I need to correct one thing that I wrote yesterday: 3G and Berkshire Hathaway each own 50% of Heinz, once the transaction is done.? I mistakenly thought that both sides were putting up equal amounts of capital, when they are only putting up equal amounts of common equity.
So when you look at the financing of the $23 billion purchase price for Heinz it should look like this:
| Financing | Amount |
| Common Equity 3G | $4.0B |
| Common Equity BRK | $4.0B |
| Warrants BRK | $0.1B |
| Preferred Stock BRK | $8.0B |
| New debt for HNZ (to be raised by JPM and WFC) | $7.1B |
| Total Consideration | $23.2B |
The equity interest of BRK is equal to that of 3G, and if things go well with Heinz, whatever the form of the warrants are, Buffett can add to his equity interest by paying a fixed price.? We don’t know the terms of the warrants — how much stock it covers, what is the strike price, how long does it last, and any other provisions.? What we do know is that though Berkshire claims to be the passive investor here, it possesses the right to become the dominant investor economically, even if it does not take control as a result.? This is a major reason to reject the thesis that BRK is 3G’s banker.? Far better to say that 3G is Buffett’s highly paid servant.? They will do the dirty work, the grunt work, and Buffett will benefit more under most scenarios.
Also, Wells Fargo & JP Morgan will be raising the debt portion of this offering.? I see it looking something like this: an entity allied with Berkshire and 3G floats bonds and raises cash.? The cash goes to shareholders, along with the cash from BRK and 3G, paying off HNZ shareholders at $72.50/share.? The debt attaches to Heinz and not BRK or 3G.? Another way would be a bridge loan prior to the merger that gets paid off by a debt offering and special dividend after the merger.
This of course makes the bond market jumpy.? The long debt of Heinz has sold off, whereas the shorter debt has not.? Here is an example of one that is in-between.? The bond market fears a lot of long-dated issuance, and a possible downgrade to junk.? $7 Billion of new debt is a lot, when you only have $5 Billion of debt, and another $8 Billion of preferred stock coming.? That is a quadrupling of common stock leverage.
What we don’t know:
- The exact mechanics of how the debt portion of the deal gets done.
- The terms of the warrants.
Now think for a moment about this from the perspective of 3G: Heinz has $1B of net income.? Buffett gets $720 million of preferred stock dividends. New debt might absorb $200 million in interest after tax.? That leaves around $80 million of profits, half of which go to Berkshire, for your $4 billion outlay, a 1%/yr return.? But consider if active management raises income to $2B, profits become $1,080 million half of which go to Berkshire, and returns to you are 13.5%/yr, leaving aside dilution from BRK option exercise.
What I am trying to show is that the tables are skewed here in favor of Buffett, again.? He has set up a deal where his partner will be very motivated to cut costs, realize synergies, etc., because they don’t make much if they don’t, while he makes out fairly well under most scenarios:
- Heinz does very well — BRK exercises warrants gets majority of economics and control
- Heinz muddles — BRK receives preferred dividend, does well.
- Heinz does badly — BRK receives preferred dividend, does well. Might have to write down equity stake.
- Heinz does very badly — BRK preferred dividend halted, buys remainder of Heinz by converting his preferred stock to equity.? 3G loses it all.? Buffett brings in competent management for his now wholly-owned subsidiary.
It’s a lot easier for Buffett to win relative to 3G.? 3G needs strong demand to win.? Buffett doesn’t.
Final note: I am not that impressed with William Johnson, the present CEO — earning? a <4%/yr return on your stock over 15 years does not even double capital for those who were willing to hang on so long.
Yes, sales have grown, but what matters to corporations if profit, not volume.? On thing thing I learned in the insurance industry — it’s easy to get sales. What is hard is getting profitable sales.? Yet how many CEOs gain bonuses partially off of sales and other meaningless criteria — far better to use something like five-year increase in fully converted tangible book value per share.? It better measures how value has? grown for shareholders.
Other things to read:
- 8K from Berkshire Hathaway on the deal.? Terse, but gives more detail than most.
- Matt Levine’s take on the deal.? Well done.
- Reuters Summary take on the deal.
- Alice Schroeder’s take on the deal.? Best I saw; worth the read.
- DealBook’s take on the deal, from my friend, Peter Eavis.
- Is Buffett overpaying for Heinz? Stephen Gandel’s take on the deal.? Also well done.
Full disclosure: long BRK/B and WFC
Good analysis, though I think we know a bit more about how the debt portion will work than you imply. It appears to be very standard LBO mechanics: The sponsors (BRK and 3G) set up an acquisition vehicle, which drops down a shell subsidiary (Merger Sub), which, at closing, merges with Heinz, leaving Heinz behind as the surviving entity. This allows BRK and 3G to own and control the acquisition vehicle (referred to in the Merger Agreement as “Parent”), which will be a passive holding company, and Heinz will be below it.
