Bidding on Freescale Sets Off Alarms
Two groups of private–equity firms have placed huge bids on the chip maker. To some, the likely debt load is just too risky
The bidding war for computer chip maker Freescale Semiconductor (FSL ) is just the latest in a series of huge leveraged buyouts. Big private–equity firms loaded with cash are setting records, as they tackle larger and larger deals in sectors such as technology, a field on which they were unlikely to tread until just a few years ago.
Freescale, a Motorola (MOT ) spinoff that sells computer chips to the wireless communications and automotive sectors, is just the sort of target that private–equity investors find attractive these days. In the past, buyouts tended to be smaller turnaround companies in old–line industries such as car parts. Now, private–equity players—having amassed more than $1 trillion in global spending power—have cast an eye toward far larger, more complex opportunities.
Private–equity firms are particularly drawn to companies with good cash flow, and Freescale has plenty of it. Operating earnings are expected to hit more than $1 billion in fiscal–year 2007, up from $923 million in fiscal 2006 and $632 million in fiscal 2005, according to a report by UBS (UBS ) analyst Thomas Thornhill. As the rollout of new computer chips has slowed, the chip companies have been able to slow their spending. That has boosted free cash flow, "making LBO transactions possible," Thornhill said.
But the bidding for Freescale, located in Austin, Tex., has opened at $16 billion, a premium to its market cap of $15 billion. That creates risk. Any private–equity transaction of that size is bound to include a lot of debt, and can cause problems down the road, especially in a volatile and competitive tech market.
The amount of debt that private–equity firms use to fund such large deals is starting to generate alarm (see BusinessWeek.com, 9/8/06, "Selling Out for Buybacks"). It wasn’t clear on Sept. 11 how much equity either of two groups bidding was prepared to inject into a Freescale deal. But one investment banker warned that the sheer scale of the deal would make a high debt load likely.
"NON–VIRTUOUS CYCLE." "To me, this is an example of the absurd levels of debt leverage that are now available in the market," says banker Ken Marlin of Marlin & Associates. "It is a non–virtuous cycle that runs the risk of disaster. In my view, this is too much risk to the limited partners whose money is invested in the private–equity firms and too much risk for the banks who are offering all this debt."
LBOs that use heavy debt can rob companies of financial flexibility needed for growth. In extreme cases, they can force the weakest companies into bankruptcy.
A group of leading private–equity firms including Blackstone and Texas Pacific Group has offered about $16 billion for the world’s ninth–largest chip maker, people familiar with the matter said. A second group of buyout firms, including Kohlberg, Kravis Roberts and Silver Lake, has submitted a rival bid, those same sources said. The New York Timesfirst reported news of the bidding war. Shares of Freescale rose 20.5%, or $6.31, to $37.06 on Sept. 11.
The deal reflects the trend toward larger LBOs, including groups, or "clubs," of private–equity firms. Such deals have made private–equity players an increasingly dominant force in mergers and acquisitions, allowing them to outbid publicly owned strategic buyers with huge market caps.
A NEW SECTOR RECORD? During the last M&A wave in the late ’90s, such strategic buyers ruled the market, using their stock as currency in huge deals. But the stock market is sluggish, giving private–equity firms with access to plentiful cash and cheap debt an edge over publicly held companies accountable to skittish shareholders.
A $16 billion deal for Freescale would be the largest leveraged buyout in tech–sector history. The record for largest tech LBO was set last year with the $11.3 billion acquisition of SunGard Data Systems by Silver Lake, KKR, Blackstone, and others (see BusinessWeek.com, 4/4/05, "A Mixed Bag for SunGard Investors"). But the record for largest buyout in any sector belongs to a group led by KKR and others, which acquired hospital company HCA this year in a $33 billion deal. It eclipsed KKR’s prior record, which was set with the $31.4 billion acquisition of RJR Nabisco in 1988 (see BusinessWeek.com, 6/13/06, "Fresh Barbarians at the Gates?").
It could be weeks before the winner of the Freescale auction is known—and the price could climb higher. The KKR–and–group bid came in at the last minute, one person familiar with the matter said. It will take two to three weeks for Freescale CEO Michel Mayer and the board to complete due diligence on the latest offer, and if the Blackstone–TPG consortium ups the ante, Freescale may need more time to evaluate its options.
IN NEED OF REVENUE. Freescale had no comment on Sept. 11, beyond a brief acknowledgment that it was "in discussions with parties relating to a possible business transaction." It warned there was no assurance that any deal would result from the talks and that it would not comment further.
Freescale has worked to get its house in order since it was spun off from Motorola just over two years ago, and it has seen its stock price more than double in that period. Mayer, a former IBM executive, has worked to cut costs. Now the biggest challenge is to generate greater revenue growth, which lags some rivals.
But Freescale is in a volatile and competitive business. The market for semiconductors is given to wild swings. It was in bad shape just two years ago, when Freescale became an independent company (see BusinessWeek.com, 7/15/04, "Freescale: Motorola’s Terrible Timing"). And Freescale faces plenty of powerful rivals in the telecom market, where Qualcomm (QCOM ) and others have larger shares.
LOOKING TO EXPAND. It also sells heavily to the automotive industry, which is under pressure to trim costs and is notorious for pressuring parts suppliers of all sorts. The company gets more than two thirds of its revenue from the auto sector, where it’s the largest supplier of chips, and the remainder from appliances and communications. While it has diversified beyond Motorola, its former parent remains its largest customer in the communications sector, suggesting that the company’s new owners will need to broaden its revenue base in that area.
It’s possible that the private–equity buyers will be able to create scale and synergies that Freescale couldn’t achieve on its own. KKR, for example, already has acquired 80% of rival Philips Semiconductor (PHG ). Putting the two companies together would help them compete on a sturdier basis against rivals such as Qualcomm and Texas Instruments (TXN ).
That volatile market could create challenges down the road for Freescale’s new owners, whoever they may be. Synergies often sound better in theory than they are in practice. But debt payments must be honored regardless of how those synergies play out. If this deal turns out to be another example of a debt–laden mega–LBO, those risks could be even higher.