Winning ugly

Steve Rosenbush

There's still a good chance that the AT&T-BellSouth deal will be approved this year, but it's increasingly likely that the Republicans on the Federal Communications Commission will have to use unconventional weapons to make that happen. The FCC is deadlocked 2-2 over the fate of the deal. link.

FCC chairman Kevin Martin is likely to bring in fellow Republican Robert McDowell, who has recused himself from deliberations on the case because he worked for companies that compete with BellSouth. Ironically, he's expected to vote to approve the deal, which is contrary to the interests of the so-called competitive phone companies he once represented. Former FCC official Blair Levin, now a telecom regulatory analyst with Stifel Nicolaus & Co. says the FCC Democrats and the companies have narrowed their differences during the past few days of crucial negotiations, but that they don't have a deal. They are still apart on a number of issues, possbily over the quesition of whether AT&T should be forced to accept binding arbitration to resolve commercial disputes with smaller rivals, Levin says. The next FCC meeting is scheduled for Dec. 20, althoug a vote could slip later into December or into January, Levin says.

It appears that the legal case for bringing McDowell into play is easy enought to make, as long as the FCC general counsel rules that the public interest is better served by having McDowell vote than having him continue to recuse himself. But it would be controversial nonetheless, and with good reason. If McDowell really ought to be recused from the case, it's hard to see how anyone can justify bringing him into action just to tip the outcome of a vote.

Blackstone places $36 billion bet on real estate

Steve Rosenbush

Blackstone Group, the private equity giant, is placing a huge bet on commercial real estate by acquiring Sam Zell's Equity Office Properties Trust. The deal is on track to pass this year's $33 billion HCA hospital buyout as the largest leveraged buyout ever. It's worth $36 billion, including the assumption of $16 billion of debt.

The deal is a bold vote of confidence in the economy. The fortunes of Equity Office, the largest office building landlord, are tied to the outlook for white-collar employment. That outlook is vulnerable to any number risks, from geopolitical trouble to uncertain outlooks for interest rates, energy prices and housing. Housing starts fell nearly 15% in October, to the lowest level since July 2000. link.

Just how strong is the economy? Pretty strong, according to the latest report from Action Economics. "Strong income growth, a low unemployment rate, falling gasoline prices, booming equity markets, and surging consumer confidence have established a solid fundamental backdrop," the economic researcher said on Monday. If they are correct, Blackstone's bet on the office building market could turn out to be a good one.

M&A party is rocking, for now

Steve Rosenbush

Researcher Dealogic reported today--and I know, this is a shock--that global M&A volume has hit an all time record. It seems that $19 billion Clear Channel deal won by Bain and its club has pushed global volume to $3.36 trillion. That beats the previous record of $3.33 trillion set in 2000. Areas of growth include financial sponors, which accounted for $563 billion in volume and now drive 17% of all M&A worldwide. And European M&A, now accounts of $1.34 trillion, of 40% of all deal volume.

Before too long, we're likely to see another record broken, as investment bankers share the largest bonus pool in history.

I know, everyone hates a buzz kill. But I won't be surprised a few years from now if the M&A party is followed by a huge hangover, as more and more of the principal on the junk bonds used to finance these deals has to be paid back. It's a borrowers market. Lenders are competing to win deals. I hear a number of them have been offering easy terms, in which a few years of interest-only payments are allowed. But if financial sponsors can't make an exit, they will be stuck with huge bills when the payments on principal kick in three, four, five or more years down the road. Weaker acquisitions are going to be under extreme pressure at that point, as limited cash flow is stretched to pay back expensive junk debt. It's like the corporate version of an exotic mortgage.

Dealmakers prepare for new era on Capitol Hill

Steve Rosenbush

The breadth of the Democratic victory at the polls on Tuesday took many financial executives by surprise. The outcome of the midterm election created uncertainties for dealmakers in M&A, hedge funds and private equity. "A Democratic Senate was not expected by the markets, and it's going to take some time to figure out what it means," said Sander Gerber, chairman of XTF Advisors, a $200 million fund that builds and manages portfolios of exchange-traded funds. The shift of power from Republicans to Democrats in the House was pretty much to be expected. "But the idea of the Senate flipping took people by surprise," one senior Beltway-based financial executive said.

