who together with New York based Jay Cooke, financed the United States Transcontinental Railroad. Andrew Carnegie sold his steel company to J.P. Morgan in 1901, which in many experts minds was arguably the first true modern buyout. Later, J.P. Morgan's J.P. Morgan & Company would finance railroads and other industrial companies throughout the United States. In certain respects, J. Pierpont Morgans 1901 acquisition of Carnegie Steel Company from Andrew Carnegie and Henry Phipps for $480 million represents the first true major buyout as they are thought of today. Even though such private equity transactions have been occurring for a very long time, the original organization of the private equity market began in 1946, due in part to the inadequacy of other options or sources of long-term financing for new businesses. There was a need in the markets and that need was starting to be met in an organized way (supply/demand). In a response to an economy fresh on the heels of World War II, and having to absorb millions of recently discharged servicemen, the American Research and Development Corporation (ARD) was founded. According to D.H. Hsu and M. Kenney: The prime movers supporting ARD were Ralph Flanders, then president of the Boston branch of the Federal Reserve and trustee at MIT, Georges Doroit, a professor of industrial administration at Harvard Business school, Karl Compton and Merrill Griswold (Hsu & Kenney, 2005). These founders firmly believed that providing management skill and experience was as critical to the overall success of new business as was a source of adequate funding. According to one of ARDs founders, Ralph Flanders, the need for ARD was of paramount importance. In 1946, Ralph Flanders summarized the need for ARD as follows:
During my last year of my incumbency as president of the Federal Reserve Bank of Boston, I became seriously concerned with the increasing degree in which the liquid wealth of the nation is tending to concentrate in fiduciary hands. This in itself is a natural process, but it does make it more and more difficult as time goes on, to finance new undertakings. The postwar prosperity to America depends in large measure on finding financial support for that comparatively small percentage of new ideas and developments which give

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promise of expanded production and employment, and an increased standard of living for the American people. We cannot float along indefinitely on the enterprise and vision of preceding generations. To be confident that we are in an expanding, instead of a static or frozen economy, we must have a reasonably high birth rate of new undertakings.

Flanders felt very strongly that if other sources of capital were not made available for new companies or individuals to reach out to, then the American economys growth would be stuck in slowmotion. Private Equity (PE), when used correctly, can help fund innovation which in turn helps create not only economic growth for the future, but also helps people create and implement new innovative ideas that increase the general publics standard of living. If you were to look back to 1946 and compare the average Americans standard of living and compare it to 2011, you would see that huge strides have been made. This isnt to say that Private Equity is the sole reason for this great nations prosperity over the years, but it has certainly played an important role. ARD was not the only dedicated Venture Capital organization created in the aftermath of World War II. According to Business Week: A few wealthy East Coast families also established professional venture capital operations ("Dynasties unify," 1946). The three operations were Rockefeller Brothers, Inc. (RBI), J.H. Whitney, and Payson & Trask (P&T). According to the New York Times: The Family fund that would prove to be the most significant was RBI ("Research venture gets," 1946), which later was reorganized and renamed Venrock. One reason for RBIs success in comparison to ARDs was that unlike ARD many of RBIs overall investments tended to be in certain government related fields where they could rely on their strong family connections in Washington (Lewis, 2002). ARD itself ended up having modest success in raising fresh capital for investment. By 1959 the first Small Business Investment Company (SBIC) was formed, but these were primarily established to manage the venture capital investments of wealthy families and did not seek institutional capital. Throughout the 1960s, SBICs attracted mainly wealthy individuals and families rather than institutional investors. By 1977 concern had risen in regards to the supposed shortage of capital in the capital markets available to fund new ventures. Then in 1978 a revision of the Department of Labors decision pertaining to the prudent man provision of ERISA governing pension fund investing stoked an almost immediate burst in demand for small-company stocks and new issues in general. This enabled partnerships to exit more of their investments, distribute funds to investors, and raise new partnership capital. Then in 1980 another hurdle was removed by the Department of Labor, stating that limited partnership investments were to be granted a so called safe harbor exemption from plan asset regulations. These regulations in

