Return of the Corporate Raiders

Burger King is supposed to represent the best of what private equity has to offer. Unfortunately, it also represents the worst.

For the uninitiated: Burger King was acquired in 2002 by Bain Capital, Goldman Sachs Capital Partners and Texas Pacific Group. The transaction was valued at around $1.5 billion, including just $300 million in equity. If this sounds surprisingly low for the world’s number two patty flipper, that’s because it was.

Burger King had been sagging under the umbrella of UK beverage giant Diageo PLC, but still managed to get a $2.6 billion bid from Bain/GS/TPG in July 2002. This would have valued BK at 7x EBITDA. Soon after, however, the overall fast-food market took a nosedive – many blamed increased competition – and the consortium withdrew its offer. The two sides spent several months renegotiating, and eventually agreed on the $1.5 billion price, which shaved the EBIDTA multiple to just 5x.

Fast forward a few years and Burger King seemed revived. It still wasn’t close to overcoming the clown, but nonetheless was able to generate increased sales for seven consecutive quarters. It also settled on a well-received advertising campaign -- the BK Mascot ones, not the absurd flowering burger ad from the Super Bowl. By February of this year, the company was stable enough to file for a $400 million IPO.

Some felt that the offering would be sidetracked by the surprise resignation of CEO Greg Brenneman, but it nonetheless priced in May at the top of its range, generating approximately $425 million and valuing the company at around $2.25 billion. Bain, GS and TPG took what seemed to be well-deserved bows. Bain even had the BK mascot show up at its most recently LP meeting (sans Brooke Burke).

But all of this was masking the unfortunate fact that Bain/GS/TPG were stripping the company of cash, and shareholders of value. I’m not suggesting Refco-like fraud here, but rather a completely-transparent, one-time $30 million management termination fee paid by Burger King to its LBO backers on the day of IPO. Most people didn’t pay too much attention, until the company reported its first post-IPO earnings earlier this week. As the Associated Press wrote:

In its first earnings report since going public, Burger King Holdings Inc., the world's No. 2 hamburger chain, on Tuesday said it swung to a loss in its fiscal fourth quarter profit because of a one-time fee associated with its IPO.

What should make this so perplexing to regular shareholders is that while Burger King’s balance sheet went from black to red, its sales actually increased. Perhaps it could have supplemented the termination fee with some of its IPO proceeds, but the vast majority of those were used to pay off a dividend to… the private equity investors. In other words, the only shareholders making money were the private equity backers. Everyone else was getting slammed.

It’s not supposed to be this way. Private equity firms are supposed to identify underperforming companies, right the ship and then make money off the fruits of that revival. Interests are supposed to be aligned. Instead, the new standard is to buy a company, return the original investment via financial engineering and then generate additional profit at the expense of shareholder value. It is unconscionable. It also is the next generation of corporate raidering.

Before you jump all over me, I recognize that Bain/GS/TPG did not engage in a 1980's-style hostile takeover of Burger King. That's why this is the next generation, and it is far more devious. Private equity firms now ingratiate themselves with company management/founders, become controlling shareholders and then pay themselves to give up said management control. This has been going on for years, but only now are public investors beginning to realize that the game is fixed. Need proof? Aftermarket performance of LBO-backed IPOs is worse than for the IPO market at large, which is really saying something in 2006.

Let me be clear: There is no valid justification for management termination fees, and private equity firms should immediately stop inserting them into IPO documents.

Bain, GS and TPG would have made money on Burger King even without the management termination fee (and without the dividend). They paid a combined $300 million for their stake, which was worth about five times that at the time of IPO. These firms like to brag about how they are able to turn companies around, and they often manage to do just that. It just seems that they aren’t confident enough to stop hedging their bets.