For Australian investors private equity funds have been very much under the radar. Not any longer. Since the Qantas play, coming on top of the Myers stores, the attempt on Coles, the PBL (Packer) joint venture, the similar deal with Seven Network, the foreshadowed or actual privatisation of Flight Centre, Rebel Sport, Super A-Mart, APN News Media (now discontinued), DCA Group (diagnostic imaging and aged care), Cleanaway and Colorado (shoes and clothing) all with the involvement of private equity funds, and more foreshadowed, there is a sense that the whole market is in play.
Private equity firms have been called the Barbarians at the gate, a swarm of locusts, a herd of elephants or the purest form of capitalism.
Terry McCrann put the standard modus operandi with typical bluntness:
The business is taken out of the public marketplace; it is loaded up with debt; the cashflow over the next three to five years is all directed at paying off the debt while it is also, hopefully, made much more profitable; then it is sold or refloated at a big profit.
So, you buy Qantas today at $11 billion and sell it back in five years at $20 billion.
Making the business such as Qantas “much more profitable� can mean a multitude of things, like off-shoring, outsourcing, paying people less, stripping their conditions and safety provisions, stripping out inessential services, sacking people, cancelling less profitable routes (who cares how people get from provincial cities to the big smoke) and selling bits off.
In broad outline the money game goes something like this. Qantas in 2006 earned about $480 million net profit, down from 2005 but now on an upward path to possibly $880 million in 2009. More pertinently, EBIT (earnings before interest and tax) will grow from $940 million to perhaps $1300 million in 2009. Current interest cover (earnings divided by interest) is said to be 5.7 times, so there is plenty spare cash, largely wasted on tax and dividend payments.
What is proposed is a leveraged buy-out (LBO) at a ratio of up to 3.5 times - say 3. There is about $4 billion debt in Qantas, which is added to the $11 billion. So the private equity partners between them chuck in $3.75 billion between them, borrow $11.25 billion and use Qantas’ earnings to pay it off. Over 5 years they would extract fees of at least $2 billion (for not doing much as these things are managed at arms length) and then sell the lean, mean and much more profitable Qantas for $22 billion in a trade sale or a float. If the debt has been paid down to say $8 billion, Qantas comes to the market with moderate 30% or so gearing and you make about $16 billion while tying up $3.75 billion.
That’s back of the envelope figuring, but you get the idea.
That’s without selling bits which are mooted to net up to $3 billion. Btw there is already a cost-cutting program in Qantas to take $3 billion out of costs.
It sounds like good work if you can get it and I’m afraid it’s a case of bees to the honey pot. It used to be a rich man’s game played at the margins but pension funds are now becoming involved. That could be your super and the loans could be courtesy of your bank, suitably parcelled, on-sold, hedged and insured. It is sometimes called ‘hot money’ because it moves fast and is interested in financial engineering (and profits) rather than running a business. In one case recently a firm was bought, a 20% fee extracted and added to the debt, then the move to bring it back to the market started 3 weeks later.
There are a number of things that worry people in the market and authorities. Principal amongst these is debt risk. The closer you can bring interest cover to 1, the more money you make, but the riskier the operation. If one or two of these things fall over nothing much might happen apart from sounding a cautionary note and bringing some sanity into the deals. But in the case of a general economic downturn there could be blood everywhere.
At present there is something like $US300 billion of private equity money looking for a home. That could mean at least $US1 trillion worth of business, only about 1% of the world’s share market. But that’s about the size of our market. Mergers and acquisitions here are at about 5% of our market and growing. There can be little doubt that the funds have found us and little doubt that WorkChoices is one of the attractions. The funds are increasing rapidly. Private equity could chew its way through our whole market over 4-5 years leaving very patchy pickings for the normal share investor. Essentially tiddlers, leftovers and regurgitated fully-priced phoenixes. No company is safe except for Rupert who has already fled to Delaware where the rules can be used to prevent any nasty surprises.
The Financial Services Authority in Britain has already had a look at risk (pdf). The Department of Justice in the US is investigating collusion. A further concern is insider trading, given the large number of people in the know before one of these deals is sprung.
Others are worrying about the reduced transparency and accountability of private companies. I must admit they send a shiver up my spine. While they will conform to laws and regulations any trace of stakeholder capitalism is gone as is any pretence of CSR (corporate social responsibility). Nevertheless they won’t knowingly trash the brand(s) of the target company and do need to operate within the norms of whatever society they are operating in. Otherwise governments will regulate them further.
