If someone deserves a year-end bonus on Bay Street this year, it's Gerry Schwartz. His Toronto-based private equity firm Onex has just reported a 138% improvement in net earnings this quarter. The recent IPO of Spirit AeroSystems Holdings Inc. brought in $1.63 billion this past November. The four funds the company runs are well-subscribed, and the new U.S. real-estate fund the company set up in January of last year is expected to soon double its money. “This has been quite a good quarter,” Schwartz said in a press release.
Even better, Schwartz's wife, Heather, took first place in our survey of stock returns of companies related to people on our annual rich list. Her company, Indigo, is up 90% in the period we surveyed. But can the good times for the Reisman-Schwartz braintrust continue?
One estimate from David Bonderman, a principal at Texas Pacific Group Ventures Inc., is that private equity firms (of which Onex is one) will replace Fortune 500 firms as the 10 largest generators of fees on Wall Street this year. That estimate bears out what we've seen daily in the business press: the funds we used to call leveraged buyout firms are back, and pulling off more and bigger deals than they ever did in the '80s. Low interest rates (conducive to leveraging) and cheap earnings at rich targets have helped, as have the seemingly limitless opportunities to globally restructure companies and take advantage of offshore outsourcing opportunities. Throw in new governance mandates for public companies that make it a pain to be a CEO of a public company these days, and no wonder so much new money has flowed into the sector. But that sets up a challenge for people like Gerry Schwartz. Is all of the attention on private equity turning into too much of a good thing?
That question is especially pressing at Onex, which had an interesting problem this year. Coming into fiscal year 2006, the company found itself with $1.5 billion in cash sitting on the books waiting to be invested. Cash generates little in the way of return, of course, and so before investors began demanding that money back (so that the owners might do something else with it) Onex promised in its 2005 annual report that it would deploy the money this year.
That's not as easy a task as it sounds. With the private equity market so hot, values have inflated and opportunities to identify undervalued companies are becoming rare — something even Schwartz has admitted. Nevertheless, the commitment was made and Onex had to act. A string of acquisitions suggests a plan has been put in motion. The big question now is whether the apparent target — the airline industry — is going to work out. And it's likely investors won't have to wait very long for the answer.
On Nov. 22, Australians were surprised to hear that a consortium of firms, led by Australian outfit Macquarie Bank, Texas Pacific Group and Onex, had launched a bid to buy Qantas Airlines and take it private. It's a large bid, a rumoured $9.9 billion in total. This represents the ongoing expansion of the private equity sector, which has seen a remarkable increase in the number and size of deals. But the deal garnered special attention in Australia — “Maple Leaf Mob Eyes Qantas Turf” screamed one headline.
From Onex's point of view, the bid makes sense. Management has committed to diversifying the Onex portfolio across the entire economy, and the company has focused on building out its health-care and aerospace holdings. In 2005, it bought up American Medical Response, Center for Diagnostic Imaging and Skilled Healthcare Group. That rounds out existing holdings in electronic manufacturing, automotive and customer management services. And Onex's most recent acquisition, announced Nov. 10, is Tube City IMS Corp., a U.S.-based steel company.
But there is more to the story than simple diversification. One of the hardest-fought takeover battles in Canadian history is Onex's attempt in 1999 to force a merger between Air Canada and Canadian Airlines. That battle was won by Robert Milton, the Air Canada CEO at the time. Many Canadians were put off by the large pay that would have accrued to Air Canada management had the deal gone through — but in the end the deal wound up in court, where it died. All of which adds up to juicy context for the Qantas bid — Schwartz's second run at an iconic national airline.
Right off the cricket bat, much of the coverage in the Australian press has been negative. At the time the Qantas bid surfaced, rumours began to circulate that Foster's — Australia's signature beer — might also fall prey to a private equity firm. The takeover-of-national-symbols story has since begun to merge into an “issue” Down Under. That there is an election coming suggests those questions will only get more pointed. Nevertheless, the consortium is going ahead with the bid, reportedly at AU$5.50 a share — which, if that is in fact the case, is a premium on the Nov. 29 close of about AU$4.80.
So, what might the funds be after? Well, the airline boasts a focus in the Asia-Pacific region, a low-cost domestic carrier, a new intra-Asia low-cost carrier as well as a number of subsidiary businesses such as flight catering, engineering, maintenance and defence. Some of these component parts could be spun out — confirming nationalist fears — but looked at from that angle, the possibility that some of Qantas's divisions may be freed up likely explains Schwartz's presence in the deal.
Onex, of course, has a history of buying divisions out of larger corporations, playing the outsourcing theme and putting together a new company (and industry killer). That was the plan behind Celestica, which Onex bought from IBM in 1996 and expanded into a massive electronics parts manufacturer that has offices from Brazil to Singapore to Spain. The pattern was repeated with LSG Sky Chefs, a one-time division of American Airlines that Onex bought in 1986 and grew into a company that served the rest of the industry. Spirit, a former division of Boeing, was rolled out along the same pattern.
In the week after the Qantas deal was announced, news of another deal surfaced, in which Onex reportedly bid on the defence contractor Raytheon's commercial airline business unit. A rumour that Onex would be a bidder for ACE Aviation Inc.'s maintenance division also circulated (ACE is expected to be sold later this year). Could Schwartz have a Sky Chef-type strategy in mind, this time for aircraft maintenance divisions? That's certainly the speculation. “No one knows what management is thinking, and Onex never discusses potential investments,” says Horst Hueniken, an analyst with Westwind Partners Inc., a Toronto-based investment dealership. “But don't assume Onex is going after a stake in the airline. They could be going after a spinoff. That's something I don't think the market has recognized.”
All of which focuses attention on the Qantas deal, which is by no means a sure thing. “The reaction down here has been surprise,” says Jason Bloom, a Sydney-based analyst with Deutsche Bank Australia. He questions the deal on the numbers: “The airline is trading at a seven-year high. It doesn't appear to be a private equity target,” he says. He also points out that after negative comments about the deal from members of the Australian opposition, party backbenchers and unions, the stock dropped below the offer price, which suggests the market doesn't think the deal will get done. Questions are also being asked about the pay package for management. “There is going to be a push back. Already the opposition parties are talking about private equity firms coming in and breaking it up. There's a way to go on this yet. But I'd give it less than 50% chance,” says Bloom. “It's probably going to be one of the harder private equity deals to push through.”
Can Schwartz bring this bid in for a soft landing? That would be good news for Onex stock owners. Investors have long complained Onex management keeps too much of the earnings for themselves, and that the stock is a laggard. But, in the past couple of months it has actually been running ahead of the market.
So does this all signal a new era for Onex shareholders? Perhaps. Schwartz certainly seems to have the confidence of the Street right now. “The fact that this company has been able to raise substantial funds for all four of its funds is a sign of the confidence in Gerry's team,” says Hueniken. And when it comes to capital markets, that's the only vote of confidence that counts.