My, how things change! In the go-go time period of 2002 through 2006, a home builder's game plan was to expand. Strategic agendas sounded like this: grow inventory, grow units, grow income, grow earnings per share, grow stock price. It seemed the stars were aligned, and balance ruled. Capital flowed freely for publics and privates, and everyone fed to satisfaction from the same capital bounty. Miracle of miracles, every pro forma and feasibility analysis worked with room to spare, and the challenge of the moment was how to do more. More land, more houses, more inventory, more pretax income. Home builders believed they'd finally solved the industry riddle, convincing Wall Street, lenders, and themselves that their business model could grow in any economic climate. The despised "cyclical industry" moniker was a thing of the past.
Black Monday, September of 2005–the waters of Katrina pooled around the rooftops, and a buyer was heard uttering the word "no." This objection resonated across America. Pace fell off, pricing began to deteriorate, and the slowdown sunk in. Wall Street can be a fickle friend as it is paternalistic in an upswing and cold and unforgiving in a downturn. Wall Street values growth and the future prospects of increasing earnings, yet loathes stagnation or deterioration.
Viewed as manufacturers, home builders face the issue of those pesky supply and demand levers. The industry simply held the throttle down too long as the assembly lines cranked out units in the face of waning demand. Could free flowing capital have been the cause for today's excesses?
Private Equity Heyday
Here's my assertion: The private equity model could ward off future excesses. How? Private equity is non-public ownership–it is a capital pool with contributions from a variety of sources. Private equity can be creative in obtaining a return on its investment. An IPO, a sale of the company it controls, recapitalization, and an equity stake for a return on capital are just a few methods. The private equity arena has become so vast that it has caught the eye of Congress, which seeks to obtain its own return by taxing private equity.
In a down market, capital plays hide-and-seek. Liquidity disappears as lenders, buyers, and Wall Street investors remind us that we are cyclical. Private equity, however, remains plentiful even as the clouds roll in as long as the hurdle rates are achievable. Everyone can still get paid.
Private equity exacts a disciplined approach to investing. A common private equity return formula is known as the "promote" structure. Promotes (or profit sharing) are achieved by the capital recipient after certain minimum return hurdles are met. For example, a return is paid to the capital recipient after a 14 percent IRR is secured by the capital provider. The capital recipient's promotes can increase as higher IRR thresholds are met (see chart). A transaction that is underwritten with the promote structure creates greater discipline–i.e. the capital recipient has no incentive to move forward on a deal that will not meet minimum IRR hurdles because no one gets paid.
Would the private equity model have instilled more discipline in us all from 2003 to 2006? Private equity rewards return on capital, which never goes out of vogue. Wall Street, investors, lenders, and owners love return on capital through the ups and downs of every cycle. Useful to remember. BB
–James Bagley is former president and COO of Orlando-based Park Square Homes. He may be reached via e-mail at email@example.com.