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Merrill Gains From Hertz Bolster O'Neal's Buyout Push (Update1)
By Bradley Keoun
Nov. 17 (Bloomberg) -- Merrill Lynch & Co. more than doubled the value of its $800 million investment in Hertz Global Holdings Inc. in less than a year, bolstering Chief Executive Officer Stan O'Neal's decision to expand the firm's leveraged-buyout unit.
Earlier this week, Hertz, the world's largest rental-car company, raised $1.32 billion in an initial public offering that valued Merrill's shares at about $1.2 billion. Add to that the dividends that New York-based Merrill and buyout partners Clayton Dubilier & Rice Inc. and Carlyle Group paid themselves, and the value of Merrill's stake increased to about $1.6 billion.
Gains from takeovers such as Hertz and British department store Debenhams Plc may help Merrill narrow the gap with Goldman Sachs Group Inc., whose private-equity investments helped make it Wall Street's most profitable firm. O'Neal, 55, said in a speech this week that expanding in leveraged buyouts was a top priority for Merrill, the world's third-largest securities firm.
``With the huge turnaround that you can get on these deals, the operating margins are going to be substantial,'' said William Fitzpatrick, an analyst at Johnson Asset Management in Racine, Wisconsin, which oversees about $1.5 billion. ``That's going to jack up the return on equity, no question about it.''
Merrill spokeswoman Jessica Oppenheim declined to comment, citing a ``quiet period'' that restricts public statements following an IPO.
HCA Deal
Merrill's has participated in at least 12 buyouts since the firm returned to private equity in 2000 after a seven-year absence. In July, Merrill, Bain Capital LLC and Kohlberg Kravis Roberts & Co. agreed to buy hospital chain HCA Inc. of Nashville for $33 billion including debt in the largest LBO ever. The firms each put up about $1.5 billion of capital for the transaction, which was completed today.
LBO firms use a mix of cash from investors, their own capital and debt secured against the assets of their acquisition targets to finance deals. They typically seek to expand companies or improve performance before selling them within five years to other funds or in initial public offerings. Merrill differs from firms such as Washington-based Carlyle and New York-based Goldman because it doesn't raise buyout funds from outside investors.
Goldman's private-equity gains helped produce a return on equity, a gauge of profitability based on shareholders' equity, was 29.6 percent in the first nine months of the year. Merrill's was 19.7 percent. New York-based Morgan Stanley, which had a return on equity of 22.7 percent for the nine-month period, now plans to raise a buyout fund of its own after exiting the business in 2004.
Profitable and Cyclical
Private equity is highly profitable because the operating costs, mainly compensation, are lower than in many other businesses, said Jeff Harte, an analyst at Sandler O'Neill & Partners in Chicago, who rates Merrill shares ``buy'' and doesn't own them.
``It tends to be a pretty cyclical business,'' Harte said. ``During bad times you post losses, during good times you post pretty substantial gains.''
There's also a risk of investor or regulatory backlash. The U.S. Justice Department in investigating the buyout industry for possible antitrust behavior and a shareholder lawsuit filed Nov. 15 accused 13 private-equity investors, including the three Hertz partners, of conspiring illegally to hold down the prices they pay when taking companies private.
Pacific Investment Management Co. and Advantus Capital Management are among the bondholders who have criticized LBO firms for overloading the companies they buy with debt. More than 80 companies controlled by LBO firms have borrowed at the expense of workers and bond investors just so they can pay themselves dividends, according to data compiled by Bloomberg and Standard & Poor's.
LBO Boost
Merrill's buyout unit, led by Nathan Thorne, 52, a 22-year veteran of the firm with an English degree from Yale University, reaped $700 million in gains in the second quarter, according to estimates by Douglas Sipkin, a Wachovia Securities analyst in Charlotte, North Carolina. That helped Merrill beat analysts' revenue estimates by $623 million, or 8.3 percent, based on a Thomson Financial survey.
In the third quarter, private-equity gains were less than $350 million, estimates Fox-Pitt Kelton analyst David Trone in New York.
Merrill says on its Web site that it typically holds private-equity investments for three to seven years. In the Hertz case, it exited in 11 months.
More Debt
Ford Motor Co. sold Park Ridge, New Jersey-based Hertz to Merrill and its partners for $15 billion, including debt, after failing to take the company public on its own.
``They found the first big cash player to come along, and these guys were it,'' William Smith, who tracks initial stock sales as president of Renaissance Capital in Greenwich, Connecticut. ``The market has moved in their favor.''
Merrill, Carlyle and Clayton Dubilier paid themselves $1.26 billion in dividends after increasing Hertz's debt by 32 percent to $14 billion. Hertz's interest expenses in the first nine months of the year almost doubled to $672.6 million.
Hertz sold shares in the IPO at $15, lower than the $16 to $18 range targeted by the sale's underwriters, which included Merrill. The stock fell 7 cents to $15.65 yesterday in 10:28 a.m. composite trading on the New York Stock Exchange today.
``Private equity investors try and get a full price when they take a company public rather than leaving a lot of money on the table, and that $16 to $18 offer price range reflects that,'' said Jay Ritter, a professor at the University of Florida who analyzes IPOs. ``With the quick flip here, it still looks like a good investment.''