The Pros and Cons of Vendor Leveraged Buyouts

Analyst: Bill Bradway

June 3, 2010

The recent news surrounding the potential, and subsequently abandoned, leveraged buyout (LBO) of FIS by a group of private investment firms is an example of a recurring process that recycles capital and raises questions for all parties affected by an LBO. FIS now intends to raise $2.5 billion of new debt in order to repurchase a like amount of its common shares at between $29 and $31 per share. As a quick reminder, major LBO transactions are nothing new to financial technology vendors. An LBO transaction uses the target company’s assets as collateral for issuing new debt that combined with the equity/cash from the new owners is used to pay off the target company’s shareholders and debt holders (if any). After the LBO, the company’s cash flow is used to pay the interest expense and to pay off the debt on or before its due date.

Notable deals over the past five years include, SunGard’s $11.3 billion LBO in 2005, lead by seven private equity firms (Silver Lake Partners, Bain Capital, Texas Pacific Group, Blackstone Group, Goldman Sachs Capital Partners, Providence Equity Partners, and Kohlberg Kravis Roberts). At the time, the SunGard LBO was the second largest LBO ever. In October 2006, Open Solutions agreed to be taken private for $1.3 billion by the Carlyle Group and Providence Equity Partners. In 2007, First Data’s LBO, lead by KKR, totaled $27.5 billion. Finally, FIS has been associated with a series of corporate restructurings that began with Fidelity National Financial’s acquisition of Alltel Information Services for $1.05 billion in 2003. Since LBOs will continue to occur, looking at the pros and cons from a bank’s (as the client) point of view is a worthwhile effort, particularly when there are other providers that offer a comparable solution to a firm that is heavily leveraged.

The LBO of First Data, the nation’s largest processor of credit card receipts, left the company with a huge debt burden that exceeded $22 billion. According to one credit analyst, First Data lost $240 million in 1Q2010 and its revenue assumptions at the time of the LBO have proven to be well beyond actual revenues. According to S&P research, First Data barely generates enough cash to cover interest payments and capital expenditures – forcing the company to aggressively manage costs. In March 2010, the previous CEO jumped to KKR to make room for a new CEO.

Pros. Looking at the deals mentioned above suggests that the target company can benefit from the leverage and dedication of its new owners. SunGard has made a number of acquisitions since its LBO, adding to its solution portfolio. While its primary market segment, capital markets, suffered the most during the Great Recession, SunGard has managed to weather the market’s ups and downs. Open Solutions just hosted its first analyst briefing since its LBO last month. In the 3 ½ years since its LBO, the company has completed a major overhaul of its core banking solution and converted all existing customers off the older version. While challenged by bank consolidation, Open Solutions completed a few acquisitions that expanded its solution portfolio and revenue base.

Cons. I wish the list of cons was very short. Management turnover is generally not a good sign. Periodic downsizing or reorganizations is worth a second look. Aggressive sales and contract renewal pricing pressure is another bad sign. Client defections that are due to poor customer support, missed deadlines for product releases and enhancements, and changes in vendor sentiment at user group meetings should sound the alarm bell. Finally, have your commercial lender take a look at the vendor’s LBO term sheet and periodically review the vendor’s status as if the vendor was a commercial loan customer. If your own lender is nervous, you should be too.