An inscrutable reader writes in to point out a fascinating Bloomberg interview I had not yet seen of Blackstone's Hamilton James. My reader wonders in email if private equity firms really consider these sorts of investments (Blackstone's Deutsche Telekom deal) viable. I wondered after this transaction once before in Going Private. It is, after all, a government-owned firm and Blackstone is only making a minority investment that lacks the control private equity firms usually demand to create the sort of change that impacts their returns. At first blush I would agree with my reader, but further examination makes it clear why this was a pretty good move by Blackstone. I've excerpted some passages below so we can try to get into James' head.
Blackstone's James on Deutsche Telekom (Transcript)
2006-05-18 14:51 (New York)
May 18 (Bloomberg) -- Hamilton James, president of Blackstone Group LP, responded to questions on May 17 about Blackstone's investment in Deutsche Telekom AG, the evolution of private equity funds, and the growth potential of Univision Communications Inc. James spoke at a private-equity conference in New York sponsored by the Daily Deal. Senior writer David Carey moderates.
(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)
The reason we like Deutsche Telekom now is it's a - it's a - it's a gold-plated company. It's got massive assets. It's got great market positions in its core businesses that aren't going away. And the biggest economies in the world look at U.S., the U.K. and Germany. Frankly, I get tired of looking at companies that are mediocre, small, marginal competitors at 8.5 to 11 times EBITDA. And when I see a good, chunky, meaty company with lots of assets that I can buy at 5.5 times EBITDA, that looks pretty good to me.
So, I think, bottom line there, we just - we thought it was a good management. A company with great assets, great market positions and a compelling price. We've had a thesis in the last few years in Europe, in general, that the telecoms were undervalued and that they would be re-rated sometime over the next five years as some of the changes that are coming - flowing to the industry get worked out; as things get re-priced as - and things like that. And we still believe that thesis.
So, there's a lot to like about Deutsche Telekom in terms of just sheer fundamental value and quality of company, that has nothing to do with anything but the value. We - you're right - we were able to set this up with a very clever financial structure; such that we essentially had 85 percent leveraged to capitalization. Effectively, these days, we put up about a third of the purchase price and equity. In our - in our deal, we ended up putting about 15 percent of the purchase price up to equity. And the leverage was in the - was in the mid single digits in terms of average cost. So here we have, by comparison to most LBOs,far more leverage, far lower cost.
So we have all of this very, very positive financial and structural things working for us. If - to use to your favorite term - if the EBITDA doesn't grow at all over five years and we exit Deutsche Telekom at five times cash flow at the end of five years, number of trades we've brought in at 5.5 times, we'll still double our money, based on the cash flow of the company. If EBITDA - if EBITDA grows like it has, at a few percent a year, and we hold our multiple 3.5 times we'd expect. And if we can - and that's before we've done anything to impact the value of the company ourselves.
I've commented before on the issue I have with LBO firms that depend on leverage, or perhaps I should say, pure financial structuring, to generate their returns. Clearly, with enough leverage massive returns almost fall out of the firm, unless revenues or costs conspire to damage earnings. For some firms that is enough.
Herein lies what I believe is the distinction between "private
equity firms" and "good private equity firms." The structure of a deal
defines the downside. The talent of the private equity firm
establishes the upside. James says it here: "...and that's before we've done anything to impact the value of the company ourselves." That's
the key. This attitude: Financial structure is a tool to enhance
returns, not to create them outright. The work really begins after the
transaction. After the deal guys have packed up and the lawyers and
accountants signed off. That's when you have to work to generate
Blackstone has something else going for them on this deal. Though it is a minority stake, this is still a state-owned firm. It is also "too big to fail." Their downside risk of bankrupcy is very, very low. The German government will probably not let it go bust and we all know how the Germans love subsidies for their state-owned ventures.
So why the minority investment? Personally, I suspect this is a stepping stone to a larger stake by Blackstone. They can get their toe wet here, feel the business out, sit in on board meetings and effectively have a strong option at a much larger, even a control stake down the line.
My reader points out that so far the deal looks bad, on paper:
Here's a back of the envelope calculation:
Eur 2.6 billion investment @ Eur 14.00 per share = 185.714 million shares.
85% debt = Eur 2.21 billion.
15% equity = Eur 390 million.
Since the announcement was made on 24 April, the DT shares have fallen to Eur 12.62 x 185.714 million shares = Eur 2.344 million value of holding. Less the Eur 2.21 billion of debt outstanding = Eur 134 million of equity. So in less than 1 month, the value of Blackstone's equity has fallen from Eur 390 million to Eur 134 million (66% loss).
Remembering, however, the nature of the leverage here we see that if they have this debt on a 7 year term (and I don't actually know what the terms of the debt are, except for the "single digit" rate Blackstone commanded), and they work down the debt properly, which is, of course, the point, and even if the stock sits at its present nadir, Blackstone will have paid Eur 390 million in equity for a 2.344 billion stake in DT.
Let us decide that we want to make it tough for Blackstone. Let's see how far their downside goes. Let us just pretend that the stock tanks by another 50%. That means Blackstone paid Eur 390 million for Eur 1.152 billion 7 years later. IRR: 16.73%. Not bad for a "total failure." That's the leverage at work. Of course, in a bankruptcy, or even serious distress, Blackstone probably loses the entire Eur 390 million. But then, this is a state-owned firm. It would be interesting to do a bankruptcy risk analysis for large state owned "utilities" and see what Blackstone's risk adjusted returns are on this basis.
Bear in mind, I haven't really gone through these numbers and I don't know much about the financial structure of the deal (term of the debt, how it is being paid off, etc).
Edit: A reader, NG, suspects that Blackstone's stake doesn't bear any particular cash flows other than normal dividends, which are probably around 5-6%, less, most likely, than Blackstone's cost of debt.
If this is so, and on reflection I believe it is, then Blackstone's acquisition vehicle is going to have to service the debt out of its own pocket.
NG also points out, correctly, that in this instance Blackstone's IRR won't be anything like described above. My analysis above only holds if the stake Blackstone stake can support its own debt (and pay down principal). If it can't then Blackstone is going to have to fund that debt service from elsewhere, and, accordingly, pillage IRR from another investment. The advantage of leverage is when you can get the acquired stake to service itself without using your own cash. That's lost here if NG is correct.
I believe this makes even a stronger case for this investment being a stepping stone for an eventual majority stake in the business. If that's the case, Blackstone's IRR will only deteriorate by the amount of interest and principal they throw in before they enjoy the free cash flows (i.e. before they take a majority stake). Since their leverage here is so high, (15%/85%) they can afford to sit around for some years before taking a majority stake and still have a reasonable deal (perhaps the ratio will look more like their usual 33%/66%). Not a bad option, really. If anyone is really interested I'll recalculate the IRRs with some scenarios on the time they sit on their "option."