Mother of all buybacks!

In what could turn out to be the "Mother of all share buybacks", Blackstone is reportedly considering the buyback of its shares, recently issued in an IPO. Daniel Gross explores the potential of this profit opportunity in an article, "Blackstone, Meet Blackstone", in The Slate.

This possibility only highlights the potential for similar adventures by smart financial managers at other private equity firms or hedge funds. The modus operandi could be something like this - identify an under valued or ailing firm; take it over with debt, and LBO; lay-off workers and spin-off unprofitable units, to dress up the balance sheet; hype up the "success", as build up to an IPO; get the firm listed at a high enough price; wait for reality to dawn, market to play itself out, and skeletons to tumble out; when share prices start falling, step in with a buy-back offer.

Consider this example. Assume publicly listed Ailing Associates 1.0 with 1 m listed shares and a Rs 10 share, trading at a discount of Rs 5. Then Predator Private Equity firm sets up Predator SPV, which steps in to take Ailing Associates 1.0 private, with 80% debt. The SPV equity is Rs 1 million and debt Rs 4 million. The value lost by public investors is Rs 5 million, and this is effectively transferred to the SPV. Then Ailing Associates 1.0 is restructured with 1000 workers laid off, and its balance sheet dressed up with some innovative financial engineering. Ailing Associates 2.0 is now the toast of global financial markets. After six months, an IPO of Ailing Associates 2.0 is announced with 1 m shares offered at an initial offer price of Rs 20, so as to raise Rs 20 million. After three months of the IPO, the honeymoon is over and reality dawns. The share prices of Ailing Associates 2.0 dives to Rs 10, thereby wiping out Rs 10 million of investor assets. Predator SPV now steps in with an offer to buy back the shares. The 1 million shares, issued for Rs 20 million, are now bought back for just Rs 10 million, with the same 20:80 debt-equity ratio. The equity share of the SPV in the buy back being Rs 2 Cr.

The balance sheet of these transactions is something like this. Investors in Ailing Associates 1.0 and 2.0, invest Rs 30 million and loses Rs 15 million. The Predator PE firm and its high net worth investors makes a total investment of Rs 15 million and gets ownership of Ailing Associates 2.0 (worth atleast Rs 10 million) plus a profit of Rs 20 million, raised from investors during the IPO. On top of this 1000 workers are laid off. Economists will invoke Joseph Schumpeter and justify this as "creative destruction". But in reality, it is a moot point as to whether this is "creative destruction" or "creative theft"!

In a matter of few months, a PE firm or hedge fund could possibly make a tidy profit by transferring money from investors to itself, with no substantial value addition. The afore-mentioned example is outlined only to illustrate a possibility, however remote. Increasingly, the lines between financial engineering and gambling or even cheating is getting blurred!