bloggingbuyouts

On July 20th I highlighted the "Dream Come True" in Avaya Inc. (NYSE: AV). At the time, I thought the $17.50 acquisition price could be bested by a competing bidder and the current acquisition price served as a floor. Since this post the stock has managed to trade off several percentage points but I believe the situation has only become more attractive.

The deal is still expected to close in the fall. Assuming the deal closes December 1st (most likely a very conservative estimate) the current annualized rate of return on the deal is roughly 16% -- a very attractive yield if you believe the deal should go through.

Should you believe in this deal's prospects? In my opinion, the answer to this question is an emphatic yes. Interestingly, two of the company's executives agree as they recently bought $1.4 million of stock going into this deal. As a Wall Street Journal article reports [subscription] today, insiders rarely buy stock before their company goes private. This buy exemplifies confidence in the deal's prospects from the inside. The buyers -- TPG and Silver Lake -- have already arranged financing, according to the WSJ piece.

If the chances of the deal being completed remain good, then why would the stock sell-off, you might ask. I think the answer to this question is two-fold. First, nearly every company in the process of an LBO sold off as the credit market showed signs of weakness during the last two months. Additionally, many funds have been cutting their merger arb exposure, likely forcing liquidations in Avaya, among other companies.

Avaya is still an interesting situation. At the current price, you are set to earn a 4-5% absolute rate of return on your money (roughly in-line with Treasuries and CDs). But you would expect to make this in 2-4 months instead of twelve. With the company's executives loading up on shares and the private-equity buyers already having financed the deal, I think the likelihood of this deal being completed remains strong.

According to TheDeal.com, Private Equity Intelligence is arguing that "the conditions for the long-term growth of the buyout industry are still very much in place." PEI is justifying this point of view, it seems, with the amount of capital still being raised by large private equity firms, despite the recent string of unfavorable news for borrowers and potential borrowers.

PEI goes on to argue that private equity funds are going to continue taking in huge sums of money as institutions raise their "target allocations" towards private equity funds -- a seemingly rational assumption.

But there are several problems with this thesis. Most importantly, I'd bet that the target allocations for private equity funds are going to decrease if the funds' returns suffer due to a more difficult borrowing environment. I'd also argue that recent fundraising success by private equity funds doesn't represent the health of the credit market -- I'd bet that many investors are simply chasing incredible past performance at these funds without recognizing that it was much cheaper to finance these transactions just one quarter ago.

While there's plenty of talent in the private equity space, I tend to believe that the difficult credit situation is going to hurt private equity performance over the next few years.

As Peter Cohan posted, one of the people in the bidding war for Dow Jones & Co. (NYSE: DJ), claimed he could launch new media initiatives to get the stock price above $100 per share. This person, Brad Greenspan, is not one to ignore, he's the innovative founder of MySpace who sold out to News Corp (NYSE: NWS).

In Greenspan's letter he suggested several ideas:

• Launch a cable channel to compete with well-established CNBC and new Fox Business Channel
• Create an online video website that could share costs with the cable channel
• Drop subscription model for the Wall Street Journal online -- begin competing with Yahoo! (NASDAQ: YHOO) Finance making money through advertising. The WSJ Online competitive position vs. Yahoo! Finance would be its premium content (WSJ, Barron's, etc.) at no cost.

Instead of proposing to buy the entire company, he offered to buy-out impatient, "liquidity-seeking" family members for $60 per share, the same price as Murdoch's offer. In addition, Greenspan, with the approval of the board of directors, hopes to perform a recapitilization through which the company would buy back shares funded by debt.

Greenspan's ideas are interesting but certainly not rare or contrarian in current times. The abandonment of the online subscription service has also been discussed at the NY Times and trying to fight for CNBC's position in the business television market is a move already being made by Fox.

To be honest, I'm shocked that investors are showing this much enthusiasm to get into a newspaper company judging from the sector's disdain on Wall Street. However, this entire situation shows the importance of the value of a brand -- the interest in Dow Jones is primarily based on the company's brands such as the Wall Street Journal and Barron's. This is a concept repeatedly discussed by Warren Buffett in conjunction with economic moats, however it is often ignored by Wall Street analysts in favor of short term considerations.

