Almost two years ago to the day we wrote about a return of animal spirits, the LBO of Heinz by Berkshire Hathaway and 3G, and the significant role debt had to play in the transaction. Yesterday Heinz announced that it is to merge with Kraft Foods to create the fifth largest food and beverage company in the world. The transaction will see Berkshire Hathaway and 3G invest an additional $10bn in the form of a special dividend to Kraft shareholders, in order to take a controlling 51% shareholding in the combined company.
In the Berkshire Hathaway 2014 Annual Report Warren Buffet spells out the acquisition criteria he looks for, most of which is satisfied here. These are that the purchase be large, that the company has demonstrated consistent earning power and good returns on equity whilst employing little or no debt, that it has strong management in place, a simple business, and an offering price (i.e. a business that is readily up for sale). I say ‘most’ as one could readily argue that $8.6bn of current long term liabilities at Kraft (as at the end of the financial year 2014) doesn’t satisfy that ‘little or no debt’ criteria. And Heinz also carries its fair share of debt at $14bn, though both figures need to be taken in context.
In the same Annual Report referenced above Buffett extols the virtues of Berkshire Hathaway and its ability ‘to allocate capital rationally and at minimal cost.’ He goes on to say that Berkshire can ‘ move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise.’ No doubt he and his partner Charlie Munger have an enviable record in doing exactly that, but recently it could be argued the pendulum has been swinging increasingly in their favour.
The mega LBOs that saw the likes of Caesars, TXU, Freescale & Clear Channel acquired pre-Lehman by multiple private equity shops acting in concert are unlikely to be contemplated today. And even if they were, satisfying the requisite 15-20% return on capital would prove challenging on the back of several up years for most equity markets.
Berkshire Hathaway on the other hand has cemented its position as a behemoth that can continue to call on massive cash reserves and an exceptional reputation. And so can it call on super cheap funding from the bond markets. Despite articulating a general distaste for debt its increasing willingness to do so saw the holding company lose its AAA/Aaa status a few years back. And more recently it would seem that the super cheap funding available from bond markets has proven too attractive to ignore. Only this month, Berkshire Hathaway borrowed €3bn from the European credit markets. At a weighted average cost of funding of 1.2% for up to 20 years the company has a huge arbitrage available that can’t be matched elsewhere. Despite the re-rating that has occurred in equity markets, an implied earnings yield of 6-7% still looks attractive if a decent portion of your term funding costs are close to zero.
With central banks continuing to ensure that liquidity remains plentiful Berkshire Hathaway is likely to sit pretty. Meanwhile, the arbitrage opportunities look set to continue. Other large deals will be on the horizon.