After their hard-won victory in yesterday’s shareholder vote, Michael Dell and Silver Lake Management LLC face the sterner test of turning around Dell Inc. (DELL:US), the computer maker they are acquiring for $24.9 billion in the largest buyout of a technology company ever.
It’s a task some of Silver Lake’s backers wish it hadn’t taken on, according to interviews with six investors in the Menlo Park, California-based firm. Three said they would have preferred the deal hadn’t gone through, while three others said they were willing to give Silver Lake the benefit of the doubt.
Since Silver Lake agreed seven months ago to spend $1.4 billion for a stake of about 25 percent in Dell, prospects for the computer maker have faded so quickly that advisory firm Institutional Shareholder Services Inc. called the company a “falling knife,” even as it endorsed the deal. To reverse the slide, Silver Lake agreed to rely on founder Michael Dell, who has presided over a 55 percent drop in adjusted net income (DELL:US) since he returned as chief executive officer in 2007.
“Now comes the hard part,” said Erik Gordon, a private-equity and law professor at the University of Michigan. “If it succeeds, Silver Lake will be crowned either the greatest tech turnaround visionary of the decade, or the luckiest duck. If the deal turns into a dog, its reputation takes a big hit.”
Shareholders approved the buyout after billionaire financier Carl Icahn and Southeastern Asset Management Inc. dropped their effort to upend the deal. The decision ends months of fighting between the parties over the computer maker’s value.
The financial adviser to the special committee overseeing the sale process for Dell’s board had pegged the annual returns Silver Lake and Michael Dell could make if their deal went through at close to 50 percent, Southeastern said in June. This was based in part on a months-old estimate of earnings before interest, taxes, depreciation and amortization, or Ebitda, of $5.1 billion for the current fiscal year.
Two brokerage analysts, who requested anonymity because they weren’t authorized to speak, projected annualized investment returns of less than 11 percent, based on the latest consensus estimates for the next few years. Private-equity managers historically have sought annualized returns of 20 percent or more.
Silver Lake, whose $23 billion in assets make it the biggest technology-oriented buyout firm, has typically fared well in large technology buyouts in which it held a minority stake. According to marketing materials for its $10.3 billion third fund, which completed fundraising in April, the firm made a 213 percent profit on a $934 million investment in Skype Technologies SA, a video-chat company; a 730 percent gain on a $324 million stake in disk-drive maker Seagate Technology Plc (STX:US); and a 430 percent profit on the $392 million it put into chipmaker Avago Technologies Ltd., as of Sept. 30.
Skype and Seagate were gambles that at first had the firm’s limited partners scratching their heads, said one of the investors, who like the others asked not to be identified to avoid damaging relations with Silver Lake. Three investors said they have confidence in Silver Lake’s chances based on its past success with these technology deals.
Skype was barely profitable and embroiled in an intellectual property lawsuit when Silver Lake and others acquired it in 2009. The suit was settled and Ebitda had more than doubled when Microsoft bought Skype for $8.5 billion in 2011. Seagate, a buyout Silver Lake led in 2000, was a bet on disk drives, a fast-evolving, money-guzzling business that other companies were abandoning.
At Dell, the biggest equity investment in Silver Lake’s 14-year history, the challenges are even bigger. Once the world’s top supplier of PCs, Dell has spent about $13 billion on acquisitions over the past five years to add enterprise computing hardware, software and services. The deals have yielded little return for investors, and the company has ceded the fast-growing mobile-computing market to Apple Inc. and devices running Google Inc.’s Android operating system.
In the last 12 months, analysts’ consensus per-share earnings estimate for this year, excluding some items, have fallen to 94 cents from $1.80. Their consensus (DELL:US) estimate for current-year earnings before interest, taxes, depreciation and amortization has dropped to $3.04 billion from $5 billion, according to data compiled by Bloomberg.
The outlook helped persuade Blackstone Group LP (BX:US), the world’s biggest manager of alternative assets such as private equity, to bow out of bidding for the company. Dave Johnson, a Blackstone executive who helped spearhead the firm’s bid, knew Dell well, having led its merger-and-acquisition efforts from 2009 to 2012.
Even before the spate of bad news for Dell this year, the buyout shaped up as risky. Late in 2012, KKR & Co., the private-equity firm run by Henry Kravis and George Roberts, decided not to make an offer for Dell because of the uncertain market for personal computers and competitive pressures on Dell. Another sponsor that had looked at Dell, TPG Capital, said no twice: last year and then during the go-shop period this year, when Dell had an opportunity to solicit alternatives to Michael Dell’s bid, according to a person with knowledge of the matter.
Silver Lake’s appetite for risk also had a limit. Shortly before the deal was signed, the special committee asked for a final, modest price boost. When Silver Lake balked, Michael Dell kicked in the extra money. In late July and early August, under pressure from Icahn, they raised their original $13.65-a-share proposal by 1.7 percent, adding 10 cents a share to the base offer and a dividend of 13 cents a share.
Even with Michael Dell bearing most of the risk, a failure to turn around Dell would damage the reputation of Silver Lake, said one backer, who runs money for a large pension.
Not all of Silver Lake’s minority deals have panned out. Last September, the firm valued its $1.01 billion investment in networking-equipment maker Avaya Inc. -- its biggest single-company investment before Dell -- at 10 percent below cost, according to a marketing document. Collectively, Silver Lake has posted more than a 19 percent average annual net return in almost 50 deals.
Gordon, the law professor, gave Silver Lake and Michael Dell credit for resisting being drawn in a wide-open bidding war. They displayed a restraint lacking in past takeover contests, most famously in the $31 billion fight for RJR Nabisco in 1988, he said. KKR’s victory in RJR proved to be Pyrrhic when the firm wound up taking a loss of $816 million on its $3.6 billion equity investment, according to a confidential KKR document obtained by Bloomberg News.
“To get the returns it needs for its investors,” Gordon said, “a company that was declining in a declining industry would have had to remake itself in highly competitive areas in which it has no competitive advantage.”
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