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Absolute Return Podcast #39: The Largest Leveraged Buyout of All Time: Does This Mark the Cycle Peak?

By November 12, 2019 No Comments


November 12, 2019—CPPIB Acquires Canada’s Biggest Wind Power Producer for US$2.6 Billion. What’s the Strategic Rationale?

Walgreens Considers Going Private in the Largest Leveraged Buyout of All Time. What are the Chances of it Happening?

GFL Environmental’s IPO Flops. Why Did They Pull the Deal?

Saudi Aramco Launches Much Anticipated IPO. Should Investors Buy the Stock?

A Review of October Factor Performance

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Transcript

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Welcome investors and podcast listeners to episode 39 of The Absolute Return Podcast. I am your host, Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: Today is a chilly Monday, November 11, 2019. Have a number of important market events to chat about on this week’s podcast, off the top.

Canada Pension Plan

Julian Klymochko: Interesting infrastructure deal this week as the Canada Pension Plan Investment Board announce the acquisition of wind power producer Pattern Energy Group for 6.1 billion U.S. dollars, this is inclusive of debt. So on a market cap basis, equity of 2.6 billion, this is a friendly deal struck at twenty-six/seventy-five cash per share. This represented a premium of about 15 percent, which is on the skimpier side. We typically see control premiums on a takeover at around 25 percent, so 15 percent not too great of a price. However, this asset was pretty widely shopped in the market. There are strategic alternatives process was well known in the media, pretty well publicized.  This deal, it reflects Canada’s largest pension funds, increasing demand for both renewable power and a stable infrastructure asset. Now, this is really shown in the valuation of the deal.

CPP paying fourteen point four times next year’s EBITDA, which is a fairly steep price, but that just shows how much in demand these type of assets are, these stable cash flowing infrastructure assets in the eyes of institutional investors such as pension funds like CPP. Now, what Pattern Energy Group does? They’re an independent power producer with a portfolio of twenty-eight renewable energy product projects. They have been operating capacity of about 4.4 gigawatts in the U.S., Canada and Japan.

Some background on CPP. They are a 400 billion dollar pension fund, one of the largest in the world, one of the most sophisticated investors in the world as well. Their goal is to pay the benefits owed to workers and Canadians in the Canada Pension Plan. They actually created a standalone group to hold power and renewable assets as a couple of years ago. This is a continuation of that trend. They have already invested more than 2.1 billion in renewable energy projects since that creation of that group. They really see a disconnect between private value of those and public market interest in those renewable energy stocks.

Nonetheless, like I said, this offer a 15 percent premium. Not a knockout bid by any means, but this was a well shopped asset, shopped on a public basis. So what’s interesting is that, number one, the stock was trading at $27 and 80 cents prior to this deal being announced at twenty six/ seventy five. Obviously the market and pre arbitrage speculators, which we discussed on last week’s episode, they were expecting a much higher premium on this deal. So unfortunately, for them, this pre arbitrage did not work out. They are getting less than expected, so that premium is based on the unaffected price prior to announcing this sale process. And the twenty six/seventy five takeover price is actually a pretty substantial discount to what the market was expecting as it was trading quite a bit higher than the ultimate price. Nonetheless, CPPIB and the merger agreement, they are actually allowing Patter Energy to shop itself. They have a so-called go shop provision, which allows Pattern Energy to go to other buyers until December 8 to seek a higher bid, which is really unusual in this context, isn’t it?

Michael Kesslering: Yeah, absolutely and you know, this may have been part of their strategy to perhaps pay a bit less of a premium, judging by the quotes from CPPIB as they do. They won’t comment on any other potential bidders joining the fray. But you know, their comments that they do believe they provided the adequate value to Pattern shareholders. You know, speaking of Pattern shareholders. The shares have underperformed competitors such as Brookfield Renewable Partners and some others over the last five years. There is likely some frustration amongst shareholders there. CPPIB looking to take advantage of that. In terms of other companies that may be interested is, you know, Brookfield Renewables, parent company, Brookfield Asset Management there. It was reported that there is likely some interest from them. As you had mentioned, Julian, they have already had our extensive bidding process. If Brookfield was interested, they likely would have already put in a bid.

