Buyout companies fishing for stock market rejections

WHERE equity investors see digital disruption, buyout firms see opportunity.

The cheap valuations of strategically challenged stocks attract private equity firms. But corporate prey are not easy targets: traditional acquisition bonuses are proving – understandably – insufficient for some battered stocks.

The latest example is Temenos AG. US buyout firm Thoma Bravo has approached the Swiss financial software provider about a potential deal, Bloomberg News reported last week.

Earlier, Temenos’ share price had nearly halved since June on fears that the company’s major banking customers could switch to new rivals who rent software online.

Temenos is itself moving from a licensing model to multi-year subscriptions. This change will reduce cash flow in the short term, as previous lump sum sales will be spread over time.

Even bearish analysts agree with the strategy, and management has set an ambitious forecast for revenue growth. But the stock market sees pain early on and won’t take a successful transformation on confidence.

There are echoes here of Apollo Global Management’s recent failed bid to acquire educational publisher Pearson Plc and Elliott Management Corp’s March deal, in partnership with Brookfield Asset Management, to buy the business from TV rating Nielsen Holdings Plc. Temenos, Pearson and Nielsen were trading at the bottom of their five-year valuation range when buyers surged.

All can also service significantly higher loans that would help a bidder fund a deal. Such targets offer private equity the opportunity to acquire an asset at a discount, reset the strategy away from the public eye, and sell the revamped company a few years down the line. But buying companies whose shares have fallen rapidly is not as simple as it sounds. For example, a buyback premium of 30% over the undisturbed market price of Temenos would imply an offer at 108 Swiss Francs ($110 or RM481) per share.

The stock was trading above this level as recently as February, and such an offer would be well below the 12-month high. These benchmarks tend to matter in mergers and acquisitions: no one wants to sell below recent trading prices if they don’t have to.

Pearson rightly rejected an Apollo proposal with a 36% premium (after adding a dividend) and just above the stock’s 12-month high. In their bid for Nielsen, Elliott and Brookfield are close to matching the stock’s recent high. They are still vigorously opposed by the first shareholder. That said, the bounty reaches an unusually high 60% and is pretty good for the Nielsen board.

Apply the same add-on to the undisturbed share price of Temenos and an offer would be worth 134 Swiss francs (RM595) per share.

The total value of the transaction, including assumed net debt, would be US$11 billion (RM49 billion), or US$3.8 billion (RM17 billion) above its market value of end of April (Temenos reports in dollars). This could still be a tough sell as the shares were trading higher than this as recently as November. This year’s valuation of 23 times earnings before interest, taxes, depreciation and amortization (EBITDA) would compare to a five-year business average of 26 times.

A deal would require a significant equity check – say US$8bn (RM35bn), assuming the lenders provided debt up to around six times the expected Ebitda for this year. But growth could compensate for limited leverage.

Some analysts predict that Temenos’ revenue could grow by around 75% from 2022 to 2027. Assuming profit margins remain firm, this then approaches a US$20 billion (RM87.5 billion) business at the same earnings multiple.

What if an exit could be made at a higher valuation? Normally this is a reckless assumption, but in processing situations it may be more reasonable. Factor in some debt reduction, and it’s plausible that even with a large premium, a buyout could achieve the required doubling in equity value over about five years.

Of course, buying businesses that need a drastic makeover is not without risk. The private equity fee structure incentivizes companies to put money into deals, so it’s wrong to assume that the buyout industry is necessarily much better than the stock market at spotting bargains. But when private equity firms go bottom fishing, the best insurance policy against seller’s remorse is to not be ashamed to demand a buyout premium that would normally be considered greedy. —Bloomberg

Chris Hughes is a Bloomberg Opinion columnist covering the deals. The opinions expressed here are those of the author.