GP Profile: Madison Dearborn Turns To Structured Equity Investments

Don’t expect leveraged buyouts to be sponsored by Madison Dearborn Partners any time soon.

The Chicago shop’s last deal was to take a minority stake, along with two other private equity firms, in Weather Investments Group, a company that provides Internet and cell phone services in Africa and other emerging markets, in June 2008. It was the firm’s first investment from its sixth fund, and it is a harbinger of things to come.

So long as there is insufficient financing available for LBOs, Madison Dearborn expects to concentrate solely on so-called “structured equity” transactions, including private investments in public equities and minority stake investments in private companies, in the coming year, Paul Finnegan, co-CEO, told Buyouts. The firm, which expects to invest $200 million to $300 million at a time, at press time was looking at three such targets.

The firm’s pullback from the conventional LBO comes as U.S. buyout and mezzanine firms are scrambling to put money to work after raising nearly $745 billion from institutional investors from 2006 through 2008, according to figures compiled by Buyouts. Madison Dearborn is itself in the midst of fundraising, having collected $4.1 billion in a protracted effort to raise $7.5 billion for its sixth fund, which initially targeted $10 billion.

The firm’s emphasis on structured equity isn’t exactly new: Such deals accounted for 60 percent of its deals and 35 percent of the equity it’s deployed from more than $18 billion across six funds. Still, its exclusive focus on these deals today demonstrates the challenges of deploying money amid a shell-shocked financing market that has crippled the prospects for large-scale buyouts.

In an indication of just how nervous banks are, Finnegan recalled how a partner recently took a buyout deal that required $1 billion of debt to seven banks. Three were immediately not interested. The others were interested, but didn’t want to lead the deal. Madison Dearborn passed.

In structured equity deals, buyout firms obviously don’t enjoy the same level as control as they do in traditional LBOs. Nevertheless, they can negotiate governance rights, liquidity rights, and negative control rights that give them a veto over major corporate decisions, changes in capital structure and other significant initiatives. In return for their capital buyout shops can get debt with warrants, preferred stock, convertible preferred stock, or common stock. Senior secured debt with warrants offers downside protection for investments in cyclical businesses, while common stock can be attractive for investments in high growth companies.

Most of the companies looking for this kind of financing today need it to refinance debt, said Jeff Seaman, a managing director at investment bank Robert W. Baird & Co. The key to making such deals work, he said, is making sure that the company isn’t so overburdened with debt that the investment proves worthless; that’s a difficult assessment to make in today’s environment. “Say you’ve got a cyclical, capital goods company, where cash flow has fallen off a cliff,” said Seaman. “It may not be easy to determine the amount of capital to right-size the balance sheet, so that’s a real pitfall.”

Structured equity deals tend to work out best, Seaman said, when the company intends to use the investment to make acquisitions or fund organic growth initiatives. For its part, Madison Dearborn is particularly interested in providing capital to three types of companies: ones that are fundamentally healthy but are struggling to meet debt obligations, ones looking to make acquisitions or pursue growth initiatives, or else those seeking liquidity for shareholders.

History Of Minority Deals

Madison Dearborn has pursued structured equity transactions dating back to the 1980s when its founders ran the investment activities of First Chicago Venture Capital. Many of Madison Dearborn’s senior team, including Chairman John Canning, Co-CEOs Finnegan and Sam Mencoff, as well as five additional managing directors, worked at First Chicago Venture Capital.

The strategy has helped the firm earn an average net IRR of 17.12 percent and an average investment multiple of 2.06 for its first five funds as of June 30, 2008, according to the California Public Employees Retirement System. The firm’s first two funds, closed in 1993 and 1997, performed especially well, had respective investment multiples of 3.4x and 2.4x; the two following funds, closed in 1999 and 2000, came in with investment multiples of 1.6x and 1.9x respectively. Fund V, closed in 2006, has so far returned 1x for CalPERS. The structured equity investments have actually outperformed others in the portfolio by a few percentage points, according to a source close to the firm. Canning expects the firm’s recent structured equity investments to return more than 30 percent.

Companies in which the firm has recently purchased minority stakes include L.A. Fitness International, the fitness club chain in which it bought a 22 percent stake in 2007 for $600 million; Metro PCS Communications Inc., the wireless telecommunications carrier in which Madison Dearborn partnered with TA Associates and three limited partners to invest $700 million for a 30 percent stake; and Sorenson Communications, a provider of Video Relay Services to the deaf community in which Madison Dearborn bought a 41 percent stake for $203 million in 2007.

Not surprisingly for a firm that makes telecom a specialty, Madison Dearborn has absorbed some lumps over the years on its structured equity deals. The firm lost the $73 million it pumped into Chicago-based Focal Communications Corp—once valued at $1.5 billion—in the late 1990s; it attributes that loss to the collapse of emerging telecom company stocks and a change in industry regulatory policy after 2000. But the investments can also yield huge returns: One of the firm’s best deals was a $31 million investment it made in 1994 in Omnipoint Corp., a wireless communications provider, which generated $603 million of realized proceeds, or a 20x return for the firm.

Corsair Capital’s investment in National City offers a prime example of the risk inherent in these investments, as well as instruction as to how firms can protect themselves. The New York-based distressed-company investor in May led a $7 billion investment in the struggling Cleveland bank, whose situation further deteriorated after the fall of Lehman Brothers and the government’s takeover of American International Group in September. Corsair sold its stake in December to PNC Financial Services Group for $5.08 billion. Nevertheless, it was not only able to recoup all of its investment, but also reportedly turned a 29 percent profit. The key was a price-reset clause that Corsair secured in the initial investment agreement that stated the firm be compensated if the bank engaged in a change-of-control transaction for less than the price paid by Corsair within three years of Corsair’s investment.

Structured equity investments can also yield other benefits to buyout firms, such as the ability to enter new markets, of which the Madison Dearborn’s investment in Weather Investments marks an example. In June, the firm teamed up with TA Associates and Apax Partners Worldwide LLP to invest $1.7 billion in the company, which is run by Egyptian telecom tycoon Naguib Sawiris. The deal gave Madison Dearborn a three percent stake. In early December, the firms, along with the Sawiris family, invested another $554 million in the company. The investment gives Madison Dearborn entry into the Mediterranean market, as well as in Pakistan and Bangladesh.