The Deal: Dell's Quandary Reflects Tech's Secular Shift

NEW YORK ( The Deal) -- Just a day after Carl Icahn publicly waved the white flag in his fight over the fate of Dell ( DELL), it was announced that HP ( HPQ) would be unceremoniously booted from the Dow Jones Industrials Average.

And, just like that, it became clear to investors, executives and everyone else that tech 1.0 is over.

That was followed by the hard fought win on Thursday, Sept. 12, of Dell founder Michael Dell and backer Silver Lake to take the PC maker private at $13.75 per share in a deal worth almost $25 billion.

For years, the vise-like grip Microsoft ( MSFT) held on the technology industry muddled lines between products, since so many PCs were wholly dependent on the Seattle-based company. Now, no different than Dell or HP., Microsoft is going through changes of its own, as the advent of iOS and Android created a secular shift away from everything Steve Ballmer tried to protect, one reason he is on the way out as CEO.

But that was tech 1.0.

"All the marketing in the world can't get you out of having a bad product in this industry," a tech industry executive said. "Brands matter a lot less than people think, and products matter a lot more than people think."

And the brand atop each Dell PC is the very name of its founder. Neither Apple ( AAPL), Microsoft nor HP are as entwined with their current leadership as Dell is today.

Michael Dell will have overseen his company's rise, from a $1,000 balance sheet in his dorm room at the University of Texas, to its 1988 initial public offering and a zenith of a $100 billion market cap a dozen years later, to, ultimately, an leveraged buyout for around $25 billion. Dell's final act as CEO will be to determine the ultimate fate of the company: whether it's services juxtaposed against consumer products, or, a combination of both. Of course, his stated intention is to revitalize his company that has been coasting downward for more than a decade.

But there's another side to the Dell success, decline and potential rebirth story and that is of LBO backer Silver Lake.

Silver Lake already has a reputation as being the resurrector of Silicon Valley. When it loaned $20 million this year to Foursquare Labs Inc., which does business as Foursquare, Silver Lake invested in a company some considered a zombie in the location-based ad game, only to see its fortunes shift practically instantaneously. A decade ago, Silver Lake pulled off an improbable win, taking scandal-stricken telecom MCI Inc. from bankruptcy and transitioning it into a winning exit to Verizon Communications Inc. ( VZ) in short order.

The Dell deal, however, is Silver Lake's biggest ever, and will stand out among its many successes, if success it turns out to be.

"Like it or not, this is the one that's going to stick with them for 10, 20 years... or forever," said a senior private equity executive.

Much like the company Silver Lake is taking private, the LBO shop owes its very existence in large part to the financial power of Dell's founder.

Michael Dell seeded Silver Lake as the PE firm grew into one of Silicon Valley's investing titans. So the firm's 2013 mega-fund to support its mega-deal looks like nothing so much as chips being called in big time. Or, put another way, a fee-generating opportunity to the LBO shop and a far more peaceful coast into retirement for Dell's founder than staying out in the public domain.

In private equity's brave new world, in which club deals are gauche and mega-transactions' poor performance can undo years of operational improvements and IRR, Silver Lake will reap most of the glory (or blame) for Dell's success (or failure) -- like it or not.

Not only is Dell facing a secular decline in the PC business, but its brand is also losing traction with consumers. And that's not something Dell can price its way out of, one technology executive said: If the company still aims to succeed with consumers, it will inevitably increase investment in the product, thereby cutting into margins for a product in secular decline, and so forth and so on into an ever-steepening downward spiral.

However, Dell's enterprise capabilities -- particularly in cloud services as more businesses shift away from in-house server management -- could still generate more revenue. That's somewhere that Dell could capitalize on its corporate brand name, not unlike what IBM ( IBM) did so successfully, one tech banker said. That, in fact, was one of the arguments that both Icahn and Michael Dell and Silver Lake made when they were fighting over the company's fate. And 3D printing could also be a natural next frontier, where major patents are due to expire soon, opening up a potentially lucrative enterprise and services business for Dell, the banker said.