There are two things I heard on the radio that scared me. One was the attitude from a BBC panel discussion that with clever computers the party can go on forever. Usually a sign that the end is nigh. The other is that pension funds (maybe your super) are starting to get into the act directly themselves rather than work through the private equity operators.
I think the Qantas deal will go ahead. Geoff Dixon as CEO is by reputation one of the best in the business. The new bosses want to keep him and other senior management. To that end they are offering them 1-2% of equity in the company. We are talking hundreds of millions here. Dixon is said to be frustrated that the share market has undervalued the company and not taken it seriously. People think S11, SARS and oil prices. Hedge funds have been trading the stock as an oil price play. This affects the company’s ability to raise capital. Also they would no doubt like to complete the current cost-cutting program at speed in the environment of lower accountability accorded to private companies.
The independent directors of the Qantas Board will see their duty as being to the shareholders. This usually means getting the best price. If they extract an extra billion or two they’ll think they have done their job. Please note that the directors of Woodside could only get $10 billion from Shell in 2001. Now it is worth about $24 billion on the market and would be worth even more in a takeover.
The government will have no technical reason for knocking the deal back. The bid will conform to the Qantas Sale Act. These people are not stupid. The only grey area is Macquarie’s involvement with Sydney Airport. My guess is that Macquarie will do whatever it takes.
The Government does have some leverage with Qantas as their operating environment depends on 57 agreements with other countries on air routes which have the force of treaties. So it is worth keeping the Government onside. Howard is thought to be sniffing the political breeze but I don’t expect the masses to rise in outrage. We are used to seeing our icons sold off.
There is an unusual aspect of this caper. David Bonderman, the co-founder of Texas Pacific Group, lead partners with Macquarie Bank in this deal, started out by scraping together $US55 million to buy Continental Airlines in distress in 1992. He is currently chairman of Ryanair, a budget carrier in Europe. The guy seems to have an abiding interest in airlines and may have longer term ambitions for Qantas that could be interesting. This is not the normal pattern with private equity funds.
Note: There were 25 articles by my count in the Australian Financial Review on Qantas and private equity over three days. None of this is available free on the internet. Much of the information given in the post was garnered from these articles.
Radio National as one would expect covered the issue in The World Today on Wednesday, in PM on Wednesday, Thursday and Friday and in Saturday Extra. Stan Corrie’s Background Briefing was more than useful.
Actually, Qantas does *not* seeme to me an archetypical case for the “strip, squeeze and sell” approach. Its value is mostly created by regulation - especially those 57 agreements - so you have to keep the goverment onside. Its only other value is from product differentation as the ultra-safe international carrier for nervous nellies.
If you stopped flying to Woop-Woop the govermnent would be all too likely to start listening to the tourist industry and allow other people to fly to Los Angeles. And your own strategy would undermine the (very dubious) “national champion” and “keep the jobs” arguments that are currently protecting the firm from the chill winds of competition. Plus the cost cutting will undermine the second source of value.
So, Brian, if that’s a foreseeable possiblity, what are the implications?
I’m not so sure that the government will be that easily sanguine about Qantas going into private hands, particularly if those hands will want to shift the heavy maintenance operations offshore.
Aside from the employment aspects, these have significant defence implications, and this concern at least partly motivates the government’s paternal attitude to the company.
dd, that’s about right, I think. De-Anne Kelly mentioned the importance of Woop Woop in return for favourable treatment on other routes.
Dixon I think is mindful of not trashing the brand and he doesn’t want to be grounded by a dispute with the unions. As I understand it Jetstar operates on individual contracts with salaries benchmarked against Virgin, even for pilots. Jetstar has just started to fly internationally so he can discipline the main Qantas unions by handing their work over to Jetstar to some extent.
The Qantas workplace agreements are up for renewal next year so it will be interesting to see how things go.
The pilots are trying to do a runner and be given equity in the airline like the bosses. No doubt they’ll fail.
I think Qantas, although it is profitable, comes in about 18th in terms of margins around the world. Dixon’s current cost-cutting exercise is badged as “sustainable future”. It does seem necessary.
I may be naive but I suspect Dixon will be motivated by the best chance of a long-term future of the airline rather than be dazzled by a $100 million carrot. He’s paid as much now as anyone would ever need.
Barnaby Joyce was burbling about the Lone Star replacing the Flying Kangaroo. He’s way off the mark. Those 57 agreements would disappear pretty quickly if they did that. Also Qantas is 46-47% foreign owned now and will no doubt stay within the 49% specified, so foreign ownership is not the issue.
