Tad Omalley: the Investment Conundrum

Tad OMalley: The Investment Conundrum

By David Birulin

The Empire Investment Group was a top-tier buy-out firm within the private
equity community. Tad OMalley, a second-year student at the Harvard Business
School, accepted a position at Empire Investment Group.

Ted received a call from his boss, Townsend Sandy Beech, the head of his four-
person deal team and founding member of the firm. Sandy requested Tad, on a
Friday afternoon, to review three presentations for possible buyout targets. Tad
was to make a presentation at the partners meeting on Monday morning,
recommending only one (1) investment and detailing the strengths and
weaknesses of all three.

The Empire Investment Group had a strong brand name and historically
sponsored very successful business partnerships. The company was strong in
structuring deals and had just recently added an advisory services operation as
a way to expand its services internationally and provide deal flow. By 2005,
Empires buyout unit consisted of 25 seasoned partners with a range of
backgrounds that encompassed financial, consulting, and operations experience.

The objective of a leveraged buy-out is to find companies, either domestically

or internationally (or both), where Empire can utilize borrowed funds or debt to
finance its acquisition. Often times a leveraged buy-out does not involve much
committed capital (maybe a 70% debt to 30% equity) that will achieve high
returns for Empire. Basically, Empire buys a company with debt, fixes the
company, and sells it. After the purchase of the company, the debt to equity ratio
is generally greater than 1.0x. During the ownership of the company, the
companys cash flow is used to buy down the debt. The overall return realized by
Empire in a Leveraged Buyout is determined by the exit cash flow of the
company or the EBIT or EBITDA, the exit multiple (of EBIT or EBITDA), and the
amount of debt that has been paid off over the investment timeline. Companies
all over the world, of all sizes and industries, can be targets of leveraged buyout
transactions. Strategically, Empire was seeking companies to buy-out in England,
the new India office, and Germany.

Empire was facing a tremendous workload and recently had lost a highly
publicized deal. Recent trends in the market had seen volume and size of
Leverage Buy-out deals rise dramatically. Opportunities were opening up all over
the world, and Empire wanted to be sure it maintained its high profile not only in
its U.S. stronghold but also in Europe, India, and Asia.

The U.S. Leverage Buy-Out Industry invested in 752 transactions for $136.5
billion in 2004. The average transaction was $181.5 million. In the 1990s,
companies had become more efficient both in terms of finance and operations as
compared to the 1980s where companies were under-productive,
underleveraged and needing efficiency increasing measures. According to the
Case Study, Corporate America is generally more efficient than in the 1980s.
There are not as many institutions where you can just cut expenses and capital
expenditures and realize a great return on investment. You have to be
prepared to add value in some way.

The industrys purchase price in 2004 was on average 7 times EBITDA (earnings
before interest, taxes, depreciation and amortization), the highest level since
1999. The average debt multiple was 4.4 to 6.6 of EBITDA.

According to the case study, another feature of the U.S. private equity market
was its increasing internationalization. In 2005, fund-raising outside the U.S. was
expected to exceed $70 million. Also, U.S. firms had established international
offices from which to deploy money. Major U.S. LBO operations like Carlyle,
Blackstone, TPG, KKR, and Bain Capital all had several overseas offices by
2005. Empire felt the pressure to compete; by 2005, the question was not
whether a large private equity firm had an international operation but what
international deals it was doing.

As an industry, marketing was word-of-mouth and targeted. Empire has an

excellent team proactively researching companies from public records who they
believe meet their financial objectives. The sales cycle can be long, but the
returns are typically high. The basic approach is to build relationships with
government agencies, company leadership, and build a business case to help
companies achieve their financial goals.

Empires product is their knowledge and ability to restructure companies, fund

improvements or reduce expenses to increase EBITDA with very little of their
own cash. Empire may be a major investor or purchase the company outright,
but their objective is to find a company whereby they can achieve an ownership
position with very little cash and over a 3 to 5 year period, sell out generating
very high internal rate of returns.

The three companies Tad is reviewing are Coming Home Funeral Services, 3F AG,
and Gurgaon Manufacturing, LTD.

