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When a Buyout Goes Bad


First came Freescale's ugly private equity deal. Now the chipmaker has lost its CEO—and its bearings

When a posse of private equity firms decided to buy Freescale Semiconductor (FSL) in 2006, Michel Mayer was a major reason why. The 48-year-old Freescale chief executive had revived the chipmaker from near death after its spin-off from Motorola (MOT) a few years earlier, sending the company's stock price soaring. But on Feb. 21, Mayer stepped up to a makeshift podium inside the cafeteria at Freescale's Austin (Tex.) headquarters and delivered a dismal message to thousands of Freescale employees: "Welcome to the first town hall [meeting] of 2008, and what will be my last." Four weeks later the French-born CEO, known for his blunt manner and penchant for fast cars, was gone.

The acquisition of Freescale by Blackstone Group (BX), Carlyle Group, TPG, and Permira Advisers had provoked much skepticism in the buyout world. Private equity firms make money by acquiring companies, restructuring them, and then selling them off—and they usually finance the deals by loading the companies with debt. But the technology sector, with its massive research-and-development budgets and boom-and-bust product cycles, doesn't fit the mold. The semiconductor industry is more volatile than most, with sales sometimes whipsawing by 25% in a single year. Freescale's rich price tag—$17.6 billion, then the biggest tech buyout ever—raised more doubts among the financial cognoscenti. "The deal was priced for perfection," says one private equity veteran. In paying so much, the buyers—some of the world's biggest and most respected dealmakers—were essentially betting that nothing would go wrong.

But much has gone wrong. Freescale, which makes semiconductors for cell phones, telecom equipment, autos, and various consumer products, is shaping up to be one of the ugliest buyouts in history. Sales started slipping just months after the deal's close. Freescale's biggest customer, former parent Motorola, slashed orders, and Freescale wasn't able to add enough new customers to offset the shortfall. Revenues for 2007 tumbled 10%, to $5.7 billion, even as the industry's increased 5%. And the news keeps getting worse: On Mar. 26, Motorola announced it was spinning off its cell-phone unit, raising more concerns for Freescale.

None of this would have been so dire had Freescale remained a publicly traded company with relatively little debt. But Freescale's owners saddled it with $9.5 billion to pay for the deal. Now the company must come up with $375 million in interest payments every six months. Freescale's junk-rated debt trades for as little as 69 cents on the dollar. "It's like somebody is calling my baby ugly," says one member of the buyout group.

Making matters worse, Freescale's owners have lost a key accounting advantage. In the past, private equity firms were able to hide the results of poorly performing companies from their investors for years; they didn't have to reveal that a company they owned had lost value until they sold it or took it public. Owing to a rule change that took effect last November, they now must mark down the value in any quarter it drops. BusinessWeek has learned that Freescale's owners—a group that also includes insurer AIG (AIG), Canada's CPP Investment Board, and GIC, one of Singapore's sovereign wealth funds—have written down their $7 billion equity stake by 15%, or $1 billion. Other firms grappling with the new rule will be watching Freescale closely. "There will be more volatility [in the industry]," says one private equity veteran.

The entire buyout business is in disarray these days, with the debt markets virtually frozen and the economy deteriorating. Technology buyouts have been especially hard hit. A Kohlberg Kravis Roberts-led group that acquired chipmaker NXP in 2006 has marked its value down by 14%. Bonds of First Data, bought by KKR in September, 2007, for $27 billion, now trade at just 83 cents on the dollar. Says David Bailin, president of alternative investment solutions at Bank of America (BAC): "Tech buyouts are where the land mines are."

But few recent buyouts have been more disastrous than Freescale's. Its owners estimate it will take four years just to recoup their investment, much less generate returns. In hindsight, they made a costly blunder, betting that semiconductors had become a mature industry with stable cash flows, and that Freescale could easily shoulder the extra debt. Some also saw it as an acquisition machine that could one day be a giant like Intel (INTC). But given its huge interest payments, Freescale is having a hard enough time scraping up the $1.2 billion for R&D and $400 million for capital expenditures it says it needs each year to remain competitive. "We have a heavier mortgage [than before the buyout]," acknowledges Freescale Chief Financial Officer Alan Campbell. To make ends meet, the company is reorganizing operations, revamping its product lines, and scouring for customers. All options are on the table—including, for the first time, a breakup. "Freescale's whole business model is being questioned," says Moody's Investors Service (MCO) analyst Gregory A. Fraser.

Freescale expects to have $1.2 billion in cash on hand by June, enough to keep it going for a while. But its longer-term future is uncertain. Last year, Freescale's market share dropped by 9%, according to estimates from Gartner (IT), after having risen 8% in 2006. And Freescale won't book sales from its next-generation mobile chip until 2010. "They're not on my short list of the cell-phone chipmakers that will survive," says Michael Thelander, CEO of Oakland (Calif.)-based wireless consultancy Signals Research Group.