One thing that you mentioned with regards to the pre arbs is, you know, that they didn’t do very well on this. You know, depending on when they did invest, they might have lost some money on this pre-arb speculation. It really does just highlight some of the riskiness that when we did discuss pre arbitrage and those situations, we did mention the risk and this is a classic example of the risk. There is always an amount of deal speculation, but, you know, sometimes it really does not pay off to get involved in those situations. One other aspect, just in terms of the strategic rationale from CPPIB moving forward, taking them private is as a private company. It is believed that they may be able to increase their leverage profile and with very stable assets such as these that are quite leveraged. It is one of the main mechanisms to increase your return on equity as the sponsor.

Julian Klymochko: Interesting. I just wanted to comment on the trading. Now, this offer prices at twenty-six/seventy-five and the stock’s trading at twenty-seven/fifty, which on first glance appears to be at a premium to the takeover price. In fact is not because you need to look at the total consideration, which is inclusive of dividends. Pattern has a relatively high dividend yield, roughly 6 percent. If you include all those dividends up to your estimated close, it’s actually trading at a discount to the consideration roughly two point three percent annualized, which isn’t really pricing in a bidding war, really not pricing in much upside beyond the current deal. However, it is priced in relatively low risk deal and I would certainly consider that is a low risk deal. Obviously no real competition regulatory concerns and CPP is obviously a buyer of the highest quality doesn’t really get more high quality than the 400 billion dollar pension fund that behemoth in their wheel house of acquiring infrastructure assets. For its arbs, a fairly safe deal 2.3 percent annualized return that you can really bank on as a merger arbitrageur.

Walgreens

Julian Klymochko: Fascinating story in the leveraged buyout space with Dow Jones Industrial Average constituent, Walgreens Boots Alliance has been in discussions to go private in what can be the largest leveraged buyout in history.

Some background on the company. Walgreens Boots is the largest retail pharmacy in the U.S. and Europe, with nearly twenty thousand stores in 11 countries that operates Walgreens and Duane Reade stores in the U.S. and Boots outlets in Europe and Asia. Three quarters of its revenue comes from their U.S. pharmacy business. Now, this pharmacy behemoth, they are one of the largest out there, they have been in discussions with several private equity firms. This was reported in the media last week for an LBO valued well over 70 billion, which is just massive in size, to give you some context with respect to the size of the bid. This would be by far the largest LBO in history, the previous largest or the current largest LBO in history, I should say. It was the 2007 sale of utility TXU Corp to KKR and TPG, which was worth about $45 billion, which also ended in disaster and end up going bankrupt, and LBO shops lost their shirt on that one. So certainly a pretty ominous sign competing for that title of largest leveraged buyout in history.

The other really interesting aspect of this deal, which investors should really take into account, is this would be the second time that Walgreens has been taken private. The last time being again in 2007, they were LBO’d by KKR and you notice that name coming up a lot. And ironically, KKR this time has approached Walgreens for a second LBO on the same company, which you don’t see all that often. But it is quite interesting nonetheless, but in my opinion you have two real ominous signs with this proposed LBO of Walgreens. Number one, the largest LBO of all time.

If you look at the current record holder, TXU in 2007, number one, not only was that a massive disaster in that it ended up in tears for the private equity firms backing the deal, but also a market that the previous cycle peak for the last business cycle right before the world spiralled into the Great Recession, 2008-2009. The other aspect investors should take into account is back when Walgreens did their first LBO, that was also in 2007, also peak of the cycle. So you take that analogy and look at it this time. You’ve got to wonder, is that marking the peak of the current business cycle? What are your thoughts on it?

Michael Kesslering: Yeah, it certainly is an interesting aspect and one aspect that I did want to point out was the initial merger, as you had mentioned, between Alliance Boots and Walgreens back in 2007. Now, this was kind of exit for KKR at that time where Walgreens acquired them. This was obviously viewed as very favourably for KKR. They kind of had couple options to exit there their position. That’s either do a secondary offering where you would have to market your shares at a discount to that current price or find and acquire and get acquired at a premium to the price. That is kind of a little background of why a private equity backer would really look for a strategic acquirer as opposed to, you know, a secondary issue is kind of their last resort.

Julian Klymochko: Yes. Interesting comment on the structure of leveraged buyout funds because they have a fixed term of typically seven years. They will buy a company and look to flip it within that seven years.  Now what is happening? Instead of owning Walgreens, the entire time KKR raised the fund. Bought it, flipped it, exited it, then raise another fund looking to buy it again, which is just you know, you look at that and all the inefficiencies that that involves. Nonetheless, a significant number of fees for the LBO sponsor, of course.

