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September 1, 2007

Private Equity’s Plunder

Private equity has been a significant player in the metals industry's M&A boom. Some companies have prospered, but greed and a reluctance to reinvest in the business may threaten the long-term outlook.

So there are limits, after all, on what private equity can do. For a while there, it seemed as though the private equity operators, with billions of dollars to invest, were invincible—almost like forces of financial nature. Certainly, when Platinum Equity LLC of Beverly Hills, California, emerged in July with a deal to buy North America’s largest service center operation, Ryerson Inc., the image of moneyed behemoths striding effortlessly across the metals landscape was reinforced.

But that’s far from the whole story. Private equity has compiled, at best, a mixed record as a metals proprietor. Impatient for fast, very large returns, many of the new private owners have larded on debt, which could weigh heavily when the next downturn arrives. While competitors are sinking profits back into the business, private equity outfits have used their new holdings to line their own pockets while putting their operations at long-term financial jeopardy. Now, even the get-rich-quick crowd is beginning to wonder whether some deals proposed by private equity managements can be justified.

In June, potential investors balked at the terms when a Metals USA recapitalization proposed to send a $150 million dividend to owner Apollo Management LLP and its primary investors while adding to Metals USA’s debt load by 18%. The recapitalization went ahead in mid-July, although investors required a higher yield on their investment.

The original investors in Apollo’s ownership of Metals USA have essentially already doubled their money. They have earned $325 million in dividends on their equity investment of about $140 million. Apollo purchased Metals USA in May 2005 for $22 a share, or $447 million in cash and debt. Still to come, if this situation follows the normal course, are the proceeds of Metals USA’s eventual sale or, perhaps, initial public offering of stock.

Sounds good for those original investors, doesn’t it? But Standard & Poor’s Ratings Services in June lowered its rating on Metals USA debt—already speculative grade or junk—to “B-” from “B.” The ratings agency noted that borrowings were a “very aggressive” six times trailing EBITDA (earnings before interest, taxes and depreciation). The ratio for most publicly held service centers is generally no more than two times EBITDA. Moody’s Investors Service, in a July report, raised concerns about the influence of private equity in general. Moody’s said recent buyouts in industries with high capital requirements, competition or cyclicality have increased risk.

“Even if the industry stays strong, over time, if you’re pulling all the money out and not reinvesting in the company in terms of ongoing operations, you’re going to fall behind the competition,” says Richard T. Marabito, chief financial officer of Olympic Steel Inc. in Bedford Heights, Ohio, who was commenting generally about the private buyout scene, and not about any particular transaction or company (see “Great Expectations”).

Adds Matthew Rhodes-Kropf, professor of finance at Columbia University Graduate School of Business in New York, “These are the easiest guys to hate in the world. They are getting rich while they are firing people.” However, he suggests that in return for quick riches, private equity performs a valuable economic service by turning around, shutting down or divesting otherwise marginal businesses. It remains to be seen, of course, the extent to which private equity—again in general— will render a service to the metals industry.

MEETING RESISTANCE

Leveraged buyouts have accounted for 18% of new corporate bonds issued so far this year, up from 5% between 2003 and 2004, Moody’s reports. For much of the past year, private equity companies could still call their own refinancing shots, despite using such devices as payment-in-kind (PIK) toggle notes, which enable borrowers to postpone interest payments, and elimination of conventional covenants that establish protections for second-tier lenders, such as ratios for cash to EBITDA.

But the more recent balance of power has shifted to lenders, who have begun to insist on conventional terms, leading to higher long-term interest rates and eventually lower potential returns for sponsors. Rhodes- Kropf estimates private equity borrowers could easily be paying premiums of 100 basis points as compared to interest rates paid on new debt several months earlier.

Daniel Pryor, managing director of Washington, D.C.-based The Carlyle Group, which owns Cleveland-based welded pipe maker John Maneely Co., says the current skepticism by investors is a market correction. He notes that as of mid-summer, maintenance covenants were being returned to deals. In addition, it became far more costly to secure the right to postpone interest payments.

“New deals will cost borrowers more money,” he says.

Adds Effram Kaplan, vice president of Cleveland investment banking firm Brown Gibbons Lang & Co., “Funds have to put more equity into deals. There are so many funds that there will be a fallout of those that are not getting [a sufficient] return.”

