Category Archives: Private equity

the DELL story heats up

February 13, 2013 By in Industry Analysis, Private equity, Stock ideas, Technology Tags: , , , , , , , , , 1 Comment

latest developments

The New York Times reported yesterday that influential investment manager T. Rowe Price has joined the chorus of holders of DELL who are protesting that company’s board-approved proposal to be taken private by CEO Michael Dell and private equity firm Silver Lake at a price of $13.65 per share.

DELL’s largest institutional shareholder, Southeastern Asset Management of Tennessee, who we now know from a 13-D filed with the SEC owns 8.44% of DELL’s common (acquired at a price of just below $16 a share), seems to be leading the opposition to the deal.  

Specifically:

–Southeastern has published on its website an open letter to DELL, in which it outlines its argument that the company is actually worth about $24 a share, almost twice what the board has okayed as an acquisition price.  

–In the letter, Southeastern also gives a thumbnail sketch of a plan, using brokerage house earnings estimates, by which DELL could leverage itself (to the sky), pay shareholders a $12 special dividend and still be able to generate annual free cash flow of over $1 per share.

The NYT Southeastern has hired a proxy firm and a mergers and acquisitions lawyer.  In its letter Southeastern says it intends to pursue the matter through a proxy fight, lawsuits and, if I understand correctly, an appeal to the Delaware Chancery Court.

what I find interesting–and worth monitoring

–Southeastern is really upset, in a way I can’t recall ever seeing in a US-based institution.

It isn’t opposed to having DELL go private per se, only to the combination of preventing existing shareholders, ex Michael Dell, from participating, and what it sees as the low-ball price.

–Proxy fights are tricky things.  Why?  Individual investors support management overwhelmingly, even when it’s loony to do so.  It’s also hard to tell how much stock has been scooped up by arbitrageurs in the high-volume trading of the past month.  These guys aren’t in this for the long haul.  They want a quick profit and an exit.

Experience tells me it will be extremely hard for Southeastern to come up with enough votes to block the deal.  But it sure does seem motivated.

Always an advocate of the ad hominem argument (e.g., “You’re ugly!”), I wonder how the directors make out in this deal.

–Southeastern says in its letter it intends to avail itself of  ”any available Delaware statutory appraisal rights.”

Here’s what I think this means:  if a tender offer is successful in acquiring 90%+ of a company’s stock, the buyer can go to court and compel the remaining 10%- to tender their shares.  That 10%- have recourse, though.  They can appeal to the court for a hearing to argue that the price is too low.  If successful, they (and no one else) receive the court-determined higher price.

I’ve only followed this kind of appeal once.  The process took three years.  During that period, the company in question deteriorated markedly.  It turned out in hindsight that the acquirer had paid a crazy-high price.  So the court stated the (now) obvious–that the original price was too much.  So the reluctant 10%- ran up a pile of legal bills and got the original acquisition price, only three years late.

I wonder how things will turn out this time.

nits (or maybe slightly bigger issues) to pick

I understand the Southeastern letter only has the bare bones of its valuation argument.  Still, I view DELL has having much less cash than Southeastern assumes.  Yes, it’s there as $$$ on the balance sheet.  But a lot comes from DELL being able to hang on to the money it gets from customers before it needs to pay suppliers–sort of like a restaurant that gets cash every day but only pays for vegetables, rent and power at the end of the month.  Another big chunk comes from advance payments from corporate customers for IT services.  That’s sort of like magazine subscriptions, where the publisher gets money as much as a year before he puts the last issue in the mail to you.  Yes, things are fine in both cases as long as the business expands.  But the money evaporates if the business begins to contract.  As I read the balance sheet, DELL’s cash, net of these timing differences and   debt, is around zero.

Borrowing a gazillion dollars does mimic what I imagine Silver Lake intends to do as/when it takes DELL private.  Pay that out in a special dividend as Southeastern suggests is an alternative to going private, however, and how is the now highly leveraged company ever going to pay the principal back?

I understand that Southeastern wants to use third-party figures in its public analysis, but I find it humorous that its authorities are:  a management whose performance has lost 2/3 of the stock’s market value in a rising market; and Wall Street securities analysts who, as a group, are notoriously optimistic and deeply beholden to company management.

 

 

 

Michael Dell taking Dell Inc. (DELL) private–why?

February 11, 2013 By in Current Market Thoughts, Industry Analysis, Private equity, Recent Market Action, Stock ideas, Technology Tags: , , , , , Leave a comment

the deal

On February 6th, DELL confirmed the rumored buyout of the company by founder Michael Dell and private equity firm Silver Lake.  The board has approved an all-cash deal in which holders of Dell common will receive $13.65 for each share.