The post-election tone for M&A was evident almost right away. On Wednesday, House Democrat John Dingell asked the Federal Communications Commission, which is supposed to operate independently from Congress, to hold off on judging the proposed AT&T-BellSouth merger until the new Congress is seated. "I think that's a sign of what is to come," Gerber said.

The question now is whether the new Democratic era will have a significant impact on the historic boom in M&A. Private equity has been particularly hot. The volume of private equity deals for the first 10 months of 2006 has broken the all-time full-year high, which was established in 2000. link.

One finance industry executive based in Washington said the current deal environment is good and that he doesn't expect it to get worse as the result of a Democratic house. But some big changes are likely. Here's a look at how the election may shape the environment for M&A, private equity and hedge funds.

Senate Banking Committee: It's expected that Senator Chris Dodd will succeed Sen. Richard Shelby as chairman of the Senate banking committee. Dodd, a Democrat from Connecticut, is considered to be more comfortable with the banking world. His leadership of the committee may be a net plus for the M&A world. Shelby, a Republican from Alabama, has been regarded as something of a populist. Change here could be a plus, one investment banking expert said.

House Financial Services Committee: Rep. Barney Frank, a Democrat from Massachusetts, is expected to succeed Republican Michael Oxley of Ohio. That means prospects for easing Sarbanes-Oxley regulations on corporate financial reporting in a significant way are reduced. Frank has indicated he may be amenable to some reform, though.

Hedge funds and private equity: There may likely be a push in the House and Senate for regulations that would increase the amount of information that hedge funds and private equity firms must share with the public. "That may very well protect investors from funds that blow up, but it could hurt the economy at the same time," Gerber said. Return on investments could decline as players are required to share strategies, allowing rivals to copy their moves. And if regulation becomes too tough, fund managers could leave the U.S. for offshore destinations. London already is luring business from New York.

Globalization: One Washington financial executive said it will be harder to strike new trade agreements, such as the one contemplated with Korea. Trying to control the globalization of markets could have a beneficial effect on some U.S. industries, at least for the short term. But the longer effect could be a drag on economic growth and deal-making, some industry insiders say.

With the House and the Senate under their control, the Democrats will be able to execute their financial and economic agenda. While health care, college savings and the minimum wage are at the top of their agenda, an energized Democratic Congress will likely find time to tighten regulations. Some investors are particularly worried that Democrats will end some of the capital gains tax cut. That could have a significant effect on markets such as private equity. The reduction in capital gains taxes was a factor in the recent surge in deal volume.

Investors and deal makers will be watching the new Congress just as carefully as the new Congresss watches them.

Is a Google-Clear Channel deal at hand?

Steve Rosenbush

Google, known for its cutting-edge Internet software, may be setting its sights on the low-tech radio market, according to one media and entertainment analyst. David Bank, of RBC Capital Markets, issued a note yesterday saying he thinks it would make a lot of sense for Google to take a minority stake in radio, TV and outdoor advertising giant Clear Channel Communications.

The idea might seem strange at first, but there are reasons why such a deal could work, according to Bank. Clear Channel is exploring strategic options. And Google may be gearing up to acquire a large chunk of advertising inventory, as part of a plan to expand beyond its core search business. link. He says Google has been adding "high profile" radio sales people in New York, Washington, Baltimore, Atlanta, and Chicago. It has little radio inventory to sell, though. Bank concludes that Google needs to add inventory, and that Clear Channel is the best option.

Why would Google, of all companies, are about the radio market? Bank says Google has its eyes on the local search market, where it sees an opportunity to sell ads to people looking for nearby goods and services. "The radio market is by definition a local market, deriving 80% of its revenue from local advertising," Bank says. "So the radio market would be a logical add-on for Google."

Google could play a role in a buyout without putting up much cash. Clear Channel has an enterprise value of about $25 billion, suggesting that a "club" of private equity firms and other investors might put in a total of $5 billion to $6 billion in equity. Any one of them could get a small but strategically important stake of, say, 5% or so, by investing $250 million in cash.

Google's stock closed today at $467.50. The stock, which dropped below $350 last winter, has been on a tear because investors believe its expansion into new markets holds promise.