4 |Page Daniel Reddy Indep endent Study the past had made it so that all venture managers had to become registered advisers, and as such they were prohibited from receiving performance-related compensation. With that restriction/hurdle out of the way, it led to outside managers of plan assets in the venture arena being paid proportionately to their success, which was a vital element in the venture capitalists mode of doing business. Finally, also in 1980, Congress lifted another extremely important restriction that had been imposed on partnerships by the Securities and Exchange Commission. Due to the fact that registration under the Investment Advisers Act is not required when an adviser has 14 or fewer clients, many of the partnerships had decidedly restricted their size to 14 limited partners. The Small Business Investment Incentive Act of 1980 redefined private equity partnerships as business development companies, thus exempting them from the Investment Advisers Act. In the aftermath of this regulatory liberalization, private equity investing exploded. Between 1980 and 1999, the United States private equity market grew from about $5 billion to more than $175 billion in investments! As the private equity markets developed, they were seemingly broken down into two distinct animals: Venture Capital Firms (VCs) & Leveraged Buyout Firms (LBOs). The case to be discussed in this paper deals entirely with the latter (LBOs). LBOs occupy a different place in the corporate lifecycle than VCs do. LBOs are generally created with the goal of taking public firms or specific divisions of the firms private. Most of the acquisitions are done through a majority of borrowed funds. During the 1980s LBOs had their moment in the sun. LBO activity ran ramped, reaching unprecedented levels. While researching this run-up in LBO activity in the 80s, I discovered that there are seemingly many explanations for their explosion. Some experts refer to the so called rise of the institutional investor (Donaldson, 2004), a return to specialization (Shleifer, & Vishny, 1991), and the eclipse of the public corporation (Jensen, 1999). In my view a combination of these factors is more likely the cause than any one factor. As anyone who has studied the markets and is familiar with the technology boom of the 90s knows, the 90s was the time when the VC firms had their moment in the sun. So many start-up companies associated with the internet craze came about during this decade. The sad thing is that most of them are long gone by this point. The end problem for the markets was that no one really new how to value these internet companies. When you do a valuation on a company using a discounted cash flow model, you use a great deal of past financial and industry data to determine a large portion of your inputs for the valuation. Considering the fact that this was a new form of company and a new industry altogether, there was no historical data to look at and no industry trends or comparative analysis to consult. Analysts had no idea what the end ramifications of the new industry would be or how it would

5 |Page Daniel Reddy Indep endent Study develop. So imputing the main driver of these cash flow models (growth estimates) was extremely difficult. When U.S. public equity markets crashed, so did VC fund commitments and venture-backed IPOs. In other words, the VC investments disappeared as they realized that their estimates of earnings, growth and value were way too optimistic in many cases. They walked away, which increased the already dramatic downturn in the markets into a free-fall. As the chart below shows, total VC investment dropped off of a cliff in 2000. Since that time VC investments have been quite slow to recover.

As this slow recovery for VC firms persisted into the first decade of the twenty-first century, global private equity investments boomed. This time, though, it was mainly Leveraged Buyouts taking place and not new VC investments. The growth continued mainly due to a global liquidity glut and the availability of rock bottom interest rates (cheap borrowing costs). According to Thomson Financial, in 2006, private equity LBO funds accounted for more than $750 billion of announced deal volume worldwide, 18% of the global total. In the U.S., nearly one-quarter of mergers and acquisitions announced in 2006 were LBOs. Nine of the ten largest private equity deals ever have occurred since the year 2004, including the largest at the time, Blackstone Groups $38.9 billion buyout of Equity Office Properties Trust. Private Equity and the Famous Dividend Recap: With all the talk these days about debt and its now burdening effect on the consumer and the capital markets, the question of whether or not these leveraged buyouts and dividend recapitalizations that are financed almost entirely by debt are truly creating value for the company and its shareholders or destroying value is extremely important. In most cases the private investors involved in these transactions create value for themselves regardless of the implications for the company or its shareholders. A tool that has gotten a lot of criticism over the years used by private equity firms called a dividend recapitalization or dividend recap for short is one of the value destroying types. This particular form of leveraged recapitalization involves a private equity-owned company that decides to issue new debt in order to pay its financial owner or group of owners a special dividend. The impetus for leveraged buyout firms to carry out dividend financings, the private equity transactional equivalent of anabolic steroids, is seemingly clear. Besides being able to earn back a portion of their initial equity investment, often in a short time frame, a firm can return cash back to its limited partners. Another issue with the dividend recap is that the dividends are paid in excess of actual annual free cash flows; thereby altering the firm in questions financial structure. Both the entities cash may be removed and substantial loads of debt