The structure of the private Dell isn’t 100% clear.  From press reports, Michael Dell will contribute his 14% holding in the company, worth $3.3 billion at the buyout price, plus $700 million in cash in return for a majority stake in the new entity.

Let’s assume MD’s $4 billion buys a 50% interest.  Given that the overall assets of DELL are being valued at $24.4 billion, this would imply that the private company will have $16.4 billion in debt to go with $8 billion in equity.  That’s a tripling of the financial leverage that publicly traded DELL now maintains–no great surprise for a private equity deal.

DELL is a mess

Profits peaked in 2005, when the company achieved a return on invested capital of an extraordinary 83%.  This year’s results (the fiscal year ends in January) will be around 40% lower than that high water mark, and will likely represent a 15% return on capital.  Strangely, the company has decided to celebrate this adverse turn of fortune by initiating a dividend.

In recent years, DELL has been attempting to transform itself from being an assembler of heavy, clunky (but inexpensive) PCs for mostly corporate users into a purveyor of corporate IT services, using IBM as a template.  Nevertheless, by far its largest expenditure since its profit peak has not been on service company acquisitions or on internal development.  Instead DELL has chosen to retire a quarter of its outstanding shares since 2005, at a cost of (I almost can’t believe the numbers) $22 billion or $23.80 a share.  With the stock was trading at around $8 before rumors of going private surfaced, this continuing decision represented $14 billion in lost value to shareholders.

Since the beginning of 2005, the S&P 500 has risen by 29.6% on a capital changes basis.  Over the same time span, Lenovo is up by 118%.  Hewlett-Packard is down by 12.7%.  Dell has lost 66.8% of its per share market value.  Acer and Asustek have been equally bad performers, although that’s cold comfort.

shock therapy?

That’s what I think this buyout is about.  It’s been clear for years that the traditional PC assembler model is broken.  AAPL’s success clearly demonstrates that.  Samsung has emerged as a very powerful competitor, as have Lenovo, Asustek and Acer.  INTC’s Chromebook initiative and  MSFT’s Surface both show frustration with the lack of competitive relevance of assemblers like DELL and HPQ.  Yet, as far as I can see, DELL hasn’t improved its PC offerings, or its service, much at all.

In my experience, mature companies can resist change in an almost unbelievably stubborn way–the source of the saying that “Turnarounds never happen.”  Maybe managers lack the skills needed to succeed in a new environment, so they simply can’t do a better job.  They may not understand the issues.  Or they may not be risk takers, preferring a mediocre-to-bad present to an uncertain, but possibly better, future.  In any event, they drag their feet.  What can one man do, even the founder of a company, in the face of widespread inertia?

Bring in a whole new management–a firm like Silver Lake that specializes in straightening out mature, underperforming tech companies.  The going private part of the maneuver is at least partly that it’s Silver Lake’s price for taking on the job.

some big DELL holders aren’t happy

Southeastern Asset Management, which owns just under 10% of DELL, is one of them  Reuters reports that there are at least a few others.

Even a cursory glance at a stock chart will tell you why.  Unless the firms in question bought DELL in the last couple of months,  or during the final days of the market meltdown in early 2009, they will be forced to recognize big losses from holding the stock.

They have some justification, since they’ve stuck with DELL through thin and thinner.  This is what value investors do.  They buy mediocre or weakly managed companies and wait for change to happen.  They’ve been right in this case that change would happen, except that it’s coming in a way they didn’t anticipate.

On the other hand, DELL probably needs much more radical surgery than the institutions ever imagined, meaning that it would best be done away from the requirements of public disclosure, from media attention and from the reach of short-sellers.  That way customer confidence is easier to maintain.

 

 

 

 

 

is the income tax preference for private equity justified? …I don’t think so

January 29, 2013 By in carried interest, Private equity Tags: , , , , Leave a comment

simplified preliminaries

Private equity investors raise money from institutional investors.  Those funds become the equity portion of highly debt-leveraged capital cocktails used to purchase underperforming companies.  Once in control of a target company, private equity typically tries to streamline operations.  It cuts overhead (including marketing and R&D) and staff, with the intention of selling the made-over and hopefully more profitable project firm, as a whole or in pieces, within five-seven years. 

