Private equity firm MBK Partners sealed its largest deal yet -- the purchase of Tesco’s Korean discount retail chain Homeplus for $6.4 billion. Now it must stem falling sales to make the deal pay off.
MBK and its consortium partners pledged on Monday to invest 1 trillion won in Homeplus, the second-largest chain of stores in Korea after E-Mart, over the next two years.
The stakes are high for the north Asia-focused private equity firm. MBK is committing slightly more equity than consortium partners Canada Pension Plan Investment Board, Korea’s Public Sector Pension Investment Board and Temasek; each of which is a limited partner in MBK funds.
The MBK-led consortium faces flagging retail sales in Korea, tough labour unions and it paid a steep entry price after fighting off competition from its peers.
The consortium is paying an enterprise value of £4.24 billion, or 9.1 times Ebitda excluding one off items for the 52 weeks ended February 28. The entry multiple was pushed up by a very competitive auction. It beat other suitors including a consortium of KKR and Affinity Equity Partners; and Carlyle which had teamed up with Sinagapore's GIC. In the early stages of the auction CVC and a partnership of Korean snack maker Orion and TPG also showed interest.
The deal is also daunting in terms of size. Not only is this MBK’s largest ever equity cheque; it is the largest Asia Pacific targeted financial sponsor-led entry M&A deal on record, surpassing the $6.2 billion bid by Varde Partners, KKR and Deutsche Bank for GE Money (Australia & New Zealand) in March 2015 according to data provider Dealogic.
To be sure it has gained control of the firm so can push through big changes and E-Mart is currently trading on an EV/Ebitda multiple of average 10.84 times, which makes the price tag look more reasonable.
Operationally Homeplus is solid; it also generates higher gross margins than E-Mart and now it won't have to pay dividend and management fees to its overseas parent anymore.
Sharing the risk
MBK is of course sharing the equity risk. Toronto-headquartered Canada Pension Plan Investment Board said in a separate statement that it has signed an agreement to acquire a stake of approximately 21.5% in Homeplus for $534 million. Goldman dropped out of the consortium due to disagreement over partnership terms, according to one person familiar with the talks.
It was unclear what size stakes the other partners were taking.
The consortium will be relying on MBK to manage the business.
To make private equity's target IRR of over 20%, MBK is likely to sell unprofitable stores and review the firm’s property portfolio. Another tactic will be to reformat stores, said people familiar with its plans.
Homeplus has 140 hypermarkets, 609 supermarkets and 326 convenience stores. It also operates 139 shopping malls adjacent to its hypermarkets, with over 6,500 tenant leases.
“When a foreign asset in Korea is taken over by a Korean player then there is usually an immediate valuation uplift,” said a person familiar with the matter. “A local player should be able to add more value as it knows the market."
MBK is also likely to overhaul Homeplus’ management, they said. It also plans to invest in new stores; revive the fresh foods segment; balance the mall and hypermarket business; and bring in key tenants to properties. Operating leverage should improve.
Worst case scenario, MBK can always monetise the real estate portfolio.
“This is a very Korean asset – the view was that a Korean buyer would be able to execute the most successful strategy,” said one person involved in the deal.
In one respect its hands are tied; Tesco said on Monday it received assurances from the purchasers that existing employment terms of Homeplus employees will be upheld and there will be no compulsory workforce redundancies. Voluntary departures are another matter.
The consortium is buying into what is effectively a duopoly. Operating in South Korea since 1999, and with 1,075 outlets, Homeplus is the number two player in both hypermarkets and supermarkets behind E-Mart.
Korea's Distribution Industry Development Act, aimed at protecting mom-and-pop stores, has limited store hours and trading days at Homeplus at the weekend, dragging down like-for-like sales over the past three years.
The first cases of Middle East Respiratory Syndrome (MERS) were reported on the peninsula in May of this year. The virus had an adverse impact on sales and tourism but the situation has since stabilised.
However Tesco's new management felt MBK could pull it off. The British grocer was particulary impressed with MBK's surety of equity and debt funding. Particularly given there were no big strategics with deep pockets in the later stages of the auction, Tesco wanted a reliable buyer.
The depreciation of the won versus the British pound during the auction put pressure on Tesco's management to seal the deal quickly.
MBK has been working on how to value Homeplus for over a year and was seen as the most prepared of all the suitors, with the most reliable financing lined up.
When Tesco launched a strategic review aimed at cutting debt, MBK was ready.
The buyers have collected about 4 trillion won in senior debt from domestic financial institutions Hana Daetoo Securities, NH Investment & Securities, Shinhan Bank and Woori Bank. NPS will provide the mezzanine finance.
Despite the unusual size of the deal, the Korean banks were able to get comfortable given Homeplus' large property portfolio is collateral. MBK was able to put up less than 50% of the price in equity.
The staple was not used as the terms were not competitive, the debt was not high enough and dollar financing would have added complication and expense.
Deutsche Bank and Citigroup are advising MBK. HSBC is acting as lead financial adviser, mostly because it is a big lender to the grocer in its home market. Freshfields gave legal advise and tight documentation work to Tesco. Cleary Gottlieb advised MBK.
Tesco expects the deal to complete in the fourth quarter of this year pending approval from Tesco shareholders and Korean regulators.