Michael Kesslering: Absolutely, and you did mention, you know, raising another fund. So Bloomberg actually reported that KKR America’s seven fund has about eight point two five billion dollars of dry powder currently. With the current trading of Walgreens, if you assume a 10 percent premium to buy out shareholders and equity making up about 40 percent of the funding, as they are of leveraged buyouts, then a PE consortium, as it has been reported that this would likely have to be a club deal. They would not be able to just beat KKR.

Julian Klymochko: Oh, would certainly have to be. I think the largest LBO fund of all time might have been Apollo or Blackstone at 20 billion.

Michael Kesslering: Yes, and so in terms of the equity portion that they would need for this transaction would be over 30 billion dollars. KKR does not have that in their America’s Seven Fund. Then beyond that, they would have to raise another, you know, 40ish billion dollars in debt financing. So really, this would be something that would be very large just in terms of the scope of including some of these large players on the private equity side. But as well as the leverage loan market, which would be very interesting to see what demand there would be for a loan such as this.

Julian Klymochko: Right, and not just levered loans, but junk bonds as well. And there’s two interesting dynamics there. Number one is on the debt side. You know, 40, 50 billion dollars. We have seen quite a few number of deals like that. I remember a big one was the Verizon acquisition of Vodafone’s interest and their U.S. business, which was a massive debt deal, which went pretty much without a hitch. I think if this deal were to happen, that the debt side would be the very, very easy side, because interest rates are so low, there is just so much demand with anything with a hint of yield on it. I think these loans and bonds of which there would be many would be structured into many different slices. I think that would sell quite easily. However, you mentioned this large equity check, which would pretty much need to involve at least a half dozen LBO shops, it appears just to come up at that size of equity check I think. That will be much more a challenge to get that many private equity firms onside and club deals used to be very popular last cycle. But a lot of firms soured on that type structure, so we’ll see if that sort of structure re-emerges.

I wanted to touch on the strategic rationale. Now, the CEO of Walgreens has a 16 percent stake and he is pretty frustrated with the share price. It has lost 28 percent of its value over the past year, which is pretty bad when the S&P 500 has been doing nothing but going up.

So life as a public company has been pretty traumatic for them. Walgreens shares have fallen pretty precipitously. They are racing to cut staff, closed stores. They have this big cost-cutting program, which perhaps they perceive as public markets, not really being too friendly with that restructuring. This buyout would give Walgreens time to adapt to a fast changing retail landscape. Freed apparently from the quarter-to-quarter demands of public shareholders. That is what the company is claiming. I mean, what private equity firm doesn’t care about quarterly performance? Right. So you got to look at the market action here. Stock up about 10 percent over the past week as the market prices. The chance of success of this happening, end of the market, as do the bonds. Bonds trading down two and a half percent. Obviously, this deal would be negative on the bonds, as they would load the company with debt. As for chances of this happening, I mean, it is definitely less than 50 percent, in my opinion. You know, massive challenges just coming up with the financing here. Obviously, valuations are quite high. Nonetheless, you look on the other side of the coin, private equity firms have record amount of dry powder, which they need to put to work. Ultimately putting that money to work means more fees for the private equity firms. So they are certainly, incentive to get a big deal like this done.

Michael Kesslering: Absolutely, and so just in terms of some of that incentive as well, is that the company has actually been returning capital to shareholders over the last couple of years at a pretty high rate. It currently has a 2.9 percent dividend yield and they bought back shares about 7 percent of shares last year. I preferred metric, the shareholder yield at about 10 percent. Now, that could likely be allocated, a vast majority of that could be allocated to debt pay down in an LBO situation. So that gives a little bit of insight into the favourability that would be looked upon by KKR to this business model, even though it has not been growing their EPS really hasn’t been growing. One last thing I did want to mention was that Berkshire Hathaway was mentioned by Barron’s, as another possible suitor in this situation. Although it must be noted that, you know, Berkshire does not typically participate in auctions. It does appear that this deal is being shopped around and so likely would result in in Warren Buffett in Berkshire, not being interested in it.

IPO

Julian Klymochko: Some interesting IPO news and continuing trend of IPO flops. This time it was GFL Environmental. This was supposed to be one of the largest Canadian IPO in many years, but it failed to generate sufficient interest and was ultimately pulled. They have this deal, flopped and what happened was investors balked at the valuation. GFL came out at a marketing range of twenty to twenty four dollars per share and they have a pretty significant debt level. With that level of risk, investors really had no interest at that price. I did hear that there was some interest. Could have maybe gotten done at 18 bucks a share but ultimately, the sponsors and the company chose to withdraw the deal and maybe come back to the market at a later date instead of taking that lower valuation what they wanted. Now, what GFL does? They are Ontario based waste hauler and they have, as I said, a massive amount of debt. They are pursuing this consolidation strategy, this roll up strategy and from that day, they have accumulated 6.5 billion of debt. Not just that, but they have yet to be profitable over the past three fiscal years. They have lost a cumulative seven hundred and thirty seven million dollars the first six months of 2019; they lost 161 million dollars. So an unprofitable, highly leveraged company. Where have we seen this before? And one example of an IPO flop was Endeavor, the owner of the UFC that was a leveraged buyout.

