What Lies Beneath

Private-equity firms know how to make companies look good. But this buyer knows how to look more closely.
Roy HarrisDecember 1, 2006

Like lots of active acquirers,
Leggett & Platt Inc. often deals with private-equity
sellers as it seeks targets in its “sweet spot”
between $20 million and $40 million in revenues.
But despite an abundance of candidates
in private-equity (PE) portfolios, finding a good
opportunity is far from easy for this manufacturer
of components for bedding, furniture, and
consumer products.

“By the time the PE firms are ready to sell a
portfolio company, they’ve deleveraged the balance
sheet somewhat by milking cash flow, and
often neglected the necessary long-term investments
to keep it competitive,” says Leggett CFO
Matt Flanigan. Not only that, but the private
owners are adept at hiding the weaknesses of
the outfits they offer for sale. “We work hard to
be sensitive to the fact that some PE sellers are putting
lipstick on a pig,” he says.

Based in Carthage, Missouri, Leggett displays a
decided “show me” mentality when it comes to picking
and choosing among available deals — especially with
financial sellers. When studying PE-owned candidates,
the company, which has become a $6 billion powerhouse
on the heels of 160 acquisitions over the past decade,
focuses on the implications of higher leverage. Specifically,
it examines to what degree managers are geared to
short-term results, thereby alienating the company’s customer
base. Only if Leggett is confident that the private
owners have done well by customers will it consider
making an offer.

Checking the Plumbing

With private equity such a huge factor in mergers and
acquisitions — it now accounts for about a quarter of
overall U.S. deal values as they approach 1998’s record
$1.63 trillion, according to Thomson Financial and
Robert W. Baird & Co. — questions about the quality of
the companies being shopped are more relevant than
ever. On one hand, executives like Flanigan often find
operational flaws beneath the surface. Yet PE firms and
the academics who study them tend to view the assets
being sold as relatively healthy, especially as measured
by cash flow and other financial measures.

In a recent study of one particular type of private-equity
exit strategy — initial public offerings — Harvard
Business School professor Josh Lerner and Jerry Cao of
Boston College found that such IPOs outperform the
market generally in “economically and statistically meaningful” ways. Higher leverage among IPO
companies coming out of private equity,
the study found, did not lead to poorer
performance but, rather, just the opposite.

“That was the big surprise,” says Lerner,
who acknowledges that “there are a lot
of reverse LBO companies that have gone
public over the years, and some people fixate
on certain cases.” In actuality, however,
he believes buyers often prepare themselves
for hefty debt and related shortcomings
stemming from a target’s PE roots, and
somehow overcome the disadvantages.

“It’s like buying an older house,” Lerner
says. “You see it’s got all these problems
with plumbing and wiring, and presumably
you’ll be more careful when you buy.”

Careful has been Leggett’s watchword
in dealing with PE sellers. So far, such
deals account for fewer than 10 percent of
Leggett’s acquisitions. The company
prefers to buy from entrepreneurs who
know their companies inside-out and
often accept performance-based earnouts
as part of the price.

Few entrepreneurial companies are
highly leveraged, but the entities being
sold by private-equity owners often are.
“Leverage is a ticking time bomb that you
need to make sure doesn’t go off,” says
Flanigan, noting that extracting cash from
a business to make interest payments can
hurt long-term growth.

Management teams installed by PE
owners can also pose a challenge. Rarely
will a firm’s founders wittingly alienate customers.
But Flanigan often sees managers
choosing cash production over customer
needs. “One way to get cash out of the system
is to reduce days outstanding on
receivables, or to stretch their vendor
base,” he notes. “An entrepreneur may be
willing to keep cash tied up in inventory in
order to serve customers. If long-standing
customers take longer to pay, he may say,
‘That’s fine.’ But if you put that same issue
before managers dealing in a leveraged
environment, they’ll say, ‘No, we want to
get that payment as soon as we can.’”

Managers of PE-owned assets may
make them look good on paper — part of
the porcine “lipstick,” in Flanigan’s view. After all, the combination of low working
capital and high leverage instantly
improves returns on equity. But numbers
ginned up by managers this way can be
deceiving. “They have been well schooled
in generating that absolute maximum
amount of cash flow, which is certainly a
shareholder value–creating priority,” he
says. “Over time, though, they may be prevented
from making good growth bets.”
Sometimes he finds disgruntled employees,
equipment worn out for lack of
investment, and a flagging reputation.

Absorbing Sponge Cushion

A Leggett acquisition earlier this year,
Morris, Illinois-based Sponge Cushion
Inc., a maker of rubber carpet padding,
illustrates the cautious approach described
by Flanigan and CEO David Haffner when
considering PE-owned targets. Sponge
Cushion, with $50 million in annual sales,
had been starved for growth capital by its
UK-based owner, which Leggett declines
to identify. Being “basically cash-generation-optimized,” as Flanigan puts it, the target needed a capital infusion to remodel and expand operations to correct the previous owner’s approach.

Debt was originally 80 percent of capitalization,
about six times operating cash
flow. But Leggett’s due diligence revealed
an unusually strong management that
seemed comfortable with Leggett’s
longer-term horizons. While no original
entrepreneurs were on the team, many
managers had worked for two previous
owners and ran the business well. “We
don’t typically buy turnaround situations;
it’s not our forte,” Flanigan says.

Leggett was so enthused that it entered
an auction for Sponge Cushion, eventually
paying a “market-based price” that likely
exceeded what a negotiated deal would
have arrived at, concedes Flanigan. But the
target’s rubber-cushion carpet padding
“was our final piece of the puzzle,” he says.
Because the deal extends Leggett’s carpet-related
product line, the company expects
it to yield a competitive advantage.

The Sponge Cushion purchase presents
another potential advantage: giving
Leggett more experience dealing with private-equity sellers. “As they sell smaller
properties, and as we buy bigger companies,
we’ll be seeing many more of these
kinds of deals,” the CFO says.

Roy Harris is a senior editor at CFO.

Hide & Seek

Some Leggett & Platt concerns
about private-equity targets.

The company starves facility
upgrades and R&D.

Steep cash interest payments
hamstring company finances.

Managers favor short-term
strategies and don’t understand
operations well.

Morale is low because of managers’
attitudes and lack of investment.

Customers are antagonized by
low inventories and stingy policies.

Source: Leggett & Platt CFO Matt Flanigan

Blame It on the Froth?

Some private-equity firms recoil at accusations that they dress up ailing entities
before selling them. Others tend to agree.

“There’s validity there; it’s a reflection of the markets,” says Mitchell Hollin, a
partner with Philadelphia-based LLR Partners, which has $620 million under management.
PE players are “pretty savvy about how to maximize value, and in frothy markets
they can get away with it because IPO investors and buyers let them do it.”

LLR is different, he says, in part because there’s low leverage in its portfolio. Also, LLR retains hefty interests in companies it takes public. “We’re not smart
enough to bet on a new industry or new platform, as well as a new management
team,” he says, chuckling. “And we’re not willing to double down on that strategy.”
LLR also tends to keep legacy management teams in place. “It’s a huge red flag if a
PE investor is going to sell most of its interest,” according to Hollin. — R.H.