Understanding Investor Returns – The Hillcrest Transaction

Fanisi Capital recently announced that it had sold Hillcrest International Schools to GEMS Cambridge International School and was waiting for approval from the regulator. Fanisi raked in Kes 2.6 billion from the exit having paid Kes 1.8 billion for the School in 2011. A quick return computation shows that they made 1.4x money back (times …

Fanisi Capital recently announced that it had sold Hillcrest International Schools to GEMS Cambridge International School and was waiting for approval from the regulator. Fanisi raked in Kes 2.6 billion from the exit having paid Kes 1.8 billion for the School in 2011. A quick return computation shows that they made 1.4x money back (times money back – TMB). The TMB is a measure used by investors to show the number of times one returns their money from an investment; 1x means one got their initial investment back with no returns, 0.5x means they lost 50% of their initial investment). The TMB on the Fanisi – Hillcrest transaction implies an Internal Rate of Return (IRR) of 5.4% – IRR is the annualized effective compounded return rate.

The above TMB and IRR assume that these are the only returns the investor achieved from the transaction, ie there were no dividends, there was no interest earned, royalties or partial exits as a result of a sale of equity. If either of the other exits or self-liquidating instruments were present the returns would be higher. The question that follows this then is; Is this an attractive return for a commercial investor? The question is relevant especially judging by the amount of coverage it had with a subtle messaging that this was a decent return.

To answer this we explore what an investor would have earned if they had put their money in other investments. First, let’s explore the yield an investor would have earned on a risk-free 10-year government bond issued in 2012 (there was no 10-year bond issued in 2011). The bond was paying a coupon of 12.70% p.a, which is higher than the return earned by Fanisi on this transaction under the above assumptions.

We mentioned some assumptions around our commentary. We would like to introduce a new one which we think would have had a significant impact on the return the fund earned. What if the entry structure was through a leveraged buyout? A leveraged buyout is a transaction that investors use to acquire a company; it combines equity from the buyer and debt that is secured by the target company’s assets. The deal is structured in a way that most of the financing cost is paid from the company’s assets and cashflows. A typical leveraged buyout results in two significant changes; namely, change in control and/or management of the company and increase in debt. You may then want to understand the advantages of a leveraged buyout:

Firstly, what are the benefits of financing a business partly through debt? Interest payments are deductible before tax computation, which lowers the cost of borrowing. Nevertheless, the cost of borrowing in a transaction is dependent on the risk profile and the level of seniority of the debt, that is, dependent on whether it is a bank debt, subordinated debt, or mezzanine debt. Secondly, the debt is serviced with cash flows from the target company. This means that as the investor would not need to worry about making debt and interest repayments reducing the amount they put on the line. Thirdly, the equity component gives investors control in the business. This helps in two ways, one they can participate in setting the strategy for the company and determine its future moves and secondly, they get to enjoy any upside that comes with their equity stake.

Important to note is that leveraged buyouts have an assumption that you can raise relatively cheap debt compared to the returns generated from the company and most importantly that the company is able to repay this debt before exit or that the exit value is significantly above the borrowings.

Let us now assume that Fanisi got in through a leveraged buyout capital structure at 40% equity and 60% debt. This would mean that the actual cash injection by Fanisi was Kes 720 million, and Kes 1.08 billion was debt making the total of Kes. 1.8 billion investment. Assuming further that during the 7 year of the investments life the company was able to repay the debt, the equity return would now be a 3.6x money back or an IRR of 20% at the exit value of Kes 2.6 billion. This would be more attractive than a 10-year government bond issued in 2012. However, it would still be below the required rate of return of 30% for most private equity investors. Traditionally, equity investors tend to target annual returns of between 25% and 30% for an investment horizon of 5 to 7 years.

What does the Hillcrest deal then tell us?

  1. The fact that an exit has happened at more than a billion does not necessarily mean that good returns have been made. One needs to consider how much was invested, for how long and in what form to have an objective view of the returns.
  2. The capital structure at entry has an impact on returns. With the caveats above, leverage increases return for equity investors because it reduces the equity outlay without necessarily reducing the exit consideration.
  3. There are several other factors that would affect the return computation, key among them is whether investments were made and exited as a bullet or in several tranches. If invested as tranches the return would generally be improved and if the exit happens in tranches you expect a downward push on the returns. The reasoning behind this is time value of money ( a discussion for another day.)
  4. An additional level of analysis that needs to be done to establish whether indeed a return on an investment is a good one is to compare the returns to those of other asset classes with a similar investment horizon. Equity should ideally have better returns compared to debt and if the reverse is true then you need to call in the experts!

 

Written by Keziah Njeri from the InVhestia Team.

File Photo from NMG website