The new debt raised by WFC and JPM will be primarily at this holding company level, though presumably the bank loans and revolving loan will be fully secured by Heinz’s subsidiaries and their assets, while new high-yield notes would be unsecured. From the 8-K with the Merger Agreement:
“J.P. Morgan and Wells Fargo have committed to provide $14.1 billion of new debt financing for the transaction, consisting of $8.5 billion of USD senior secured term loan B-1 and B-2 facilities, $2.0 billion of Euro/ British Pounds senior secured term loan B-1 and B-2 facilities, a $1.5 billion senior secured revolving facility and a $2.1 billion second lien bridge loan facility. The obligation of J.P. Morgan and Wells Fargo to provide this debt financing is subject to a number of customary conditions, including, without limitation, execution and delivery of certain definitive documentation. The final termination date for the debt commitment is November 13, 2013. Additionally, Parent also intends to roll over certain of the Company?s current outstanding indebtedness that is not subject to acceleration upon a change of control and that either does not contain change of control repurchase obligations or where the holders do not elect to have such indebtedness repurchased in a change of control offer. ”
http://www.sec.gov/Archives/edgar/data/46640/000095010313001110/dp36304_8k.htm
Note that the reference to a bridge loan is common in these deals, but my expectation — consistent with past practice — is that while there is a committed bridge there is no actual intention to fund a bridge loan to the acquisition vehicle (Parent), and instead the idea is to market high-yield notes. But the committed bridge is there so BRK and 3G can close the acquisition, as in this agreement, consistent with market practice, there is no condition that the financing from the banks actually be in hand (a “financing out”), and, according to the disclosure, the banks’ conditions have been tied to the acquisition conditions — there won’t (or shouldn’t be) be situations where they can refuse to fund but 3G and BRK are still obligated to close. You can see Section 7.13 of the Merger Agreement to see some of the obligations of Heinz to prepare financials and market the debt (very common in LBO deals). So I think we can fairly safely say that the new debt belongs to Heinz, not 3G and BRK. There won’t be any support from the investors.
Note also that the above is why I am unsure about your calculations above about the “new debt” are slightly off — though I could be wrong and I welcome any correction. At least some portion of the new debt will be used to simply refinance the old debt (see Section 7.13(b)(ix) of the Merger Agreement, which requires Heinz to obtain payoff letters of its existing bank debt), though some Heinz debt will roll. But this would still mean that new debt would be more in line with $14bn, not $7bn.
That said, maybe the best way to think of this would be a pro forma cap table for the acquired company, showing what the total debt of the acquired Heinz would be.
In that case I still think you come out with an even more leveraged picture than you have above, though I think all of your points about BRK’s upside remain. And it also highlights to me another benefit BRK got from this, which was 3G’s expertise in packaging and structuring this deal, which is designed as essentially a regular way LBO. The only unique aspect is the 50/50 common equity ownership of the acquired entity (though PE shops do “club” sometimes) and BRK’s “mezzanine” financing of preferred and warrants, though I’ve seen sponsors do “sponsor loans” to fund acquisitions when they have extra cash and charge even more than 9%.
Final note on the warrants: It’s not clear that Berkshire would get control of the new entity even if they exercise the warrants. Buffett on CNBC repeated that 3G would have “day-to-day control,” despite the 50/50 equity ownership. This tells me that 3G has been given operational control regardless of the equity stake in the joint venture/LLC Agreement, and we simply don’t know if the exercise of warrants even given Berkshire greater than 50% equity ownership would change that. It might, but it might not. It’s very common in real estate deals for one party to put up 70-90% of the equity but cede day-to-day control to a minority partner, who, after satisfaction of a hurdle rate, takes a big commission or even splits the economics 50/50 for “finding and executing” a deal. Buffett undoubtedly has lots of experience in these kinds of structures and this one is tailored to this particular situation.
Hopefully these are helpful comments. I am a big fan of your blog.
These are very helpful comments — thanks for the link to the 8-K filing — not sure how I could have missed that one, but I looked for it and did not find that one — think my error was stopping at the date 2/14.
Many thanks.
One correction to my above post. I mistakenly said the bonds would likely be unsecured; given that the committed bridge loan is going to be second-lien secured, I’d expect the bonds to be second-lien secured bonds as well. This actually further supports the notion that this is a very leveraged transaction — the bond market is “hot” right now, so the idea that this deal needs secured bonds implies that the guys on JPM’s and WFC’s high yield desk already view this as a very leveraged deal.