Private equity firm TPG Capital has reportedly shown interest in Tesco (LSE: TSCO)’s £2bn-plus Dunnhumby data business. So it’s not hard to imagine one step further, that Tesco could be snapped up by private equity firms in a leveraged buyout deal aimed at breaking up the UK’s largest retailer.
The risks may outweigh the benefits, but the allure of a Tesco buyout is clear.
A Leveraged Buyout Of Tesco
In leveraged buyouts (LBOs), the acquirer loads debt on the balance sheet of the target. Equity capital can be as low as 20% or less of the total capital needed to run the operations, while the reminder is debt or equity-like capital, which may or may not include repayments of the principal until maturity.
Fact: new owners could lever up Tesco’s balance sheet, but such a move would bring huge risks.
Under private equity ownership, the cash flow of the target is used to reduce leverage. For an LBO to be successful, the equity capital should appreciate on the back of improved profitability or growth, or both, as debt is paid down. Private equity usually targets an internal rate of return of at least 20% annually.
Fact: in the current market, growth will unlikely provide a helping hand to Tesco’s new owners, who would have to be quick to sell prized assets at a marked-up price.
A Private Equity Consortium
As far as an LBO of Tesco is concerned, at least four private equity firms — say, Blackstone, TPG, KKR and a smaller player — would be needed to execute a deal in region of £26bn, including net debt. This is the first hurdle. It’s seldom a good idea to bring together more than two private equity firms into the same deal.
Furthermore, a private equity consortium would likely need to finance at least 40% of the purchase price with fresh equity. As such, each firm would have to write a cheque of about £2.5bn. That would give the new owners a safety net if things went wrong. Private equity don’t like to use their own cash to buy stuff, one reason being that “own cash” is a precious commodity that dilutes the economics of any deal.
Of course, it would make lots of sense to run Tesco as a private business because the retailer wouldn’t have to withstand market scrutiny on a quarterly basis. But how much would Tesco actually cost? And how about the implied net leverage under private equity ownership?
Crunching The Numbers
Tesco has a market cap of £14.3bn. It has total debt of £11bn, and a gross cash position of £3.5bn, so its enterprise value is about £22bn. Under a “takeover scenario”, I assume a 30% premium to Tesco’s current market cap, for an implied equity value of £18.5bn and an implied enterprise value of £26bn.
Assuming a take-private deal is financed by a conservative mix of equity and debt (40%/60%), the implied net leverage for 2015 and 2016 would be 4.2x — this also assumes Tesco’s adjusted operating cash flow remains constant over time. Bad news: this is a pretty high net leverage ratio for a retailer whose profitability and earnings are shrinking.
Still, a private equity consortium may be able to get the backing of a large number of lenders. Then, the all-in cost of debt may be at least 100 basis points lower than Tesco’s current cost of debt, which would save Tesco about £100 annually. Peanuts.
Tesco has plenty of assets that could be divested, and new owners may well believe that a comprehensive restructuring plan should hinge on the sale of less profitable international assets. As I recently argued, employees and suppliers have virtually no negotiating power, which is important for private equity firms when they evaluate their investment opportunities.
Ultimately, though, the problem goes down to the possible take-out price.
I still believe Tesco’s fair value is 233p, or about 9% above consensus estimates (for a 30% upside from its current level if you think I am right…). If a bear-case scenario plays out, however, Tesco stock could drop to 165p. Then, Tesco may be forced to sell assets sooner rather then later to prevent large write-downs.