6 |Page Daniel Reddy Indep endent Study assumed in the process. The fact that the dividend is not covered by the free cash flows creates a leveraging of the firms financial structure, which can easily affect the financial flexibility of the firm negatively. One may ask, with rates as low as they are and the after-tax cost of debt capital low, arent these transactions just plain old good financial engineering? No way! Because by altering the firms financial structure they are then robbed of financial flexibility, which has a real tangible cost. A firm creates value for itself and shareholders by being able to produce free cash flows. How can depleting the equity cushion aid the firms purchase of new productive capital or resources that will in the end help it produce new and added free cash flows? How will these newly structured firms be able to gain access to capital for expansion and other such value-generating business activities, given that their balance sheets are now loaded to the hilt with fresh unsustainable debt? How will they be able to truly compete and grow in a competitive landscape when they cant gain the required access to capital at a competitive price that would allow for important projects to proceed? One would think that the board of directors who are supposed to be acting in the best interests of their shareholders would step in. In many cases though they are ultimately tempted by the upfront cash dividend and promises of future cash riches, which it seems that banks are all too eager to lend. According to Bank of America, one of the largest beneficiaries of the fee income associated with these sorts of deals, they point to the acceptable 6% default rate of companies that go through these transactions. So has the ultimate objective of companies today become not to default? Firms such as HCA Inc., who have been through these dividend recaps, may not have actually defaulted, but they have been placed in a precarious position structurally and may never fully recover. Other examples include such names as Burger King, KB Toys, Warner Music, Burlington Coat Factory and many more, who have enriched the private equity firms involved, yet have forever changed or in some cases dismantled once solid, position leading companies. My view of the role of good private equity funds is that they should improve companies operationally and lower the cost of capital for those that are financed inefficiently. Seemingly there would be no squabble with these private equity funds earning these returns if they were in fact building enterprises or creating jobs. But alas they do not make their fortunes by creating or discovering new life saving drugs or creating new and innovative businesses that will help drive this economies future growth prospects. Rather they gain it by simply trading existing assets amongst themselves for their own personal gains!

7 |Page Daniel Reddy Indep endent Study Many of these private equity firms are once again dabbling in certain deeds that got Wall Street and big business fat cats in trouble in the post Enron era, such as conflicts of interest, inadequate disclosure, shady accounting methods, influence peddling and much more. In the end for corporations the only way to create sustainable growth is for the company in question to earn an increasing amount of free cash flows. This really takes place through a growing capital base which can earn a steady and normalized cash based Return on Invested Capital higher than the firms cost of capital. In reality the dividend recaps are by definition the antithesis of value generation. They steal actual capital resources instead of allowing the firm to maximize its opportunities with actual value-creating capital. Case Summary: In the following two cases I am going to look at two very different companies that were taken private in LBO deals through private equity investment, where one company (HCA) has seemed to have made it through the process, albeit with much larger amounts of debt and a totally different capital structure, while the other (LIN) could not and was taken into bankruptcy in 2008. Both of these corporations were taken private for similar reasons and in a similar fashion. Whether or not the actions of these groups of private investors actually added value to these two corporations is the real question. Because isnt that the goal of private equity investment: to add value for the shareholders and to restructure companies into healthier cash flow producing entities? CASE 1 HCA INC. The first case that I will discuss is in reference to HCA Inc. Accounting for about 4% of total U.S. hospital admissions, HCA is the largest private hospital owner and operator in the United States. It operates 164 hospitals and 106 outpatient centers, offering a broad range of health services. HCA has operations in 20 states and in England, but a majority of its operations are in the Southern U.S., particularly in Florida and Texas. HCAs outpatient services make up a large 38% of total patient revenue. The hospital operator had been under private equity ownership before, completing a $5.1 billion leveraged buyout in 1989. According to Business Week, when HCA went public again in 1992, it handed its backers at the time (including units of Goldman Sachs Group Inc., JP Morgan Chase & Co.) a more than eightfold gain. HCA was taken private again in 2006 for about $30 billion with an equity check that was only worth 15% of its purchase price! Last year before the company was taken public again, HCA