Coming Home Funeral Services is located in the United Kingdom and was the
largest operator of funeral services in a fragmented market. The business is
comprised of three (3) channels; Funerals, Crematoria/cemeteries, and Pre-
arrangement. Coming Home has a national network of funeral directors with
broad geographic coverage. In addition to its 516 outlets it has contractual
relationships with over 160 independent funeral directors who perform
prearranged funerals where Coming Home does not have a presence.

From a brief summary of its cash flows, Empire could earn 5.45 times their
investment of $40 million over a three year period. The purchase price is $240
million (not adjusted for the exchange rate between the US dollar and the euro)
and Empire believes they can purchase Coming with $200 million in debt and the
other $40 million in equity. Assuming the multiple of revenue and EBITDA stay
the same (2.1 of revenue and 7.8 of EBITD), Empire would make $218 million
between the sale of the business at the end of three years and the 3 years cash
flows. The present value of this transaction is $134.6 million (See Funeral
Business UK Chart below).

The Key Market drivers are very predictable; i.e. number of deaths, funerals, etc.
The financials exclude the CAPX expenditure since the expenditure will not
contribute to EBITDA. The Management Strategy cost reduction is acceptable but
not achieved in 2004. Market share is steady at 12.24%. The only real driver is
price and its the most important. The company will increase price to match
inflation without eroding the volume. Customers tend to be insensitive to price as
they rarely shop services; the business is based on trust and comfort.

The company does have rumors of unethical practices even though the company
was cleared of all charges by a government investigation. The good news is the
final reorganization reinstated the current management team, who have spent
their entire careers in the industry and felt it was a calling more than a job.

The exit strategy would most likely happen by taking the company public or
selling it; with the most probable outcome taking it public.

3F AD is the second company Tad is reviewing. It is a Flavors-and-Fragrances

subsidiary of a large chemicals conglomerate. The business has been performing
below industry norms and needs investment and upper management focus. 3F is
headquartered in Germany and developed, produced, and sold fragrance-and-
flavor additives worldwide. Since 2002 margins have trailed the industry. Based
on the information submitted, this company was very difficult to evaluate.
However, the base assumptions to grow sales and revenues are questionable.
The company has had 1.50% annual growth since 2001 and is forecasting a 6%
sales growth rate in 2005 through 2008. EBIT is expected to grow annually 60%
from 2005 to 2008 without much detail on how this will happen. It appears there
is something going on with expenses, interest, depreciation or amortization when
we compare the growth of sales at 1.5%, EBITDA 25%, and EBIT of 60% from
2005 to 2008 compounded annually. There is not enough detail in the
presentation to understand how this will happen. Even though, the case study
says it is assumed after the purchase, the team will refocus the core businesses
to increase efficiency and sales conversion for the Flavors division, continued the
growth of the Fragrance group, trim the management ranks, streamline the
decision-making process, and reinvigorate the R&D effort.

If we take the numbers as forecasted and assume the purchase price of $1.005B
(1.5 times revenues and 16 times EBIT), at the end of 4 years, we could have a
net present value of $1.076B or 6.4 times the cash investment. If Empire could
finance 70% of the $1.005B purchase price, then Empire would need to invest
$301.5 million.

Using the value of a firm formula and a 10% discount rate, the firm could be
valued at $2.7 billion by 2008. Using 3.1 multiple of sales, the value of the
company in 2008 would be $2.6 billion. And, if we use a 6 (rather than 16)
multiple of EBIT, the value of the firm would be $2.47 billion.
Barriers to entry are significant as major clients have distinct needs that require
long-term connections with their suppliers. The company believes demand will
increase twice or thrice in the fast-growing less-developed nations of Asia, Latin
America, and Eastern Europe. The industry is consolidating due to the high cost
of research and development, however, 3F spends less than the average in the
industry 7% vs. 7.9% of revenues. 3F lost several European accounts and the
company faced the threat of price pressure from one of its key customers and
the possibility that market consolidation of both customers and competitors
could reduce margins.

The company supply chain was unwieldy and could restrain the companys
ability to respond to client needs, and the business lines tended to work as
inward-looking silos, rather than sharing customer insights and development
expertise.