Private equity is paid in two ways:  through recurring management fees for its projects, and through a share of the profits when the project company is sold.  Applied to private equity, carried interest refers to the practice of having the private equity managers’ compensation structured, either mostly or entirely, as equity–ownership interests in projects.  As a result, although the compensation sounds a lot like what hedge funds charge, it is taxed as long-term capital gains rather than ordinary income.   This “tax shelter” feature of private equity was highlighted in last year’s presidential campaign, which showed that Mitt Romney’s paid Federal income tax at about a third of the normal salary rate.

most investment professionals pay normal income tax

Last year, Representative Sander Levin of Michigan introduced a bill to close the tax loophole that private equity uses.  Mr. Levin has been quoted as saying that it isn’t fair for investment professionals to pay taxes at a lower rate than workers in other industries.  I agree.  I should point out, though, that Mr. Levin is wrong about one thing.  The income of the vast majority of investment professionals–private equity being the only notable exception–is already taxed as ordinary income.

is there reason for a tax preference for private equity managers?

Do private equity managers perform an important economic and social function that would not be accomplished if their compensation were taxed at normal rates?

The two potentially positive arguments that I can see are :

1.  that private equity managers are an essential part of the “creative destruction” that continually reinvigorates the US economy.  They take idle capital out of the hands of those who use it badly and put  those corporate assets into the hands of people who can employ it more effectively.  Sounds good.  But I haven’t read a single study of the private equity industry that shows conclusively that private equity makes the companies they acquire very much better.  Yes, barnacles get scraped off the bottoms.  But researchers I’ve read conclude that any supernormal returns generated by private equity projects come from the debt-heavy (read: very risky) financial structure they fashion in their project companies.

2.  that they provide counterbidders to trade buyers ( i.e., industrial companies) who would otherwise capture M&A targets too cheaply.  That’s probably true.  But this doesn’t man any extra social good is created.  This is more an issue of into whose pockets the purchase premium goes–the buyers’ or the sellers’.  Private equity tilts the field toward the sellers–who, by the way, happen to be the guys who have spawned and tolerated the inefficient entity.

lobbying legislators has been the key to preserving carried interest (no surprise here)

Heavy lobbying by the private equity industry, both in the US and in Europe, has protected the carried interest tax avoidance device so far.  Not for long, though, in my opinion.  Mitt Romney, a key figure in private equity a generation ago,  became a public illustration of how private equity mega-millionaires use the carried interest loophole to make their tax bills from Uncle Sam all but disappear.  It didn’t help, either, that Mr. Romney was inarticulate and disorganized during the campaign–and completely blown away organizationally and in the use of technology by Mr. Obama.  And Mr. Romney was supposed to be the cream of the private equity crop.  

dissecting the fiscal cliff

November 12, 2012 By in carried interest, Current Market Thoughts, economics, fiscal cliff, Private equity, Strategy Tags: , , , , , , Leave a comment

I’m back home, in the land of electric power and heat, but no internet or TV.  I’m using my phone as a mobile hot spot, but I can’t seem to get a look at the layout of this page.  Sory if the numbers below are hard to see.

Hurricane Sandy humor:

–a runaway Coca-Cola truck knocked down a utility pole on our street on Saturday, splaying live wires all over the place.  Luckily it wasn’t the more important one the big tree knocked down during the storm.  PSEG cleaned up in a matter of hours.

–I called/chatted with Comcast to find out about restoration of internet/TV service.  The two people I spoke with were very nice but said they had no idea.  Both confirmed that Comcast continues to charge customers for service even though there is none.  You have to call them and ask for a refund!!!  Why am I not surprised?

Today’s post:

“Economic Effects of Policies Contributing to Fiscal Tightening in 2013″

On November 8th, the Congressional Budget Office issued an update on its fiscal cliff analysis, titled “Economic Effects…”.  The report makes several points:

1.  ”driving over” the fiscal cliff isn’t a good idea

The problem is the domestic economy is still very weak.

The CBO predicts that continuing Washington stalemate would cause a short but sharp recession in the US during the first half of next year.  Growth would resume from the crunch, but from a lower level, in the second half.  But this would be by a small enough amount that real GDP would still end up in the negative column for the full year.

More important, unemployment would spike upward to an estimated 9.1% a year from now, postponing the return to economic normality for the country (meaning reduction in the unemployment rate to 5.5%) until early in the next decade.

2.  the status quo isn’t so hot, either

Continuing the current situation where Washington continually spends more than it takes in will ultimately force interest rates in the US–both for the government and for private borrowers–higher than they would otherwise be.  Maybe a lot higher.  At some point we’ll have a repeat of 1987, when domestic lenders refused to buy any more government debt and the long bond spiked to 10%.  The CBO implies that this is only a remote possibility at present.  But as the debt grows the problem becomes progressively harder to solve.

3.  the long-term solution

(I haven’t seen anyone write about this.)  For the CBO, two moves are important.

–broaden the tax base, don’t raise rates.

–reduce entitlement spending.

