EMI disaster reveals the truth about private equity’s ‘magic sauce’

Guy Hands. What was he thinking? There was no way he could have come out of his court case well. Even if it had been proven somehow that David Wormsley, chairman of Citigroup’s British broking team and once a close friend of Hands’, had tricked him into buying EMI, the case would have shown that he has no more negotiating skill or emotional neutrality than the rest of us have when confronted with our dream house and a dodgy estate agent.

During the case, he more or less admitted that he was so desperate to own EMI that he upped his bid for the firm by a billion or so based on a couple of last-minute phone calls, in which he says Wormsley told him that a rival bidder was in the running. The price he paid was then based not on a rational calculation of what EMI’s current and future earnings stream might be worth, but on a need just to beat the other bidder and have the firm at all costs. This can make sense when it comes to dream houses. But it never, ever makes sense in business. Which might explain why Terra Firma codenamed the deal Dice.

Even if Wormsley had in fact been plotting with EMI’s former chief executive, as the Times put it, “to deliver Terra Firma as a generous bidder that would not pry too far into EMI’s business activities”, that wouldn’t for a second have absolved Hands from his failure to do his due diligence properly and from the fact that, having failed to do it, he paid the wrong price.

He must have known that. So what was the case about? Sour grapes? Embarrassment? A refusal to accept a loss? Buyer’s remorse? A mid-life crisis? A shameless punt in an attempt to recoup lost money? Who knows. But whatever the reason, it is no wonder it took the jury a mere five hours to find against Hands.

He now has to deal with the fact that he is going to have to try to get his investors – who are presumably furious with him – to inject more cash or lose control of EMI. He’ll also have a bit of work to do recovering his own completely tattered reputation and stopping the rest of his industry from lynching him for the attention and general embarrassment he has brought upon them.

As Citi’s lawyer put it, the key behind private equity is making people believe that you have some kind of “magic sauce” that turns tin into gold. Hands vs Citi has shown that the magic sauce doesn’t work when credit markets aren’t working and asset prices aren’t rising. Or perhaps that cheap credit and asset bubbles are in fact the main ingredients of the magic sauce. Whoops.
Still, the publicity here doesn’t make Citigroup look particularly good either. Not only did the case lay bare the constant conflicts of interest knocking around in investment banking, but the bank was hardly financially savvy during the deal either. They lent Hands £2.7bn for this lousy deal despite the fact that credit markets were already collapsing and one of their credit officers sent an email around saying “Oh dear Oh dear, I can see us taking a huge loss on this deal.”

Which they have. They were never able to syndicate it – the financial crisis intervened – and they ended up stuck with it. Now they have to figure out what to do next. None of the potential solutions are particularly good for EMI, as Anthony Hilton points out in the Evening Standard. It is worth noting that operationally things are improving quite nicely at EMI (a trading profit of £121m in the 12 months to March). Its current problems stem not just from its business, but from the huge weight of the magic sauce (debt…) that Hands and Citigroup saddled it with. Something worth remembering as the saga drags on.