The exit alternatives would include a sale of the entire business or the two lines
separately, either to a competing F&F player or to a major competitor. They
could also do an initial public offering or Empire might keep it and refinance it,
given the strong projected cash flow, or it could sell it to another LBO house.

The third company Tad is reviewing is Gurgaon Manufacturing, Ltd. It represents

an opportunity for Empires new India office. This deal is very important to
cement a number of important relationships. This deal was referred by a very
well respected banker with longstanding ties both to GMLs founder and to
Empires executive team in NY. GMLs founder would be an important reference
for Empire among Indias manufacturing families to get additional business
opportunities, which the new India office needed.

GML has a long history in manufacturing. It is now focused on the growing

domestic four-wheeled vehicle market. Due to rising export sales, auto makers in
the developed world are increasingly looking to India for highly machined parts
at competitive prices. OMalley is quoted as and its low cost base, these folks
could make real inroads with the major auto makers, especially in light of the
huge fixed costs facing many North American producers. GML is looking to raise
$60 million to support investment in new equipment to expand the product line
and increase export sales.

In the chart below, the $60 million investment will increase sales from 21% to
53% per year from 2006 to 2010. Sales growth will mostly pass straight to the
bottom line as shown in EBITDA and EBIT. Over a 5-year period, if Empire
finances 70% of the $60 million, they will have an internal rate of return of 276
percent and the transaction will have a $716 million net present value over 5
years. The value of the firm is estimated pre investment at $140 million and post
investment at $200 million. The value of the firm by 2010 could range between
$1.15 B and $2.1 B as a factor of sales or EBITDA respectively. Calculating the
value of the firm using EBIT on weighted average rate, the value comes in
between $1.3B and $2.1B as well. Empire would need to invest $18 million cash
and $42 million in debt.
The management team was strong with OMalley receiving praise on the
management team; with the exception of the CFO but OMalley was not really
concerned about this. This investment would let Empire draw on its global
locations and expertise, practicing the worldwide investment techniques that the
firm hoped to use as a competitive advantage against other top tier LBO groups.
According to the case, it would also provide the India team with a chance to
work with partners in the U.S. and Europe, helping to integrate them into the
fabric of the operation.

OMalley had a concern, would the team have the skills necessary to add value
as active investors? OMalley thought there would be a number of initiatives to
add value as an investor including replacing the CFO, making contacts with North
American and European auto makers, facilitating acquisitions, and assisting with
global strategy among them.

Also, this deal was different in that Empire did not have control of the deal. The
firm would be a substantial shareholder but it would still be a minority position in
common stock. OMalley had several good questions with not enough time to get
the answers before Monday.

Options:

In determining the options available, Tad noted that Beech wanted to get back
to basics. Beech wants to find a few good, well-priced deals in reliable areas to
reinforce the firms reputation with the limited partners available to manage
each deal before going back to raise the next fund. Beech also wants to show
that Empire was keeping up with the times by moving overseas yet staying
with Empires rock-solid tradition. Tad wanted to stay away from any deal that
seemed too fluffy.

The goal, and Empires reputation, is to buy companies cheaply, leverage them
heavily, and flip them to a market hungry for initial public offerings and mergers
and acquisitions. OMalley also understood he had to communicate which styles
firms had. There were distinct styles, for example:

* Buy a platform firm and consolidate an industry around it;

* Create efficiencies and added value by changing the acquisitions strategy; and
others

* Emphasized growth, buying firms that could add value through organic growth
as opposed to financial leverage.

In considering each option, OMalley needed to consider the resource problem.

Basically, each LBO required a partners time. The partners were overworked and
had too many deals to work on. Therefore, consideration of partner time was
high on the list. The German office did not have this issue however.

The first option is 3F AG. The plan is to create efficiencies and added value by
changing the acquisitions strategy; focus on the core business, improve
efficiency and increase sales and increase research and development to a
minimum of industry levels 7.9% of revenues. This option fits Beechs direction
to get back to basics; buy low, sell high and leverage as much as possible. The
EBIT multiple is 16 at entry and will be at 6 when sold; however, the value will
more than double from $1.005B to $2.470B. There are many options to sell the
business to get the right price. Of course, the forecast in sales, EBITDA and EBIT
are aggressive. And, does Empire have the resources to execute on such a large
transaction?