4.  in the short term, however…

(short = the next two years)

…postpone part or all of the fiscal cliff elements.  Address the deficit issues in an aggressive way in 2015, when the economy will presumably be healthier and unemployment lower. That way, we have a much better chance to get chronic unemployment under control.  If so, we’re likely to reach full employment in 2018–a time when we can attack the government fiscal mess in a more serious way.

5.  components of the cliff

The numbers are the boosts to real GDP that each would likely provide:

extend expiring income tax provisions for everyone          +1.4%

do so, but omit high-income earners                        +1.3%

extend payroll tax reduction, emergency unemployment benefits             +.7%

eliminate defense spending cuts               +.4%

eliminate non-defense spending cuts          +.4%.

my take

–The CBO analysis doesn’t take anticipatory effects into account.  In other words, it doesn’t address the issue of whether the slowdown in growth we’re now seeing in the US is adjustment in advance to the worst-case (“driving over”) scenario.  If so, the positive economic effects of breaking the logjam in Washington could be greater than the CBO estimates.

We can certainly see effects in the number of M&A deals being done before yearend—DIS/Lucasfilms is a good example.  But there are lots of others.

–Whether income tax rates rise for high-income filers has very little economic significance.  +/- 0.1% in GDP growth amounts to a rounding error.

–From a stock market perspective, the Obama-proposed increase in the tax on dividends is the key possible change that I see.

–Generally, I’m skeptical about arguments that depend on “fairness,” because I think the concept is so perspectival.  In a lot of cases, “fair” equates to just “I get more and you get less.”  Having said that, I think one of the most un-fair things in the tax code is Romney-esque carried interest, whereby high net-worth financiers turn ordinary income into capital gains.  I wonder if that loophole will be closed.

 

 

private equity zombies–very hard to kill

June 21, 2012 By in carried interest, Private equity Tags: , , , , , Leave a comment

what they are

The Wall Street Journal has been writing recently about private equity “zombie” funds.  These are funds that whose managers refuse to liquidate and return the proceeds to the original investors, even though the typical 8-10-year fund life has already passed.

A given private equity investment is supposed to last around five years.  That gives the managers time to make operating improvements and locate a buyer to sell the now-polished-up company to.  Add a year or so to that, so the managers to find enough good investments to use all the fund’s capital.  Add another, in case recession makes buyers temporarily wary.  That’s how you get to 8-10 years of life for the total fund.

In theory, private equity managers have no interest in keeping client money.  True, they get a recurring yearly management fee of around 1% of the assets under management (based, incidentally, on their own estimate of asset value–another bone of contention).  But their big payoff comes from their “carried interest,”  the 20% or so of the capital gains generated by each project that clients cede to them.  Private equity managers only collect this when the project is sold and proceeds returned to the clients.

The details, including the “sell by” date, are all spelled out in the private equity contracts.

How, then, can “zombies” arise?

The combination of two circumstances keeps them lurching around:

–failed investments, ones with no capital gains possibility, and

–clauses in the early private equity contracts that gave the managers (unlimited) extra time to find a buyer.  The intention was good–to not force the private equity managers to sell at a bad time.  In most cases, however, there was no other provision giving clients a course of action if they disagreed with the managers’ assessment.

The result is hundreds of failed private equity funds that refuse to liquidate, because managers want to continue collecting an annual fee.  They claim they’re looking for buyers, but…  The WSJ thinks that what we’re seeing now is just the tip of the iceberg.

two lessons

1.  Buy in haste, repent at leisure.  In the early days of any new investment fad, buyers rush headlong to be one of the first owners of the new thing.  They rarely look carefully.  If they are alerted about possible pitfalls, like no recourse if the private equity manager refuses to give back remaining money, they ignore the warnings.

2.  In desperate times, almost no one remains honest.  I’m an optimist.  I have great faith in human nature.  But in “zombie” circumstances, this is always a foolish bet.  At the very least, a professional with an obligation to protect clients’ assets shouldn’t rely on the kindness of strangers.

why not let sleeping dogs lie?

Institutional investors appear to be making a big push now to get their dud private equity investments resolved, even by selling them for half nothing (assuming they can find a buyer at all).

Why?

Two reasons:

–for taxable investors, an investment loss has an important tax value.  The present value of the loss deteriorates over time, so the sooner it’s used, the more it’s worth.

–keeping a dud investment on your balance sheet makes you look like an idiot.  Well, when you bought the thing, you were an idiot.  That’s the way it is.

But there’s invariably someone on your board of directors who will ask about it at every meeting.  Prospective clients may even make little gasping sounds if they recognize it on your list of holdings.  The black eye you’ve given yourself will only fully disappear when the investment is sold.  This is especially important if you see more of these coming down the track.

 

Follow

Get every new post delivered to your Inbox.

Join 193 other followers