BusinessWeek Online - Deal Flow

Sallie Mae deal at risk

The $25 billion buyout of student loan company SLM could be scuttled as Congress debates new laws that would cut funding for the market. The private equity consortium, which includes JC Flowers, JP Morgan and others, argues that the legislation could "result in a failure of the conditions to the closing of the merger to be satisfied, according to a statement by SLM.

I can't help but wonder if the legislative issues are a cover for deeper questions over whether the deal makes sense. The buyout includes a 50% premium over the market price before the deal was announced. Analysts at S&P questioned whether the deal made strategic sense. link.
The market has changed a lot since the buyout was launched in April. Investors are much more skittish when it comes to buying highly-leveraged debt. link. Maybe the buyout firms simply decided that the market might not readily absorb more debt tied to what some perceive as a risky and expensive deal.

M&A advisor questions whether Avaya buyout will pay off

I thought that TPG and Silver Lake's $8.2 billion buyout of corporate phone-maker Avaya made a lot of sense. Sure, the company is in a tough business and faces competition from all sides, but buyout firms are supposed to be good at mananging those challenges. Telecom deal advisor Paul Bowen, founder of Bowen Advisors, in Cohasset, Mass., is more skeptical. He sent me a long email questioning the wisdom of the deal. Thanks, Paul. I'm passing along the full text of his analysis. What do other people think?

"When the deal dust settles, the interesting question will be how will Avaya's new ownership expect to compete more successfully? My strong belief is that the company will struggle. This future uncertainty has nothing to do with Avaya and everything do with industry dynamics.

"What are these industry dynamics of which I speak? Enterprise telephony is rapidly shifting away from Time Division Multiplexing (TDM)-based Private Branch Exchanges (PBX) to hosted IPCentrex solutions and PBXs. Whether it's BroadSoft with its hosted IPCentrex solutions, Asterisk with their low-end Internet Protocol (IP) PBX or the ever present IP-focused behemoth Cisco, competitors are attacking Avaya's core business from all sides.

]]> "At the high end of the market, as defined by size of the corporate customer, one can only conclude that the Private Branch Exchange (PBX) business lacks global scale. Nortel and Lucent (Avaya) historically have had leading market share but struggled to translate that share into new geographies. Siemens has never held a meaningful presence in a foreign market with the exception of its headquarters in Germany. Alcatel has at best been a number four market share player. While Cisco has arguably exhibited the best execution over the last five years, a closer look reveals that the CallManager strategy has much more to do with selling packet-based routers and switches than it does with selling PBXs and IP phones. Cisco's sheer size and raw profitability has allowed this strategy to work in an era of declining revenues and weakening of traditional PBX players.

"The high end of the PBX market has five years of declining revenues before ultimate capitulation. The capitulation will primarily come at the hands of a hosted service provided by traditional service providers (e.g., Verizon). Enterprise IP connectivity and the power of Voice over Internet Protocol (VoIP) allows service providers to finally provide differentiated services that are simply too powerful and have low price points for corporations to resist. In the middle of the market, from 400 seats to 10,000 seats, desktop telephony, provided by the likes of Microsoft, BEA, Oracle and now Google (a.k.a., the data or internet players), stands to revolutionize your "telephone experience" no less radically then e-mail revolutionized corporate communications.

"At the low end, generally defined as "key systems" or sub-400 seat accounts, the transformation is no less radical. The Asterisk open source movement is well beyond a fad and is now capturing significant portions of the market. Yes, open source, the same concept that has fueled Linux use in corporate operating systems, has also found its way into corporate telephone systems. It works. It's cheap. And it improves nearly every day. Avaya acquired Nimcat Networks to compete in this market, but has not seen the industry share they expected.

"Truth be told, Avaya has done an admirable job protecting its installed corporate and call center customer base while transitioning from analog to digital; TDM to IP; Primary-Rate Interface (PRI) to Session Initiation Protocol (SIP). The current management team deserves credit because they have generally delivered for their large corporate customers and, in so doing, generated nearly a 25 percent premium for Avaya shareholders.

