Private equity's horror show

Over the past two decades the script of the Hoyts cinema chain story has been the stuff of a B-grade action movie.

From the city to suburban multiplexes, from private equity to publicly listed. From the money-making Packers to an ill-fitting newspaper group, then back to private equity.

For the most part, Hoyts has proved a horror flick for buyers - a corporate tearjerker, even a snuff film.

Now its latest owners, the private equity firm Pacific Equity Partners, is laying the groundwork to get out after less than three years.

Hoyts's executive chairman, David Kirk, says the group, comprising the Hoyts film chain, distribution network and advertising business Val Morgan, held a beauty parade for advisers this week to consider exit options.

"In the private equity business it's something you're always considering. It's budget setting time, so we're setting out planning for the year," Mr Kirk says. "The options are a trade sale or IPO. No decision has been taken, nothing is in play. We're having a more focused look at options. It's a definite possibility this year."

The Hoyts business, says Mr Kirk, is "trading very well". Admissions are up and blockbusters are drawing crowds.

Still, accounts lodged with the corporate regulator show potential buyers face a debt pile and hefty contractual commitments for capital expenditure, should they buy a ticket to opening night.

A decade after arriving from the US in the 1980s, the local Hoyts operations took a colourful turn when a consortium of Hellman & Friedman, Lend Lease and Hoyts management, including Peter Ivany, a son-in-law of the founding Fink family, bought the business.

It was floated in 1996 before the late Kerry Packer's Consolidated Press Holdings took it private in 1999.

In a related party transaction that raised eyebrows, the Packer family's private company offloaded the business in 2005 to its Publishing & Broadcasting Ltd in a joint deal with West Australian Newspapers. The Packers pocketed $347 million while PBL and WAN took on more than $170 million in debt.

It was a miserable experience, reinforcing a business truism: don't buy from the Packers.

Hoyts contributed just $16 million or 8 per cent of pre-tax earnings to WAN in 2006 and it was forced to write down the value from $205 million or $145 million in its accounts. Adding to the pain, the then WAN boss, Ian Law, would become chief lieutenant at Packer's PBL soon after.

At the height of the cheap-debt private equity splurge in 2007, PEP stepped in, paying $440 million. WAN and PBL each received $150 million or $23 million less than they tipped in.

PEP has now been in charge of the candy bar for two years, moving through the business cutting costs. As PEP prepares the groundwork for its exit, questions surround the state of the business and structural changes facing the industry.

Accounts filed with the corporate regulator for Hoyts Group show the business is consolidated in the US. But special purpose accounts filed with Australian Securities & Investments Commission for a company called Auholdco1 Pty Ltd identify it as the local companying running the Hoyts cinemas, film distribution and Val Morgan cinema advertising businesses. Sources close to Hoyts confirm they are the consolidated accounts.

In early 2008, shortly after taking control of the business, PEP issued shares in Auholdco1 to a US entity, Hoyts Group Holdings LLC, in return for $110 million. All PEP's Hoyts directors, Rickard Gardell, David Grayce, Rob Koczkar and Simon Pillar, resigned from the Auholdco1 board leaving the Hoyts CFO and CEO, Vincent Lloyd and Delfin Fernandez, as directors.

It is understood the move was for tax purposes, allowing US funds in a PEP entity to benefit from a trust structure. PEP maintains control of Hoyts. It used a $265 million syndicated senior facility and a $25 million subordinated term facility as part of the transaction.

The accounts reveal Hoyts reported a net loss after tax of $16.9 million in the 12 months to June 30 last year after a $9.3 million loss the year before. No dividend has been paid to shareholders over the past two years. Private equity deals often gear up the balance sheet with cheap debt to pay out dividends from cash in the company to the shareholders before selling out, leaving new owners to pay down debt and rebuild a business.

Potential buyers of Hoyts will also note the debt pile. The business has $251 million in interest-bearing liabilities on the balance sheet. Hoyts has total assets of $447.8 million and has total liabilities of $366 million. Total revenue was $300 million, from operational revenue of $60 million.

The accounts provide little evidence of Hoyts spending on capital expenditure over the past two years. In fact, contracted capital expenditure commitments were zero. Over the next five years - after PEP's exit - $370 million of work is contracted to be performed.

Onlookers say the pace of change hitting the industry, such as the arrival of 3D films, means cinema operators will have to keep spending in order to keep the crowds coming as digital home delivery gains traction.

Operating expenses including rent more than doubled last year.

PEP is eyeing a profitable exit that would deliver a return of 2.5 to 3 times its original investment. A source close to the business says of the $440 million purchase price in 2007, PEP put in about $150 million in equity, using about $300 million in debt.

With the business making about $50 million a year, it has been able to pay down debt to about $200 million, meaning there is, in effect, $250 million in equity. Having bought the business at 10 times earnings on $45 million pre-tax earnings in 2007, PEP has grown earnings to about $60 million, meaning if it can sell at a similar multiple of 10 times earnings, PEP will garner about $600 million for the sale. After accounting for the $200 million in debt owed, PEP will be left with $400 million in equity, having put in just $150 million.

Mr Kirk would not comment about any details of Hoyts financial position. He argues the business faces little structural change as cinemas have proven they remain a "night out".

Hollywood loves a happy ending. And while PEP may be confident about a profitable exit, scepticism abounds over private equity sales such as the recent Myer float.

When PEP bought Hoyts, one observation summarised the deal like this: "Selling popcorn for a living is an appropriate metaphor for slick privateers. Take a corn kernel, add a bit of heat and oil and - POP! - it's puffed up to twice its size, full of hot air and ready to add a sugary coat to flog for an inflated price."

The question now is if punters will pay $15 for a ticket and $5 for a choc top to be part of the show.

PEP's boss, Tim Sims, and Mr Kirk will no doubt argue exactly that at today's private equity industry gathering in Sydney.