Investors balked at that deal based on debt concerns and valuation. That deal ended up getting pulled. Another one, which we have discussed ad nauseam, was WeWork not necessarily on the debt side, but it was a valuation issue in addition to corporate governance. Nonetheless, this GFL deal was expected to raise as much as $2.4 billion dollars. That is in U.S. dollars, so if we compare that to other landmark deals in Canadian history, there is only a few comparable to Ottawa sale of Canadian National Railway in 1995 that netted 2.2 billion. Manulife Financial’s first public offering in 1999, which raise 2.5 billion. So this really ranks up there with some of the largest IPO in the Canadian history. Then you look, this was supposed to be an exit for the private equity backers, which include BC Partners and Ontario Teachers’ Pension Plan. But it just shows you the strength of the private markets. There’s just so much capital there that companies don’t need to rush to go public anymore because they now have the luxury of deferring an IPO, hit up their sponsors for more private equity and just stay on the private side and not worry about it. Tried to hit the market when there is a better market conditions. But I mean, can market conditions get any better than as they are right now?

Michael Kesslering: Absolutely, and I mean, as you mentioned, you know, an IPO or an acquisition is just one of the exit strategies used by private equity. So really, this is another example, I believe, when BC Partners and Ontario Teachers had acquired their stake in GFL. They had bought the company and I believe this was in 2018 from HPS Investment Partners, Macquarie and Hawthorne Equity. Really, the exit now has been to exit to another private equity firm. That really is not a sustainable exit strategy, so it will be interesting to see how this will end up. You know, some of the deployment of private equity capital initially into these transactions as some of these well-worn IPO or IPO acquisition exit strategies become less available. So that’ll be something really interesting to follow here.

Julian Klymochko: Right and with those continuous exits to other private equity shops, which we refer to as LBO hot potato, it is really a game of musical chairs. You can only really play that song and dance, you know, a limited number of times because, you know, you can only leverage buyout companies so many times. The other potential exit strategy is always to a strategic acquiror, but on GFL, I am not sure if there would be any strategic appetite on a highly leveraged company like this one. I think public markets is probably ultimately their best source of exit. Ultimately, the sellers here, it appears that they are kind of getting a bit greedy. Nonetheless, have a quote from the CEO, Patrick Dovigi here. He stated that the existing shareholders have determined that U.S. $18 per share. “We don’t believe that represents fair value for the company. So the shareholders have decided to inject more equity into the business to fund the future growth of the company and revisit the public markets at a later date.” So there you have it. GFL pulling their IPO for now, perhaps revisiting it at a later date. But it will to be seen if market conditions are any more favourable at that point.

Saudi Aramco

Julian Klymochko: In an IPO that looks like it is about to go ahead, Saudi Arabia, their state owned oil company, Saudi Aramco, they officially move forward with their plans for an IPO. They filed their prospectus just a couple of days ago, on Saturday, 600 pages. So a lot of information in there. Now, this IPO is expected to be the largest of all time of the whole world, not just the U.S., which has been home to some massive IPO, as I believe Alibaba might have been the largest at 20 billion. However, this one could be significantly more than that. They are estimating between 15 to 30 billion. Now, this would represent only 1 to 2 percent of the company making it very, very unique because this will be a very small portion of the company that they’re seeking to IPO initially The Crown Prince, Mohammed Bin Al Saud, a.k.a. MBS, he touted a valuation of two trillion for Saudi Aramco. Now you are hearing market analysts saying that it is just too high of a valuation, looking to be perhaps 1.2 to 1.5 trillion dollars. And where this valuation is coming from is based on dividend yields. Aramco said it would pay out seventy five billion in dividends next year. So at that valuation of 1.5 trillion, the company would be yielding a 5 percent dividend yield, which is comparable to Royal Dutch Shell at 6 percent and Chevron at around 4 percent. What are your thoughts on valuation process behind this one?