"Now fast forward to the likely scenario we will encounter under Silver Lake and TPG ownership over the next five years. Enterprise telephony has reached an inflection point that will leave the business looking nothing like it has over the last 100 years. The question to ask: has Avaya's leadership already figured this out?

"In summary, one can only conclude that the corporate chieftains at Avaya knew exactly what they were doing when they agreed to sell to private equity buyers. The potential corporate acquirers, knew precisely what they were doing when they allowed private equity buyers to acquire Avaya. Which begs the second question that reporters and bloggers have not been asking; did the private equity buyers at Silver Lake and TPG have any idea of what they were getting into when they acquired Avaya?"

Another view on strategic buyers

I argued yesterday that strategic buyers are often at a disadvantage when they are in competitive situation with financial sponsors. Ken Marlin, the founder of investment bank Marlin & Asssociates, has a different view, which I am passing along. Thanks, Ken. Here's his full email, which looks at the issue in the context of whether a strategic buyer has a chance of winning a bidding war for telecom equipment maker Avaya, should one erupt.

"I would think that this could be a private-equity play because these kinds of companies tend to have strong cash flows and leverageable assets. So, I would not be surprised to see someone like Silver Lake in the mix. But, Cisco and Nortel both would be potential strategic buyers. For two reasons, strategic buyers always can outbid the financial ones – if they want to. It’s a matter of how badly they want the company.

"Strategics can get the same debt leverage as the private equity players. But, also they can get synergies and have a lower hurdle rate. What I mean by synergies is that the strategics can reduce combined costs and thereby bring more cash flow to the bottom line, and also they may be able to leverage product lines to generate more revenue (or in some cases raise price.)

The second reason that a strategic can out bid the financial player is that the strategics have lower hurdle rates. The PE players typically need to earn an internal rate of return of at least 20%. The strategic just has to meet or exceed his own cost of capital which is probably closer to 8% these days. That too allows them to pay more."

Avaya: a near-perfect private equity target

For years, telephone handset maker Avaya was a sleepy corporate backwater in the old AT&T corporate empire. No one seemed to want to own it. AT&T spun off its entire network equipment making division as Lucent Technologies in 1996. But even Lucent decided that it was better to go separate ways, and parted with Avaya a few years later.

Sooner or later, most out of favor companies have another opportunity to shine, though. Avaya’s chance has arrived. Corporations are spending billions to replace their own phone systems with new ones based on Internet Protocol technology, creating a surge in demand for Avaya’s IP phone systems.

Now the company is in play. Shares of Avaya soared $2, or 14.6%, to $15.67, after news reports said the company had held talks with several potential acquirers. The company, which has a market cap of $7.05 billion, is in talks with private equity firm Silver Lake Partners, as well as telecom equipment maker Nortel Networks (NT), one person familiar with the matter said.

The talks illustrate how cash-rich private equity buyers continue to dominate the world of M&A, making it difficult for strategic buyers to win deals. Avaya should be an ideal acquisition for Nortel or another big telecom equipment maker such as Cisco Systems (CSCO) or Siemens (SI). It’s corporate phone systems could round out a network maker’s product portfolio and generate revenue growth. But talks with Nortel have stalled over the issue of price.

Avaya’s a near-perfect target for a private equity buyer such as Silver Lake. The company’s balance sheet is free of debt. It generated $647 million in cash during fiscal 2006, nearly twice the $334 million it generated in 2005. It ended 2006 with $899 million in cash on its books. Private equity companies, which use debt to boost the return on their investments, are probably drooling at the chance to load up Avaya’s balance sheet with debt that could be used to pay new owners a hefty dividend.

In theory, a strategic buyer should be able to outbid a financial buyer because it has the opportunity to exploit synergies with its existing business. In practice, that argument doesn’t work very often. “The market discounts revenue synergies. A strategic buyer can’t argue, as it did in the ‘90s, that revenue synergies justify a price,” says Bob Profusek, head of the M&A practice at Jones Day, a global law firm based in New York. He said strategic buyers also bear the increasingly heavy burden of having to win shareholder approval for deals. Shareholders are more likely than ever to reject deals they don’t like.