8 |Page Daniel Reddy Indep endent Study paid out a total of 4.7$ billion in special dividends (3 separate times in one year totaling the 4.7bill). The total almost equaled the near $5.5 billion in equity used by the group of private investors to initially take HCA private (the rest of the $30 billion was all debt funded). The obvious next step for the group of investors (Kohlberg Kravis Roberts & Co., which trades as KKR & Co. and Bain Capital LLC) was to take HCA public again. The IPO went forth on March 9, 2011, offered at the high end of its range at $30 per share, making it the largest private equity backed IPO in the U.S. ever. A total of 126.2 million shares were sold, 2.2 million more than expected. According to the Wall Street Journal, Underwriters had set out to price the deal between $27 and $30 a share. Of the shares sold, 38.5 million, or 30%, were sold by prior owners, so those proceeds won't even benefit the actual company! According to data from Dealogic, the deal raised a total of $3.79 billion. The obvious problem to me is that the raised $3.79 billion wouldnt even cover the $4.7 billion in new debt that had been added to HCAs balance sheet to pay for the special dividends (all done in one year). The IPO would really be just added gravy or icing on the cake for this group of private investors, adding to their already enormous returns, gained by leveraging HCA to the hilt. Before I get into the valuations of HCA at 2006 and again in 2010, I want to discuss the way that HCA financed the dividend recaps in 2010. In the last of a stream of dividends paid out to private investors, HCA Inc. used a specially formed company to pay a $2 billion dividend to its private-equity owners. The payout plan is another indication of the dizzying heights in 2010s junk-bond sales boom. According to Thompson Reuters, companies have raced to issue a record number of junk bonds and in some cases have provided less protection for investors than in the past. The dividend, HCAs third this year, will be financed through the sale of $1.5 billion in JUNK debt maturing in 2021 and the use of HCAs credit lines. The new debt will be funded by HCAs operations and could be very risky for new HCA debt holders. The new debt lacks collateral or guarantees from the operating subsidiaries and will be structurally subordinated to existing HCA debt. These new bonds will also have limited protections against future debt issuances and dividends. According to a reporter from the Wall Street Journal, the debt issuance is yet another sign of irrational exuberance in the junk markets. According to Thomson Reuters, in 2010 companies globally have sold $264.9 billion, 50% more than in 2009. The previous record was $186.4 billion back in 2006 before the credit crisis. For my case analysis, I went back and downloaded all of the relevant financial data for HCA up to 2006. My intent was to value the company using a 2-stage free cash flow to the firm model (to value the companies operating assets) while using the same valuation model to value the company in 2010 when HCA was again taken public, to see how the company would be able to grow going forward with

9 |Page Daniel Reddy Indep endent Study such a large amount of debt on the books and how much the shift in HCAs capital structure would affect overall value. In valuing HCA with financial data from 2006 I came up with a total firm value of $29.77, billion about .2 billion less than the group of private investors valued the company when they took it private in 2006 (see attached spreadsheet #1). The main driver of this free cash flow model is the growth rate used to project future cash flows. What I built into the model was the option to use an internal rate of growth, calculated by: Return on Capital * Reinvestment Rate. This fundamental measure of growth measures the growth rate in after-tax operating income, as long as the reinvestment rate and return on capital remain relatively stable. The growth in operating income is a function of both how much a firm reinvests back (reinvestment rate) and how well it reinvests its money (the return on capital). I added an option in the model to use the historical rate of growth in EBIT over the last 5 years as well as an outside estimate of growth (either ones own estimate or an analysts). In the model there is a built-in option to assign weights to each growth rate used (whether or not you choose to use all three or just two or one). I feel that this creates a more consistent estimate of growth. For example, if your fundamental growth rate is reasonable but you feel the company may be able to grow beyond that rate due to industry characteristics, economic situations or government regulations or lack thereof in that specific industry, then you can add in your own estimate of growth as well and give that a weight in the overall weighted average calculation of growth going forward. All analysis/valuation is subjective in nature and trying to come up with the exact growth rate at which the firm will grow earnings is impossible. But you can make your estimates of earnings growth better by using more than one option. So before HCA was taken private, the companys operating assets were worth about $30 billion dollars (which is right about where the market valued them as well at the time). This of course is before the company was leveraged to the hilt with debt. So we now go out four years to 2010 and value the company to see if all of these shenanigans have really made HCA more valuable or less. If the company would have been left to its own devices and grown at my assumed 5% over the last 4+ years and did not accumulate all of the debt that it did, would it have fared better? What I decided to do was to run two separate models with the 2010 data. Both were the same style of model as the one used for the 2006 valuation (2-stage free cash flow to the firm). But where they differed was in the amount of debt used. First, I valued HCA using all of the 2010 data except for the excessive debt levels obtained through the dividend recaps. In other words what would the company be worth if it hadnt gone private and been loaded up with all that debt or still been taken private, but had not been plundered and pillaged by its private investors?

