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Bloomberg: Is the Dell Stub the Right Investment for You?: Real M&A

By Tara Lachapelle, Brooke Sutherland & Miles Weiss

Blackstone Group LP (BX) and Carl Icahn’s bids for Dell Inc. (DELL) are employing a rarely used deal tactic that has yielded both big payouts and big losses for shareholders.

The offers allowing investors to retain stock in the floundering personal-computer maker may help them win over shareholders like Southeastern Asset Management Inc., who want the chance to make more money alongside buyers. Still, investors must be prepared to take on the risk of potential losses as the firms seek to turn the Round Rock, Texas-based company into a contender in tablets and cloud computing, said Scott Rostan, a former M&A analyst whose New York-based firm Training The Street teaches new hires at banks about mergers.

So-called stub equity “may appeal to investors with a longer time horizon and a higher risk-reward tolerance,” Rostan said in a telephone interview. “But with potential reward obviously comes risk, and it’s going to take years to turn around Dell.”

Clear Channel Communications Inc. shareholders are still waiting for a payout with the stock down 84 percent since private-equity firms Bain Capital LLC and Thomas H. Lee Partners LP closed a deal for the company in 2008, when a slump in the economy and radio advertising sales deepened, according to data compiled by Bloomberg. Meanwhile, KKR & Co. handed investors who retained shares of Amphenol Corp. (APH) a 103 percent gain in the first year following the 1997 purchase of a majority of the cable-television equipment business.

Go-Shop Period

Blackstone and Icahn submitted proposals to Dell’s board on March 22, the deadline of the so-called go-shop period designed to solicit competing bids. Dell said March 25 that the proposals may be superior to the already agreed-upon $24.4 billion buyout offer from founder Michael Dell and private-equity firm Silver Lake Management LLC.

Blackstone’s plan values Dell at more than $14.25 a share, while Icahn would pay $15 a share in cash for as much as 58.1 percent of the stock. Under both plans, the buyers will borrow money to help fund the transaction, and some shares may continue to be publicly traded, giving current shareholders a choice between cash and stock. Blackstone didn’t specify its cap on the equity portion.

The special committee of the Dell board of directors will be reviewing the proposals from Icahn and New York-based Blackstone, according to David Frink, a spokesman for the company. Chief Executive Officer Michael Dell isn’t speaking publicly about the process, Frink said.

Dell Trading

Icahn didn’t respond to a request for comment sent to his spokeswoman Susan Gordon. Representatives for Blackstone and Silver Lake declined to comment.

Even before the new proposals were made public, Dell shares had been trading above Michael Dell and Silver Lake’s offer of $13.65 a share. Five analysts surveyed by Bloomberg Newsearlier this month projected that the bid would be increased to as much as $14.90 to $15 a share in order to win support from minority shareholders, which need to approve the deal. The stock ended at $14.50 yesterday. Today, Dell slipped 0.5 percent to $14.34.

“What shareholders are telling you is that the floor is not $13.65,” Louis Meyer, a special situations analyst with Oscar Gruss & Son Inc., said in a phone interview. “Just based on the reputation of Blackstone, people are saying ‘I’m willing to give it the benefit of the doubt. My floor is now $14.25.’”

For Blackstone and Icahn, a leveraged recapitalization offers a cheaper alternative to a full takeover, according to James Hill, who runs the private-equity practice at law firm Benesch, Friedlander, Coplan & Aronoff LLP. It’s also a “hybrid of necessity” that can help win shareholders’ approval, he said in a phone interview from Cleveland.

‘Clever Way’

In the case of Dell, the stub equity option also eliminates the need to incorporate Michael Dell’s stake in a bid, according to Erik Gordon, a business and law professor at the University of Michigan in Ann Arbor.

“It’s a clever way of possibly making this deal happen,” Gordon said in a phone interview. “This is a way of dealing with Michael, and it gives them a way of dealing with people who are screaming that any of these prices could be unfair.”

Icahn’s offer assumes that Southeastern Asset Management and T. Rowe Price Group Inc., the largest investors after Michael Dell, would contribute their stakes and won’t receive a cash payment.

Southeastern Asset Management has criticized the current $13.65-a-share deal, saying it undervalues the computer maker. The firm, which has estimated Dell should be valued at $24 a share, said March 25 that it’s pleased with the proposals from Blackstone and Icahn, in part because of the option to keep an equity stake.

Gains, Losses

A representative for Southeastern Asset Management declined to comment further. Kylie Muratore, a spokeswoman for T. Rowe Price, which also opposed the original buyout plan, said yesterday that the firm isn’t commenting on Dell.

A leveraged recapitalization with an equity stub allows stockholders “to share in the gains and losses,” Steven Kaplan, a finance professor at the University of Chicago’s Booth School of Business, said in a phone interview. “For investors who think the price is too low, that’s attractive.”

