In the coming need to do homework, it is often good to read books about finance because they offer a summary and a perspective that you will not likely receive by reading the newspapers and blog posts. Recently picked up a book called King of Capital by David Carey and John Morris published by Crown Business, NY, 2012.

Leveraged buyouts are based around cash flow. The cash flow determines how much debt a company can afford to take on and thus what a buyer can afford to pay. Cash flow is the deal maker’s raw “show me the money” measure – the amount that remains after operating expenses are paid.

One way that buyout firms make profits is to use the cash flow to pay down the buyout debt. In the early day’s of industry, the models were formulated with the aim to pay every dollar of debt within 5 to 7 years. This was an average time of holding the shares and when the debt is repaid, the buyout firm reaped the benefits of the sale. A second way to generate a gain is to boost cash flow, through revenue increases, cost cuts or a combination. If a company has repaid its debts, the owners can reborrow against its cash flow and pay its owners a dividend. This is known as dividend recapitalization.

Sometimes private equity plays an important role in the health of a company. In the case of Safeway, when KKR bought it, KKR discovered Safeway’s executives had never scrutinized how it used its capital. whether its investments were paying off, or where it made money and lost money. KKR set to work on analyzing Safeway’s real estate to determine which properties were so marginal as grocery stores that the company was better off disposing of them. Often times in large organizations, they have many assets but not all them make sense where the industry is expected to head. They made sense looking backwards. In the Safeway example, KKR eventually brought the number of stores from 2,400 to 1,400 reducing the size from $20 billion in sales to $14 billion. However cash flow rose 250%, the company reduced its debt and planned expansion in profitable markets. KKR eventually made more than 50 times the money they put in over the 14 years of ownership.

There are wonderful stories about regional companies or medium sized companies growing to become national companies and they are many examples. However Blackstone has 3 rules. In a cyclical industry do not overpay. You never know when the top will be. Second if you buy a medium sized business do not have ambitious turnarounds. Third, if an investment calls for reengineering operations, do not have a Blackstone manufactured plan. Develop a plan with seasoned executives and consultants knowledgeable enough to judge if the plan will fly.

Leverage buyouts work well when the system works well, if there is a healthy IPO market; corporations strategic plans are fluid; access to bank loans and credit is low; institutional money wants to be involved in the alternative investments; ideally prices are rising. There are many variables and most will not always be in sync which is the reason smaller investors – capital preservation and not losing your money should be high on the list.

Linking to dividend paying stocks, there is always much to learn from reading about leveraged buyout firms but remember everything they touch does not make money. There are many variables and leverage buyout firms worry about risk management, however they need to risk more otherwise their investors will go elsewhere. As an investor, you can decide what not to do.

There are more questions than answers, till the next time – to raising questions.