“In this case, the financial buyers are more likely to have an edge,” says Phil Phan, professor at the Lally School of Management and Technology at Rensselaer Polytechnic Institute. While Avaya has a significant business in IP technology, much of its revenue still comes from more traditional phone systems, Phan says. Therefore, the real value of a buyout will likely be in restructuring to reduce costs and serve existing customers but increasing the service component of their offerings. To fight the IP battle, they will need a significant amount of new investments,” Phan says. A financial sponsor like Silver Lake is better match, Phan says.

Carlyle Group Plans to List First Publicly Traded Fund

My colleague Emily Thornton passed this scoop to Deal Flow:

Private equity powerhouse the Carlyle Group plans to file to list its first publicly traded fund by the end of June, people familiar with the transaction have told BusinessWeek.com.

Recently, private equity firms already flush with billions of dollars in cash have been rushing to raise even more money on public markets. In March, the Blackstone Group submitted filings with the Securities & Exchange Commission to take its management company public. And in February, Fortress Investment Group began publicly trading on the New York Stock Exchange.

While Carlyle will not be taking its entire business public, it does plan to list a leveraged finance fund made up primarily of mortgage-backed securities on the Euronext stock exchange. Former Bank of America vice chairman James H. Hance Jr., who joined Carlyle in 2005, will be the non-executive chairman of the fund. John C. Stomber, who joined Carlyle in 2006 from Cerberus Capital Management where he was a managing director focused on structured finance transactions, will be CEO.

People close to the transaction believe Carlyle could raise as much as $1 billion for the fund through the public listing. Carlyle presently has $56 billion in assets under management.

Carlyle declined to comment on whether or not it will be listing a fund citing Securities and Exchange Commission restrictions.

Goldman backs wireless broadband startup Arcadia

Arcadian Networks, a wireless broadband company that servces rural industries, said Thursday it had raised an additional $30 million from lead investor Goldman Sachs. The New York-based telecom startup has now raised a total of $90 million.

Arcadian automates the information-gathering process for rural industries in sectors such as electricity, gas, oil and coal and emergency services.
By deploying high-speed, IP-based wireless networks, Arcadian can enable a range of services, from remote meter-reading to higher speed broadband access for police officers in the field. Arcadian said its neworks will help improve public infrastructure without taxing the public. A better infrastructure can lead to more efficient use of energy and resources, it said in a statement.

Arcadian is part of a new generation of telecom startups that hope to do better than the flame-outs of the late '90s. The upstarts of 10-years ago never made any money, because they couldn't sign up enough customers fast enough to pay down their huge debts, let alone make a profit. The passage of time has brought down startup costs for telecom companies. Wireless technology has matured and demand for data has grown. Incumbents such as Verizon and AT&T have become bigger and more sophisticated as well, so startups will face new challenges as well.

Arcadian and other upstarts such as Wimax carrier ClearWire are trying to build a compettive telecom business model that actually works. The fact that the quesion is being taken serously again is worth noting. If they succeed, a slew of big telecom IPOs could hit the market a few years from now.

Another view on IT services buyouts

I wrote today about the buyout boom in the IT services sector. link. Investment banker Ken Marlin, the founder of tech and media-oriented advisor Marlin & Associates, offered a long and thoughtful analysis that frames the issues in a cogent way. I am sharing his email in full:

"Not all service companies have become great take over candidates. Mostly it’s the ones that have become “technology enabled” - those that leverage technology to fuel growth and not just people - especially those that have crackled the code of “recurring revenue”.

"A few years ago, when economists talked about “service companies” they were mostly talking about restaurants or auto repair facilities or lawyers, or accountants. These firms have at least two common attributes: one is that they are somewhat people-intensive. That is, in order for them to double revenue, they must come close to doubling the number of people involved in delivering the service. A second attribute is that they rely on “one-off” sales. Each time they provide a service, the client has to make a new purchase decision.

