Some of Dell’s current shareholders are up in arms over the proposed leveraged buyout of the quarter-century-old personal computer company. They argue that it’s a sweetheart deal for Michael Dell and a way for him and private equity firm Silver Lake, along with Microsoft, to hang on to Dell’s cash and keep any future profits from a future turnaround to themselves.
Another way of looking at the $24.4 billion transaction is that it is a test for the classic private equity model. The whole concept of private equity is based on the assumption that a group of companies – typically mature companies generating a reasonable amount of cash flow from operations, but in need of some kind of strategic overhaul to either reinvent or restructure themselves – are better off not being run as public companies, with their boards owing a fiduciary duty to a wide array of public market investors.
The private equity world is full of problems, to be sure. Over the years, managers in this space have branched out from their core discipline to launch hedge funds, credit funds and other investment products. They have used every opportunity to add extra debt to their portfolio companies simply in order to pay themselves a special dividend and remove any equity risk associated with their investments.
Last year, according to a report just released by PitchBook Data Inc., secondary buyouts were a more common exit for private equity investors than sales of businesses back to the public via an IPO or to other businesses. That flies in the face of logic, since the goal of any LBO is to extract the maximum value and streamline the company. If a second group of private equity firms step in to do their own LBO of a company that has been through the process once, that likely means either that the first group has failed or that the second group has a faulty analysis.
Then there is the rather interesting way in which the industry has structured compensation, enabling it to claim that its employees aren’t just earning salaries but rather capturing long-term capital gains, also known as “carried interest.” (Watch for the Dell transaction to put new life into the “carried interest” tax controversy in the coming months, too.)
Despite all those issues, these days the argument for going private may be even clearer than it was back in 1989 when KKR finally wrapped up the now-iconic $31.1 billion leveraged buyout of RJR Nabisco. (Back then, Dell itself was only about five years old, and had gone public only a year earlier.) In the decades that have elapsed since then, the demands on companies to increase revenues and earnings steadily, quarter after quarter, has only increased. Companies that fail to deliver – and that then fail to return value by using the cash on their books for outsize dividends or buybacks, are ruthlessly punished.
All that short-term behavior on the part of public market investors is logical, especially in the current environment in which every little bit of incremental return is valuable. But being a publicly traded company subject to those pressures in the midst of a major secular change in your core business is immensely perilous. How can a board and management with a fiduciary duty to maximize value for shareholders juggle the competing definitions of “value”? For some, it will be short-term returns, while others within the company may see it as using cash to make riskier or longer-term strategic investments that may not pay off for some time and that may be seen as gambling with the company’s assets by outside investors.
That’s precisely when the idea of private equity ownership makes sense, at least in theory. By taking the company private, Michael Dell and the folks at Silver Lake – who have already completed some successful turnarounds of formerly public technology companies – can take those risks. Yes, they will be doing so using the cash that is already on Dell’s books, as well as the debt that they will use to finance the transaction. But they will be paying current owners a price of $13.65 a share for those assets – assets that, collectively, had been valued at less than $11 on the day before the first rumors of a buyout began to spread.
Clearly, Michael Dell is correct to suggest that the public investors didn’t recognize the value of what he had been trying to do at Dell, shifting the business away from the slumping PC market and emphasizing software, services and data networking instead. Perhaps investors were correct in discounting those new businesses, and perhaps the $24.4 billion bet by Dell and Silver Lake, with Microsoft’s backing, will fail. But the damage will be limited to a smaller number of professional investors who have industry expertise, a more intimate knowledge of the company and the ability to put the question of immediate profits to one side in hopes of generating greater and more sustainable profits in the future.
There are times when it is perfectly appropriate for a company to be or to remain publicly traded. Conversely, a company that has stumbled or that faces a major secular change in its core business may better serve investors by retreating from the public market, especially when those public market investors, as Henry Blodget so pungently pointed out appear unwilling to shoulder the higher risks that could generate higher returns down the road.
Sure, shareholders who stuck around and believed in the vision of a new Dell were willing to take the risks. They aren’t thrilled by having to relinquish their hopes of a bigger payday after riding the stock lower over the last year. But at the end of the day, there weren’t enough such investors to keep the company’s share price at a level where an LBO made no sense. That’s capitalism.
Some of the specific issues surrounding the Dell LBO may well end up being tested in the courts, if shareholders follow through and sue. But the ultimate test will come over the next two to three years, as Michael Dell and his new partners push forward with their proposed transformation of the company. If it works, the rewards will rightly go to the private equity investors who were willing to take a risk that made public market shareholders nervous.
