The private equity (PE) firm KKR is seeking to buyout Walgreens in a huge leveraged buyout deal. Let’s look at how leveraged buyouts and PE firms work. Understanding the drug store business is also important since the business has significantly evolved over the last 30 years.
If you're unfamiliar with leveraged buyout deals, this is essentially what it is.
- KR wants to borrow most of the money from bond investors to finance the deal. While higher levels of debt are a smart way to increase returns when interest rates are so low, excess borrowing is putting the debt buyer’s “return of capital” at risk. A bond investor always wants both a return ON capital, as well as, a return OF capital. Otherwise, those bond investors would be investing in equity.
- KKR will have very little equity (financial ownership) in the deal, but they will have complete control over Walgreens entire operations. This is similar to buying a home, but borrowing over 95% of purchase price. Remember what happened to homeowners who did the same thing in the housing crisis. While the mortgage companies and the banks made great returns, the debt holder (home owner) took the brunt when the loans could not be paid. If anything happens that puts the debt service payment at risk (think not being able to make the mortgage payment), there is a high risk of the firm going bankrupt. This is essentially what happened with Toys-R-Us and many other firms.
- With complete control, KKR wants to have the absolute least amount of their money in buying the equity. Since they will have complete control of the entire operations, the least amount of money they have invested the better for KKR. And, if it does go bankrupt, they will not have a significant exposure to loss. They would take the loss on their equity investment, but everyone else would suffer much greater losses - think employees, management, and suppliers. As a consumer, there will be less choices for buying drugs. Economics tells us that limited suppliers will result in higher costs to everyone.
- While the loan KKR is trying to float would be KKR's loan by legal definition, the loan will, in essence, be Walgreen's responsibility. The deal will be legally structured to keep KKR having the least responsibility as possible for the repayment of the debt. While that seems odd, this is how leveraged buyouts are structured. The PE partners and the banks who float the loans will usually walk away with huge returns even if the deal goes belly up.
- KKR will then proceed to squeeze every financial resource from Walgreen's operations. This will begin with cutting back on employees and management. They will cut the remaining employees' salaries, and close stores. In essence, Walgreens would be run on a bare-bones basis. Retail drug stores are known for being a high cash flow business. That is a significant advantage in paying debt down at a fast rate which means a faster turnaround for the KKR.
- The PE firm will minimize continuing capital expenditures in the company being bought out. Growing firms need continuing capital expenditures to expand and grow their businesses. The PE firm’s interest is short-term, so their interest is to use the buyout firm’s cash flow to quickly pay down the debt, allow the PE firm to achieve very high returns on a relatively small equity ownership and get out of the deal before it becomes obvious the buyout firm’s value is being decimated.
The argument for private equity is that public firms are often bloated in their cost structures. This is true, but private equity takes the firm the extreme opposite direction and makes the firm so tightly run that employees bear the brunt of excessive cost control. Good employees or those who can leave, will leave the organization. For the employees who are left at the firm, the motivation to work at the firm will be diminished.
People not working at the firm may say that the costs should be cut. I agree that costs should be kept under control, but like anything in life, the answer is somewhere in the middle. If the organization is squeezed too tightly, a lot of bad things will happen. It will significantly diminish motivation of those who work there. Employees will cease to communicate with others in the interest of preserving their own jobs versus building up the organization. Outsiders may feel this is all good and well until they themselves are subject the draconian environment instilled by PE firms in their never ending quest to enrich themselves. You only have to ask a friend who has been employed by a firm that has been bought out in a leveraged buyout.
The drug store business has consolidated over the last 30 years. The mom and pop pharmacies were bought out by the big players to increase financial efficiency and create economies of scale. This resulted in three major players surviving - CVS, Walgreens and Rite Aid.
The drug store business is a low margin business. They make very little from each sale they make and they make even less with new entrants coming into the business such as Amazon’s mail order, Costco’s pharmacy, grocery stores pharmacy and other modes. They are squeezed from above by their suppliers of patented drugs who tell them what the prices they will pay. They are squeezed from below as third-party providers tell them what they will reimburse for the retail customers. The generic business was an advantage for a while where they could earn better margins, but that business has evolved. The generic business has come under much higher pressures since buyers have become less aligned with brands and realize a chemical compound is just a chemical compound. Who care who makes it as long as it’s safe. The lowest price will achieve the same result.
Rite Aid has never been able to come back from their debacle of the late 1990's. Walgreens used to be the big player in the industry, but that has since been diminished. CVS which was once the smallest player of the big three has become the giant. CVS has seen the hand writing on the wall and they are moving steadily into providing care services between the traditional drug store model and the physicians. Last year, CVS firmly went into this business by buying Aetna.
The PE business is awash with cash. The universe of opportunities to profit from PE deals are becoming less and less with significantly more risks involved. PE firms might have a lot of cash, but they don't earn fees on the cash from their investors until buyout deals are made. This creates incentives for PE to invest in marginal deals. If the deal goes bust, the principals of the PE firms will still walk away with their money. The high-net worth individuals who put money in the PE firms will take the losses on the investments. By far, the biggest losses will be borne by the companies they buy out as employees are laid off, salaries are cut and operations are closed.
While everyone is always looking for the Achilles heel for the next market downfall, this big money chasing whatever deal they can get may be it. In the end, the PE firm will get out with profits while the smallest person, the employee, will pay dearly. The few making the big bucks will not care, they do not have to live with the ongoing financial ruin they caused to the many.