In 1997, Kohlberg Kravis Roberts & Co., now known as KKR & Co., acquired a 75 percent stake in Amphenol for $1.5 billion in cash and debt, while allowing shareholders to retain a 25 percent stake in the coaxial cable manufacturer.

‘Our Cake’

When KKR sold the last of its shares in 2004, the buyout firm said its $340 million investment in Amphenol had returned $1.4 billion to KKR investors. The publicly traded shares had more than quadrupled by then. In a March 2001 report, Gabelli Asset Management Inc. said that Amphenol showed the potential profits available from investing in stubs.

“We have our cake in the form of premiums paid by LBO groups to buy portfolio companies,” the asset management firm wrote in the report. “Every now and then, we get to eat it too, by holding on to stubs that allow us to participate, along with the LBO group, in realizing a portfolio company’s full upside potential.”

While an equity stub has the potential to unlock more value for Dell shareholders, they also have to be prepared for the risks of a stake in what will be a highly leveraged company, Gordon said.

“The leveraged recap doesn’t make it easier to turn around the company,” he said. “If you stay in the company, nobody has magic that makes your stock worth more unless they turn the company around. You’ve got to really believe that that’s going to happen.”

Clear Channel

Dell last year had privately forecast that it would earn $5.6 billion in operating income for 2014, a figure that is now going to come in around $3 billion, according to a person familiar with the matter. Dell is struggling as consumers shun PCs and laptops in favor of tablets and smartphones.

Steve Gerbel, founder and president of Chicago Capital Management, a Chicago-based hedge fund focused on merger arbitrage, said he recommends taking the certainty of the cash offer for Dell because a turnaround could be lengthy as the company’s business declines. He said his firm sold its Dell shares when the stock surpassed $13.65.

In the buyout of Clear Channel by Bain Capital and THL, shareholders were given the choice to take either $36 a share in cash or one share of CC Media Holdings Inc. (CCMO) — a shell company created for the deal — for each Clear Channel share they owned. CC Media was offered as an alternative form of payment when Bain Capital and THL cut the value of the cash portion.

‘Struggled Grievously’

Investors who have owned CC Media since the $17.9 billion transaction closed in July 2008 have lost 84 percent.

“If you’re a shareholder and you felt that the deal was underpriced, you might want to hold onto your shares rather than giving them up,” Josh Lerner, a professor at Harvard Business Schoolwho specializes in private equity, said in a phone interview. “But clearly it involves making a substantial bet. With the benefit of hindsight, we know that Clear Channel struggled grievously subsequently.”

The stock drop had much more to do with the timing of the transaction than the form of the deal, said Jonathon Jacobson, the co-founder and CEO of Highfields Capital Management LP, the money management firm that pushed for a public equity stub at the time. The Clear Channel deal closed in 2008, when the U.S. recession deepened and the radio advertising business dried up, Jacobson said in a phone interview.

‘Different World’

“It was a different world,” said Jacobson, who currently serves as one of two independentdirectors on Clear Channel’s board. “The advertising business and radio business in particular fell off a cliff in 2008 and 2009 and has since recovered, but not to pre-crisis levels.”

Concerns about Dell’s viability may help explain Blackstone and Icahn’s motivations to pursue leveraged recapitalizations, according to Peter Lobravico, New York-based vice president of merger arbitrage trading and sales at Wall Street Access Corp.

“The fact that you didn’t get any all-cash bids during the go-shop is kind of confirmation that you have to be a little bit careful with this thing,” Lobravico said in a phone interview.

Offering stub equity allows the acquirer to share the risk of the deal, said Pavel Savor, an assistant professor of finance at the University of Pennsylvania’s Wharton School in Philadelphia who has published research on M&A. At the same time, offering stub equity also eliminates some benefits of going private, such as no longer having to file quarterly reports, he said.

Leveraged Recapitalizations

While leveraged recapitalizations were more commonly used by companies in the 1980s to defend against hostile takeovers with added debt and more concentrated stock holdings, private- equity firms eventually started using the tactic to help secure shareholder support and reduce costs. Prior to an accounting rule change in 2001, private-equity firms had more incentive to carry out stub deals because it helped shield them from requirements to write down goodwill, which is the portion of a takeover price that exceeds the book value of the target’s assets.

In his letter to Dell’s board, Icahn cited his partial takeover of CVR Energy Inc. (CVI) as evidence of his track record. His firm amassed an 82 percent stake in the oil refiner last year after offering to acquire the entire company. While investors that sold to him were paid $30 a share, the remaining traded shares ended yesterday at $51.19.

Mario Gabelli, the founder of Gamco Investors Inc., which oversees more than $36 billion in assets, said yesterday in a phone interview that his firm bought an arbitrage position in Dell when the buyout was first announced. He said he’s yet to decide whether to take cash or retain a stake in the computer company if that option became available.

“If a private-equity firm like Blackstone has done their math right,” this is a way for a Dell shareholder such as Southeastern “to get part of their money back or participate in the ongoing success of the leveraged enterprise,” Gabelli said.