"In recent years, we have seen the rise of technology-based service companies. These include companies that sell on-line information (think AOL, Yahoo and Google) or who sell software-as-a-service (SAS) – which is a field rapidly being embraced by virtually all software vendors. That includes traditional licenese and maintenance software vendors such as IBM, Oracle, SAP, and, yes, even Microsoft, as well as newer ones such as Salesforce.com. These firms sell access to their software via the web, on a subscription basis that produces recurring revenue.

"The new digital service economy operates with very different economics than more traditional service firms. To double revenue, they may have to double the amount of computer power or storage capacity--but their people costs grow at a much slower rate. And they sell recurring subscriptions, which makes their future revenues much more certain and predictable. Combine these new attributes with the fact that the cost of computer power and storage keep declining on a per-unit basis, and you have a whole new dynamic. Modern technology-enabled service firms have become cash-generating machines. That’s why they are such desirable take over candidates. That’s why banks are so willing to lend to help fund these transactions."

Alternative investment fees under pressure

Pension funds and other big investors have been saying for some time that hedge fund fees are too high. Now private equity funds are coming under the same sort of pressure. "Private equity management fees have come under the
spotlight recently, with increasing comment in the press
about the absolute levels of management fees that (limited partners) pay
on their investments," market researcher Private Equity Investor says in a new report. The base fee is 2%, but additional fees can be charged if a fund hits certain benchmarks, pusing fees to the 5% range, the report says.
The report says the critics overlook the fact that private equity is a labor intensive form of investment, in which funds are heavily involved in restructuring and running the firms they buy. Higher fees reflect that work. The key is whether the returns are satisfactory, whether the fees are comparable to those charged by other funds, and whether fund managers and investors interests are aligned.
That may be true. But private equity returns have likely peaked. And if that's the case, I wouldn't be surprised to see fees heading lower as well.

Derivatives create new ways for betting on LBOs

Today, I take a look at how hedge funds are using insurance policies, known as credit default swaps, to make bets on companies they think are likely to be acquired in a leveraged buyout. link. Private equity investors typically look for a rate of return of 20% of higher. CDS's identified in a March report by Goldman Sachs could generate blowout returns, even by the rich standards of private equity.
The report says credit "protection" for retailer SUPERVALU could generate an internal rate of return of 74.7 if the company were taken out. That's because the price of the CDS would rise to reflect the increased probability of default associated with the higher debt level that LBOs typically bring. Buying "protection" for oil giant Sunoco could yield a return of 70.4%, and an insurance policy on healthcare services company AmerisourceBergen could produce a yield of 64.2%, Goldman says. Other top-five CDS picks included Electronic Data Systems, with a projected return of 56%, and Computer Sciences Corp., with a projected return of 53.6%. Many investors are betting on CDSs along with stocks and bonds of the underlying buyout target, in a strategy to boost returns.

Lazard chief's pay reflects boom

Goldman Sachs CEO Lloyd Blankfein may have done CEOs across the financial world a huge favor by earning a stunning $54 million in 2006. Blankfein set the bar for CEO pay so high that no one else is likely to get much scrutiny. Lazard issued a proxy statement today saying that CEO Bruce Wasserstein received $22.8 million in compensation for 2006, up 61% from the prior year. Operating income rose at half that rate. Then again, the stock price, now at $50, has doubled since the firm's IPO nearly two years ago. About $18 million of his compensation was in the form of restricted stock. Given that payout, it's no surprise that Blackstone and other private firms are racing to go public.

BCE talks driven by regulatory issues

Like just about everything else in telecom, the buyout talks between the Ontario Teachers' Pension Fund and Bell Canada parent BCE are driven by regulatory issues. BCE wanted to enjoy a tax loophole popular with many Canadian companies for the last few years. Income trusts own many smaller Canadian companies. That has allowed them to avoid paying corporate taxes on distributions to the trusts, as long as those distributions are within certain limits. The Canadian government, concerned that is losing tax revenue, has put an end to the game. The prospect of larger companies such as BCE turning into trusts led to tax reform last fall. Now the Ontario pension fund wants to own BCE directly so it can control costs more closely in a tighter regulatory and tax environment.