Readers of my recent posts have repeatedly heard my warnings that private equity is going to begin having much more difficulty borrowing capital to complete leveraged buyouts. While this is certainly not an eclectic or overly contrarian idea, there are still many private equity perma-bulls on the street.

The New York Times is reporting on the debt markets "squeezing" private equity. According to the article, high yield borrowers are demanding higher interest rates on their loans. In my opinion, this is a very fair stance because the credit markets are in no way pricing in the potential risk that lies within.

If private equity firms are forced to pay higher interest rates for capital its entire model for the buyout is flawed, because the cost of capital is imperative to coming up with a valuation, especially for funds who plan on loading the company with debt. Many have rightly speculated that the private equity boom of the last several years was primarily the result of low borrowing costs.

The primary companies at risk in this type of environment are the banks providing bridge loans to these private equity firms. Basically, a bridge loan is a loan granted in the interim while the bank tries to raise capital for the company or sell this loan to another person. But in this environment of increased skepticism towards the whole private equity complex, banks are stuck holding these loans on their balance sheet as they can't find investors interested in buying the loan.

I recently was in the office of a high yield-focused hedge fund. According to the people I spoke to, hedge funds are in fact becoming much more hesitant to lend money in the lower-end of the credit structure. But many people are beginning to get very interested in the bank debt of private equity companies because the LBO would have to be a total failure for this debt to default. Interestingly, despite the fact that the bank debt is so high on the capital structure, many of these securities are trading below par.

It's widely acknowledged that buyout fever has to come to an end at some point, but few people in the press seem to be advocating this end coming soon. I guess I'm a contrarian on this issue -- I think there are clear signs that the private equity craze is wearing down. Well, a contrarian to everyone except the private equity firms' leaders.

Today, news that Apollo Management is hoping to go public through the "back door" hit the wires. This type of offering (called a 144A) allows Apollo to "sell shares of itself quickly while avoiding for several months the disclosure involved in a public offering," according to a New York Times piece on the story. This filing essentially allows Apollo to sell only to institutional and other "sophisticated investors," rather than any investor who can trade on the New York Stock Exchange. However, Apollo hopes to be trading on the New York Stock Exchange by the first quarter of next year, according to the Times.

For some reason, investors still want to buy into Blackstone Group (NYSE: BX), KKR's upcoming offering, and probably Apollo's future offering. I don't know how many times it needs to be said, but I'll say it again: these executives aren't selling to the public to share from their bounty -- they are selling out because they realize things can only get worse from here. Apollo isn't rushing to sell its company for no reason -- it believes bad times are coming.

According to the Deal Journal blog, 3Com (NASDAQ: COMS) is receiving potential buyout offers from several interested parties, including Silver Lake Partners and Bain Capital. Nortel Networks (NYSE: NT) is also a potential buyer of the company, according to Deal Journal's sources.

Interestingly, 3Com has Citadel Investment Group involved as an activist investor. Citadel, which is Kenneth Griffin's investment vehicle, owns 8.4% of the company as stated by this 13D filing. And one must wonder whether these buyout offers are attributable to this 13D letter from Citadel, which makes it clear that the firm believes that 3Com is deeply undervalued. It's also interesting that Robert Chapman, an activist known for his vicious attacks on management, owns the stock in his fund but doesn't have an activist role.

3Com seems like an interesting acquisition candidate because it looks cheap on a sales basis when compared to its industry. Although the company has trouble actually earning money on its sales, this might interest private equity firms because many believe they can run the company "better" if its privately owned and not publicly traded. 3Com doesn't have any debt after backing out the cash on the balance sheet, and as a result potential acquirers could perform a leveraged buyout and not risk overloading the company's balance sheet with debt.

As I covered last week, Carl Icahn increased his bid for Lear (NYSE: LEA) to $2.9 billion. As I tried to make obvious in my post this price was still considered inadequate by the majority of the "smart money" in the stock. Yesterday the expected was made official: shareholders rejected the deal. As it was noted on Deal Journal, rejecting buyouts is a rare occurrence in today's day and age. In fact, this is only the 8th deal to be rejected by US shareholders since 2003, during which more than 1,000 deals transpired.