But the size of the deal itself means the odds could be stacked against Silver Lake's Glenn Hutchins & Co.: Energy Future Holdings Corp., RJR Nabisco Holdings Corp. or Clear Channel Communications Inc. all come to mind as LBOs that staggered under the their debt load. Then again, none of these deals permanently tarnished the images of Henry Kravis, Scott Sperling, Robert Weaver or Stephen Pagliuca.

History's biggest LBOs have generated more losers than winners and for a tech-centric PE firm to succeed in what is considered its wheelhouse, extracting a successful IRR from a boom-market deal and doing so independently, will be a story worth repeating during Silver Lake's roadshow -- if the investment firm ever chases an IPO of its own.

Despite throwing in the towel on his attempted leveraged recapitalization, Carl Icahn kept trying to jockey for a better share price. But even the proxy advisors don't appear to have felt he, or anyone, ever deserved much more than originally bid.

For those still in Icahn's camp, insisting the shareholders were robbed on the deal, consider this: The company lost nearly 80% of its value over a 13-year period. Dell is only going private now because its decline has finally made it a viable target for private equity. The company is, even according to its own special committee, trapped largely within an industry facing secular decline.

As a private company, Dell's shuttering and selling businesses and shuttling jobs overseas won't be met with the same scrutiny -- or criticism -- it would likely have received as a public entity.

So whether the background story is that Michael Dell privately arm-twisted his old buddies at Silver Lake into going in on a big enough to fail deal, or the private entity firm saw potential where few others did, there's a lot for the new private equity owner to do in a relatively short time period. But with Dell's PC top line continuing to shrink -- market researcher IDC reported in April that Dell's PC revenue suffered a first- quarter double-digit decline -- and with a board that has been pre-occupied for the better part of a year with the takeover, the company now needs to be nimble in changing course, possibly through M&A.

But striking big deals with so much debt could make strategy shifts cumbersome.

Right now, it appears that Silver Lake's teaming with Michael Dell will represent the biggest true LBO of this bull market. Yet, were it not for Michael Dell's sizeable slug of stock, Silver Lake could not get this deal done without another equity partner -- and that says a lot about the state of mega-LBOs. Silver Lake's $25 billion deal might have gone by much more quietly in the LBO boom days of 2006 and 2007, but in a slumped M&A market -- one that private equity's inaction has contributed to substantially -- it's all eyes on Dell.

There are other big strategics that may look to follow Dell's example: HP is among tech 1.0 names that have been suggested by M&A sources as likely to make divestitures. HP, as it struggles to put an embarrassing accounting flop behind it, will be compared -- for better, or for worse -- to Dell, and the LBO will factor prominently in the comparison. HP's decline in the PC industry has been more painful even than Dell's as of late and the company's stock rebound all but mandates that its board start figuring out a way to reward shareholders who hung in throughout its Autonomy scandal.

So the Dell deal not only represents private equity's gaining a very big foothold in the technology sector but also a secular shift for another maturing U.S. industry.

Then there's what's in it for Michael Dell, besides every founder's nightmare: losing control of his baby. The PC maker's founder may have been eager to embrace public markets and expansion capital in the late 1980s, when he was barely a college dropout with a big idea, but Michael Dell quickly tired of cumbersome compliance requirements. He clearly prefers to control his own company -- Dell's only time out of the CEO role was a brief period from 2004 to 2007, during which its market share in critical lines of business continued to plummet.

That fall from grace compelled Michael Dell to return to the top leadership role at the company that bears his name. With an LBO, he greatly reduces the size of the windows into his PC maker, and can ride out the years of its twilight without quarterly earnings calls, sometimes painful analysts' queries and, best of all, without Carl Icahn getting in his ear.

Written by Jonathan Marino.

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