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Dell: The Return Of The Prodigal LBO?

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This week rumors surfaced that Dell (DELL) may be taken private in a highly levered transaction. We haven’t seen news like that since 2007, when Hilton was involved in a similar transaction in the $25 billion range. Is this a wayward transaction, or more symbolic of a return to big deals?

Before the mid-2000’s, the market was a big supporter of leveraged buyouts, or LBO’s.  There were many advantages that an LBO could deliver to certain companies that were lumbering along without much strategic direction, but still had plenty of potential to grow.

The stories were simple and required little strategic thought to make a profit: close a division here; move manufacturing operations offshore etc.  The steady, predictable cash flow was there to support the giant debt levels from the transaction.

When I run Dell through our internal “LBO Screen,” the company certainly passes from a financial perspective. Cash flows are strong, debt levels relatively low. I can immediately see how Dell would hit any basic screen out there based purely on financial factors.

To me, the possible transaction raises more questions about what I can read into the market at this point, if the deal goes through.  Not since 2007 has there been a deal of this size, so if the transaction is closed, what does that imply that the market’s supporting such transactions? And what can we infer from the fact that the first big deal out of the box would be Dell?

I would posit that Dell is a special case, and does not signal to the rest of the market that the prodigal LBO has returned. There may be other forces at work here—forces far more subjective. In the glory days, young LBO analysts screened for companies that were the best targets to approach, or the best industries to improve by applying simple cookie cutter efficiencies.  But I think those days are gone.

The past four years of low interest rates, slow growth, and high unemployment have forced many companies to embark on their own internal improvement programs without external intervention by LBO sponsors.

In spite of their appeal, there have always been differing opinions over the effectiveness of buyouts and their economical appeal. Prior to 2007, most companies that were taken private just needed to “grow at GDP-like rates” for several years, then be taken public at a higher multiple than they were bought, which would produce a reasonable return for investors.

This calculus worked well for companies that had little need for strategic shifts.  However, if a company has decided to change strategic direction, then a leveraged recapitalization of the balance sheet is not necessarily the best foundation to retool the enterprise.

Newly levered-up companies have scant experience operating with big debt burdens.  The Greek chorus of large interest payments will be present at every strategy meeting, and will certainly limit the range of bold departures senior staff may be considering for such a “strategic changer” company.

It’s pretty obvious that Dell is not a “grow at GDP-like rate” company. Instead I would classify it as a “strategic changer.”  As a public company, I think Dell would have a better chance of convincing shareholders that a material change in their strategy would make sense. Most likely the company will shift focus to cloud services from computer manufacturer, an effort that requires time, patience and a strong balance sheet to support the effort.

If Dell undertakes these changes as a public company, shareholders will certainly question the details. Most likely some impatient investors will sell, creating downward pressure on the stock for a while.  But other new participants would buy the emerging story.

On the other hand, an LBO transaction is not a very patient one.  The performance clock starts running at the close of the deal.  These private investors have a definite timeframe for their investments, and it’s usually driven by fund lifetimes and expected returns; not by company-specific details.

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Public companies are sometimes hesitant to make dramatic changes to their strategy because shareholders expect consistent earnings growth without a hiccup. Going private can mitigate a lot of that pressure, as long as the decision is made for the right reasons. In Dell’s case the decision must be made carefully to ensure the best returns for interested parties.