The Deals That Didn't Happen
How buyout firms exercised discipline despite all the criticism
By Kelly Holman February 18, 2008
The best deals -- as some investors may discover -- may be the ones that aren't completed.
It's an obvious notion that cannot be overstated. Entire investments can be wiped out if a private equity fund's portfolio company does not perform as well as expected or, worse, slips into bankruptcy.
Factors like the credit market turmoil on Wall Street, a slowing economy, rising energy and raw materials costs are making the financial sponsors that walked away from deals last year look smart. Private equity financiers backed off from transactions at financial terms that seemed uneconomic, faced down reputation risks, and turned out to be disciplined investors at the end of the day.
"In times of crisis, the discipline approach to deal terms wins out. While getting a deal done on terms is optimal, lost capital is going to be worse for a fund's returns than capital that hasn't been invested," says Rebecca Silberstein, a partner at Debevoise & Plimpton in New York.
For the financial institutions involved in arranging multi-billion debt syndications for leveraged acquisitions, the benefits of uncompleted deals are apparent. Underwriters of debt used to finance mammoth deals that collapsed found their loan inventories suddenly lighten up. Some of them, no doubt, breathed a sigh of relief.
The crux of last year's deal collapse was the credit market crunch. The easy credit markets that enabled buyout firms to finance acquisitions at aggressive multiples ranging from as much as 9 to 12 times cash flow or higher pretty much ground to a halt following the subprime market meltdown over the summer. Investors in leveraged credits like collateralized loan obligation funds retreated en masse, leaving Wall Street banks saddled with unsyndicated debt, ultimately resulting in large write downs.
Private equity buyers, as a result, sought to renegotiate transactions when banks balked at financing deals.
Some transactions, like Blackstone Group's $1.8 billion acquisition of Mount Laurel, N.J.-based specialty finance company PHH, fell apart directly as a result of debt issues. The New York firm was unable to secure enough credit from JPMorgan and Lehman Brothers to complete the purchase of PHH by the transaction's closing date of Dec. 31, 2007, because of a $750 million financing shortfall. Blackstone wound up paying a $50 million break-up fee. Chances are that the renowned investment firm run by Stephen Schwarzman is not terribly upset about losing PHH because the consumer finance industry is in turmoil.
Termination fees are recorded as losses on a fund's investment record. But, break-up fees that may amount to as little 3% of an LBO's total transaction size are much smaller than the equity at stake in an acquisition. Investors may put up as much as 40% of equity in a purchase with the remaining 60% consisting of debt. Of course, the debt and equity percentages may vary, but the point is paying a termination fee is a small price to pay relative to losing an equity investment in a deal gone bad, observers say.
But, don't blame ugly credit market issues for the collapse of every LBO. Financial buyers in some cases discovered that something specific had occurred within the target company they were acquiring, according to industry observers like Silberstein.
If there was a poster child for such a situation it was the $8 billion recapitalization by Kohlberg Kravis Roberts and GS Capital Partners, the private equity arm of Goldman Sachs, of audio equipment maker Harman International Industries. The pair of New York private equity buyers firms decided against buying Harman International on the basis of exercising the rarely-used material adverse change clause, or MAC, in their merger agreement.
A MAC is a standard part of merger agreements allowing an acquirer to walk away from an acquisition or renegotiate terms if a material change is believed to have taken place in the target company's business in the time period following the signing of a purchase agreement.
Prior to the April 2007 announcement that KKR and GS Capital agreed to purchase Washington-based Harman for $120 per share at a 17% premium, the company had posted promising quarterly results. Its net income totaled $71 million on $882.8 million in sales for the quarter ended March 2007, compared with $64 million of net income on $801.5 million in revenues for the prior year quarter.
Five months later, however, the financial buyers squelched the acquisition. The stage was set for other deals to fall apart on the basis of MACs.
KKR and GS Capital's decision was validated when Harman posted $43 million in net income for its second fiscal quarter ending on Dec. 31, 2007, marking a 53% decline from its 2006 second fiscal quarter income of $81 million. Harman chief executive Dinesh Paliwal attributed the drop to a drop in demand from the auto sector as well as rising material and research costs.
The banks that had agreed to finance Harman's purchase -- Banc of America Securities, Credit Suisse, Goldman Sachs and Lehman Brothers -- were off the hook for at least $4.5 billion of debt financing arranged for the transaction. The two private equity firms saved face by agreeing to invest $400 million in Harman's convertible preferred shares and avoided paying a $225 million termination fee.
Sometimes, a buyer cannot invoke a MAC clause, but walking away from a deal may still make sense.
"While terminating a transaction by calling a MAC is a possibility in appropriate cases, in situations where that option is not available, it can be far better to pay a breakup fee than to acquire a business that no longer justifies the offer price," says Bill Kirsch, a partner at Paul, Hastings, Janofsky & Walker who chairs the firm's private equity practice.
Just days after news about KKR and GS Capital's decision to back away from Harman came to light, New York private equity firm JC Flowers and co-investors JPMorgan and Bank of America back-pedaled on their $25 billion, $60-per-share purchase of Reston, Va.-based student lender SLM, also known as Sallie Mae. The JC Flowers group that had committed to invest $8.8 billion of equity retreated from the purchase because of legislation that would affect the company's student loan business and impact future financial performance.
