Bigger debt could undo Qantas, say observers

A report in this morning’s Sydney Morning Herald says that revelations that the private equity suitors of Qantas have left the door open to strip as much as $4.5 billion from the company have prompted warnings that higher debt levels could weaken the airline.

“In my opinion it will leave the company weaker,” said Don Gimbel, Senior Managing Director of New York-based Carret Asset Management, which manages Australian funds and invests in Australia, adding, “It will make it an unattractive investment.”

Australian Shareholders Association Executive Director Stuart Wilson said on Friday the ASA’s main concern was Qantas unravelling because of high debt levels adding that would be the taxpayer who paid the bill if the Government were forced to bail out the company “whilst the private equity players get their money back and more”.

It is the prospect of a riskier investment that is swaying Adelaide-based investment house Argo Investments which owns 2.9m shares to consider accepting the APA offer for its Qantas shares, with Argo MD Rob Patterson saying, “We’re still tending to think we’ll accept,” adding, “The main reason will be the risk from dramatically increased leverage in the business.”

Queensland Senator Barnaby Joyce said on Friday: “Any other business person would tell you that it is beyond the pale of what is fiscally prudent.”

Mr Gimbel said: “You’re taking out of the right hand and putting into the left hand and Tthey [the bidders] feel it is important to get paid a reasonable fee for being able to rebuild the balance sheet of the company.”

Shareholders who accepted the bid before it was extended on March 23 can withdraw their acceptances and they have a month to do so.

March 23 was the day Balanced Equity Management dealt APA a major blow when it announced it was not going to accept the $5.45 a share offer, but those who accepted after March 23 are locked in.

This is because shareholders can only withdraw their acceptance in a negative or “adverse event” and APA argues Thursday’s extension was a “positive” event, given it boosted the chances of the deal succeeding.

In Australia buyouts have made outstanding returns for private equity investors, but failed to ignite the investment portfolios of those retail and institutional shareholders who bought in when their private equity owners refloated them on the stockmarket.

It is expected that the APA consortium will move to relist Qantas in some form on the stock exchange within five years and APA has also failed to rule out splitting off some parts of the business for private sale or public float.

The latest revelations also raise questions about the Qantas board’s decision to back APA’s bid for the company – an airline whose profits benefit from tight government controls over access to many routes, with Senator Joyce saying, “I wonder greatly if there wasn’t $300 million on the table for the executives of this company whether they truly believe whether this new proposition is in the best interest of Qantas.” adding, “They are playing silly buggers with us and they were expecting we weren’t onto it.”

Standard & Poor’s said on Friday it would probably lower Qantas’s long-term credit rating if the APA bid succeeded and stockbroker JP Morgan estimated in a research report published on Friday that the consortium could pay $2.26 a share in dividends and capital returns in the first year of ownership.

The broker also estimated APA could pay out an extra $2-a-share dividend in three to five years, with stockbroker ABN Amro saying APA’s desire to gain full ownership of Qantas could see remaining shareholders, “extract a higher and more lucrative offer further down the road to buy out their stakes, with this could be in excess of the $5.90 to $6.50 we previously indicated for a higher bid.”

Paying early dividends – often through fresh debt – is commonly a feature of private equity deals in the US and the phenomenon of “dividend recaps”, when a company borrows to pay a dividend, has attracted public criticism in the US.

The private equity buyout of Hertz attracted strong criticism as the bidders borrowed $US1 billion ($1.2 billion) six months into their ownership at the same time that the company was losing money.

Equally controversial was private equity’s tilt at Burger King, which saw the bidders repay their initial investment within three years and move to float the company – for a return of $US1.8 billion. The stock initially failed to perform on relisting.

The use of dividend recaps is rising with Standard & Poor’s research showing banks lending $US71 billion for dividend recaps in the past three years, compared with $US10 billion over the previous six.

A US survey of 75 private equity firms commissioned by Pepper Hamilton and PricewaterhouseCoopers found a third used dividend recaps in 2006.

A Report by The Mole from The Sydney Morning Herald