Yahoo-AOL unlikely

Steve Rosenbush

A story today says Yahoo has approached Time Warner about the possibility of buying its AOL unit. link. The piece in Fortune includes a pretty strong denial from a source close to Yahoo, who says Yahoo didn't approach Time Warner and that there are no active conversations between the companies. I hear from a source familiar with the matter that the overture "did not happen."

Why would Yahoo want AOL? "Search is a scale business, and such a deal would build great scale," says Ryan Jacob, of the Jacob Internet Fund. "The more scale you have, the more clicks you get, the more you can charge for ads."

Acquisitions certainly play a role at Yahoo. link. Investors want to see more growth from Yahoo, which has seen its stock price decline 35% over the last year. Jacob thinks Yahoo might be better off with smaller companies that have a younger demographic, though.

Some strategists like the idea of a Yahoo-AOL deal. "It makes tremendous sense on several levels," says investment banker Ken Marlin, of Marlin & Associates. He thinks both risk becoming irrelevant if they don't do somethng bold. He likes the scale that would come of such a transaction, and he says AOL and Yahoo would be good cultural fit.

Regardless of whether the deal makes sense, it doesn't appear to be happening. Even if both parties were willing to do a deal, it could be complicated by the fact that Yahoo rival Google owns 5% of AOL. As Jacob notes, no one can say for sure how Google would react to the prospect of AOL and Yahoo joining forces against it. Best bet: not happy.

News Corp. beefs up MySpace video

Steve Rosenbush

News Corp. made improvements to MySpace Video over the weekend. The changes came just after News Corp. CEO Rupert Murdoch met with Google CEO Eric Schmidt to address conflicts created by Google's $1.65 billion acquisition of YouTube. link. The changes were first reported by TechCrunch. MySpace now features videos on its homepage. User profile pages now include a section called Video Space, which displays videos. These videos appear on profile pages automatically after they are uploaded. That eliminates the need to paste code into a profile. YouTube still requires users to take an extra step by cutting and pasting code onto a Web page before they display a video.

There's no question that News Corp. has decided to focus more on video as a response to the Google-YouTube acquisition. Many YouTube videos wind up on MySpace pages. As Google starts integrating ads into some or all of those videos, News Corp. wants to make sure that it gets a cut of the revenue.

If News Corp. can't come to terms with Google, the conflict could turn nasty. News Corp. could block YouTube from its site and force its users to use MySpace Video. That would run the risk of alienating MySpace users. But MySpace already is the number-two video site, even though it hasn't placed much of a priority on developing video until now. That suggests that News Corp. might have a chance of winning a fight with Google. Neither Google nor YouTube have had much luck in the social networking arena where MySpace leads by a huge margin.

Google has plenty of leverage, though. For one thing, it's Google. The Internet powerhouse signed a $900 million agreement with MySpace this year. News Corp. wants to expand that agreement, which is currently focused on search ads, to include other realms such as display ads and video.

It's tough to imagine that either side is willing to let this conflict spin out of control. "I think a lot of what's happening right now is posturing. Each company wants to protect their property, but they also recognize that they can't go it alone. Everybody needs somebody. They just want that somebody to need them more," says Jeff Lanctot, vice president of digital agency Avenue A/Razorfish.

YouTube: So far, it's free!

Steve Rosenbush

There's been plenty of discussion over Google's $1.65 billlion acquisition of YouTube. link. The price has convinced many people that the second coming of the dot-com bubble has arrived. That could turn out to be correct. But as one investment banker noted to me yesterday, Google is using its own stock to pay for YouTube. The value of its stock has increased by more than $1.65 billion since word of the deal leaked out last week. So from a certain perverse point of view, one could argue that Google actually got YouTube for free. That may change if Google stock takes a turn for the worse, and if the decline can be pegged to the YouTube deal. But for now, one might argue that that YouTube is free until it isn't.

Mark Cuban: Not backing down on YouTube

Steve Rosenbush

Last week, billionaire Internet entrepreneur and Dallas Mavericks owner Mark Cuban said he thought anyone who bought YouTube was a moron. link. Now that Google has agreed to pay $1.65 billion, is Cuban standing by last week's assessment? "Of course I do. I think they put themselves in a small upside, big downside position. But that's what makes talking about this fun. Congrats to the YouTube guys," he said in an email to be earlier today. The issue, Cuban says, is that YouTube faces some of the some legal pitfalls that destroyed Napster. The company ran afoul of copyright law.