SLM said that its net income was expected to decline from 1.8% to 2.1% over the next five years as a result of the legislation, which one source familiar with the buyout says was a low-ball estimate.
JC Flowers' agreement to acquire SLM in April was tailored with a specific material adverse effect clause that considered student loan legislation unlike the standard MAC language in merger agreements, says the source.
SLM counter-punched with a suit against the investor group in October, seeking payment of a $900 million termination fee. The Virginia company ultimately dropped its suit in late January, ending months of contentious legal wrangling and the fee imposed on the buyers. The deal's cancellation also enabled Bank of America and JPMorgan to get out of financing $12.5 billion in senior secured debt as stipulated in the purchase.
JC Flowers decision proved more prescient than imagined last week when SLM was unable to sell $200 million of student loan securities through a sale run by Goldman Sachs, according to New York's Keefe, Bruyette & Woods.
"I think people, even Chris Flowers, began to worry about the balance sheets of their targets," says David De Weese, a managing partner of Paul Capital Partners, a New York secondary market-focused private equity firm. "The transparency that people thought was there turned out to be less than fully adequate," De Weese says.
One of the smaller transactions that didn't make it to the finish line was ValueAct Capital Partners and Silver Lake Partners' $3 billion, $27.10 per share purchase of Little Rock, Ark.-based Acxiom in early October. Though the company and acquirers did not supply a reason for the buyout's termination, Acxiom reported in July that its financial performance declined prior to the deal's cancellation. The company reported a net loss of $11.5 million in the first quarter of fiscal 2008. ValueAct, a San Francisco-based hedge fund, and Silver Lake, a Menlo Park, Calif.-based private equity firm, opted to pay a reduced $65 million termination fee.
Other deal cancellations were decided in the wake of court proceedings.
In December, New York's Cerberus Capital Management and Greenwich, Conn.-based construction equipment rental company United Rentals terminated their $4 billion merger agreement signed in July. Cerberus ultimately paid a $100 million break up fee to walk.
Not every private equity buyer sought to walk away from deals in the wake of credit-market challenges. Some renegotiated transactions.
For example, Boston's Bain Capital Partners, Washington's Carlyle Group and New York's Clayton, Dubilier & Rice retooled their purchase of Atlanta-based Home Depot Supply for $8.5 billion in August, taking an 18% haircut and investing an additional $450 million of equity to secure financing arranged by Merrill Lynch, JPMorgan and Lehman Brothers.
One deal that has yet to close in 2007 but was agreed upon in November 2006 is Thomas H. Lee Partners and Bain Capital's $27.4 billion, $39.20 per share buyout of San Antonio, Texas-based Clear Channel Communications. The $14.8 billion market-capitalized company with more than 1,100 radio stations and 39 television stations, which has a $600 million break up fee, is being closely watched in the deal community. Since being amended twice from an original purchase price of $37.60-per-share the transaction was approved by the Federal Communications Commission, as well as Clear Channel shareholders in September 2007. Last week, it received Department of Justice approval. The DOJ's approval came at a cost: Clear Channel had to sell radio stations in Cincinnati, Houston, Las Vegas and San Francisco. The pair of Boston private equity firms own media companies that manage radio station operations in those cities.
Bankers, analysts and Clear Channel executives are optimistic that the company's purchase will close in the first quarter. But, the banks involved in financing the buyout are rumored to be interested in getting out of the purchase, says one market source. That's not surprising since there's lackluster demand for leveraged loans.
A decline in ad spending is expected to impact the bottom line of most media companies, though Clear Channel is expected to largely steer clear of the decline.
According to Houston wealth management firm Stanford Group, Clear Channel's radio-related revenues may only decline as little as 5% as a result of softened ad demand, while its outdoor advertising that generates roughly 50% of its sales is expected to benefit from 4% growth in 2008.
Clear Channel oversees more than 800,000 outdoor advertising displays in over 60 countries. Hence, it's no surprise that the company derives about 50% of its outdoor ad-related revenues from outside the US.
However, Clear Channel's stock performance has deteriorated over the past year. Its shares have traded at a range of $27.77 per share to $38.58 a share.
On Thursday, the day it was expected to announce its fourth quarter results after the market's close, it shares changed hands at $29.88 per share.
As of the third quarter 2007 Clear Channel's financial performance looked solid. The company reported in November that its revenues increased for the quarter by 5% to $1.7 billion whereas its income for the third quarter before discontinued operations amounted to $256.3 million, or 51% over the prior year quarter.
While the investment banks that arranged aggressive financings for private equity deals have been hamstrung by the credit market, bankers say corporate boards and financial advisors may make it tougher for LBO firms to walk away from deals.
Termination fees have yet to increase, but "the price will be paid by everyone in the private equity community," says one financial sponsor banker at a prominent New York bulge bracket firm who declined to be named. "The boards of directors will try to get their sell-side advisors to eliminate any wriggle room on the part of buyers."
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