Finance

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

(Updated )

Should private equity firms really be following in the footsteps of activists?

According to the Wall Street Journal, KKR & Co. has earmarked 15 percent of its $9 billion buyout fund -- or $1.35 billion -- for "toehold" stakes in public companies. The idea behind the strategy is to take a position and then, as a shareholder, push for divestitures or potentially gain an advantage ahead of a takeover down the road. 

KKR's current stakes include J.C. Penney Co., NetScout Systems Inc., Lumber Liquidators Holdings Inc., Integer Holdings Corp. and Marvell Technology Group Ltd., according to data compiled by Bloomberg. It's unclear if all are toehold positions.

Deal or No Deal?
Since the third quarter of 2013, KKR has tweaked its stake in chipmaker Marvell Technology. It now sits at roughly 2%.
Source: Bloomberg

If effective, these minority holdings can act as an appetizer, with the main course being a controlling stake in what becomes a closely-held company. Or as Alex Navab, KKR's head of Americas private equity, explained this year in a Preqin Q&A:

"We leverage our existing private equity ideas, efforts and capabilities to identify and opportunistically take toehold positions in public companies that we could envision potentially owning and where we think we can influence and drive value creation to generate private equity-like returns."

It's not necessarily a new maneuver: KKR has taken toehold stakes going back at least a quarter century, and it's not alone among private equity firms in pursuing these types of investments. Amid fierce competition, such stakes can give their owners the upper hand ahead of potential buyouts. But is this the way to go?

The trick with toeholds, as any rock climber knows, is in picking the right place to put your foot -- a misstep can be perilous. For KKR and its peers, that's true, too: Poor investment choices can result in losses, which in turn can hurt a fund's overall returns. And unlike most private equity endeavors, which involve some level of control, these passive minority holdings don't traditionally grant access to additional information or a board seat, meaning firms have less power to influence an outcome. 

Even without any direct investment, management of publicly traded companies are generally willing to take meetings with private equity firms, seeing them somewhat as white knights when they're under pressure from activist investors. (On Monday, Blackstone Group agreed to a deal for Team Health Holdings Inc. that may not have come together without the presence of Jana Partners). Plus, would-be suitors can gain advantages over others by teaming up with key existing investors, rather than putting up their own money. KKR should know: it triumphed in a 2007 bidding war for Alliance Boots thanks in part because of its partnership with the group's executive deputy chairman, who already owned 15 percent.

The reasoning for taking toehold stakes varies from firm to firm and some even claim to be long-term holders with no intention to put companies into play. For private equity firms looking to morph these holdings into deals in which they can participate, it's proven to be a tough task. KKR's toeholds in First Investment Bancorp and Texaco some 25 years ago, for instance, didn't lead to the firm progressing its ownership any further. 

There have been some exceptions, led by technology specialist Vista Equity Partners. It owned stakes in Infoblox Inc. and Marketo Inc. before agreeing to deals for both companies this year (and as I've written, the firm's next target could be hiding in plain sight among its current holdings).

And back in 2011, a consortium led by Leonard Green & Partners LP was able to snap up BJ's Wholesale Club Inc., thanks in part to the firm's 9.5 percent toehold. But the firm has since dipped in and out of companies including Bed Bath & Beyond Inc. without pursuing an acquisition.

In-N-Out
Leonard Green & Partners took a Bed Bath & Beyond toehold stake but didn't pursue a buyout of the company, whose market capitalization has shrunk to $6 billion
Source: Bloomberg

Moreover, private equity firms aren't always nimble and stock declines can mean they get stuck for months, if not years, waiting for shares to rebound so they can at least break even. Right now, it's not looking good for San Francisco-based Golden Gate Capital LP which took a position in Ascena Retail Group Inc. over a year ago at an average of $12.84 apiece. With the retailer's shares now trading at roughly $4.88, it's sitting on a paper loss of around $140 million. 

Size Down
The decline in value of Golden Gate Capital's Ascena holdings illustrates how toehold stakes can go wrong
Source: Bloomberg, filings

While KKR has so far profited from its position in Marvell (it's tweaked its holdings over the past three years), it's certainly not being very proactive. Recently, the firm's been more of a seller than a buyer, indicating it may have retreated from the idea that it will buy the $6.7 billion chipmaker.

A KKR buyout of any of its other holdings would be a chance to prove that it's worth spending $1.35 billion on slugs of stock rather than investing that money in bread-and-butter transactions. Because after all, isn't it in the business of private -- not public -- equity? 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

(The story has been updated to clarify KKR's equity positions in the third paragraph and reflect KKR's profit on Marvell in the penultimate paragraph.)

  1. It likely took a loss on this position.

To contact the author of this story:
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net