YouTube and Google management insisted Monday that all copyrights will be respected. But Cuban says that could be part of the problem. "If all copyrights are going to be respected, they are going to have to take down millions of videos. There is also the question of whether YouTube can really be YouTube if every video has to be checked, even if electronically, for copyrights and then approved by the copyright owner."

Cuban also raises the point that content owners are are willing to live with online distribution of their programming may balk when it comes to digital manipulation of their work by others. "What happens when an artist decides he/she doesn't want that particular person lipsyncing or some gay couple in drag is smooching to the latest Christian release and the label objects?" Cuban wonders. He makes the argument at length on his blog, Blog Maverick.

But just because someone can sue, doesn't mean they will. Some observers believe that copyright holders in the film and TV world are much more eager to take advantage of online distribution than the music industry was a few years ago. Investment banker Ken Marlin, of Marlin & Associates, framed the issue this way in an email to me earlier today:

"No, I don’t believe YouTube faces big risks from copyright holders. First, the bulk of their content is user-created and copyright issues are not applicable. Second, they have already begun reaching out to copyright holders to work out deals with them. Third, the copyright holders learned from their Napster debacle. They now realize that they can’t stop technology any more than they can stop the tide – and further, it’s not a zero-sum game. Electronic file sharing companies are creating a new business category. There is an opportunity to generate revenue where none was generated before. Thus, the copyright holders are no longer looking to stop the YouTubes of the world, instead they are seeking to embrace them and share revenue with them."

Institutional investors pouring cash into private equity

Steve Rosenbush

One week after the end of the third fiscal quarter, it was apparent that 2006 was going to be a year of new benchmarks for increasingly large and powerful private equity firms players. Global mergers and acquisitions by financial sponsors, or private buyout groups, hit $570 billion during the first nine months of the year, up 51% from the prior record set during the first nine months of 2005, according to market researcher Dealogic.

Private investors are playing a bigger role in M&A, which has traditionally been dominated by large, publicly held corporations. link. Financial sponsors accounted for 22% of total, announced M&A volume during the first nine months of the year, up from 18% during the first nine months of 2005, Dealogic said.

Experts say the growing power of buyout specialists like market leader Blackstone Group, and other major players like Texas Pacific Group and Kohlberg, Kravis Roberts, stems from their prior success. “My view is that the private equity mega firms are able to raise large funds and do large deals because they have had top returns, and now the big public and private pension funds want to invest in the private equity market,” said John O’Neill, a partner and private equity advisor at Ernst & Young LLP Transaction Advisory Services. Returns in the private equity sector can be as high as 50%, he said.

Shutterfly Sets IPO Price Range

Justin Hibbard

First, thanks to Deal Flow reader and indy blogger Mr. Wave Theory for the excellent analysis of DivX's proposed IPO. Perhaps he or another reader can weigh in on Internet photo service Shutterfly, which today priced it proposed IPO at $13 to $15. That price could value the company as high as $354 million, or 13.3 times trailing 12-month earnings. The company's revenues, earnings, and cash flow are highly seasonal. Shutterfly posted a profit last year, but all of the profit--and 49% of 2005 sales--were booked during the fourth quarter (people take a lot of photos around the holidays). Moreover, that holiday rush took a big bite out of Shutterfly's cash when the bills for photographic paper and other supplies came due in the first quarter. In the three months ended March 31, the company paid out $10.7 million to cover accounts payable and accrued liabilities, driving its cash balance down 33% from the previous quarter. Shutterfly's biggest risk is competition from big-box retailers like Wal-Mart and Target, which let customers order prints of digital photos on their web sites and in their stores. How Shutterfly will compete with those margin-crushers over the long run is an open question. I've used Shutterfly's service for several years and love it. As an investment, however, the company is a bit risky for my taste.

Alcatel buys Nortel 3G unit

Steve Rosenbush

Alcatel is continuing its rollup of North American telecom equipment assets. The French telecom equipment giant, which is in the process of buying U.S. telecom gear leader Lucent Technologies, said Thursday it will acquire the high-speed wireless equipment making assets of Canada's Nortel Networks for $320 million in cash.