The second option is Gurgaon Manufacturing, Ltd. The investment is only $60
million with $18 million in cash proposed. The net present value is $716 million
over 5 years and $286 million over 3 years. The opportunity to advance the
Indian office is big, but it is not aligned with the Beech direction of back to
basics. The issue of not having control of the investment makes this a tough
deal to pitch given the objective to buy low, sell high and flip the investment to a
market hungry for public offerings and mergers and acquisitions.

The third option is the funeral business in the U.K., Coming Home Funeral
Services. 83.4% of the purchase price is financed with debt. The forecasts are
reasonable and reliable and the management team is solid. The total profit is
$218 million on the $40 million investment for a 5.45 multiple over just 3 years.
The purchase price of the firm has a multiple of EBITDA 7.8 and Revenue of 2.1.
The value of the business will rise from $240 million to $312 million in just 3
years. The style is to buy the firm and consolidate the industry around it. Coming
Home is the largest funeral firm in the U.K. and the exit strategy will be to take it
public. The cash flows are solid and consistent. Given the resource constraint of
the company and Beechs instruction, this option may be the best for the
Monday meeting.

Given the 3 choices:

* 3F AG has an NPV of $1.397 Billion over 4 years;

* Coming Home Funeral Services has an NPV of $134 million over 3 years; and

* Gurgaon Manufacturing, Ltd has an NPV of $716 million over 5 years.

The best choice is Coming Home Funeral Services. For only $40 million, this
leveraged buy-out is 83% leverage and fits all of Beechs requirements. 3F AG is
also a good choice if we can solve the resource problem. Given the short time
frame to make a recommendation, Coming Home is a better choice. The other
choice, Gurgaon, does not fit our business model. We do not have control and will
have a minority position. However, for the long term benefit of the India office,
we should do a deeper diver to see if we shouldnt do this deal for the benefit of
other deals that may come our way.

If we can only choose one investment, I recommend choosing Coming Home

Funeral Services.

Thanks,
Dave.

Out of the three choices, 3F AG, is clearly the best investment opportunity. On
pure growth potential alone, 3F AG is an attractive investment. The industry as a
whole is expected to increase at 2-3 times the current rate in less-developed
nations of Asia, Latin America and Eastern Europe. In addition to this, the
industry has been consolidating rapidly over the last couple of years and 3F is
one of the world leaders in this business. This means that 3F is poised to take a
firm hold on a good chunk of the market share in a fast growing industry. In
addition to this for barriers to entry for this industry are significant. This make
this a great opportunity for Empire to enter into a market that is rapidly growing
and very difficult to get into. Finally and perhaps most importantly 3F has
developed very strong relationships with blue chip clients. This really brings
everything about the deal together. This strong relationship with blue chip clients
provides a very strong foundation for the business, a business which is growing
fast and is difficult to get into.

Yellostone Cattle Bank, is the incorrect choice to make an investment. The

biggest reason for this is the fact that the available stock represents only 40% of
the total equity making Empire a passive investor. This is unacceptable for a
large venture capital firm. If the firm is to make a significant investment in a
company it needs assurances that their money will be used wisely. As a passive
investor Empire will have no guarantees. This factor alone takes Yellowstone
Cattle Bank out of the picture as an investment. In addition to this, Yellowstone's
CEO is notoriously strong willed and difficult to work with. While he has had a
good record of performance to this date, there is no guarantee that this success
will continue. In addition, it is all but a certainty that he will ignore any outside
advice if things start to fall apart, an option that he has open to him due to the
fact that Empire will not be a majority investor.

Coming Home Funeral Services is also the incorrect investment choice. First of
all, it has recently endured a massive public relations hit, with rumors and
criticisms of unethical practices. While the majority of the charges have been
cleared, the damage has been done. In addition to this growth in the business
itself has been decreasing. In the past year they fell short of the budgeted 5%
growth and only grew 2.7%. This is almost half of their goal. The combination of
slowed growth and poor public image makes Coming Home Funeral Services an
unattractive investment.