`The Hottest Hand' In DealmakingMark Maremont
Thomas H. Lee's grin is as bright as the computer screen on his desk, which displays the stock price of Snapple Beverage Corp., a marketer of bottled iced tea and fruit drinks. The Boston financier took Snapple public in mid-December at $20 a share. The stock is now at 33. But Lee did even better than that. Last March, he and several investment funds he controls did a leveraged buyout of Snapple, paying just $1.76 a share for their stake. In just nine months, that $27.8 million investment has multiplied almost 19 times, to an astonishing $521 million. Lee's personal profit: nearly $100 million. "It's the blockbuster deal of the 1990s, so far," says Texas financier Richard E. Rainwater, a legendary buyout operator in his own right, who participated in a couple of Lee deals a few years ago.
The Snapple deal is the latest in a string of Lee successes. Another longtime Lee-controlled company, Autotote Systems Inc., was one of the top 10 gainers on the NASDAQ market last year. And Lee is preparing two more promising stock offerings. Says Rainwater: "For the moment, Tom Lee has the hottest hand in the business."
SMALL POTATOES. Lee's secret is that he focuses on midsize companies, such as Snapple, which offer huge growth potential--at a time when better-known LBO firms are suffering indigestion from the megacompanies they swallowed in the 1980s. "We think we have the best investment record in the country," says Lee. Many of his institutional investors would agree, having reaped huge returns from their equity stakes in Lee's deals. Among the institutional investors: Harvard, Yale, Eli Lilly, Prudential Insurance, Shell Oil, and Nynex. Success has brought the 48-year-old Harvard BA a net worth above $200 million, plus the trappings of wealth: a private jet, a mansion in Brookline, Mass., and one on Martha's Vineyard.
Unfortunately, the 70,000 individual investors who put almost $900 million into two of his LBO funds--sold with the help of Merrill Lynch & Co.--aren't faring as well from the Lee deals (table). That's because their money mostly went to purchase junk bonds to finance the buyouts, while Lee, and a select group of institutional investors, bought nothing but equity--and lots of it.
The two funds were so-called mezzanine funds. In a typical $100 million LBO of the late 1980s, the equity holders would put up $10 million of the purchase price and would borrow an additional $50 million from banks. The other $40 million was funded by issuing high-yield subordinated debt--junk bonds. A mezzanine fund was a hybrid: It would buy the junk bonds and would also get a small slice of the equity pie. In theory, that gave mezzanine funds a high yield as well as a chance to grab equity gains.
Trouble was, given the thin equity cushions of late 1980s deals, junk bonds tended to get wiped out if a company went sour. But mezzanine funds like Lee's didn't get enough of the tasty equity pie in successful deals to make up for those flops. In other words, these funds got the worst of both worlds: the high risks of equity and the low returns of bonds. As an equity investor, Lee also lost his money in the deals that bombed. But he more than made up for that with huge equity gains on several winners.
Consider Snapple. In the buyout last March, Lee and his institutional investors purchased $22.8 million in stock and then saw their stake soar in the boffo public offering. His public mezzanine investors, however, got only $5 million in Snapple stock, purchased $24 million in bonds, and provided another $24 million in temporary "bridge-loan" debt. The debt got repaid from the proceeds of the public offering. In the end, the individual investors nearly doubled their $53 million investment ($48 million of it debt)--a good return, except when compared with Lee's nineteenfold gain.
DEAL FRENZY. Despite some big gains, the two funds have had only spotty success. ML-Lee Acquisition Fund I, founded in 1987, invested in a series of duds. The main reason: At the time the fund was launched, deal mania had reached such a frenzy that many LBOs were overpriced and overleveraged. One such disaster was Diet Center Inc., a chain of weight-loss clinics on which Fund I has taken a $54.5 million write-down. Lee also lost money on it.
In public filings, Fund I is shown as having no net gain for investors over five years, while the three-year-old Fund II is showing just a slight gain. But Lee says that's misleading, since the filings do not show unrealized gains on sever-al investments. Using internal Lee Co. estimates, which are generous to Lee, BUSINESS WEEK has calculated an estimated current value for both funds (table). They show Fund I with a still paltry 2.5% annual yield and Fund II with a more respectable 14% annual return. But contrast that with the estimated yields Lee and his institutional investors have earned by taking equity in exactly the same set of deals: 47% on Fund I deals, an eye-popping 470% on Fund II.
