What makes Qantas such a tempting takeover target for private equity investors?
The recent takeover bid for Qantas Airways sends a clear message that any publicly held airline can become the target of a leveraged buyout by private investors. Nobody is immune from the predator's gaze. Even British Airways, not mentioned as a remote takeover opportunity in recent years, is being touted as a target, having secured union agreement on plugging a £2.1 billion ($4.1 billion) hole in its pensions fund.
The Qantas bid opens a new chapter in private equity's airline investment strategy. Instead of buying troubled carriers at bargain prices and betting on asset sales and the upturn, these bidders aim to buy a profitable carrier, leverage its net worth to help fund their purchase, and rely on its strength in a few years to give them a profitable exit.
The A$11.1 billion ($8.7 billion) Qantas bid has been carefully crafted to slip under the minimums set by Australia's foreign ownership, investment, and competition laws. Non-voting warrants give a different weight to each bidder's economic and voting rights (see table on opposite page). As proposed, Australians will hold only 51% of the equity, but 61% of the votes. Foreign pension funds as a group will hold just over 15% of the votes. Yet no single offshore entity will control 15% of the voting rights, even though foreigners together claim 49% of the economic stakes.
David Bonderman's Texas Pacific Group is the largest foreign investor. With Australia's Macquarie Bank, he is a driving force behind this bid. Bonderman's role caught many by surprise after he warned the IATA annual general meeting in June: "It's time to sell, ladies and gentlemen. This is as good as it gets in the airline industry and it's only going to get worse."
But those with longer memories recall that Bonderman considered a stake in Australia's Virgin Blue and supported Tesna's bid to revive Ansett in 2002. He has been watching Australasia, where he holds other investments, for an airline deal ever since.
Bonderman's aviation pedigree is well known. He turned a $65 million stake in Continental Airlines in 1993 into $700 million five years later. He is chairman of Ryanair, a low-cost pioneer. His Texas Pacific Group also helped America West and is now considering investing in India's Spicejet and Alitalia. Even though Bonderman thinks the industry cycle is starting down, he saw Qantas as a deal that justifies ignoring his own advice.
Foreign player
Only slightly less visible is Gerald Schwartz, who controls the Canadian buy-out firm Onex. Best known for its unsuccessful bid in 1999 to merge Canadian and Air Canada and take over both, Onex is the other big foreign player in the Qantas bid.
Allco was the last big piece in the puzzle. Macquarie needed a big domestic investor to offset the foreign stakes. Macquarie could not raise that stake itself. One of its divisions controls Sydney airport and it knew competition authorities would never stand for the same bank owning Australia's biggest airport and its biggest airline. Macquarie reckoned its own Qantas stake should stay under 15%, which meant it needed other domestic investors to put up at least 35% if Qantas was to remain majority Australian-owned.
Sydney-based Allco Finance was a natural because of its long-standing ties to Qantas. Its head, David Coe, recalls that Qantas was his first customer in 1981 when he bought a Boeing 747 "for about $50 million or so" and leased it to Qantas. Coe's company has been leasing aircraft to Qantas ever since, and is now an operating lessor for a big part of the Qantas fleet. "I have worked with Qantas for 25 years," Coe told local media. "Their DNA is part of my DNA."
The presence of Rod Eddington, former Ansett and BA chief, and David Turnbull, Cathay Pacific's former chief, on Allco Finance's board also proved decisive. Allco Finance is only contributing A$700 million to the Qantas deal, but its sister company Allco Equity Partners is putting in A$1 billion.
No way would Peter Yates, who heads Allco Equity, have invested that kind of cash in an industry he knows so little about, but his sister company's long-standing links to Qantas, the presence of Eddington and Turnbull on their board, and the plan for Turnbull to become a Qantas director if this deal goes through, all convinced Yates that this "seasoned team" had, in his words, the "skills to execute". The Allco Group will thus become the single largest force in Qantas, with just over 35% of its equity and 46% of the voting rights.
If the industry is indeed heading for a slowdown, as Bonderman predicts, why are such sophisticated investors committing themselves now to a $8.7 billion airline purchase? Analysts generally attribute the rise in private equity investments to a flood of money from retirement funds and receptive debt markets because of low interest rates. Globally, over the past five years private equity's share of merger and acquisition activity has grown from 5% to 20%.
The airline industry is more volatile than private equity typically likes, but rising traffic and softening fuel prices have also drawn investors to this sector. Nigel Wright, an Onex managing director who concentrates on the aerospace business, says: "We view aviation as having long-term growth trends above the rate of economic growth." How this translates into a Qantas bid reads like a checklist for other airlines on the likelihood of becoming a takeover target.
First, tax laws favour the heavily geared. Under Australian law, as a company's debts rise, its taxes drop. With the A$7.5 billion extra debt this deal will add to its balance sheet, Qantas will save A$200 million a year in income taxes. That saving can be applied to help pay off the new debt.
Second, favourable debt terms are available to bidders such as Texas Pacific, Onex and Allco. Not only are the rates right, but they have also convinced banks to lend on terms they call "covenant lite". Instead of the normal debt coverage ratios that, if breached, trigger repayment and financial crises, the banks have been willing to offer softer terms and accept more risk.
Undervalued
Third, Qantas shares were undervalued, according to some analysts, so that the bidders are able to offer current shareholders a very-hard-to-refuse 33% premium. Stephen Bartholomeusz, Australian business analyst, says Qantas has been trading at only 10.4 times its earnings, where its peers trade at an average of 13 times. At the bid price, he calculates that Qantas is valued at 5.8 times its pre-tax earnings, in line with its peers, and 14.1 times its earnings. In short, compared with other airlines, Qantas has been undervalued.
Fourth, Qantas has a money-making track record. It has generated about A$2 billion net revenue for each of the past three years. Add the expected tax savings, and the airline has the ability to repay its added debt. Going forward, Qantas is also well-positioned to stay strong. The Allco Group, which knows Qantas better than any other bidder, cites the airline's strong domestic base and international potential. It views Jetstar's overseas launch positively. Allco's Yates predicts: "The important part for the international business will be Jetstar."
Finally, the pre-bid debt-equity ratio at Qantas is about half that of its global peers. Not only does this give it one of the industry's top credit ratings, but it makes Qantas nearly irresistible to a leveraged buyout. The A$11 billion takeover offer is financed with only A$3.5 billion equity and A$7.5 billion debt, which, if all goes to plan, will be paid from future cashflow. This makes Qantas a deal too good to ignore.
So long as the world is awash with cash and easy money is available from debt lenders, private equity investors will stay on the hunt. Any publicly held airline with a strong balance sheet and reliable cashflow faces the prospect that its strength will be leveraged to support a similar takeover.
Source: Airline Business
