You may need some particularly strong coffee to get through this week’s column, because I’m going to be rummaging through the details of a regulatory filing by PRA Health Sciences, the contract research organization headquartered in Raleigh. The company, which offers outsourced clinical trials to the biotechnology and pharmaceutical industries, has filed with the Securities and Exchange Commission to become a public company again.
Those of you who are now expecting a column evaluating PRA and its prospects will be disappointed, because it’s PRA’s owner that has caught my attention. The company is owned by KKR, one of the largest private equity firms in the world, and the regulatory filing, known as an S-1, offers a rare opportunity to look into the private world of private equity.
While private equity relies heavily on public pensions for its investments, it insists that its financial arrangements and business practices remain hidden. Regrettably, state legislatures and pension officials are all too willing to afford private equity firms this privilege. However, when a private equity firm like KKR wants to reap its reward by taking public one of its companies, it is forced to reveal a bit about itself and its practices.
While I’ll do my best to turn the arcane and technical into something interesting and worth reading on a Sunday morning, the methods of private equity are always shrouded in jargon in order to deter the reader from realizing just how private equity makes its money. The decision by KKR to take PRA public demonstrates two of the most important facts about private equity. First, luck, not skill, plays an inordinate role in generating profits. Second, the systematic reliance on built-in conflicts of interest, all of them probably legal, generates huge and reliable profits for large private equity firms. Please pour yourself another cup of coffee and join me inside the hundreds of pages that explain KKR’s ability to make lots of money by owning PRA Health Sciences.
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The role of luck
In 2007, PRA was very profitable, unleveraged, and a bit unloved by the stock market. Gemstar Capital Partners, another private equity firm, which had previously owned a majority stake in PRA, decided to buy back the company for about $800 million. As you’d expect, it used a great deal of debt to consummate the deal. Of course, the credit bubble burst, and the global recession ensued. Gemstar’s timing was awful. It had to cope with tightening credit and weakened business conditions.
Finally, in June 2013, Gemstar sold the company to KKR for $1.4 billion. I don’t know what kind of return Gemstar earned on the investment, but it took a long time to materialize and undoubtedly pales in comparison to KKR’s windfall. The folks at Gemstar are probably just as smart as the ones at KKR. The only difference is that KKR had much better timing and luck in acquiring PRA.
KKR invested about $450 million and borrowed $1.25 billion to purchase PRA. Unlike Gemstar’s experience, credit markets were once again offering highly favorable terms, and the stock market was soaring. In the short time since KKR acquired PRA, stock prices have risen by over 20 percent, and publicly traded CROs, such as Quintiles, have appreciated even more. KKR is ready to reap its reward in a little more than one year because PRA’s stock will most certainly be priced at significantly more than the $5 per share KKR paid for the acquisition.
During the brief time that KKR controlled PRA, there hasn’t been enough time for KKR to add any real value to the business. However, KKR won’t admit that it was lucky. Rather, it will point to its extensive expertise in health care. KKR will also cite PRA’s improving margins, and rising backlog as proof of its ability to add value. The reality is that KKR was simply fortunate enough to show up at just the right time to snatch up PRA from Gemstar.
Exploiting the opportunity
KKR has done more than just capitalize on its luck. Big firms like KKR make sure that they create numerous opportunities to create profits for themselves, regardless of the return on the investment. This is where legalized conflict of interest enters the picture, and another cup of coffee should be poured.
Although KKR was already earning a management fee of about 1.5 percent from its investors plus the potential for a bonus, known as “carried interest,” it created multiple opportunities to generate significant additional fees for itself. Amazingly, KKR’s investors agreed to let it get away with this. For starters, KKR charged PRA an extra $18 million as a “transaction fee” for doing the deal in the first place. It’s hard to understand the justification for this fee when KKR’s investors already paid it to source and close the deal in the first place.
The transaction fee was only the beginning. KKR also required PRA to incur a “monitoring fee” by compelling PRA to retain Capstone Consulting, a wholly owned consulting firm. Capstone was paid $850,000 when the PRA deal closed for unspecified advice and then received a lucrative 10-year contract pegged at $2 million per year with an automatic increase of 5 percent per year. Since KKR owns 100 percent of PRA, the company had no choice but to accept the contract.
Now that PRA is going public, Capstone’s monitoring deal will come to an end. However, Capstone won’t go away empty-handed. PRA will be forced to pay Capstone a large termination fee for the 8-1/2 years remaining on the contract. KKR will eventually reveal this number, but I’d estimate it will come to $20 million to $25 million. In other words, Capstone will pick up $20 million to $25 million for doing nothing.
Time will tell
KKR’s ability to make money from PRA doesn’t end with transaction or monitoring fees. KKR’s wholly owned investment bank made $1.6 million helping to sell the debt that financed the transaction and will earn an even bigger fee for helping to underwrite the IPO. When the IPO is completed, another KKR subsidiary, KKR Asset Management, will earn a tidy profit because a good portion of the proceeds will be used to pay off debt at $1.095 per dollar of debt. Under the terms of the debt, PRA must pay off debt at a premium if it is called (retired) early. It’s another win for KKR.
Unlike a normal business that must go out and compete for these fees, KKR has a built-in and unfair advantage. When KKR extracts any kind of fee from PRA, it is dealing with itself. Since it owns 100 percent of PRA, it can require PRA to enter into these arrangements and set the terms. This represents a clear conflict of interest. However, as I mentioned at the outset, it’s probably legal because the institutions that put money into KKR’s funds gave it this latitude.
Why should you care? The largest firms like KKR operate in the shadows and are growing in power and influence as hundred of billions of dollars flow into their funds. Although PRA is merely one relatively small example, its proposed IPO demonstrates the power of private equity to engage in speculation and generate vast levels of fee income along the way.
PRA Health Sciences may turn out to be a good investment as a public company. Time will tell. However, when you combine luck with the legal ability to self-deal, it’s a golden opportunity for private equity to make a bit of money for its investors and a lot of money for itself. PRA Health Sciences has delivered for KKR and helped it to become even more powerful.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/