There is no evidence that Lee has done anything illegal or unethical. The terms of the partnerships' investments, which are similar to those of other LBO mezzanine funds, were fully disclosed to investors. Still, the partnership interests were sold during a time of frequent press reports of huge profits from LBO deals. Perhaps encouraged by brokers, unsophisticated investors may well have expected much larger returns than they received and may not have appreciated how little they would share in the hottest successes. Says Steven P. Galante, editor of newsletter Private Equity Analyst: "The individual investor doesn't have the savvy of the institutions, or the negotiating clout."
LBO funds in which the general public could invest were a rarity. ML-Lee I was the first one. In sales documents, Merrill billed the funds asan "unprecedented" chance for "individual investors . . . to participate in the high-yield debt and equity returns long associated with financing . . . leveraged acquisitions and recapitalizations." Prospectuses pegged the return goal of the individual transactions to Merrill's high-yield debt index, which in the late 1980s hovered between 12.5% and 14.5%, plus an additional 7 1/2 percentage points, for a total yield of over 20%.
To Lee, the disappointing results are regrettable, especially Fund I's, but temporary. Says Lee: "We never suggested this was anything other than a risky investment." Several of the troubled companies in the portfolio have been restructured, he says. Along with Merrill, he predicts that Fund I "will have a positive record when we're all through" and that Fund II could be a big winner, thanks to Snapple-like stock offerings. He and Merrill disagree with complaints from retail investors that they got only the pokey debt end of the deals, while Lee feasted on the equity. Fund investors "bought a different investment" than Lee did, says Merrill Managing Director Kevin K. Albert.
Investor ire has sparked a nasty class action, led by two Fund II investors. Their main complaint revolves around the fund's first and biggest investment: $48.5 million worth of junk bonds in Hills Department Stores Inc., a Canton (Mass.) discount retailer. Ten months later, in February, 1991, Hills filed for Chapter 11. Says plaintiff William Seidel, a retiree from Vermilion, Ohio, who invested $10,000: "Merrill Lynch played the fund up as a tremendous investment, almost a sure thing. It's a lot different from what's coming out."
Among other things, the suit charges that Lee had a strong personal interest in shoring up Hills. The company was founded by Lee's grandfather, and Lee had taken it private in a 1985 LBO. Lee personally owned 18% of Hills's stock when Fund II invested. Lee denies any impropriety in the Hills deal: "Hills had a strong underlying operating profit. We were investing for the upside, not as a bailout." He says the U. S. retail climate chilled after the Iraqi invasion of Kuwait in August, 1990. "Nobody could have predicted what happened."
Lee's LBO experience started early, soon after he left a fast-track career at Bank of Boston Corp. in 1974 to buy small, troubled companies and turn them around cheaply. Lacking much money of his own, Lee borrowed to acquire most of the equity for his early deals. And he plowed nearly all of his gains into subsequent buys. Today, he's one of the few LBO operators who put a big portion of their personal wealth on the line. In 1982, he and his partners made a splash with Guilford Industries Inc. Lee took it public, eventually reaping a $30 million profit. It was, he recalls, "the deal that put us on the map."
CAPTIVE SOURCE. That was enough to attract Merrill and its institutional clients. The big securities house raised a $50 million LBO equity fund for Lee to manage. Lee matched it with $15 million of his own money. In 1985, chafing under constraints he felt from his partners, Lee split to set up his own LBO shop. Merrill approached him with the ML-Lee funds idea. They raised $492 million for the first fund and $400 million for ML-Lee II.
This captive source of funds has proved a huge advantage for Lee. While most buyout firms have to raise debt money to complete deals, Lee could often move more quickly than competitors by approaching a seller with the financing in place.
But the arrangement involved a potential conflict of interest. In structuring a deal, for example, Lee, as an equity investor, might skew the terms to suit his interests over those of the Fund I or II investors. While institutional money managers would probably spot the bias, individual investors would likely be oblivious. To deal with the issue, Lee and Merrill worked out safeguards for public investors with the Securities & Exchange Commission. The most important was the addition of three independent general partners who would supervise the funds and approve any out-of-the-ordinary deals. One of them is Vernon R. Alden, former chairman of Boston Co. and also a director of McGraw-Hill Inc., publisher of BUSINESS WEEK.
