Harman/Levinson/Proceed/Lexicon/Revel/ Deal Busted

Two Private Equity Firms Back Out of $8 Billion Buyout of Audio Equipment Maker Harman International.


Makes me wonder what was the "material adverse development"? Could it have been Tweeter's demise? or, did business suddenly fall off a cliff? or, maybe they lost a big contract with an automaker?
The MAC was the inability of the buyout firms involved to obtain appropriate financing due to the recent structural changes in the credit markets.
Something "fell off a cliff" with Q4 earnings which were 25% below expectations. There is a slight delay in the launch of a new line of Mercedes (with Harman stereos going in them), but given that Hyundai, Peugeot, and others are lining up to get Harman integrated systems in their top-of-range models it should not be a real problem. And given that there is a $225mil termination fee that the would-be-buyers would have to pay to walk away, I would expect the due diligence done would have been good enough to get to the "questions of Harman's financial health" (especially given no debt and $500mil free cash flow per year and OEM mfg capacity booked out for a year-plus). It'll be interesting to see what it is...
Private Equity has kind of worked like flipping houses in an up market....many players with no intention of remining as owners for any significant length of time...i.e. many speculators that should not be in the market and who are just looking for a quick gain. The "adverse development" is that, in future, it looks less and less likely if there will be buyers left to flip stuff to (at ever more inlfated and ridiculous prices....)
It's the credit crunch. KKR didn't like the terms the bank was offering to finance the debt. In addition, KKR doesn't want to be holding a luxury manufacturer in a slowing/tightening economy.
Most private equity firms want to close their deals in this environment because the economy is still fairly robust and the corporate world outside of the housing industry is still doing quite well. On the other hand the banks that made firm financing commitments to fund these buyouts on economic terms that are now only worth 90 cents on the dollar require that they perform on their commitment and take on average a 10 cent loss per $ of financing, or try to find a way out of an MAE or MAC clause that is generally very tightly written.

In the case of Harman this is the first big deal where it just so happens that the highly reputable firm, Goldman Sachs, is playing the role of both equity investor, along with KKR, and financing source. A potential conflict of interest? Why would Goldman's private equity managers want to force a 10 cent loss on the Goldman leveraged buyout financing bankers? Harman did announce a weak 2nd quarter but is that enouch to wiggle out of the deal? Anticipate lots of litigation if Harman's board exercises it fiduciary obligation to it's shareholders with a stock price down over 25% on yesterday's announcement.

From an audio perspective this can only be good news. I cannot imagine a set of circumstances where a leveraged recap like this would be of benefit for product innovation and maintaining high levels of customer service.
English, please, for us non-MBAs.
When PE funds do these kinds of deals, they "agree to pay" $8 billion to buy the company (as the headline says). What actually happens is that PE funds come up $2-3bn themselves to buy the equity, and also come up with a group of people willing to put up another $5-6bn to buy bonds against the cash flows generated by the company. Usually, something like 50-75% of the takeover is funded with debt. The PE fund does not take on the debt, the company they are taking over takes on the debt (in this case, Harman). If Harman, separately, wanted to sell a $200mil bond in normal times for the credit market, it would not have a great deal of trouble (other than it's a small deal) and the spread (percent that they would pay over a benchmark - say government debt) would not be terribly wide. However, when they put themselves in debt to the extent that the PE funds like to do (let's say 10 times the amount of earnings generated before interest, tax, and depreciation are subtracted), the company has become less credit-worthy and therefore the people lending the money want to get a slightly higher interest rate for the increased risk. These are "junk bonds." Usually, PE funds get guaranteed financing and then make the deal. The 'guaranteed financing' includes a bridge loan (and sometimes more complicated things) to pay for the thing in cash, then a refinancing package into bonds, whereby the investment bank guarantees that the borrower will pay a certain interest rate. Investment banks (like Goldman Sachs) are eager to act as arrangers for the loans/debt because the fees are quite good on leveraged loans and junk bonds, and they tend to think it gets them an inside track to act as investment bank when the PE fund tries to sell the asset on (either in an IPO or to another buyer), which will of course generate more fees.

The recent credit crises sweeping financial markets has meant that all kinds of credit have seen spreads widen vs Treasuries - even to the extent that banks lending to each other in the money market, and highly credit-worthy companies borrowing extremely short-term money in the commercial paper market have found it difficult to borrow at anywhere near normal rates (or at all). This has meant that junk bond investors are no longer willing to buy 5yr bonds with a coupon of 1.5% over LIBOR and instead want to receive 3.5% over LIBOR. The investment bank who guaranteed to the PE fund that they would pay 1.5% over LIBOR signed a contract to that effect and the PE fund will generally want to hold them to it. If the PE fund does hold the investment bank to the deal, the investment bank will only be able to find buyers for its bonds at the 3.5% over LIBOR level, which in this case would be something like 90 cents on the dollar.

In this case, the math is that if GS is the sole arranger for the bonds (which could be $5-6bn) and they lose 10% on those bonds (they actually would only lose abt 8% if they sold at 90 because they keep the 2% fee), they would lose $400-500 million at this point. Davidny's suggestion is that it is possible that GS' private equity arm might not want to stick it to GS' investment bankers and so have claimed MAC (if GS and KKR share a $225mil break up fee, GS' share would be substantially less than the $400-500mil loss on the bonds).

