Michael Dell is going to get his way. Last Friday, the “independent” committee of the board of directors governing the company he founded signed off on a revised “going private” transaction that makes it highly likely he’ll finally succeed in his months-long quest to buy out Dell in conjunction with private equity firm Silver Lake Partners.
There are good reasons for both shareholders and bondholders to be alarmed by this transaction – albeit, different reasons. Let’s ponder the first, and most obvious objections to start with, because the considerations that stock investors care about have been most in the news.
The Dell/Silver Lake buyers have agreed to pay an extra 10 cents a share (or $13.75 a share) plus a special dividend of 13 cents a share. They also pledged to pay out the next regular dividend (another 8 cents a share) in order to win the de facto support of the independent board committee, which agreed to alter voting rules in Dell’s favor. As long as shareholder abstentions were counted as votes against the proposed transaction, Dell and Silver Lake may have struggled to win approval for their proposed deal, especially given the opposition from some major stock holders and a rival bid from activist investor Carl Icahn.
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The stock market seemed to be happy with the deal cut between the directors and Michael Dell’s group. Shareholders may feel better as the value of their stock increases, but they shouldn’t feel thrilled about what has happened. The agreement strikes many observers as a cozy little arrangement between the founder and his board, especially given that the shareholder referendum on the revised proposal is scheduled for mid-September, while Dell’s annual meeting – the first occasion that Icahn will have to effectively challenge Dell by presenting a rival slate of directors – won’t take place until mid-October.
The deal, then, is largely a fait accompli, but it’s far from a triumph for corporate governance. When in doubt, directors should create a level playing field, not tilt it in favor of one side or another in this kind of dispute. Their role is to represent the interests of all investors, and the terms of the two transactions are close enough now to warrant offering shareholders a clear choice. Instead, the board committee has altered rules governing the transaction to make it more possible for Dell and Silver Lake to emerge victorious, even as the bidders have struggled to win shareholder support for the deal and postponed votes that they were likely to end up losing.
If corporate governance advocates don’t squawk loudly about the special committee’s decision to revise the terms of the transaction, perhaps bondholders will. True, Fitch Ratings came out with a statement saying that it doesn’t believe that the higher cost of the buyout would have enough of an impact on the company’s debt position to warrant any further warning. Fitch already has Dell on credit watch, though, and has warned it is likely to cut the company’s current BB+ rating by a couple of notches once the final outcome has been determined. The final rating, the agency has said, “will depend on Fitch’s comfort with Dell’s long-term enterprise strategy.”
Even if credit-rating agencies aren’t worried by the sweetened offer – which will result in more leverage being loaded on top of the $4.1 billion of long-term debt already on its books – bond investors might well be irked by the decision to make the capital structure more wobbly. As Gavan Nolan, director of credit research for Markit, pointed out in a recent commentary, credit default swaps on Dell’s debt saw spreads widen sharply before Michael Dell and Silver Lake made their bid. Back then, the market applied a lower risk of default to Dell’s debt, even though the company had no clear strategy for extricating itself from the deterioration in its core business. Today, with both Dell and Icahn putting forth rival scenarios, the market is more anxious about the ability of Dell to survive and thrive.
Markit’s analysts choose to view the Dell announcement as a hallmark of a bull market in which the interests of bond owners – who rank senior to shareholders in a company’s capital structure – take a back seat to the demands of those shareholders. For my part, I think the message is a broader one: The risk for bondholders isn’t just that a company might default on its obligations, violating a debt covenant or filing for bankruptcy. Rather, the recent mania for relatively high-yielding debt – understandable in light of the rock-bottom yields on Treasury securities throughout the last four or so years – has resulted in the underpricing of an array of other risks, such as excessive leverage.
It’s a timely reminder, as investors are in the midst of rediscovering their enthusiasm for junk bonds, dumping investment-grade corporate bonds and snapping up companies that – like Dell – are deemed by rating agencies to be at greater risk of heading into financial trouble down the road. The spread between junk and investment-grade debt was narrower in late July than it was a year earlier, in spite of the Fed’s warning that it may taper off the monthly bond purchases that have kept interest rates so low.
Stock investors may be content, if not delighted, by the Dell/Silver Lake decision to sweeten their bid for the beleaguered company, but they shouldn’t be thrilled at the manner in which this has been handled, given the message it sends to other boards about governance. Bondholders may be relieved that Fitch and other rating agencies aren’t ringing the alarm bells about the sweetened deal, but may wonder at the willingness of the bidders to load a bit more debt onto the balance sheet of a company they have presented as being on its last legs. Michael Dell may have won his battle – but the price may not be paid by him alone.