10 | P a g e Daniel Reddy Indep endent Study The answer to that question is that without the immense amount of debt, HCAs operating assets would have been worth $44 billion dollars with an equity value per-share of $78. To explain further, I used the 2006 pre-takeover debt levels in the first valuation and assumed that HCA, who had been paying down outstanding debt from 2002 through 2006, would continue to do so going forward. The second model in 2010 used the actual debt levels that are the reality as of 2010 due to the dividend recaps. In the model, HCAs total firm value drops by about $5 billion dollars and the equity value per-share is halved to $35 dollars per-share! Morning Star analyst Michael Waterhouse has a fair value or intrinsic value per share rating of $32 per-share. I also used a lower cost of equity in the model using pre-takeover debt levels due to the fact that in my eyes, the lower levels of debt and positive equity values made the overall operations of the firm less risky. With the added debt load HCAs financial flexibility was far less then it would have been had it not taken on all the added debt. So the question for investors becomes whether or not this new HCA with the extremely high levels of debt can operate and grow at a healthy pace, as well as what kind of return are they going to see from the companies shares? While its not unusual for companies like HCA that exit LBOs to have more total debt than total assets, it means that they will need to pay down that debt with cash flows instead of using the cash flows to pay a dividend to shareholders or buy back its shares in the open market, thus limiting potential returns for shareholders in the near to mid-term future. Unlike many companies that have the same situation occur to them, HCA will be able to operate going forward, but at a much lower rate of growth than may have otherwise been possible. HCA does have a few good things going for them that will help lift them out of this financial mess of a balance sheet. But I do feel that current management will be walking on thin ice and any small slip could have disastrous consequences for HCA. Unlike some other buyouts associated with the boom years that had less predictable income streams, HCA has reported between 5% to 6% revenue growth every year while it was private, except in 2010 when it slowed to a minuscule 2.1%. Coincidently, 2010 was the year HCAs group of private investors loaded up and borrowed $4.7 billion in debt to fund three separate large dividends. HCAs private investors did however increase profit margins, returns on capital, and free cash flow by selling underperforming assets, controlling costs, cutting capital expenditures, and focusing on higher-margin outpatient services, which will help the company going forward. Longer term, HCA should benefit from having the majority of its locations in the fast-growing Sun Belt, with about half of its operations in Texas and Florida. Additionally, the 65 and older population