Mark, that’s a big question. I’ll have to take a longer run at it.
Robert, the unions were pushing the national interest line in terms of jobs, defence and emergencies. Although the deal is not a foreign takeover I understand it will trigger FIRB review. No doubt the Treasurer will specify certain things to meet the national interest as he sees it. And this in return for continually keeping Singapore Airlines and Emirates out of the trans-Atlantic route etc.
That’s my bet, but I could be wrong.
It is thought that Costello’s statement that the Qantas Sale Act would not be changed was code for telling the backbenchers that he’s awake and on the job. It’s the only way the statement makes any sense.
Just wanted to say an excellent summary of all the issues, Brian. Won’t be needing that copy of the Fin now!
it all seems a bit mad to me.
you get a lot of borrowed money at low interest rates and search around and put it into a company but then don’t have the control to cut costs and sell the assets later at a higher price.
Bubblemania. people looking for ROEs that are on the risky side because of low inflation.
trouble coming up
Brian, your back-of-the-envelope calculations about Qantas simply suggest to me that the market has undervalued the asset.
If these deals do realise hidden value, then so much the better.
If my superfund is selling undervalued assets I’m angry.
If my superfund is buying undervalued assets I’m happy.
Why should we tolerate a world of pretend Corporate Social Responsibility?
The structural imbalance is that capital movements are borderless, but labour movements are more and more constrained.
It is unlikely that voters will tolerate a borderless world of population movements.
Therefore, workers and citzens need some protections against capital flight.
1. Democratic control of superfunds. That’s a small price to pay for the tax concessions enjoyed by superfunds.
2. A small transaction tax on every currency swap, divided equally between the governments whose currencies are swapped. This turns pretend CSR into real Corporate Financial Liability. The rate of tax can be negotiated between the two governments, allowing flexibility.
I think their is a real danger in MBL getting too big.
What if - in 5 - 10 years time Macquarie Bank is subject to a management buyout?
You have all of these key assets that exist both as public needs as virtual monopolies or oligopolies. Remove public scrutiny and just imagine what Mac Bank could do??
Lets face it, the staff have plenty of shares, plenty of cash, and plenty of access to debt and equity investors - they could probably do it.
Dixon has argued for years that QANTAS is seriously undervalued. Terry McCrann argues more broadly that Australian Super Funds continually undervalue Australian businesses.
Yet I agree with Bring Back the Currency Lad’s blog that there is the real danger of another bubble.
BTW I read that this particular fund is also looking at British Airways.
Brian
I worked for a firm that took an airline private in a deal similar to this. These guys don’t know what they are getting themselves into.
The airlines run with too much debt when the game should be played with far more equity. As you pointed out, the buyout consortium wants to add even more. Wish them luck, they’ll need it.
In event, this purchase may actually allow more deregulation. Let’s hope.
There was a little noticed comment that came out of G20 possibly because most of us were more interested in watching a bunch of idiots throwing stuff at trucks.
The ECB’s Trichet and others showed a great deal of concern that there is too much money; he called it liquidity, sloshing around the world. This means one thing, short rates around the world are going higher and the yield cuvee inverts even more. This is not a good time to be taking on debt. When the yield curve inverts it’s horrible time to be taking on debt.
Most of these private equity firms should delete the world equity anyways. They are leveraged up the ying yang with equity being only a small layer. The rest is debt.
Lets watch the merry-go-round of acquisition, debt repudiation and recapitulations in a few years time. Meanwhile let the shareholders enjoy getting taken out at a premium to current market.
Look at how much cash is around. In a short period of time, KKR made a bid for PBL, Coles Myer and Channel 7 (?). They are desperate to put on deals on their books and chasing any skirt that moves.
Anyways, i hate qantas and hope it goes bust.
Great, great post by the way.
“Yet I agree with Bring Back the Currency Lad’s blog that there is the real danger of another bubble.”
It’s here. The Central banks are too worried in busting it in case the entire real estate market goes into the toilet.
These private equite firms are the cary in the mine as far as the boom goes.
sorry ……..canary in the mine
” The head of Australia’s largest bank today warned the boom in private equity transactions in the domestic market will inevitably turn to bust.
National Australia Bank group chief executive John Stewart told a business luncheon that it will take only one syndicate to fold to see the boom unravel.
“Everyone feels private equity is going to end up in tears,” Mr Stewart said.