Although Icahn didn't get Lear, I don't think he's too miserable -- he still stands to receive the equivalent of roughly $25 million simply for trying to buy the company! Yes, that's right, shareholders are going to dish out $12.5 million in cash and 335,570 shares (roughly worth $12.5 million) simply because the under-bidding Carl Icahn tried to steal their company, with management's support --- another example of great leadership in American business closely succeeded by Whole Foods CEO John Mackey.

"Any fool can buy a company...you should be congratulated when you sell." - Henry Kravis, KKR

In recent years, the spike in assets for the private equity industry has caused a boom in buyout activity throughout the world. Buyouts are everywhere, from the United States to Australia.

The theory behind the private equity strategy is that a company can be run more successfully under a well-trained private management team than it can be run as a publicly traded company. People argue that because the company is private, the management team has more room to make change because it doesn't need the consent of shareholders.

While this argue is rational, many people seem to forget that the private equity firms don't want to hold a company forever -- they want to sell the company back to the public as a theoretically better company and cash out. As a result of the recent super-spike in buying activity in the U.S. markets, one could rather easily see way too much I.P.O. activity several years from now, when the funds want to take the companies back to the public market.

When a new investor first studies merger arbitrage, the concept seems incredible -- the ability to make almost guaranteed profits, especially because it seems that deals are pulled or rejected ever so rarely. But as this new investor begins following the market more, he quickly learns that deals are in fact pulled. Recently, we saw the firms interested in purchasing SLM Corp. (Sallie Mae) (NYSE: SLM) pull their deal. As you can see from the chart on the right, this killed the arbs involved in the deal.

I don't think this is going to be the last time that a potential private equity deal is pulled, much to the disappointment of arbs. As I've been covering on BloggingBuyouts, I think the credit situation in the United States is quickly turning sour. Many professionals in the fixed income space who I talk to constantly talk about not being paid enough interest to justify the risks that they are taking. As a result, I believe private equity firms are going to have much more trouble in borrowing the money they need to continue their leveraged buyouts. I think arbs are going to face more pain in the future.

According to The Deal, the S&P Leveraged Commentary & Data Index fell to its lowest level in four years yesterday morning. For anyone who follows the credit markets closely, this should come as no surprise. I recently spoke to one multi-strategy (but high-yield focused) fund manager who expressed extreme skepticism about the current debt market. In his eyes, the risks aren't being accounted for in interest rates and investors are being paid less to take risk than they have been in previous years. Therefore, this fund manager is much more heavily involved in equities than credit at this point in time.

As the article goes on to say, this is likely to have implications for the entire private equity industry for several reasons. First, it will likely become much more difficult for private equity firms to gain the capital to complete deals. In addition, and perhaps more importantly, the private equity firms might be forced into paying more for their credit as a result of the recent "repricing" in the debt market. This move could bust the financial models private equity firms use to justify their deals. For example, a company's value can vary dramatically in the eyes of a private equity firm if the cost of equity moves from 6% to 7%.

While this likely isn't the end of the private equity boom, I'd argue that events such as these suggest that the easy money days of buyouts are quickly becoming a thing of the past.

While it seems like almost everyone who is "against" the private equity and hedge fund guys (especially those out of the money management business), few people actually try to change the way they do things. One such person who has is Congressman Dennis Kucinich.

Leading up to the Blackstone's (NYSE: BX) IPO, Kucinich tried to delay the company from coming public by working with the SEC and arguing that the move posed many dangers for the 'average investor.' While Kucinich argued that, because Blackstone is involved in the hedge fund/buyout business - a business that is regulated to only include high net worth investors - the average investor shouldn't be allowed to own stakes in these businesses. The problem with his argument in this case was simple - investors in the IPO aren't investing in Blackstone's funds, instead they are taking an ownership in the underlying business. Confusing these two things - investment in a FUND versus in the underlying BUSINESS - is a tremendous mistake.

However, Kucinich is not stopping there. According to DealBook, Kucinich plans to hold hearings on the future of private capital (hedge funds, private equity, venture capital, etc.). One could easily infer that Kucinich hopes to gain increased regulation on the industry in terms of both investment standards and ownership standards.