NOT SO NEW

Private equity isn’t entirely new to the metals industry. New York-based Kelso & Co. acquired Earle M. Jorgensen Co. in 1990 and held it for 15 years in an unusually long turnaround before taking the service center company public in April 2005. The company had improved sales and profitability under CEO Maurice S. “Sandy” Nelson Jr., but the initial public offering (IPO) was undersubscribed. EMJ was acquired by Reliance Steel & Aluminum Co. in April 2006.

Metals companies have flashed on the radar screens of private equity acquirers more consistently since the industry upturn of 2004 because they have produced reliable earnings and offer tangible assets that can be used to back loans. Service centers are attractive targets because their assets are liquid, says Jonathan Rose, who specializes in metals and mining at UBS Investment Bank in New York.

The investment time frame for private equity investors typically is three to five years. That’s traditionally been thought to be the time required to make the acquired business more efficient, less costly and more attractive to subsequent buyers. But Metals USA filed for an IPO less than a year after it was acquired by Apollo. Atlanta-based service center PNA Group Holdings Corp. filed for an IPO in April, less than a year after its acquisition by Los Angeles-based Platinum Equity. Neither offering has come to market.

Even in typical buyouts, the payoffs can be substantial. Most funds expect returns of at least 30% annually, and some earn multiples on their investments. The payoffs are big because the risks are big, which is why only large pension funds and wealthy investors play the game.

DIVIDENDS AND MORE DIVIDENDS

The use of debt to pay for enormous dividends is certainly one of the most questionable of the aggressive new practices.

For example, Apollo financed its May 2005 buyout of Metals USA with a $140 million investment (before fees paid back to itself), a $450 million asset-based loan backed by inventory and accounts receivable, and a $275 million private placement, Securities and Exchange Commission (SEC) filings show, representing an equity stake of less than 20%.

In December 2006, Metals USA floated a note to finance a $150 million special dividend to Apollo. Then six months later, it announced a recapitalization of $300 million that includes a second $150 million dividend, with the balance to retire previous notes.

Including an earlier $25 million dividend paid in 2006, Apollo’s investors stand to earn an estimated $325 million, or a 130% return on their investment (before fees and expenses) even before taking Metals USA public. If Metals USA went bust tomorrow, investors would come out fine—not so the company’s estimated 2,900 employees, its 18,500 customers or its second-tier lenders.

The Metals USA recapitalization hit a chilly market in June as investors objected to the use of terms such as toggle notes, especially to fund dividends.

The $150 million increase in debt, or an increase in total debt of 18%, was a concern for Standard & Poor’s analyst Marie Shmaruk, who cited in the June report “our concerns about end-market demand and the timing of the issuance.” She added, “We view Apollo’s releveraging of the company within six months of its last special dividend as an aggressive financial policy that did not allow for a meaningful debt reduction.”

The concern is understandable. After all, Metals USA filed for Chapter 11 reorganization in November 2001 with less total debt, around $480 million, compared with $601.3 million at the end of the second quarter. Apollo and Metals USA executives did not return phone calls seeking comment.

FINANCIAL EXPERTISE AND CONSOLIDATION

Private equity acquisitions do benefit at least a few people other than the original investors. For example, family owners find it far easier to sell in an up-market characterized by the unusual liquidity private equity helps make possible. To the extent that consolidation is good for the metals industry, private equity can help make more consolidation possible.

For example, Platinum Equity purchased Houstonbased Metals Supply Co. in June 2006, only a month after it acquired PNA, which includes Chicago-based Feralloy Corp., Houston-based Delta Steel L.P. and Atlanta-based Infra-Metals. Metals USA spent more than $50 million on two acquisitions last year, including the assets of Tulsa, Oklahoma-based processor Port City Metal Services Inc. and Ontario-based Dura-Loc Roofing Systems Ltd., a producer of metal roofing products, an SEC filing shows. In July, it acquired New Jersey-based aluminum distributor Lynch Metals Inc. for an undisclosed amount.