“The only question is do you join in while it is making good money for everyone.”
“When you know there is a problem is when the first syndicate fails,” he said.
“All you need is one deal to fold then it will start unravelling, I suspect.”
Mr Stewart said the major banks are in a better position than they used to be and are not holding all the risk in the private equity deals. ”
Is Stewart giving a salutory warning, talking his book, or both?
JC, just asking,
Sounds ominous. So what would you recommend?
I am taking into account that when Israel attacked Lebanon you said we all should have turned our equities into cash because this was ‘the big one’.
If we had done that, we would now have regrets. No?
A lot of questions raised while I was down the back attacking the shoulder high grass in the city council’s land this arvo.
Scepticlawyer and jc, thanks. I struggling to come to terms with this stuff. I feel the government should tell these capitalist cowboys to piss off, but the UK Financial Services Authority says it’s good:
Best thing since sliced bread according to them, but they are worried about bubbles and debt. They also point out that in case of failure there is a question of who owns the debt because of:
So the administrators can’t mount a rescue package because they are faced with a miasma rather than a bunch of bankers.
As for economic benefits, one effect is to concentrate the gains and to disperse the losses. At least the participation of pension funds provides a bit of a siphon to get some of the rewards back to the little people.
As to how the private equity mob can gain ownership largely on the basis of debt rather than equity, reap all the rewards and then not be responsible for the risk, I’m staggered, but I think that’s what they are saying.
According to Geraldine Doogue’s Saturday Extra guest, the super funds here are only participating as part of a diversified portfolio.
But one of the effects of this sort of activity is going to be to push up share prices. You only have to look at media shares now. All expensive and way above where they were a few short months ago, if they haven’t been taken out of play altogether like PBL and Seven.
So super funds who find the sharemarket unrewarding (hence there entry into the private equity circus) will find it even more unrewarding as time goes by.
wpd, I haven’t seen Terry McCrann’s comment about super funds undervaluing companies. Possibly he’s talking about short-termism wit technology start-ups. Those super institutions that compete for funds don’t like to have a bad quarter. One effect of this is that they like takeovers, as do stock brokers. All that money suddenly has to find a home which triggers more brokerage. The problem may be that the market starts disappearing before their eyes as companies go private. Also wealthy investors may go off and buy bluegum or olive plantations to escape capital gains tax, leading to asset inflation in those markets.
So the ‘weight of money’ problem which is definitely there is being amplified by debt. It seems to me that unless the underlying productive activity increases it has got to end in tears.
But then I’m not an economist and I do have a fondness for depressing scenarios.
Spiros, Stewart, the man from NAB, always sounds like a pretty straight shooter to me.
wpd, the comment about the fund looking at BA is interesting. I have a suspicion that Bonderman is interested in airlines. I don’t follow them in detail, but I recall that BA was an early investor in Qantas with a 25% stake. It seemed as though they were on the way to becoming a genuine world airline. Presumably they had to pull back after S11. Bonderman may be reviving the world airline dream.
Qantas, of course, had a rare stroke of luck because Ansett bit the dust around that time. Still their profits took a big hit in 2001.
Katz, I’ve had a look at their 10 year historical financials and I’m not sure Dixon is right to complain about undervaluation. Profit and earnings per share (EPS) increased quite nicely from 1997 to 2000. Then after the hit in 2001 there was an upward trend to 2005, but another setback in 2006 (fuel prices for sure). But EPS in 2008 will only be roughly the same as 2000. The dividend yield is a bit above average for industrial stocks, but the forward forecasts are flat. Debt has risen and I know they are on a capex pause because 20 Airbus jets at $350m each are going to be delayed.
The numbers don’t excite me and I’ve always regarded Qantas as below investment grade.
Max, Macquarie is worth about $18b so even the rich suits who work there would need a bit of help. The guests Geraldine Doogue talked to thought banks would be exempt from the private equity locusts. I don’t actually see why and you are right to worry about monopolistic utilities being privatised. I’m sure the drafters of the Qantas Sale Act didn’t envisage privatisation or I suspect they would have ruled it out.
jc, can you tell us peasants what you mean by an ‘inverted yield curve’. Is the net result that the bank pays you to take its money when the effect of inflation is taken into account? And that means in effect deflation which is deadly for holders of debt? My head’s a bit thick tonight and I’ve never taken enough interest in money markets.
BTW you comments were very interesting.
