Monday, 21 January 2013

The return of LBOs - For whom the Dell tolls

"It was easier to live under a regime than fight it." - Ernest Hemingway, For Whom the Bell Tolls, Chapter 34.

"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

In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fuelled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 

The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  
Energy Future Holdings is loaded with 37.4 billion USD worth of obligations whereas Texas Competitive is saddled with 32.2 billion USD in debt, 700 million USD of which is due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 

KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp is moving towards bankruptcy and restructuring according to Bloomberg article by Richard Bravo and Mark Chediak - TXU Teeters as Firms Reap $528 million fees
"Energy Future’s long-term debt has soared to $42 billion since the buyout and the company is poised for its seventh straight quarterly loss as it struggles with natural gas prices 73 percent below their 2008 peak. Moody’s Investors Service says the company may need to restructure next year and derivatives traders are pricing in a 95 percent chance of default within five years for its deregulated unit." - source Bloomberg.

The issue with TCEH was that their breakeven cash flows needed in 2011 was based on 6.40 USD/mcf sustainable gas prices to cover all interest expenses and 450 million USD of maintenance CAPEX according to CreditSights calculations in April 2011. Of course it went horribly wrong for natural gas in 2012 and the "assumptions".
- source

When too much leverage and when assumed breakeven on natural gas prices are so far out from reality, it does not end well for the TXU/TCEH bondholders and could get even uglier if natural gas price falls again towards the April 2012 lows...but that's another story and we ramble again...

Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council.

While we already delved into the insidious returns of cov-lite financing in our September conversation "The World of Yesterday":
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance."

In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":
"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

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:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.
After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."
But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:
"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

The latest news surrounding the possibility for Dell to go private via the use of a LBO, have made us want to look into more details about the return of the LBOs, which was previously linked to the previous credit bubble. It was fuelled, in similar fashion by "cheap credit". 

Following a comment from Dave Merkel, writer of the Aleph Blog in relation to our post "Chart of the Day - S&P 500 pension equity allocation" ("Private equity is replacing public equity in many DB pensions. The "Chart of the Day" may not mean what you think."  - David Merkel), 

Here comes the time for us to go into the Dell case, and the unsurprising come-back of the mega-LBOs. So yes David, you are right, private equity and large LBOs are coming back with a vengeance.

During the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news such as the one relating to DELL. 

For instance, the latest news surrounding DELL have cause a serious "denting P&L" kind of spike in the CDS price - source Bloomberg:
This kind of "sucker LBO punch" significantly hurts your P&L if you have been a net seller of CDS protection on DELL in this tightening spread environment (+200 bps on 5 year...).

Sector wise, the result is similar, DELL has indeed widened significantly relative to some peers on the LBO news as displayed by the below graph of CMA, part of S&P Capital IQ:
The latest news surrounding DELL is that it has hired Evercore to seek higher bids should a buyout be formalised according to Bloomberg:
"Silver Lake and its partners are close to lining up about $15 billion in funds for a buyout of Dell, the third-biggest maker of personal computers, people familiar with the situation said last week. The deal would likely value Dell between $23 billion and $24 billion, said one of these people." - source Bloomberg.

A similar Texan company that went through a similar buyout than DELL, was Freescale Semiconductor Inc back in 2006 which was bought for 17.6 billion USD by Blackstone and loaded with 8.1 billion USD worth of debt.

Following the 2008 crisis, the ability for the DB pensions mentioned by David Merkel to monetise their investment was shut down because the IPO market went down by 70%. Endowments and pension funds which poured into private equity pools during the "credit" binge, did not receive the return they thought they would get on their investments.

So why DELL is looking at a LBO? It stock price fell 29% in 2012 due to increased competition from the likes of LENOVO.

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.

In this "deflationary environment" (falling prices) in the PC space, both DELL and HP have been losing market shares to Lenovo in both end-user segments. As we posited before, whether it is for the car industry, or the shipping industry, it is, end of the day, a game of survival of the fittest which entails serious strategic adaptations for some.

"Lenovo shipments gain 24% in industry beset by falling prices" - source Bloomberg
"PC shipments should increase while prices decline as value markets such as China and India grow to become larger portions of the market. Intel-branded Ultrabooks are spurring innovation in PC technology that appeals to mass-market buyers, and has been largely absent in recent years, apart from the laptop. Lenovo's shipments grew 24% in 2Q." - 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:
Although DELL has been losing PC Market Share, it has managed to increase its market share in the Global Server Market.

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
"Dell's debt is 89% of total equity as of the end of 3Q, with a total of $9 billion on its balance sheet. With cash and equivalents of $11 billion and a trailing free cash flow of $3.1 billion during the last four quarters, this debt burden is not insurmountable, especially with low rates and an A- S&P credit quality rating." - 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:
"Dell's free cash flow generation of $3.1 billion, $2.2 billion net cash position and valuation metrics (7.6x ex-cash P/E and 6.9x price-to-free cash flow) may appeal to a buyer. Dell is discussing going private with TPG Capital and Silver Lake, Bloomberg News reported. An assumed 30% premium to Dell's Jan. 14 price would create the industry's first $28 billion deal, topping HP's $25 billion 2001 acquisition of Compaq." - source Bloomberg

But from a strategic point of view, it all depends on the strategic orientation DELL will embrace under its new ownership. The intensity in the competition for PC from the likes of Lenovo, makes it increasingly difficult for DELL to protect its own turf as PC have become more commoditised and are facing as well a change in consumer spending patterns with the increased developments of smartphones and tablets.

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."

Stay tuned!

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