Such conflicts are hard to sort out, but fee income surely isn't. Lee's has been princely. The fees allow him to run a lavishly furnished office in one of Boston's premier buildings. But most important, the fees flow so freely that there's money left over for Lee and his partners to use as equity in deals. Hence, the LBO-fund investors, in effect, are providing not only the debt for Lee's deals but even some of his equity--free of charge. Pressed on the point, Lee at first denies that any of his equity comes from fees, then concedes it's "10% or 20%." A rival LBO fund head likens this to "a money machine," saying "it points to an enormous misalignment of interest" between Lee and the ML-Lee investors.
The fee structure is handsome. Merrill got about $55 million for marketing the funds. And as the funds' manager, Thomas H. Lee Co.--of which Lee owns about two-thirds--gets an annual management fee of 1% of the total assets, not including a 0.45% administration fee. Although 1% sounds small, with $850 million under management, it adds up. Plus, Lee's firm gets 20% of all profits if the fund surpasses a 10% return in a given year, which Fund I did several times early on. To date, Lee's company has raked in almost $65 million in such fees.
FAMILY AFFAIR. That's not all. Lee's firm gets a closing fee of $200,000 to $1 million or more when it buys a company and annual "monitoring" fees averaging $200,000 for running each company in the portfolio. Multiply that by two dozen deals, and you're talking real money. True, these fees are similar to those of other funds, although fees have fallen lately. Some feel LBO funds are too generous anyway.
Yet give Lee credit. He is a long-term player. Despite troubles at many companies he acquired in the late '80s, Lee didn't cut and run as some LBO operators did. Albert L. Prillaman, CEO of Stanley Furniture Co., based in Stanleytown, Va., says the furniture-industry recession put Stanley into a tailspin soon after Lee's firm acquired it. "But," he says, "they supported us with the banks and with additional investments" to help overhaul operations.
It may have been this predilection to support his companies that led Lee into the Hills Department Stores debacle. Lee's grandfather, Robert W. Schiff, had started a chain of Columbus (Ohio) shoe stores that eventually merged with Hills in the early 1960s. In 1985, when Lee's uncle was chairman of the company, Lee got involved. He and management took the company private in a $646 million LBO, then later took Hills public again.
But by early 1990, Hills needed new investment. It had made a big acquisition and faced a deadline for repaying some of the buyout debt. Its stock had sunk from a high of $10.75 in early 1988 to $4 in late 1989. Critics say Lee found it difficult to separate his emotional ties to Hills from his business sense, a charge Lee strongly denies. In any case, Hills raised about $50 million each from ML-Lee II and Westinghouse Credit Corp. in the form of junior subordinated debt--near the bottom of the payback pile in case of default.
Lee says the decision by Westinghouse to invest on the same terms shows that the ML-Lee fund was getting a fair shake. He also points out that the investment was approved by the fund's three independent directors. Says one of them, Joseph L. Bower, a Harvard business school professor: "There was complete disclosure of everything." The investment in Hills, he says, "was very thoroughly discussed."
Still, some wonder if Lee was wise to have the public fund invest in a company he personally controlled. "In this business, people like Lee face this sort of potential conflict all the time," says James H. Reinhardt, managing director at pension-fund adviser Pathway Capital Management in Los Angeles. "Most decide they don't want the headache."
DAZZLING GAINS. One group of investors has no complaints: the big institutions that put money into a $468 million equity fund Lee and Merrill raised in late 1989 and early 1990. They joined Lee in taking sizable equity positions in Snapple--and reaped immense gains. "The things he has in the new fund are off to a very good start," says Fred Ruebeck, director of investments administration at Eli Lilly & Co. Lee's own calculations show that the $150 million already committed from the equity fund has more than quadrupled in value.
Nor does Merrill have any complaints about the mutually profitable relationship with Lee. Again, take the Snapple deal. When Snapple's co-founders decided to sell, they hired Merrill to represent them. After the LBO auction in March, Lee emerged with the prize. Merrill's fee on the transaction: $2.7 million. Nine months later, when Lee decided to float Snapple to the public, Merrill was the lead underwriter, garnering an estimated $3 million in fees. The firm defends the fees as normal.
Lee thinks the current climate for LBOs is very favorable: low interest rates, a resurgent junk market, and plenty of companies for sale. He predicts a bumper series of deals. But most of the ML-Lee fund money has already been spent. As before, the ML-Lee investors are likely to get only scraps from the feast.