An earlier post explored the “tax welfare” characteristics in much private equity (PE) investment in the U.S. This post explores the second key characteristic of PE, which is the preying on “cash cow” companies.
One of the greater misstatements common in the business press is that private equity firms like Bain Capital target “troubled companies” for takeover and rescue. A takeover market for truly “troubled companies” does exist, but it is relatively small, and it is very high-risk. Instead, the preferred target of PE firms is the “cash cow” business.
In the late 1960s the Boston Consulting Group (BCG) created a paradigm-changing model that segmented businesses into four categories based on their relative market share and growth prospects. The quadrant consisting of mature companies that have high market share but slow growth they labelled “cash cows,” which, in hindsight, proved to be an unfortunate designation (and as a dog owner, I don’t care for the “Dogs” quadrant moniker either).
A generation of 1970s MBA students, and those into the years beyond, were often taught the perspective from this business model that these cash cow companies are slow and lazy, with inept management. The large cash flows from these companies, which are often larger than their accounting profits, need to be “milked,” according to BCG model, to provide the capital required to feed the “Stars” and “Question marks,” two of the other labels placed on companies in the matrix. The large fixed-asset bases of cash cows, so the MBA wisdom went, were to be mortgaged and leveraged in order to create even more capital to self-finance more acquisitions.
And so, PE firms have been on a 40-year cash cow acquisition binge, successfully leveraging some, but also destroying many in the process. A 2012 analysis of Bain Capital by The Wall Street Journal found that about 22% of its acquisitions up that time either went bankrupt or otherwise went out of business within eight years, and another 8% had lost all of Bain’s initial investment amounts.  Similar results are common among other PE firms.
Who are the cash cows?
From a probabilistic risk perspective, cash cows often look different in the real world from how they are portrayed in the BCG model. First of all, many of the most successful long-standing companies in the world either are cash cows, or are on their way to becoming cash cows. The best ones have managed themselves into a relatively-secure, lower-risk business niche in the near term, providing employment stability for their workers, and a solid economic engine for their respective communities.
Cash cows are the multi-generational small manufacturers who dominate their market niche. They are the long-time restaurants and retailers with loyal clientele. They are the local patrons of the arts and everything else that makes a community a good place to live. They are often geographically away from the economic “hot spots,” and may be the only sizable employer in smaller towns.
In the long term, however, cash cows are vulnerable to declining market share as new competition comes in, and this is their primary risk point. But that suggests careful managerial stewardship of products and markets, focusing on strategic re-investment. Excessive debt leveraging, the normal PE acquisition method, only manages to destabilize the business, increasing risk needlessly when it already has the capital required for re-investment in its own “cash cow” business lines.
Cash cow companies have become vulnerable targets for takeover by aggressive PE firms in three primary ways. First, if they are closely-held by a single family, the generational need to “cash out” can initiate a sale. More likely, however, the public stock market is usually so focused on quarterly growth in earnings that it “punishes” cash cow firms through bidding stock prices lower.
And last, PE firms will often overbid the market in order to snatch a quick, clean buyout, which starts the investment off on a very bad footing. If a stable $100 million business is bought out for $150 million, then it becomes immediately one-third less profitable as its former incarnation. Site closures and consolidations then inevitably ensue, not because they make sense, but because the business is suddenly less profitable than it needs to be in order to pay back the over-priced investment.
Were it not for the tax subsidy on interest for the high-risk debt required to leverage these takeovers, and the potential to get at the excess cash to pay huge “carried interest” fees (both discussed in this earlier post), the buyout most likely would not happen. But they do happen, and the subsequent death rate, especially for many in smaller cities dependent on their local multi-generational cash cow, is high. It is often “murder by merger.”
Part Three of this series has been posted.
- Maremont, Mark. “Romney at Bain: Big Gains, Some Busts.” The Wall Street Journal, 9 Jan. 2012.