DRAMATIC MAKEOVER

Freescale has been in similar straits before. "When I joined the company, it had been given up for dead," says Mayer. "I had people coming to me and saying, What are you doing?'" Earlier in the decade, as part of Motorola, Freescale had few high-tech innovations in its pipeline and had piled up huge losses. Mayer, an executive in IBM's (IBM) semiconductor business, joined in May, 2004, to run the soon-to-be-spun-off company, and quickly began a dramatic makeover. He cut costs aggressively, moving more manufacturing overseas and slashing perks such as free broadband cable and car allowances. He also freshened up the management team with top executives from IBM, beefed up R&D, and ventured into new product areas such as chips for music devices. The moves were successful: Freescale showed nine straight quarters of earnings growth, a period during which its stock rose from 14 to more than 30. Mayer even began gearing up for an acquisition binge to diversify Freescale's product line and rev up profits even more.

In early 2006, Paul C. "Chip" Schorr IV, Blackstone's head of technology deals, approached Mayer about a possible buyout. The two had known each other since 2003, when Schorr, then at Citigroup (C), tried to buy a piece of the Motorola spin-off. Over the years, Schorr and Mayer talked frequently about the state of the semiconductor industry and bounced investment ideas off one another.

Mayer flew to New York over Labor Day weekend in 2006 to meet with Schorr and representatives from three other buyout firms, Carlyle, TPG, and Permira, at the law offices of Skadden, Arps, Slate, Meagher & Flom. The CEO spoke with confidence about the company's prospects: Sales of mobile-phone chips were expected to increase by as much as 20% in 2007 and auto chips by up to 8%. Freescale, Mayer said, was also on the verge of landing new mobile-phone customers, which would lessen its dependence on Motorola. Not that there were any worries there: Motorola's flip-top Razr phone was a monster hit, with some 30 million sold in 2005. Mayer assured the prospective buyers that Freescale would keep chugging along in the face of a slowdown in semiconductors because it was far more diversified than its peers, which include wireless chip players Skyworks Solutions (SWKS) and RFMD (RFMD). Mayer then met with representatives of each of the private equity firms to answer more questions. One attendee was so impressed that he trumpeted Freescale's "world-class CEO" when pitching the deal to his superiors.

The buyout firms thought they were getting a bargain. By their estimates, Freescale's stock, then trading at around 27, was undervalued relative to its peers, which were tethered tightly to the unpredictable chip-industry business cycle. Freescale didn't seem likely to suffer the same earnings swings, the prospective buyers thought, and should fetch more.

Just as the private equity firms were putting the finishing touches on a $37-a-share offer, another group—KKR, Bain Capital, Apax Partners Worldwide, and Silver Lake Partners—swooped in with a proposal to pay between $40 and $42. KKR had just bought Royal Philips Electronics' (PHG) semiconductor business, later renamed NXP. By merging Freescale with NXP, KKR figured, it could wring out more than enough cost savings to justify the higher price.

TAILSPIN TIME

With the new offer on the table, Mayer headed to Dallas for a three-day marathon of presentations to the new bidders and their investment bankers, lawyers, and accountants. At a kickoff dinner, Mayer curtly told the 30 or so guests that Philips had been trying to offload NXP for a while, and that he had passed on it. "I thought it was funny," says someone who attended the dinner.

The rival bid forced the Blackstone-led group to up its price to $40 a share, some 33% above Freescale's market price. Blackstone's team also promised to finance only about 60% of the purchase with debt, less than other buyouts at the time. And the firms arranged a $750 million line of credit as a safety precaution in case the semiconductor business slumped. "We didn't take as much money as the banks were offering," says Carlyle Managing Director Daniel F. Akerson. Freescale's board was sold. The deal closed on Dec. 1, 2006.

Within weeks, however, Freescale's condition began to worsen. Motorola, which accounted for a quarter of Freescale's revenues, went into a tailspin: Sales of its Razr phone had plummeted and its new phone, the Krzr, wasn't generating much buzz. In the first quarter of 2007 Motorola's market share dropped to 18% from 22% a year earlier. Soon after, giant cell-phone maker Nokia (NOK), which Freescale had been counting on as a new customer, decided not to use the company's chips in a new phone model. "People said, Whoa, the roller coaster just turned the other way,'" says an executive at one of the private equity firms that owns Freescale.

It didn't help that another recent change in accounting rules required Freescale to reflect on its books the difference between the value of the company's physical assets and the buyout firms' purchase price. That took a big bite out of profits: In April, 2007, it posted a $539 million first-quarter loss, after booking a $212 million gain a year earlier. In town hall meetings with employees and conference calls with investors, Mayer explained away the paper losses, assuring everyone that operating earnings were in the black and cash was plentiful enough to cover Freescale's interest payments.

The private equity firms seemed mystified, however. They weren't naive enough to think Freescale would never hit a rough patch, but they figured that if cell-phone chip sales slipped, other divisions would make up the difference. They didn't expect falling cell-phone sales to buffet the whole company, but that's what seemed to be happening.

