Freescale IPO won't skate us back onside just yet

We are approaching five years since the US$17.6 billion LBO of Freescale Semiconductor in September 2006. Plenty has happened in the intervening period, and the climate for investing has been difficult. And yet, even before the global financial meltdown, the Wall Street Journal penned a piece branding the deal “cautionary LBO tale“.

As with the SunGard LBO, a cotiere of top tier buyout firms lead the transaction: Blackstone Group, Carlyle Group, TPG Capital and Permira. CPP Investment Board invested our money in the deal as a limited partner in Blackstone (via fund IV or V), TPG IV, and also did a direct co-investment ala the SunGard deal (see prior post “How are we doing on SunGard after 5+ years?” April 13-11).

At the time, the SunGard LBO had been the largest tech LBO in history, but the US$17.6 billion Freescale transaction quickly became the new poster child of tech mega buyouts.

Interestingly, prior to the deal’s original public announcement, rumoured bids had been in the range of US$16 billion according to a WSJ report at the time — but demand for the asset drove the price up another 10%. It is worth noting that the rival bidders included LBO firms KKR and Silver Lake, both of which were also backed by LPs such as CPPIB at the time.

Unintentionally funding both sides of any given LBO auction is one of the downsides of a limited partner backing most of the world’s top buyout firms.

With almost five years under our belts as part owners of Freescale, how are we doin’? According to the company’s 2010 financial statements, product sales grew from US$3.5 billion to US$4.45 billion, which is fantastic. Operating losses improved from a US$1.2 billion in 2009 to just US$61 million in 2010. Unfortunately, this wasn’t sufficient to break even, and we lost US$1.053 billion on the net income line.

Mind you, because of the US$500 million plus in interest expense and the various amortization requirements, EBITDA came in a US$526 million. Shareholders’ deficit now tops US$4.9 billion. That’s a mountain of blown cabbage.

According to a recent Reuters piece, the pending IPO of Freescale isn’t going to correct the original mistakes of the deal:

Selling stock has at least one other important benefit for the current owners. It sets them up to divest if the chip sector boom should get white hot.

It’ll be a painful step, though. NXP, another pre-crisis chipmaker mega-LBO, went public last August. It has a similar profile to Freescale and an enterprise value of a little over eight times last year’s EBITDA. Put Freescale on the same multiple, and it would be worth about $9.4 billion.

Adjust for the $1 billion of cash on Freescale’s books and its $7.6 billion of debt, and it leaves, on paper, around $2.8 billion of equity for the company’s backers. That’s less than half the estimated cash they put in at the time of the buyout.

Let’s assume CPPIB had just US$150 invested in this deal, both via its commitment to the two LBO funds and the separate decision to do the direct co-investment. On December 1, 2006 closing date, the $150 million of USD would have cost us C$171.675 million. If we assume the Reuters’ estimate of a 50% drop in our equity investment is accurate, our US$150 million is now worth just US$75 million, which winds up to be worth C$72.3 million this morning — pushing our paper loss to 58%.

Over time, we can hope that Freescale’s IPO will skate us back to par. Institutional investors who buy the IPO will be doing so with a view to getting a lift. But the stock will need to go up ~140% before we get back to our original cost base. Given the sector that Freescale is in, and the specific growth prospects for anyone in the chip space, a 140% post-IPO lift is going to take at least a few years. This is no Facebook.

If things go well, we might be back to flat in 2014 or 2015.

I’ve not yet been able to figure out how much money we made on the Dollar General co-invesment, for example, and one suspects that it was a good outcome. But losses to date on EMI, Freescale and SunGard will have more than wiped those gains away. There may be other gems in the direct PE portfolio, but how do we really know?

According to the latest CPPIB financial statements, we have $21.3 billion in drawn private equity investments. Of which about $20.5 billion is which are characterized as “Level 3” assets, which means that the values are based upon “inputs for the asset or liability that are not based on observable market data” according to the CPPIB’s auditors. That’s code for the simple fact that the individual investment values are decided by the owner of the asset, in consultation with their auditor.

Perhaps, if there was more granularity on the private asset valuations (see prior post “Thanks to Washington, we know how CPPIB is doing” Mar 29-11), we could have a better feel for the latent good news in this important part of our $140 billion portfolio. So far, if EMI, Freescale and SunGard are indicative of our investments in the direct PE asset class, the independent and objective observable data isn’t very pretty.

MRM