Brian
I agree - i dont actually see how why “banks would be exempt from the private equity locusts” either
$ 18bn for Mac Bank is not much more than the Qantas deal - if you factor in the staff shareholdings and the very rich people on Macquaires Roladex’s it could be done.
WPD
I’m a trader, I’ve turned over a lot of stuff since then. Got it wrong as I thought it would turn into something bigger. No ego involved.
“jc, can you tell us peasants what you mean by an ‘inverted yield curve’. ”
Brian
Yield curve inversion means when short rates are higher than long rates.
Long rates are more market determined in the sense that the central banks have less influence on long rates.
When short term rates are higher it means the central bank is squeezing out liquidity and usually portends to a slow down or recession.
Best time to be active in stock markets etc. is when there is the positive yield curve, thats when short term rates are below the longer term ones. It means the Central bank is loose.
WPD
The game i play is all about capital preservation and risk reward. In other words it’s ok to be to be wrong when conserving captial. My reading of the Israeli/ Leb thing was that it could have turned nasty especially with the way the Iranian was talking and the Israeli tendency to take threats seriously…. ie when someone say they want to kill you, believe them.
Brian… You missed your calling in life. You shoulda been a stock analyst.
I know two people who work for macquarie bank - alas they don’t directly share in the profits… they just work very hard.
JC thanks for the response. And I apologise for the tone.
Brian, Australia Talks Back (Radio National), dealt with that specific issue to-night. The view seems to be that, politically at least, it won’t be allowed to happen.
Dick Smith was scathing of those at Macquarie Bank, specifically questioning their expertise.
Can a ‘defamed’ entity sue?
wpd, I heard the whole session of Australia Talks Back. I was a bit disappointed actually. They missed the point entirely that foreign ownership is already 46 to 47%, so it was framed (incorrectly) in terms of foreigners taking over. Also when they were not focussing on the huge carrot dangled in front of management they seemed to assume that there would be new management other than Dixon. I suspect Dixon is an essential part of the package. I doubt whether Macquarie and the Texas mob would be game without him.
It was interesting to hear people’s reactions and stories, but there was quite a lot of misinformation. Unfortunately Paul Barclay cut off one of the most interesting, ie Paul Simon, former CEO of Woolworths, was talking about how KKR wanted to buy Woolies for $1.8b when John Spalvins went bust. It was floated instead at $2.40 in 1993 worth $2.4b. It’s now $21.40 and worth $25b.
I think he was going to say that companies can prosper as public companies, no worries. It depends largely on appropriate leadership and competent and focussed management. They can also tank if the management is crook.
wpd, the Radio National audience would always oppose what is happening to Qantas. But I can’t see people going to the barricades. Maybe there will be a backbench revolt, but it doesn’t need to go through Parliament. It depends on Howard really (forget Costello). If he wants to knock it back he’ll invent a reason, but I think the consortium will put a proposal that covers all the bases and conforms to formal requirements.
jc, I can’t read a balance sheet, so I couldn’t be a stock analyst. I suppose I could learn.
Sacha I know some people in Macquarie too. It’s a big outfit and the Sydney deal makers are a race a part, even within Macquarie.
I probably should outline my own involvement.
I’m a direct share investor looking after 6 portfolios in all, using 3 different investment philosophies. It’s mainly mine, hers and ours invested on a ‘buy and hold’ basis, larger companies selected for safety, yield and some growth.
I’ve also got a smaller portfolio invested according to ‘value investing’ principles. Mostly smaller companies with growth potential. Buy when they are not yet fully appreciated by the market and sell when they reach full value. Collect dividends along the way.
Then I’ve got a couple of small bunches of speccies, great potential, but could go broke. I’m under water with these, but still hoping and expecting.
I’ve been doing this for 15 years. I reckon it takes about 10 years to learn the ropes. I started in 1991, during the recession. Now at any time we probably own about 40 different stocks.
Mostly I work through Macquarie Financial Services (with two different advisers) a Division of Macquarie Equities Ltd, which of course is owned by Macquarie Bank. So I get their equities research, also ABN AMRO Morgans with whom I have an account. I subscribe to independent research from Investorweb, Intelligent Investor and the AspectHuntley database which has consensus recommendations from all the main broking houses.
That’s my real job when I’m not mowing lawns for rich people and pensioners or plotting the downfall of capitalism on LP.
I still owe Mark an answer on the implications of these leveraged buyouts for normal share investors, but I might do that in a separate post.
Thanks, Brian, I’d be interested and I look forward to reading it.