Tuesday, February 12, 2013

Why is Dell Going Private?

Many know the story already. The story about how Michael Dell formed his own company in his college dorm room to sell personal computers. The story's plot soars toward an apex. Dell eventually took his company public, seized substantial market share, and eventually became a billionaire. His stake in the company today exceeds $3 billion (while he has maintained substantial wealth outside the company).  But the story is far from over.

In recent years, the company has struggled to maintain market share and has suffered ups and downs in earnings and share prices.  It has reached a pivotal point, where it must decide what it wants to be, who its customer base should be, and what products, beyond conventional desktops, should it sell.  In recent days, founder Michael Dell decided it's time to buy back the company from the public and take it private with investments from himself and the private-equity firm Silver Lake. While reviewing alternatives (remaining a public firm or seeking higher bids from other groups or Michael's group), the company's board is near an agreement to permit Michael Dell and his group to purchase Dell, Inc. for $24 billion.

Fans of private-equity can't help but emit a cheer in unison, as they see this as a signal that the era of big deals (big buy-outs in the billions) is back. That era has not yet returned, partly because big deals require mammoth financing, especially from banks, who have been shy in recent years about stepping up to provide funds to support leveraged buy-outs.

Meanwhile, why has Michael Dell decided that it makes sense to go private via a buy-out?

The proposed deal is not too complex. Michael Dell has found a way to raise $24 billion.  He will contribute the $3 billion-plus stake he already has and will add more (up to $1 billion) from his own investment fund, the fortune he extracted from Dell and runs separately.

Silver Lake will invest $1 billion. Dell, Inc., the company, will repatriate as much as $3 billion in cash in overseas subsidiaries to repurchase stock of existing shareholders. And then comes a mountain of debt:  $14 billion from a bank group and $1 billion from Microsoft. Microsoft still yearns to work with Dell in partnership, perhaps to ensure Dell will continue use its software. But Microsoft elected to invest in the form of a loan, not in equity. (Microsoft's loan suggests, too, it desires an exact cash return on its investment and a fixed time horizon.)

Nevertheless, the deal shoves three times the amount of its existing debt burden onto the Dell operation and onto its balance sheet.  That is essentially the traditional impact of private equity--the rearrangement of a company's capital structure such that debt has a prominent role and operations must generate a consistent flow of cash to meet higher levels of interest and principal payments. Deal-doers and industry analysts had already determined the company is capable of generating a stable flow of cash from current operations from quarter to quarter to service debt. But more debt  requires the company to meet sometimes onerous financial covenants and requirements.

Michael Dell had likely decided the following:

a) Under a different ownership and capital structure, he could implement a different company strategy to achieve earnings growth and, therefore, a substantially higher company value to the new owners.

b) With the new structure, he can make changes more quickly and easily without having to encounter many constituents, including other major shareholders, the public markets, research analysts, a board of directors he has less control over, and a band of other naysayers.

c)  As a private company, he could take more risks with new ventures, ideas and products without the laborious task of vetting public markets, ratings agencies and research analysts.

d) And as private company, he won't have to present a quarterly scorecard of earnings projections, targets to meet, and overall performance and be routinely scolded or penalized for not meeting targets.

A typical private-equity investor has a goal of going private, stripping down the company to reduce costs, increasing cash flow and re-emerging as a more valuable public company. Founder Michael Dell has yet another fundamental objective. He must determine and then implement that relevant strategy. That strategy will likely rely less on a consumer client base and seek to tap into a corporate client base.  It wants to escape desktops and laptops and venture more deeply into corporate systems, data storage and cloud computing. Dell, its founder reasons, must become less like Apple or H-P, more like IBM.

It will be easier to engineer such a transformation beyond the sneering eyes of public markets. Reporting requirements will be less strenuous. Moreover, it will easier to digest a quarterly loss, while the new company funds new investments or a radically different structure. 

Not having to pay a dividend will help, too. Cash normally paid out in dividends will be diverted to meet interest and principal payments on the debt load. The burden of debt will seem to be more bearable than the burden of meeting research analysts' expectations four times a year.

There are still risks in a different approach and risks in implementing a substantially different strategy. But as Dell and Silver Lake see it, there are risks in the status quo.

There will also be the challenge in managing the expectations of three large stake-holders:  Silver Lake, Microsoft as lender, and the bank group.  Silver Lake will not want to be a permanent investor. It will want out and seek to enforce a five-year plan.  Banks will impose somewhat strict financial requirements, will require approval of certain business strategies, and might choose to be difficult in a downturn. 

The deal is not yet done, but will likely proceed as announced. Dell, Inc., the company, not Dell the founder, will be permitted to explore other offers and strategic options to be fair to current shareholders. (There could be another suitor interested in offering more than $24 billion.)

Michael Dell gets five years to prove going private was the best move for current shareholders, for Silver Lake, and for himself.

Tracy Williams

See also

CFN:  What Should Apple Do With Its Stash of Cash? 2012

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