11 | P a g e Daniel Reddy Indep endent Study is the fastest growing demographic in the U.S. Since this segment overwhelmingly dominates hospital admissions, the acute care industry should see increasing patient volume during the next decade or so. Thanks to its operations in Florida, HCA also sits in one of the largest Medicare markets in the U.S., as the Census Bureau estimates its 65 plus population will approach 30% of the state's total population by 2030. A nationwide obesity epidemic also adds a tailwind for cardiovascular related hospital services. As a result of healthcare reform, many analysts expect an increase in health services from the approximately 30 million uninsured patients expected to gain health-insurance coverage. Even with all of these positive points for HCA, a big negative is HCAs capital structure, which I believe puts equity holders at an extreme risk. HCAs IPO added about $3 billion in new equity capital, but even so HCA by my estimate will still have a negative book value and debt to capital ratio. The biggest problem still remains the overall financial health of HCA. Despite its stable operating cash flow, management has a small margin of error. HCA faces more than $12 billion in cumulative debt maturities through 2015. With about $2 billion in free cash flow annually, HCA probably will be forced to refinance a large portion of its debt obligations. With nearly all available cash going toward debt service, HCA's dismal cash position isnt likely to improve any time soon. HCA may have made it out alive, but it is my opinion that the shares are currently fairly priced and I would not recommend purchasing the stock until a sizeable discount (or margin of safety) is made available due to the risk associated with the excessive debt load. Case #2: Linensn Things: Linens 'n Things (LIN) was one of the nation's leading large-format specialty retailers of home textiles, housewares, and decorative home accessories. In 2005, the company operated over 500 stores in 45 different states as well as five Canadian provinces. Linens 'n Things maintained impressive growth during the 1990s but stalled out during the beginning of the 21st century. When a series of initiatives failed to turn things around, the merchandiser opened the door to potential buyers in 2005, agreeing to be acquired in February, 2006 by a newly formed entity controlled by Apollo Management, L.P. Affiliates of Apollo Management, L.P., National Realty & Development Corp. and Silver Point Capital Fund Investments LLC collectively contributed approximately $648.0 million in equity, while the remainder of the $1.3 billion deal was financed with debt. At the end of 2005 Linens 'n Things had a total of $2.13 million in debt on its balance sheet, and after the acquisition by Apollo Management, the companys debt level jumped to $733 million. As discussed earlier in the paper, this added level of debt to firms can alter or negatively impact their

12 | P a g e Daniel Reddy Indep endent Study financial flexibility. This seems to be exactly what happened with Linens 'n Things. According to a statement by Linens 'n Things management in the 2006 prospectus; In connection with the Transactions, we incurred significant indebtedness and became highly leveraged. After the acquisition the retailer had $1.5 billion in total liabilities compared to $809 million in total equity! Just two years after being taken private, the once largely successful retailer filed for bankruptcy in May of 2008. While the Clifton, N.J., company had $2.8 billion of annual sales, profit was sagging and its debt level of $856 million long-term at the end of 2007 was seemingly becoming increasingly difficult to manage. The business model of the No. 2 household retailer had been broken, unable to withstand the assemblage of forces pulling it apart. In addition to a worsening economy, a deteriorating balance sheet, and deteriorating credit markets, the company was facing stiff competition from the likes of Bed, Bath & Beyond, the top industry player, as well as trying to contend with the home furnishings departments of Macy's Inc., J.C. Penney Co., Target Corp. and Wal-Mart Stores, Inc. Just like with the first case (HCA), my objective was to value Linens & Things with pretakeover debt levels and then value them again using the added debt to see how much value was being destroyed by adding so much debt so quickly to its already deteriorating balance sheet and business model. I used a 2-stage free cash flow to the firm model, which is best suited for firms where varying levels of debt are expected to be the reality going forward. Again the major driver of this type of valuation model (growth rate) was derived using a weighted average rate of growth attained through three separate estimate options of growth (fundamental, outside analyst estimate, historical). For the Linens & Things model I normalized the capital expenditures at the firm due to the fact that they were extremely volatile, especially in the last year (2004-2005). I also used a normalized reinvestment rate due to the same issue as was the case with the capital expenditures. Valuing the retailer with pre-debt takeover levels produced an intrinsic value per-share of $23 and a market value of equity of $1.2 billion. This would have pegged the firms shares as overvalued at the time considering the shares were trading at $26.32. In my view the estimate obtained from the valuation model used is probably closer to the true intrinsic value of the firm than where the market valued it at the time. My reason for feeling this way is that the business was deteriorating fundamentally due to strong levels of competition and deteriorating profitability. Looking below at the embedded chart from my analysis, one will see visually that all of the profitability ratios have steadily declined since January of 2000. The only measure of profitability that has not steadily declined but held flat at best is the gross profit margin. Another key that led me to believe

13 | P a g e Daniel Reddy Indep endent Study that the company was having trouble was the fact that their ROE was actually less than their cost of equity, which shows that management was investing in this expansion of stores at an overall return that was less than the cost of funding the projects. This in itself was destroying value at Linens & Things before the LBO came along and destroyed even more value. No wonder they had to file for bankruptcy! They were being destroyed on the inside as well as from outside investors. And when the LBO added the extra leverage and the economy went into a tailspin it was just too much for the struggling chain to deal with.

