Is Private Equity Giving Hertz a Boost?

LAST fall, Mark P. Frissora, the newly hired chief executive of Hertz, kept running into the same question from potential investors.

Private equity firms have helped make Hertz more efficient, but its debt burden has soared.

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Trying a U-Turn

Mark P. Frissora, chief executive of Hertz, with a car created for the company by the racecar driver Carroll Shelby. When Mr. Frissora came to Hertz after the buyout, he moved quickly to cut costs, and without laying off a large percentage of the work force.

Hertz, which Ford had sold just 11 months earlier to a consortium of private equity firms for $14 billion, was trying to sell shares to the public in an offering that valued it at $17 billion. As Mr. Frissora tried to drum up interest in the offering, skeptical investors kept asking him the same question: Why was Hertz worth $3 billion more in less than a year?

“I had to spend the first 15 minutes of every road-show meeting trying to explain this,” Mr. Frissora said in a recent interview, still sounding somewhat exasperated by the experience.

His job was not made any easier by the fact that the private equity investors — the Carlyle Group, Clayton, Dubilier & Rice and an investment arm of Merrill Lynch — had piled $12 billion in debt on the company, and then paid themselves a $1 billion dividend, which amounted to nearly half of the $2.3 billion in cash they had invested.

“Very smart investors thought there couldn’t possibly be any value left,” Mr. Frissora said.

Judging by the company’s share price, many investors have changed their minds. Since the initial public offering in November, Hertz’s shares have risen 43 percent from their $15 offering price, to $21.51.

Indeed, Hertz now looks as if it was not necessarily the model of the big, bad buyout that its fiercest critics had suggested. Its private equity owners looked at the business with fresh eyes and made a number of changes that improved operating performance. By streamlining how the company cleaned and refueled vehicles, they doubled the number of cars that could be processed every hour and re-rented. Hertz was able to do so without huge reductions in the work force: it cut less than 5 percent of 32,000 jobs.

Even so, the private equity guys also saddled Hertz with billions of dollars in debt, which is taking its toll on the company. Interest expenses of $901 million pushed Hertz’s net income down to $116 million in 2006, from $350 million the year before. That gives the company less maneuvering room should the economy — or its own revenue — slacken. Still, analysts say they remain uniformly optimistic because Hertz’s pre-debt performance has been improving sharply this year. And while it carries a big pile of debt, it has less than other recently privatized companies and just slightly more than Avis Budget.

Still, it is unclear whether Hertz is the exception or the rule of the recent buyout boom. Tightening credit markets pose a threat to all companies carrying big debt loads. For example, Freescale Semiconductor, which was taken private last year, saw its debt trade at 91 cents on the dollar last week amid concerns about the company’s financial prospects. But default rates on corporate debt currently remain near record lows of about 0.7 percent. If interest rates rise and debt payments skyrocket, some private equity darlings could stumble. In the 2001 recession, the default rate rose to 8.3 percent.

“Hertz is an example of a success story, but you have to be unbelievably courageous to believe history won’t repeat itself with some other companies,” said Steven Rattner, co-founder of the Quadrangle Group, the private investment firm, who has been sounding the alarm about the dangers of cheap debt. “We’re not magicians or alchemists.”

Nonetheless, a close look at the industry over its three-decade history shows that, on average, the firms have actually managed to improve, at least marginally, the businesses they own. “The empirical evidence is actually quite good,” said Steven N. Kaplan, a professor at the University of Chicago Graduate School of Business, who conducted the seminal study on the subject in the 1980s. “There is no evidence in any large sample study that they harm operating performance.”

No one has completed studies of the most recent boom, which has its own set of new wrinkles: bigger targets, higher premiums and much bigger upfront fees, all of which strain comparisons with private equity’s performance in earlier decades. Few academics appear to be studying the operational performance of recent buyout targets, but Edith Hotchkiss, a finance professor at Boston College, has been running the numbers. She is scrutinizing 176 companies taken over from 1990 to 2006, and her conclusion so far is positive.

“We continue to see operating gains,” she says, but she cautions that profit margins among the current takeover targets don’t match the operational returns of earlier decades. “The magnitudes are not as high,” she says.

SO how, exactly, did Hertz justify the $3 billion in new value before its I.P.O.? Easily, Mr. Frissora said, as he leaned back in a chair in a conference room at Spencer Stuart, the recruiting firm that brought him to Hertz. But his candid answer was not a complete ode to Hertz’s private equity owners.

He said a third of the value was simply a result of “market-related timing”: because of increased air travel, shares of other travel-related companies had jumped sharply since Hertz was acquired.