Michael Kesslering: It really seems like they are pushing the valuation based on the dividend yield. So, you know, very similar to just a preferred share offering or subordinated debt rather than equity. But as well as other valuation methods. Now, when the underlying assets of Aramco were nationalized in the 1970s, the owners, which are now Exxon and Chevron, were compensated at book value.

Julian Klymochko: Forced sellers.

Michael Kesslering: Yes, they were very much forced sellers. So, I mean, you’re never going to get a fair price and that sort of situation. But if the market were to value Aramco on this basis, it would actually be only valued at about three hundred and eighty billion. But, you know, when looking at an energy company, book value really isn’t the proper metric to be valuing them at. It is a cash flow generating company; it makes more sense to be value get out on a cash on cash flow multiple. But I did think that was very interesting just in terms of the different valuation tools used between then and now. Looking at the offering and I mean, this is I believe the first time this was announced was in 2016.

Julian Klymochko: Right.

Michael Kesslering: When MBS had originally brought up, you know, floating some of the company.

Julian Klymochko: Right, over three years ago.

Michael Kesslering: Yes and there’s been plenty of different detours from this. I mean, now it looks like it will only be a listing in Riyadh, no longer looking at a co-listing in London or New York or anything like that at this current iteration of the plan. When looking at it as an investor, being a minority shareholder and with the disclosure concerns that you do have with a government entity, which you own, Saudi Aramco really is. It really makes it this equity a risky proposition despite its large size, because, I mean, it is being marketed as a dividend yield. But you know that that dividend can be cut. It can be changed at any point in time. It can also be increased, but you know, it could be changed at any point in time. So you really are not protected on the downside here, despite this being a very, very large cap name.

Julian Klymochko:  Right, and so it is a real tricky one here to justify buying. Not only do you basically have no rights because Saudi Arabian government will control this. They are only selling 1 to 2 percent. So obviously, shareholders pretty much have zero say no rights. And you’ve got to be concerned on the corporate governance with respect to a state owned entity. That is always an issue more so even here, just given the geographic nature of this and some of the history behind that. The other thing you have to consider, as you mentioned, it is only trading on the Saudi Arabian exchange, which limits retail participation. I believe you need to be a mutual fund of at least half a billion dollars in assets in order to trade on there. So retail cannot really get access to it outside of a fund structure, but nonetheless at the valuation with corporate governance issues and the lack of shareholder rights. This is a pretty easy one to pass on, especially since it’s so difficult to trade for investors.

October factor performance

Julian Klymochko: Lastly, I wanted to touch on October monthly factor performance. First off, in the U.S., you have the multi factor model down a couple of percent. And that was largely driven by negative factor performance and a quality and operating momentum largely on the short side. Yet a big rally in the low quality names and also on stocks whose price momentum was poor over the past twelve months. They had a bit of a dead cat bounce in October. On the positive returning side, value continues to do well, up 3.5 percent on a log only basis in the U.S. and then overvalued names actually dropped 2 1/2 percent. Adding to the U.S. long, short value outperformance. But you add up all of our factors and that ended up in a negative 2 percent among short multi-factor return. However, in Canada, you had a different story; actually had seven and a half percent of alpha from the long, short multi-factor portfolio and that was driven by two factors. Largely you had very good value performance, but what is interesting about value long short is that on the long side it actually dropped about half a percent where all of the value performance and more came from was on the short side. So stocks with negative EBITDA, stocks with negative free cash flow that is how we view kind of the worst value stocks. Actually dropped twelve percent, giving a lot of positive performance to the short side of that trade. The other thing on the trend side, so your long trend portfolio up over 5 percent or short trend portfolio down over 4 percent. So we had positive performance there, you combine those two factors along with the other ones results in net alpha for seven a percent for the multi-factor long term portfolio. So in summary, a good performance out of Canada, poor performance out of the US, but value continues to outperform.

Michael Kesslering: And what this really highlights is something that we have mentioned before. You know, the differences between factor investing and smart beta. Is it really highlights the importance when you’re trying to extract Alpha out of these factors that we’ve identified is investing on the short side as well to capture that full factor premium.

Julian Klymochko: Not just that, but it provides a benefit of diversification so you can capitalize on generating returns from market drawdowns or just poor performance of those stocks that we expect to not do so well.

And that’s it for us. Episode 39 of the Absolute Return Podcast. As always, if you enjoyed it, you can check out more at absolutereturnpodcast.com. Feel free to recommend it to your friends, co-workers, family. Leave us a review if you would like. Until next week, we will check with you soon. Cheers.

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.