As the buyout firms increased pressure on Mayer to stop the bleeding, he resorted to layoffs, firing 700 people. One former engineer says that as she walked into her boss's office to sign her pink slip and collect cardboard boxes to cart away her belongings, she thought about how three months earlier the manager had gushed about her importance to the organization.

The unexpected moves made staffers more uneasy about Mayer, for whom many already had mixed feelings. On the one hand, the buyout had created a ton of wealth for them. But Mayer, a tightly wound Frenchman in Texas, had bruised many an ego with his forthright style. He also seemed like an outsider to many lifers who had toiled at the company for decades.

The board, meanwhile, had trouble assessing the tech sector in general and Freescale in particular, say Freescale executives. Directors fired off demands to managers regarding everything from cost cutting to general strategy. Mayer and Campbell, the CFO, grew so exasperated that they asked the board to standardize their requests in monthly conference calls. "We asked them to speak in one voice to us," says Campbell. "We want to be productive."

As Freescale's profit picture deteriorated, its private equity overlords succumbed to infighting. The new accounting rules were a matter of especially fierce debate. When the 10-person board, which included two members from each of the four buyout firms, first discussed the matter on a conference call in September, 2007, there were at least four different opinions. It took five months for everyone to agree on the size of the markdown. Some argued that Samsung and BlackBerry-maker Research In Motion (RIMM) had signed on as potential customers, meaning an upswing was near, while others pointed out that publicly traded semiconductor stocks had begun to slide precipitously. "It was hard to say that Freescale wasn't down," says one board member.

Directors also disagreed among themselves on critical decisions, such as how to handle the company's contract with Motorola. After the buyout, Motorola agreed to purchase more than $2 billion worth of Freescale's chips in 18 months—but it ordered only a tiny fraction of that amount in 2007. Blindsided, the board searched for a solution. Should it force Motorola to comply? Should it tweak the deal? After months of tense negotiations with Motorola management, the two parties struck a compromise: Freescale would give Motorola more time to comply with the contract, in exchange for a one-time payment of several hundred million dollars. "It was a challenge for the company all year," says Carlyle's Akerson.

INVENTORY HEADACHES

The private equity firms were also trying not to fulfill their critics' most pointed prediction: that they would slash the precious R&D budget. After several meetings, the board decided to trim only modestly, from $1.2 billion to $1.13 billion. But Mayer would have to spend the money more wisely. "Either we need more growth out of research and development, or we're spending too much," says one buyout executive.

In December, 2007, as another giant debt payment loomed, Freescale was sitting on a pile of unsold inventory. Mayer, who was known to spend 14 hours a day in the office, raced to improve Freescale's financial picture. He worked his senior managers especially hard. "We were on call 24/7," says Campbell. Mayer and a team of managers traveled to China and Japan to drum up business, inking deals with automakers there. He also reorganized divisions by chip type rather than customer type, so that he could assess how each product was faring and allocate resources better. Among his first changes: moving R&D funds from the mobile handset group to the more- stable auto-chip business.

Mayer also hired former AMD executive Henri Richard, another Frenchman, to head a new, centralized sales force. With the zeal of a motivational speaker, Richard prodded the group to be "proactive" with customers. He also reminded them that Freescale was still No. 1 in certain areas, like autos. "We are clearly one of the key players in the automotive space, and we have to behave as such," says Richard, who adds that "it's our God-given right to define the future of the market."

But just as Mayer was leading the company's fourth-quarter charge, he was also beginning to inch toward the exit. He had made $50 million in the buyout and appeared to have grown tired of serving multiple private equity masters, say people close to him. Richard says Mayer didn't want to endure a lengthy turnaround process. "I could sense he was ready for something bigger," he says. Mayer says his four-year contract was up and he didn't want to renew. Some of his bosses, however, say he had signed a new contract at the time of the buyout that superseded the old one.

Despite Mayer's increasingly tense relations with the board and sinking popularity among some staff, his decision to leave created anxiety inside Freescale. Rumors had been swirling that the company would sell off its wireless division, prompting employees to start interviewing for other jobs. Freescale's directors decided to delay the formal announcement of Mayer's departure until February so they could line up a replacement first. Richard M. Beyer, the chief of Milpitas (Calif.) chipmaker Intersil (ISIL), agreed to take the job after having grilled board members for seven hours about the company's prospects. His ties with Blackstone's Schorr, a Freescale board member, helped clinch the deal. During Schorr's Citigroup (C) days, he bought a division from Harris Corp. that eventually evolved into Intersil.

The Brooklyn-born Beyer, a former Marine who's fluent in Russian, doesn't seem deterred by Freescale's balance-sheet troubles. "The fact that it has heavy debt is just the structure of the deal," says Beyer, who plans to spend his first few months on the job getting up to speed on Freescale's customers, products, and employees. "I don't believe it's a problem in the sense that it will preclude us from doing the things we need to do in terms of investments or mergers a


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