An attempt by private equity funds to take down NYSE-listed Yum China is a red flag for investors as it shows the bidders were prepared to pay a lofty valuation, banks were ready to fund the ambitious deal and too many cooks were lined up to run the flagging business.
The consortium comprising Hillhouse Capital, Kohlberg Kravis Roberts, China’s sovereign wealth fund China Investment Corp. (CIC) and Baring Private Equity Asia made the $17.63 billion offer to management in July, according to two people close to the deal.
Yum China, best known as the operator of the KFC, Pizza Hut and Taco Bell chains, is serving up American fast food with a local twist in China such as sao bing, a traditional northern China pancake and zongzi rice dumplings with salted egg flavouring.
If Yum China’s management, led by chief executive Joey Wat, had not rebuffed the offer, the funds would have attempted the second-largest buyout in Asia Pacific on record, based on Dealogic figures. That would put the deal just below private equity’s $20.6 billion acquisition of Toshiba Memory which was completed in June, and just above the $16.2 billion leveraged buyout of Singapore’s GLP in January.
That's now extremely unlikely.
The deal "is dead as it gets," a person familiar with the deal said. The members of the consortium had agreed they would not turn hostile.
Besides, the private equity funds made their a $46 a share offer prior to Yum China's recent surprisingly poor second quarter earnings results on August 8, so the offer they believed was priced to perfection no longer stacks up, the person added.
Another private equity firm is unlikely to take up the baton given management already rejected such a high bid while large strategics are generally focused on becoming more asset light.
That could come as a shock to the wider investment community.
“Investors still believe that the deal is on,” said Deutsche Bank research analyst Anne Ling, commenting on a sharp spike in Yum China’s share price even after news broke that management had rejected the bid.
Nevertheless, the fact the offer was made at all illustrates the rising valuations that cashed-up private equity funds are prepared to pay for businesses that are clearly not thriving.
DRY POWDER
The consortium offered $46 a share in cash for the fast food operator, a premium of 42% over the shares' recent low of $32.30 plumbed on July 25, but still below their all-time high of $48.18 hit on January 26.
It's was a high price tag that surprised rival funds, given that analysts at investment banks had pencilled in an average 12-month target price of $42.20, with a range from $30 to $47.6.
The consortium’s offer valued the company at an enterprise value of $17.63 billion based on the number of shares outstanding, or a very generous 14 times the company’s 2018 forecast consensus Ebitda (earnings before interest, tax, depreciation and amortisation).
The trouble is private equity funds have money to splurge and very few companies in Asia of any size available to buy.
Private equity firms globally are sitting on record levels of undeployed capital, collected from investors turning to alternative asset classes for yield after years of record low and even negative interest rates.
Asia Pacific-focused private equity funds had $253.2 billion of dry powder in 2017, up from $77.3 billion at the height of the Global Financial Crisis, according to data provider Preqin.
They need to put that capital to work and start earning the returns they have promised to their own investors, known as limited partners (LPs). But it is hard for private equity to deploy this quantum of capital across Asia’s less developed markets where companies are small, say in Southeast Asia, or where private equity’s brand of capitalism is less accepted by companies’ directors, as is the case in Japan.
The result is fierce competition for ever larger deals, with private equity firms clubbing together to get the job done.
Club deals, involving three or more private equity funds, were widely denounced in the wake of the Global Financial Crisis after several companies collapsed under the weight of debt burdens incurred during leveraged buyouts.
Such large consortiums can struggle to reach consensus at critical junctures in their portfolio companies’ business, especially if the company is struggling, noted a senior private equity manager.
At the height of the last buyout boom, KKR, TPG and Goldman Sachs clubbed together to complete the $45 billion mega-buyout of Texas energy giant TXU — the biggest leveraged buyout in history at the time. In 2014 TXU went bust, struggling to service its $42 billion in debt.
The only way the deal would make sense for private equity funds’ investors is if CIC took much the lion’s share of the equity risk and offered the other consortium members a structured solution, said one private equity specialist in Hong Kong. Sovereign wealth funds tend to have a lower return expectation than buyout funds – which target at least mid-teen returns for their own LPs.
However, no such structuring existed among the consortium members, the person close to the deal added.
BETTING THE BANK
For the funds looking to deploy huge dollops of capital the clock is ticking. By many measures equities are looking overvalued and investors’ sentiment is increasingly fragile.
