FEATURE: More Than Ever, G.P.s Feel Public Market Pain –

Private equity investors by nature are supposed to have faith in strategies that favor long-term growth over instant gratification. But if there’s ever been a time when that faith has been tested, it is now. The past several months have seen many convertible preferred share deals, recently trumpeted as exciting alternatives to control transactions, sink underwater. The recent Nasdaq meltdown, along with general malaise across many sectors, has caused the share prices of many companies in which buyout firms own securities to decline to sub-conversion-price levels. These declines have occured in both New Economy and Old Economy sectors.

While private investments in public equities (PIPEs) provide some downside protection, it is doubtful that many buyout firms with those investments in their portfolios will be happy just collecting dividend payments.

In some cases, the damage is nothing to worry about yet. Complete Business Solutions, for example, to which Clayton, Dubilier & Rice made a $200 million commitment, currently is trading around $20 per share, and Clayton Dubilier’s conversion price on the security is $23 per share not an insurmountable distance to a nice return. Thomas H. Lee Co.’s $300 million investment in Metris is looking healthier still. Despite recent market volatility, the stock is trading near its conversion price of $37.25 per share.

Other deals are more troublesome. Thomas H. Lee Co.’s other big convertible preferred investment – an equity commitment of $500 million to Conseco Inc. – is down considerably. The deal, the Boston firm’s largest equity commitment ever, gives Thomas H. Lee Co. a conversion price of $19.25. At the time of the investment, the company’s shares were trading at around $20 per share after steadily falling from a high of $58 per share. Conseco’s stock now trades near $6 a share, which means that if Thomas H. Lee Co. is to see any return on the investment beyond a 4% dividend, Conseco’s stock price will have to quadruple.

In today’s stock market, stunning recoveries are not unusual, but in the meantime, the general partners at Thomas H. Lee Co, as well as at manymajor buyout firms, are being forced to have their investment wisdom second-guessed on a very public stage (see table below).

Bump in the Road

A year ago, when buyout firms began to invest in convertible preferred shares with greater frequency, many industry observers questioned the wisdom of such an investment strategy. Some limited partners worried that PIPEs would simply give them greater exposure to the public markets. Others were concerned that buyout firms would not get enough control over their investments to justify the G.P. carry and management fees.

Proponents of PIPEs say the structure allows buyout firms to get involved in undervalued companies that are starved for growth capital, thanks to a tight debt market.

Michael Klein, vice chairman of Salomon Smith Barney and head of the financial sponsors group, is one industry professional who still feels that minority deals will continue to be seen as attractive investments by buyout firms. “It’s a business model that many firms are embracing,” he says. “It’s an effective way for them to use capital, and there’s still downside protection. While there is day-to-day volatility, it’s still a structure that we feel comfortable using.”

Klein says that, historically, 50% of all value created by buyout firms has been after their portfolio companies went public. “Buyout firms having investments in public companies is not unusual,” he says. “What is unusual now is that [the portfolio companies] are public right from the start.”

One investment professional at a major private equity firm says reports of the demise of PIPEs are premature. “Just because stock prices have fallen, it doesn’t mean there’s anything wrong with the structure of convertible preferred deals,” he says. “We have a three to five year investment horizon. If you have stocks that temporarily slip underneath the conversion price, it doesn’t mean the investment’s a failure. More important are the business fundamentals.”

“Everybody likes to look like a genius right out of the box,” he adds. “What it comes down to is that a bunch of us didn’t time these [investments] as well as we could have.”

Bruce Pollack, a managing director at Centre Partners, knows the rewards that patience can bring. In 1998, his firm made a $43.5 million equity investment in publicly traded Salton Inc. The security has a conversion price of $11. Partners at Centre watched anxiously as the share price dipped briefly to the $7 range. That proved only a brief dip in the road the stock now trades at $43 per share.

Pollack adds that he has no idea what will become of the many investments done by buyout firms that involve technology risk. His firm approached Salton as a value play, a strategy many investors have temporarily abandoned. “Only in the past three weeks have we been right,” Pollack says.


Select Convertible Preferred Share Deals, 1999-Present

Investment

Apollo Advisors LP/

The Blackstone Group Allied Waste, $2,000M

Apollo Advisors LP/

Thomas H. Lee Co. Wyndham International Inc., $700M

Clayton, Dubilier & Rice Complete Business Solutions, $200M

Cypress Group Danka Business, $200M

Forstmann, Little & Co. McLeodUSA Inc., $1,000M

Hicks, Muse, Tate & Furst ICG Communications, $230M

Globix Corp., $80M

RCN Corp., $250M

Rhythms NetConnections, $250M

Teligent Inc., $200M

Hicks Muse/Chase Capital Viatel, $300M

Kohlberg Kravis Roberts & Co. CAIS Internet, $100M

DPL, $500M

Intermedia Communications, $200M

Silver Lake Partners LLC Cabletron Systems, $200M

Gartner Group, $300M

Thomas H. Lee Co. Conseco Inc., $500M

Metris, $300M

Thomas H. Lee Co./Bain/

CSFB Private Equity CTC Comm. Group, $150M

Cont’d

Dividend Conversion Recent

Price Price*

10% $18.00 $5

N/A $9.75 $2

N/A $23.00 $20

6.50% $12.50 $5

3.50% $18.25 $21

N/A $28.00 $25

7.50% $40.00 $20

7% $39.00 $29

8.25% $37.50 $19

7.75% $57.50 $31

7.5% $46.25 $36

N/A $16.50 $15

8.5% $21.00 $23

7% $36.00 $34

N/A $40.00 $22

6% N/A $14

4% $19.25 $6

9% $37.25 $38

8.25% $50.00 $34

Source: BUYOUTS *as of 4/25/00