The deal contract between Harman and the buyers precludes missed forecasts, a slowdown in the audio industry, or the economy at large as being a material adverse change (MAC). The financing has been stuck to the investment bank already so that is not (usually) a worry for the buyers. If the change really has been a MAC, theoretically, the buyers could walk away without paying the break-up fee though as Davidny suggests, Harman's initial reaction to say that they dispute the buyers' claim that there has been a MAC means that Harman is going to fight the buyers who suddenly have cold feet (the fall in the stock price is a weird one - it causes damage but the "damage" has to be claimed through tort (not living up to the contract), not through simple loss, which means it is really up to Harman's board to act on behalf of shareholders - though they will because they are afraid of shareholders' claims). All things considered though, it is likely that the vast majority of shares at this point were held by merger arbitrage desks trying to earn a spread too - though given what happened in August, I would have avoided plain-Jane PE-fund-buyer balance sheet merger arb trades in the US like the plague.

I also agree with Davidny's last comment - it is really difficult to imagine a deal like this (a leveraged "recapitalization" which usually have lots of covenants attached to the debt so that cash flow must be maintained at high levels) where product innovation and service "costs" are going to be well-supported. Though, one thing to say for KKR (disclaimer: no affiliation blah blah blah), on average they hold their companies for 7+yrs (vs average PE fund holding period of roughly 3-4yrs) so they do take a long-ish view (though it helps that they have a huge portfolio of companies, cross-sell products wherever possible (see the Sun deal) and all their portfolio companies pay consulting fees to their captive consulting company).
My benchmark for deals was 6x Enterprise-Value-to-EBITDA, financing rates aside.
Is it really true that KKR is the second largest private employer in the US?
i'm not a business major either, but my concern is that Mark Levinson survives and grows. a friend of mine tells me that the cost of repairing a ML component (one that you would really like to continue using in your system) is expensive- unfairly so. i have to agree they seem to be charging customers a lot of money. plus they never developed SACD or a universal player. OTOH, the absolute sound thought the new 326S preamp was outstanding. i wish they had listened to the optional phono modules as well- so far as i know no one has reviewed those.
i presently own 33H monoblocks, and in spite of their "aged" design, and the fact that one of them has stopped working and is going to cost me dearly to repair, they sound markedly better than several very good amps i have had IN MY SYSTEM before. my speakers are very revealing, and in all honesty, there's never been a time that i have wished for better amplifiers to drive them. which would seem to indicate that, at least for me, they would be difficult to beat without spending a great deal of money, AND probably having to go with high-powered (high-maintainance?) tube amps. maybe Dartzeel will make monoblocks someday- but they also might cost close to $40k...
but again, my point is, that without that Mark Levinson logo in the mix of high-end audio, (at least for me) it would be a huge loss- this is a company that has predominantly chosen INTERNAL design changes over cosmetic changes over the course of their history. they have also taken many of the ideas and technological improvements from their more expensive models and later encorporated them into their more affordable ones. other than audio research, mcintosh, and _____, there's a relatively short list of companies that have maintained excellence and avoided flashy marketing decisions. so it is my hope they will thrive and continue to develop new components, with an inner circle of trained ears to decide what to encorporate into those components, as they supposedly did in the past.
i recall a review that stereophile did awhile back comparing DAC's from several companies, including a Burmeister model costing over $30,000, and several less expensive models, including a ML-360 (without the arlon circuit boards in the 360S). they concluded after listening to the levinson that it was way too close to the burmeister's sound quality for comfort, even though it lacked some features and a beautiful mirror-finished siver cabinet. the reviewer frankly could not justify spending the extra money, unless you just "had to have" the more exotic component for reasons more personal than objective.
maybe the reviewer was a bit off in his conclusions. but i rejoiced the strong probability that Levinson did a great job in designing the 360, and that, even if IT was too expensive for some folks, it might be something to save up for when your present CDP wears out.
as for me, many years ago i worked (literally) my way up from a denon amp to a hafler, and finally to a traded-in Levinson 23.5. i thought it was the most beautiful amplifier i'd ever seen, and it really smooshed the hafler pretty badly (an XL-600- 300W/CH). instrumental textures were so much better, the overall realism of the music was so superior that it wasn't even funny. and the hafler had plenty of power, so i didn't even care about that at the time. one of my friends told me the hafler had perfect square waves, and (therefore) the levinson was simply a huge waste of money, that i got "sucked in" to the big lie that the expensive equipment manufacturers conjure up to make alot of money off of people who don't know much about the actual costs of designing and building circuits and putting them in a "pretty box". he had the money if he'd wanted a krell or a rowland, etc., but he didn't even want to hear the amp- i mean, what if it turned out he was wrong? so he simply considered me to be a fool. maybe so, but not without a huge grin on my face as i took out my favorite music.
KKR is up there. I recently attended a presentation where a KKR country-head spoke and his intro said something to that effect (something like $100bn+ in revenues and 250,000 employees across all "portfolio companies").
Well, forecasts for Q1 next year are out, look horrible, and the would-have-been buyers have decided to pay their $225mil to walk away. Now it is a matter of whether Mr. Harman and board want to take them to court...
this deal simply fell through because the investment firms would not make enough $$$$$$$$

read between the lines here...if it would be highly profitable, they would have followed through with the deal