Funds need to deploy before the US’s longest ever bull market runs out of puff and credit committees at banks slash the debt they are prepared to extend for underpinning buyouts. While the mandated lead arranger of the debt may feel comfortable with the credit, he has to bear in mind the syndication process can become drawn out while sentiment in markets changes quickly.
Bankers were ready to partly fund Yum China’s mega-buyout even though credit committees are starting to become twitchy over valuations, according to banking sources in Asia.
The exact split between Chinese banks and Western institutions hadn't been decided but the consortium was confident enough to proceed to an offer.
Covenants for lenders, as well as valuations, have been stretched thin in Asian buyouts in recent years.
As a salutary reminder of what can go wrong, UTAC Holdings, the Singaporean chip testing firm which was taken private for S$2.2 billion ($1.6 billion) by TPG and Affinity Equity Partners in 2007, only exited bankruptcy this year.
The buyout of UTAC was the only so-called cov-lite deal, meaning the loan agreements don't contain the usual protective covenants for lenders, of any size ever seen in Asia.
An illustration of topsy-turvy sentiment among lenders was KKR’s $1.8 billion buyout of Korea’s Oriental Brewery in 2009. It was the first major deal signed after the GFC in Asia and struggled to secure $800 million of senior debt at a multiple of 3.5 times, according to a banker involved in the financing at the time. That deal was a blowout success.
ROLLING UP SLEEVES
Private equity firms generally have to make substantial improvements in companies’ operations if they pay a high price and still expect to hit their return target.
In the case of Yum China, the consortium planned to drive expansion into smaller cities even more aggressively than management, which is already adding two stores a day.
They had thought to use their connections among Chinese property developers to secure prime locations. The club also could count on CIC’s local government contacts to smooth any political constraints to growth and help offset the trouble foriegn multinational companies often suffer in China by extending the sovereign wealth fund's political halo.
The consortium also plans to use up Yum China's digital delivery to boost sales, potentially leveraging the traffic referred from WeChat, JD.com and Belle International.
Hillhouse, a Tencent and JD.com shareholder, obviously has the operating chops. Hillhouse’s acquisition of Hong Kong-based retailer Belle International in 2017 is performing ahead of management’s plan, according to a person familiar with the matter.
Key to the private equity funds' plan was taking Yum China private. Once removed from the public spotlight and away from the pressure of quarterly earnings the consortium planned to tackle some of the thorny issues at Pizza Hut by closing down some of the more challenged locations.
Proof this strategy is effective can be seen in the performance of McDonald's China after it spun out in 2017. The business is performing ahead of expectations, according to one person familiar with its management team.
Longer term the consortium could have refranchised some of the stores. Yum China has a particularly high ownership of stores compared with most developmental licensees who typically operate at least 70% of systemwide stores, although this would have required permission from Yum! Brands according to the master licensing agreement.
However, the consortium's eyes may be bigger than their stomachs when it comes to Yum China, the largest restaurant company in China with around 8,200 units.
When Louisville, Kentucky-headquartered Yum! Brands, Inc. spun off Yum China in November 2016, the franchisee did not have the growth prospects of, say, McDonald’s China.
Same store sales growth at Pizza Hut sagged and were flat at KFC in the second quarter of 2018 while restaurant margins fell 3.7 percentage points year-over-year. This was partly due to competitors’ aggressive price promotions and cannibalisation from their own aggressive store expansion.
The future is not looking too bright either. Consumer spending in China is slowing, labour costs are rising and an American fast-food chain could well be hit by a consumer boycott as the China-US trade war escalates.
It remains unclear why Yum China’s management rejected the generous offer.
Yum! Brands was broadly supportive of the buyout, which could have buoyed long-term royalties, and the munificent offer prompted vigorous debate at board level, ultimately staunch opposition but a couple of individuals who wanted more time to turn around Pizza Hut blocked the deal, the person said.
As the tenth anniversary of the Global Financial Crisis looms, investors should take the moment to how far we are coming full circle.
While existing investors in Yum China may have missed out on a big payday, the wider financial community: private equity funds, debt providers and portfolio managers should take note of the dangers inherent in such an ambitious plan and be thankful for what could be a very near miss.
This article has been updated to add context