The unit makes 3rd-generation technology, which supports the rapid transfer of voice and data, from Internet traffic to video and music. Nortel is selling the unprofitable division so it can focus on even-faster 4th-generation mobile technology, which will rival the speeds of fixed line broadband connections found in homes and businesses, vastly improving the quality and depth of mobile multimedia. It also will continue to make 2nd-generation wireless products, which support voice and slower-speed data applications such as text messaging.

The price of the transaction was lower than Wall Street estimates, according to analysts at Merrill Lynch. They expected a sale in the $400 million range, and other brokerages expected the sale to fetch as much as $500 million, Merrill analysts Arya Vivek and Tal Liani said in a report.

But the deal will focus Nortel operations and boost profitability by eliminating a money-losing unit, the analysts said.

The larger question is whether Nortel can become more successful by concentrating on a few markets where it can be number one or two. "As Nortel redefines their business model I expect more of these kinds of announcements. It seems if they cannot lead and be profitable we can expect to see Nortel get out of any business," telecom analyst Jeff Kagan wrote.

Conglomerates continue to fall out of favor, on the theory that they're too hard to manage, that synergies among businesses are a fiction, and that too many units under a single corporate structure are forced to compete for limited capital.

Nortel, like Lucent, once sought to provide pretty much everything that a telecom carrier could want. There's really only room for one such supplier now, and it's Alcatel.

Now we will get to see whether Nortel's stripped down and focused approach will work in practice as well as it does in theory. The Merrill analysts aren't so sure. "The sale of 3G assets could prove shortsighted," they said. That's because 3G growth prospects are greater for now than those of 4G, which remain speculative. But perhaps that's the point. By focusing now on an emerging market, Nortel has at least a chance to become a dominant player.

DivX Sets Price Range for IPO

Justin Hibbard

Just when you thought an alien had abducted the tech IPO market, along comes DivX. The six-year-old, San Diego (Calif.) company develops software that lets people create and play highly compressed video files that can easily be distributed over the Internet and wireless networks. DivX on Aug. 29 set the price range for its proposed IPO at $12 to $14 per share, signalling it could raise as much as $127.4 million. The company would receive $104.5 million of that sum since the rest would go to current stockholders who are unloading their shares in the offering. Among the sellers: VC firm Draper Richards; SVB Financial Group, parent company of Silicon Valley Bank; and Samsung Venture Investment Corp., the VC arm of Samsung. Another Vonage this ain't. Last year, DivX turned in EPS of $0.09 on sales of $33 million, up 102% from the previous year. Gross margins have been expanding steadily for three years and are now at 92%. The company turned cash-flow positive last year and in the 12 months ended June 30 generated $9.9 million in free cash flow, which was 21% of revenues. Read DivX's latest red herring here, and let us know what you think in comments.

The least important, most water-cooler worthy VC post you will read today

Tim Mullaney

So I'm doing this story for the magazine about venture capital, which I can't tell you about yet because I haven't published it. (Sorry, Jeff Jarvis, I don't do my reporting -- yet -- by spreading my ideas all over the street). And I'm messing around on the Web site for Oak Investment Partners, a venture firm that just raised a $2 billion-plus investment pool that is one of the biggest VC funds ever.

And there's this fascinating coincidence.

Regular readers of this blog know I follow an e-health software and services startup called athenahealth, not least because of the pure entertainment value of the fact that CEO Jonathan Bush is the cousin of the President of the United States.

But guess who's on his board?

Would you believe Ann Lamont -- as in, Oak general partner and wife of Ned Lamont, the millionaire Democrat who just beat Joe Lieberman for the Connecticut Senate nomination? You know, the guy who won by lambasting Lieberman (with help from this blog and this blog) for being too nice to, too close to, too, well, kissable by...Jon Bush's cousin?

No, of course you wouldn't.

But it's true.

And I couldn't not blog that. It's just too funny.

The world changes, but apparently the eastern establishment is still a pretty small place.

I asked athenahealth for a comment, and here's what the flack said: "Our CFO was in the Clinton administration."

DFJ's Stealth Companies

Justin Hibbard

Draper Fisher Jurvetson, the VC firm that hit the mother lode last year when its portfolio company Skype sold to eBay for $4.1 billion (including earn-outs), has a pair of potentially interesting startups in stealth mode.

Continue reading "DFJ's Stealth Companies"