In my opinion, there's a deep issue here that Mr. Kucinich is confusing. While a business's operations might need regulation, perhaps deep regulation (think alcohol, tobacco, firearms businesses), the way in which the average investor can go about purchasing shares in a company should not vary as long as a businesses line of work is considered legal by law.

On Monday, it was announced that Sun Capital acquired 75% of Limited Stores, the clothing unit of Limited Brands (NYSE:LTD)for no cost. Limited Brands will record an after-tax loss of roughly $42 million, according to the company. While Sun Capital theoretically paid "nothing," the fund did make several promises - $50 million in equity capital to the clothing chain and the arrangement of a $75 million credit facility, according to United Press International.This move follows Limited's sale of 75% of its Express clothing line to Golden Gate Capital.

Sun Capital is a $10 billion LBO firm based in Boca Raton, Florida which specializes in underperformers or turnarounds in the small-mid size range, according to the Palm Beach Post.

This move, as well as the Golden Gate transaction, seems to make sense for Limited Brands because the company can now focus its attention on its two higher-performing and more popular brands - Victoria's Secret and Bath and Body Works. In addition, the company has gained the much needed $50 million equity contribution and $75 million credit facility to help restore Limited Stores. Lastly, the company didn't lose all upside potential in Limited Stores, as it still owns 25% of the company.

This transaction also looks interesting for Sun Capital, considering they essentially received 75% of the business for $50 million. This seems like a very value-conscious deal when considering Limited Stores did almost $500 million in sales last year.

Negative sentiment from earlier posts today by Zac Bissonnette and Peter Cohan towards private equity can also be detected in this week's Economist, in different ways. Zac's post discussed the negativity displayed in the Moody's report, which discussed the firm's belief that private equity firms don't have a long-term time horizon when making investments. Peter's post opined on the Moody's report and referenced an older post he wrote with points that are still very relevant today. For example, the fact that money seems to be flowing in PE funds at a rate that can't be maintained much longer. I recommend readers check out both Peter's and Zac's posts.

Still more bashing? Well, yes. In this week's Economist, the "Leaders" section AND "Briefing" section joined in on the bashing.

Today, Carl Icahn increased his bid for Lear Corporation(NYSE:LEA) by $1.25 per share to $37.25, or $2.9 billion through his American Real Estate Partners LP. The roughly $100 million increase seemed to appease the board's lead independent director who professed his belief that accepting the deal was in the best interest of shareholders. This increase, however, doesn't appease the largest shareholder, Richard Pzena. In an interview, Pzena said, "We're voting against this...we're not looking for an extra dollar," according to Reuters. In the same interview, Pzena maintained his view that Lear is worth $55-$60 per share. Pzena was not the only unhappy person with Icahn's first offer, either. The California State Teachers Retirement System and Institutional Shareholder Services were both fervently against the $36 offer.

With his offer, the company's board accepted Icahn's $25 million breakup fee. Therefore, if the deal doesn't go through, Icahn will pocket $25 million. This also dissatisfied Pzena who said, "It is highly unusual and very coercive. It's saying to shareholders, 'If you don't do this, it will cost you."

Lear's prospects look very bright. Following a very strong downturn in the entire US-auto business, the company is recovering nicely. Analysts expect $2.94/share in earnings next year, versus just 9 cents per share in 2006, according to Yahoo! Finance. While Pzena's $55-60/share valuation seems rather high when looking at the stock's recent action, the stock's long term performance is familiar with such numbers, as displayed in the chart
below.

Today, buy-out firm Apollo Management raised its bid for Huntsman Corporation (NYSE:HUN) to $6.5 billion ($27.25/share), a 2.8% increase from a previous offer, according to Reuters. This rise can be attributed to bidding competition from the Dutch company Basell, which previously agreed to buy Huntsman for $25.25.

Apollo's offer is roughly 18x analyst estimates for full year 2008 earnings, and about 20x this year's earnings. This is in-line with the industry's 20x earnings multiple. Apollo is likely attempting to purchase this company to increase Huntsman's margins, as the company currently produces a weaker gross and operating margin than its industry - 14.6% gross margin vs. 20.8% for the industry, and 5.5% operating margin vs. 7% for the industry. Over the last several years, Huntsman has steadily decreased its liabilities, mostly attributable to cutting long term debt roughly in half.