When Private Equity Fails – Freescale
It’s no secret that the golden age of private equity is over. 2005-2007 were incredible years, not only for the PE firms, but also for the players who sold out at the peak. Sam Zell became infamous for selling Equity Office Partners to Blackstone for $23B literally as the real estate market crested in early 2007.
It’s been a few years since boom time, and the private equity industry is still sitting on a lot of acquisitions. The ultimate goal of most leveraged buyouts is an IPO, ideally following successful execution of a revamped corporate strategy and several years of operational tweaks to cut costs and improve profitability. This can’t happen until there is investor appetite and the company is in good shape financially. Since PE firms need to eventually return money to their limited partners who invested in the fund (or to shareholders in the case of Blackstone, KKR etc), a delay to this eventuality is punishing.
I decided to look at Freescale Semiconductor as a case study – almost 4 years later, how is their massive leveraged buyout treating them? Freescalewas Motorola’s chip unit, spun off in 2004, then taken private in an $18B LBO in 2006 by Blackstone, TPG, and others (called a consortium deal). The process was actually very competitive – they barely beat out KKR and Silver Lake (which are much more well known in tech) in a bidding war. Freescale was widely viewed as a gem in the chip industry.
Fast forward to 2010. Revenues have rebounded at tech firms (I wrote about Intel’s record quarter here). More notably, earnings have recovered due to a combination of cost-cutting measures and inventory cyclicality etc. Despite this favorable climate, Freescale remains under a world of hurt. Their situation would not be nearly as dire had Freescale remained a publicly traded company with relatively little debt. Clearly, the consortium of PE firms who purchased Freescale did not see the impending economic train-wreck and over-leveraged Freescale’s balance sheet. Basically, the capital structure they put in place in the buyout depended on stable cash flows and was way too risky. Freescale remains nowhere close to meeting conditions to reemerge publicly, despite a broader market recovery in the equity markets.
Like many US chip firms, Freescale is also seeing increased competition from more nimble firms, both domestically and in Taiwan. As management looks beyond basic chip requirements and decides what key IP / functionality they must embed, they are staring down the barrel of large R&D costs. For example, integrating ‘high value’ functionality such as graphics into their embedded processor line would require massive investment to compete with nVidia, Mediatek, etc… Investment they cannot afford. Or how do they hold on to their lead in e-books (they are in both the Kindle and Nook) when firms who missed the e-reader boat step up their own investment? (rumor has it that Freescale has zero content in the Apple tablet).
Freescale has restructured its debt numerous times by chasing more favorable interest terms, but that will end if interest rates creep upward. They have a few other options outside of an IPO, such as a secondary offering, selling convertible notes, or spinning off a division for cash. All tough options.
As much as management wants to put the LBO behind the company they can’t. Interestingly, they have chosen to publish financial results to the public, something not required of a private firm. My hunch is that they attempt transparency so their customers et al don’t see them as a big sinking black box. But do as they might, their debt overhead hamstrings every decision they make and is internally and publicly known as their biggest challenge – how do you invest in R&D and growth when you have financially engineered yourself into oblivion.
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