BCE talks: eliminating the middle man

The Ontario Teachers' Pension Plan is exploring a possible $45 billion buyout of Bell Canada parent BCE. The talks, first reported by The New York Times, could lead to the largest buyout in history, a record that doesn't stand for very long these days. The talks are interesting in several ways. But Ontario is almost alone among pension plans because it makes its own private equity investments. Most pension plans prefer to be limited partners, investing in deals led by other investors. "We've been leaders in private equity since we entered the field 10 years ago. We're there for the return," Jim Leach, who runs the $6 billion private-equity fund at the pension plan, told me last year in an interview. (link: http://www.businessweek.com/investor/content/nov2006/pi20061107_031256.htm?chan=search ) The fund, which has owned businesses such as Samsonsite luggage and the Toronto Maple Leafs, has returned an average of 26% a year.

But the highly competitive, capital intensive and still-regulated telecom business is a tough one LBOs, despite its heavy cash flow. It will be interesting to see whether a pension fund, of all things, can cut costs at such a labor-intensive business with a legacy as a national franchise. If they can make this work, it wouldn't be surprising to see other large telecom companies that lack the scale of Verizon or AT&T become LBO targets.

Balance of power tilts back to big companies

Verizon's stunning legal victory in patent suit against voice of IP upstart Vonage should be seen as part of a broader trend favoring big companies. Just a few years ago, it was common wisdom that upstarts would eat away at the market power of big companies like Verizon. Now Verizon and others are fighting back, using the courts and the market place. Viacom's suit against Google and YouTube is another example of how big companies are regaining their sense of power in a market that has been shaped by smaller players in recent years. Private equity giant's proposed IPO is another sign that the balance of power is swinging back in the favor of big companies. As many private equity experts have noted, the main message of the Blackstone IPO is that much bigger companies are now fair game for IPOs. While the pending TXU deal is on track to set the LBO record at about $45 billion, there's a lot of speculation that a $100 billion LBO (Home Depot?) could happen this year. The flip side of that argument, one private equity manager noted, is that large cap stocks are undervalued.
A few years ago, it was fashionable to dismiss big companies as dinosaurs. But as they Vonage decision shows, the analogy doesn't really work.

Satellite deal: Do broadcasters protest too much?

The proposed merger of satellite radio companies Sirius and XM has elicted a damning response from radio broadcasters. They helped fund a Carmel Group study that has powerfully attacked the deal's central defenese in a Justice Department antitrust review. The satellite radio companies argue that the market has changed, and that satellite radio now competes with iPods, Internet radio and high-definition terrestrial radio. Critics say that's nonsense, that satellite radio is a separate market defined by its government-issued licenses, and that iPods aren't sold as a substitute for satellite radio. Analysts at researcher Stifel wonder if the opposition will be viewed as a defensive maneuver, "highlighting" that the DOJ may consider terrestrial radio a competitor to satellite. Still, Stifel puts the odds of this merger closing at only 55-60%. That's far from a sure bet, although Stifel argues the risk-to-reward ratio may be compelling because the market is suddenly counting on the deal's rejection.

A public Blackstone Group would persue different kinds of deals

The Blackstone Group's potential IPO would force a shift in focus for the private equity giant. As a public company, Blackstone would lose some flexibility, says Phillip Phan, professor at the Lally School of Management at Rensselaer Polytechnic Institute. Private equity firms are free to spend four or five years building up an acquired company without having to worry about satisfying the quarterly demands of public investors. As a publicly held company, Blackstone's transactions have require a quicker turnaround in the range of two years, he says. He believes there are plenty of targets in emerging markets, from Eastern Europe to Asia, that could be turned around in that time frame. So a public Blackstone might push deeper into the global market, too.