Carlyle has served as a consolidator of the tube market with its $568 million takeover of Maneely, which owned Pennsylvania-based Wheatland Tube Co. and Seminole Tubular Products Co. of Ohio. Maneely subsequently acquired Ontario-based Atlas Tube Inc., a maker of structural tube, and Sharon, Pennsylvania-based Sharon Tube Co., which produces welded steel pipe, mechanical tubing and seamless pressure pipe.

The bigger bang of consolidation could come when the current generation of private equity owners unwinds its investments under the typical three- to five-year time frame.

Supporters of private equity purchasing note that financial buyers are more willing than strategic acquirers to purchase companies that are in precarious financial condition—that’s how they make such big returns.

“They’ve generally shown an appetite to commit when no one else would,” says James Moss, a partner with First River Consulting in Pittsburgh. “On the whole, they’ve maintained the assets and improved them and moved them on to strategic owners.”

Rhodes-Kropf of Columbia University says private equity earns its returns by tackling the tough problems at troubled companies—what he calls the “buggy whip-makers of the world”—that conventional companies would otherwise shun.

“No one wants to be the guy that says, ‘Let’s liquidate this and go home,’” he says. “Someone is going to make money, while another loses [his] job.”

What’s more, private equity owners are nothing if not financially disciplined, eager to put into effect high-return efficiencies that family owners might find distasteful, such as layoffs of excess staff, inventory reductions, sales of underperforming assets or other steps. Private ownership shields the company from the glare of the public markets, which is helpful if it is in the midst of a turnaround.

Pryor says Carlyle’s expertise in lean manufacturing, gained from its ownership of dozens of companies in aerospace and defense, automotive, energy and heavy industry, enabled it to reduce working capital tied up in inventory and improve operating cash flow at John Maneely. That, in turn, permitted Maneely to pay off 25% of its debt in the first six months as the company generated approximately 60% more cash than it committed to its lenders for that period. “There was a lot of money tied up in stuff that was not adding value,” he says, referring to raw material and finished goods.

Moreover, Maneely has been better able to attract top talent because of the Carlyle name, the opportunity of new incoming managers to earn equity and the larger business platform. The company, largely through acquisitions, has grown to $2.2 billion from $800 million at the time of the buyout in March 2006. Pryor points to the recent hire of Michael Mechley as vice president of procurement for Maneely operations. Mechley was previously manager of closed die forgings at General Electric Co.’s aircraft engine division in Cincinnati.

Mechley confirms that he wouldn’t have been attracted to Maneely without Carlyle’s expertise and staying power. “With the Carlyle ownership, this will be a stronger company,” he says.

Smaller private equity owners say they add value as well. Denver-based Republic Financial Corp.—which in January acquired a controlling interest in Ohio-based Clinton Aluminum & Stainless Steel Sales—says it brings a different perspective to hiring decisions. For example, Clinton plans to hire a full-time purchasing manager for the first time. Previously, the purchasing representative also handled sales. “The sales guy wanted to buy as much as he could,” says Paul Morrison, managing director at Republic. “The [dedicated] purchasing person should be more disciplined and careful about over-buying.” With the sales person able to spend all of his time selling, Morrison expects benefits to be “in the millions.”

Morrison says Republic expects to help manage inventories more closely at Clinton to help avoid the wide swings that often plague the industry at times of shifting demand. “We'll move them down quickly if the market softens,” he says.

GROWING SKEPTICISM

Investor skepticism will likely slow private equity’s momentum, particularly if the metals industry enters a cyclical downturn. Moody’s recent report questions whether the higher returns provided to private equity are driven by stronger management teams or merely the use of leverage.

“Of concern to Moody’s is the willingness of private equity firms to issue special dividends despite commitments to reduce leverage, sometimes within 12 months of the transaction’s closing,” the rating service says in its report.

Pryor defends the use of dividends as merely another way to return money to investors, although he adds that Carlyle has not paid itself dividends from Maneely.

The use of borrowing is appropriate, he says, because lenders require companies to use excess cash to pay down debt rather than distribute it as dividends. So the only way to distribute dividends is to recapitalize the company and effectively pay out the accumulated cash at one time rather than distribute it over a longer period.

The beneficiaries in private equity buyouts aren’t fat cats, he asserts, but are often university endowments and large pension funds or other institutions that invest the savings of public employees and other working people.

“We’re not sitting here smoking cigars,” he says.