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Terra Firma's Purchase of Music Giant EMI Hit All the Wrong Notes

Like many mortgage borrowers during the financial crisis, private equity financier Guy Hands bought more house than he could afford. In this case, though, the property he purchased was venerable music house EMI, which Citigroup (C) is seizing after one of the more spectacular leveraged buyout flops in recent years.

The takeover is a surprise, and it's unclear if Terra Firm approved the transaction. Reports The Deal's Richard Morgan (no public link):

First, EMI's previous owner, Terra Firma Capital Partners Ltd., is in the midst of appealing a jury's verdict that Citi did not commit fraud while assisting Terra Firma in its purchase of EMI.

Second, Terra Firma's next covenant check on the £2.6 billion of senior financing borrowed from Citi to acquire EMI won't occur until March. And this was to have been followed by a three-month reprieve to allow Terra Firma to raise funds for any equity cure arising from the covenant check.

Hands made three major mistakes in buying EMI. First, the timing was lousy. His buyout firm, Terra Firma, took out a big loan from Citi in buying the music label for $6.6 billion at the top of bubble in 2007. When things crashed, so did EMI's value. Terra Firma investors have lost $2.8 billion on the deal. It was the same error that wiped out a number of prominent PE firms that had taken the plunge on tech and telecom companies just as the Internet boom was turning to bust.

Big gamble, big crash
Second, Hands gambled -- big time. Although large LBOs were common at the time, as PE buyers capped a buying binge that started in 2003, Terra Firma sank nearly a third of a $7.3 billion fund into acquiring EMI. It also overpaid, with the deal valued at a pricey 18 times cash flow. And like a number of other buyout firms during the PE boom, Hands swamped EMI with debt, damaging its balance sheet as the company was trying to regain its footing.

Third, he underestimated the difficulty of reviving a music label during a time of tumultuous industry change. U.S. music sales have been falling fast, while online business has been fairly flat. As a result, EMI sales plunged after the deal. Things got even worse when a number of the company's marquee acts abandoned ship, including Paul McCartney, the Rolling Stones and Radiohead (pictured above), amid concerns that Hands might dial back on lucrative contracts. Management turmoil at EMI further complicated getting the company back on track.

It didn't help that Hands and his lender on the deal were at war. Terra Firma sued Citi in 2009 after accusing the bank of giving it bad advice during the original acquisition. (A court recently ruled in Citi's favor, although Terra Firma is appealing.) The firm's relations with Citi, which might've been persuaded to restructure EMI's debt, soured.

Citi is presumably eager to wash its loan portfolio of EMI. In taking over the company, which had sales of £1.6 billion for the year ended March 31, 2010, the bank is slashing its debt load by 65 percent to £1.2 billion. That could make acquiring EMI more palatable, with deal speculation already heating up. EMI's most likely destination? A PE firm:

Kohlberg Kravis Roberts, which already has a music publishing joint venture with Bertelsmann (BTG) called BMG, leads a pack of private equity suitors including Apax, Apollo and Permira. Existing EMI rivals including Vivendi's (VIV) Universal Music and Sony's (SNE) separate recorded music and music publishing companies are also looking closely to see whether they can bulk up by buying parts of EMI. Industry executives do not rule out wealthy individuals or funds becoming involved.
Hmm. Could be deja vu all over again.

Image from Wikimedia Commons, CC2.5

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