"A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explains the origin of the term LBO." - source Wikipedia
Back in February 2011, we also discussed the dangerous return of Cov-lite loans financing and we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:
Old habits die hard:
DELL Share price 1 year evolution (18th of January 2012 to 17th of January 2013) - source Bloomberg:
DELL reported weak results in its Q3 with revenue below its prior guidance range (down 10.7% YoY) and EPS below expectations. DELL's is facing increasing headwinds in the PC space and has seen its business fall sharply in the third quarter in both consumer and commercial markets.
"Lenovo shipments gain 24% in industry beset by falling prices" - source Bloomberg
As reported by Bloomberg, Dell's "PC Competitiveness" is a much in focus as its financial metrics - DELL, HP and LENOVO, market shares evolution:
The Global Server Market Share was impacted by the macroeconomic weakness of 2012 which drove, according to Bloomberg a 4% YoY decline in 3Q server revenue. DELL was the only top five server vendor to increase revenue, with 8% growth. HP saw its revenue in that space fall 12% while IBM declined 8% ahead of new products being introduced in the fourth quarter. Oracle fell 23% as it moves away from low-end servers - source Bloomberg:
While Dell's current 9 billion USD debt pile isn't insurmountable at 89% of total equity as of the end of 3Q, the serious threat posed by Lenovo warrants caution in relation to its future under a new owner via a LBO, because Lenovo has leapfrogged HP to become the top global notebook maker with 15.9% market share:
"The overall portable market fell 7%, led by declines at Hewlett-Packard (19%), Dell (18%) and Acer (7%). Apple grew 10% and Asustek 8%. Tablets and smartphones appear to be increasingly hurting portable sales." - source Bloomberg
From a pure deal point of view, we agree with Bloomberg in the sense that Dell's cash flow and valuation makes the private equity option looks rational - source Bloomberg:
If DELL is to survive, even under a new "leveraged" ownership, it will have to adapt fast, given that across most of its product lines (storage, software, peripheral, mobility and desktop) have seen important declines as per their recent 3Q results (PC business declined 19% YoY with desktop down 8% YoY and mobility down 26% YoY).
For DELL, the only way is up, up the value chain that it is (entreprise solutions and services) for the LBO to increase its probability of success and to avoid being saddled by debt like its Texan neighbor Freescale Semiconductor Inc.
Moving back on the private equity deal flow and in relation to David Merkel astute comment, relating to pension funds allocation to private equity, a recent note by independent credit research house CreditSights entitled "LBO Risk Revisited for HG Bonds" from the 20th of January 2013 explains clearly the rationale behind private equity allocation:
"The correlation between strength in the high yield origination cycle and private equity deal volume is hardly a new one since the HY market exploded onto the scene in the 1980s. The problem with high yield origination booms is that they have had a habit of quite literally exploding as they did after the LBO binge of the mid-to-late 1980s and after the TMT cycle. In the LBO boom of 2005-2007, the end was also quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains. The reality is that a wide range of LBO deals are still in limbo from the 2006-2007 period and it will take more time to get those deals off the books via an IPO or strategic buyers. That does not prevent new funds from being set up by new investors or to see higher allocations from pension funds raising their commitments to private equity. These funds need to plan on meeting their return shortfalls in future years, and their allocations in high quality fixed income make for very difficult math." - source CreditSights
One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...).
As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."
For us, mega-LBOs, such as DELL, are another "smart way" in snaring in "yield starving investors" in the "credit mouse-trap".
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."