A $9 Billion Buyout Bid Puts the U.K. Market to Shame

(Bloomberg Opinion) -- The latest private equity deal in the U.K. — the biggest in more than a decade — raises an awkward question for investors in the London stock market. How can the U.K.'s fourth-biggest supermarket chain be worth more to a consortium comprising Canadian pensioners and U.S. buyout and real-estate investors than to the home crowd? It looks like the starkest evidence yet of private investors exploiting the widespread aversion to U.K. stocks.

The group that's agreed to pay 6.3 billion pounds ($8.7 billion) for Wm Morrison Supermarkets Plc is led by funds run by Fortress Investment Group LLC, a buyout firm owned by Japan's Softbank Group Corp. Alongside are the Canada Pension Plan Investment Board and Koch Real Estate Investments LLC, part of the business empire of the billionaire Koch family.

This does not look like a conventional leveraged buyout. The all-in price including assumed net debt is around 9 billion pounds. The consortium will fund that with just over 3 billion pounds of equity, the rest from new borrowings. To get a private equity-style 20% return would mean taking out 8 billion pounds from a sale after five years. That's a tall order.

Morrison generates a lot of cash so part of the required uplift could come from paying off debt. At least 2 billion pounds of deleveraging looks plausible. But the acquirers would still need to sell the business for more than they paid. To do that would require both growing Ebitda and selling on the same punchy 8-times multiple of profit on this measure that Fortress says it's offering. Good luck with that.

U.K. retail faces inflationary cost pressure that is hard to pass on to consumers due to intense competition on price. Maybe with private equity's relentless focus on performance, Morrison could lift Ebitda margins slightly from the current 6%. (Tesco Plc's are expected to be around 7% this year.) But even if that happened, could the consortium really sell Morrison on the same valuation multiple? This sector is changing fast. Who knows how grocers will be valued later this decade if the sales migration online accelerates.

Against that backdrop, the investment makes more sense as a lower-return, longer-term hold. Management would then be focused on defending Morrison's annuity-like cash generation and improving efficiency here and there. But if that's the case, couldn't stock-market investors be persuaded to see Morrison the same way? There is nothing these buyers — essentially a joint venture between private equity, long-term investors and real-estate experts — can do that the company can't do now.

For example, there's no law stopping Morrison imitating some of the buyout playbook as a public company, incentivizing management aggressively and borrowing to fund a large special dividend. It could create a joint venture for some of its property assets without necessarily pursuing a major sale-and-leaseback of Morrison's stores (which the consortium says isn't on the cards anyway).

Suppose Morrison Chief Executive Officer David Potts proposed such a strategy, would the stock market see any value in it? Even though the pandemic boosted the supermarket sector, Morrison's stock price didn't respond positively. And the U.K. doesn't — yet — have national pension funds like Canada's that take a super-long view.

Against that backdrop, you can see why the board felt the 252 pence-a-share offer price, plus a 2 pence dividend, is good enough. While the 42% premium over the stock's value prior to recent takeover speculation isn't so high as to merit automatic acceptance, Morrison shares have been above that level for only a few weeks in the last five years.

Moreover, getting Fortress on the hook sets a reasonable bar for a potential counterbid, most obviously from rival buyout suitor Clayton, Dubilier & Rice LLC. Morrison shares jumped above the consortium bid in early trading Monday, pricing in the chance of a better alternative. U.S. private equity firm Apollo Global Management Inc. said it was evaluating a possible offer but hadn't approached Morrison.

Rejecting this offer in the hope the shares could get to the same altitude on their own could easily leave current shareholders stuck in the mire. The same calculus will probably apply to the next private equity bid in the U.K.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.