When you combine the most oft discussed investor in the world with the largest takeover of a packaged food company in history, you get a market event ripe for analysis. Below are five of my thoughts on the transaction and potential implications on your portfolio.
Leveraging Low Volatility
In a January 2013 article, Making Buffett's Alpha Your Own, I showed that investors could have replicated the returns of Berkshire Hathaway (BRK.A, BRK.B) over the last twenty years by buying low volatility stocks, as proxied by the S&P 500 Low Volatility Index (SPLV), and levering them up consistent with the leverage employed by Berkshire Hathaway. An equity stake in Heinz (HNZ) is consistent with this strategy. In fact, Heinz was the fifteenth largest holding in this index given its low trailing volatility, putting the company in the 97th percentile of the S&P 500 (SPY) based on low volatility. If understanding the Low Volatility Anomaly and use of leverage is the overarching key to Buffett's long-run success, then Seeking Alpha readers can replicate this strategy without having to pay twenty percent takeover premiums like in the Heinz deal.
Leveraging Transactions Focus on Operators
Past episodes of leveraged corporate acquisitions prominently featured financial buyers. I have been long of the opinion that levering up a company with stable cash flows is a homogeneous skill that was not unique to wunderkinds at top private equity firms. After the LBO boom of 2006-2007 fizzled into a host of overlevered and underperforming companies and a scarred financial system, companies do not appear ready to repeat the sins of the recent past. The top three M&A deals of 2013 have had unique features that separate them for pre-crisis LBOs. The Dell (DELL) deal was in part financed with the repatriation of the company's offshore cash, and founder Michael Dell's total equity contribution is roughly four times larger than that of the largest private equity sponsor Silver Lake. The Virgin Media (VMED) purchase by Liberty Media's John Malone was a strategic buyer expanding his media empire.
With the Heinz deal bringing 3G Capital into the fold, each of these deals prominently featured operators, new stakeholders with deep rooted knowledge of the respective industry. 3G Capital's ownership group formerly owned Brazil beer giant Ambev, which combined with Belgian Interbrew in 2004 to become InBev before purchasing Anheuser Busch in 2008. The company later bought Burger King in 2010. The ownership group understands the food and beverage industry, and more importantly using the industry's stable cash flow profile to delever debt saddled post-transaction balance sheets. Dell combined a buyout firm focused on the technology space, Silver Lake, with a founder and CEO who once revolutionized the industry and might have the operating flexibility to take a second shot at a transformational change as a private company.
A Kinder, Gentler Re-Leveraging
The Dell and Heinz deal also featured nuances of the transaction that will limit the amount of public debt that will need to be raised. While John Malone's acquisition was likely heavily influenced by the low rates in the speculative grade bond market as Virgin Media tapped the market in a multi-billion dollar and pound deal the next day, the Dell deal will need to raise less bond financing because of the offshore cash and the Heinz deal features an $8bn preferred stake from Buffett that will limit future bond issuance. While these transactions have been spectacularly large, they will not over-extend the credit markets in the short run, which I view as positive for future deal flow and as an extension a positive for the equity markets.
Emerging Market Growth
The Heinz deal multiple of around 14x enterprise value/trailing EBITDA was a bit of a shocker. Plenty of market pundits have recounted that while buying an iconic domestic brand felt like a Buffett move, the price felt more than full for the famous value investor. Ketchup and baked beans does not feel like a growth stock, but the company has produced organic growth for thirty consecutive quarters, a period that included a deep global recession. Heinz's growth is occurring in emerging markets, and is where the company expects to grow into its transaction multiple. If the United States and Brazil's wealthiest investors are positioning to reap the benefit of faster emerging market growth, shouldn't you be positioning your portfolio toward these economies as well? The strong performance of domestic stocks that have driven U.S. shares to five year highs has further diverged performance versus EM stocks. In the Heinz deal, Buffett and Lemann are betting on emerging market growth, perhaps emerging market stocks will reverse their recent underperformance relative to U.S. stocks.
Value in Heinz Debt
While the initial financing details of the transaction left much to be desired, the picture was becoming clearer on Friday afternoon. Berkshire Hathaway is committing a total equity investment of $12.12bn consisting of $4.12bn equity and $8bn of preferred with a 9% dividend. 3G Capital will also contribute $4.12bn of equity, but the remainder of their fifty percent share will be financed with new debt at Heinz. The company will rollover its existing debt without change of control provisions, and JPMorgan (JPM) and Wells Fargo (WFC) have lined up $14.1bn of new financing. The banks will contribute $8.5bn of term loans denominated in dollars and $2bn of euro/sterling term loans, a $1.5bn senior secured revolver and a $2.1bn second lien bridge loan. The new debt financing is expected to be structurally subordinate to the new senior secured debt.
The overarching question from bondholders is what happens to the existing debt. The post-recession issues from Heinz have included change of control provisions that allow bondholders to put the debt to the company at $101. Some pre-recession bonds do not have this feature and are likely to remain outstanding. Fitch has already downgraded the debt to BB+, and equivalent below investment grade ratings at the other rating agencies will likely lead to additional selling pressure from ratings constrained investors. As I wrote recently in The High Yield Bond Trade For the Long Run, a wide pricing gulf exists between BBB and BB rated debt that favors BB bonds which provide incremental spread above their incremental default risk. The reason is that many institutional investors have restrictions on how much BB and lower-rated debt they can own, which leads to additional selling pressure. The bond market has already widened the spread on long duration bonds that are likely to stay outstanding to 300/30 year from the low to mid 100s. At yields of 6.20% for twenty to nearly thirty years, I like the idea of lending money to a food company with Warren Buffett having invested $12 billion behind me in the capital structure. I like the idea of lending money to an operator in 3G Capital that has already shown the ability to de-lever a large transaction in Anheuser-Busch Inbev. If additional rating pressure further widens the bonds, retail investors without ratings constraints should consider examining the bonds. If the company is able to successfully improve its credit profile, tightening credit spreads could offset the impact of the likelihood of rising rates and provide good value in a fixed income marketplace that offers little in this low rate environment.
The Heinz deal is a fascinating case study in my assertion that leveraging low volatility stocks can lead to Berkshire-like risk and return. The trend towards buyouts that feature good operators and less financial leverage is both good for the high yield bond market and likely good for equities as it expands the capacity of deals that can be consummated. If this transaction by some of the world's foremost investors is about emerging market growth, then emerging market stocks, which have underperformed post-crisis, could be an attractive asset class. Retail buyers might see value in HNZ debt given the stability of the business and the deep pocketed equity ownership beneath you in the capital structure.