Now if you add in the $733 million in added debt from the LBO deal, the value of Linens & Things drops off the cliff. The value per-share drops down to a little over $10 and the equity value in the company drops significantly. Whether or not this group of private investors used the debt to pay out a special dividend like in the HCA case seems really irrelevant to me, and if they did pay out a special dividend they hid it very well. Regardless, the added debt taken on in the LBO destroyed value in the firm just the same. Overall the added leverage crippled the companys capital structure and destroyed any real ability to restructure itself in a positive value generating way. Closing Thoughts: Private equity has the ability to really help both investors and the economy when it functions in an ethical manner. When private equity firms make long-term investments in companies with the intended agenda being to help them grow their businesses, including increasing R&D spending, developing new products and business strategies, hiring superior management, cutting costs and creating more efficiencies and increasing capital spending on value generating projects, they in turn create value, not destroy it. This growth-orientation often results in jobs created or saved, and additional growth by healthier, more profitable companies. When functioning as they should, private equity buyout funds can play two distinct and important roles in the U.S. economy. In the real, physical economy of factories and offices, private equities operations can further the productive use of existing assets and resources, usually by identifying companies with untapped potential. By making additional investments in assets and future value generating projects, they in turn would be reorganizing the firms operations in ways that increase their value. But as of late they tend to use increasingly alarming levels of debt to finance their deals and then leave these obstructive levels of debt for the companies to deal with.

14 | P a g e Daniel Reddy Indep endent Study The U.S. economy just went through a massive recession/credit-crisis, where excessive debt levels were at the heart of the overall problem. Yet we seem to have learned nothing from that experience and are at it again! Private equity is a big key to the success of our nations economy over the long term. Instead of flip-flopping highly leveraged assets with each other, private equity funds need to be redirected to more suitable and economically sensible activities, such as funding innovative companies that cant get the funding from the public markets yet, due to a lack of financial information or earnings history. My end conclusion on the dividend recapitalization process is that it extracted value from these two companies instead of creating it. The new debt did nothing but destroy value within both of these companies: the very exercise extracts value right out of the business while adding value to only a select few private investors, leaving the companies to pay off the debt on their own. Instead taking undervalued companies private and, by cost cutting, creating new and improved efficiencies across the supply chain, adding new markets and products, value adding acquisitions, and then retaking the firm public seems a much more superior way to not only create value for the firm but to create value for the shareholders as well. While the U.S. is seemingly slowly but surely losing the competitive international battle, it would seem that making a case that self-dealing is the way out would be quite absurd. Creating tax incentives that are aimed at enhancing productive capital and R&D should be at the forefront of lawmakers and congresses minds and agendas. If nothing is done and things continue the way they are, the long term prospects arent good for anyone.

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Bibliography :(APA) Hsu, D.H., & Kenney, M.K. (2005). Organizing venture capital: the rise and demise of american research and development corporation, 1946-1973. Industrial and Corporate Change, 14(4), Retrieved from http://www-management.wharton.upenn.edu/hsu/inc/doc/papers/david-hsudevelopment-corporation.pdf Dynasties unify. (1946, June 15). Business Week, 21, Research venture gets sec blessing. (1946, August 9). New York Times, 24, Lewis, J.E. (2002). Spy capitalism: itek and the cia. New Haven, CT: Yale University Press. Donaldson, GD. (2004). Corporate restructuring: managing the change process from within. United States: Harvard Business School. Shleifer, AS., & Vishny, RV. (1991). The takeover wave of the 1980's. Journal of Applied Corporate Finance, 4(3), Jensen, Michael C., Eclipse of the Public Corporation. HARVARD BUSINESS REVIEW (Sept.Oct. 1989), revised 1997.. Available at SSRN: http://ssrn.com/abstract=146149 or doi:10.2139/ssrn.146149

16 | P a g e Daniel Reddy Indep endent Study The private equity advantage. (2008, December). Retrieved from http://www.pegcc.org/wordpress/wp-content/uploads/moodys-report-2008-the-pe-advantage.pdf