Private Equity Pursuing Music Giant EMI

Reuters reports that three American private equity firms, namely Fortress, Cerberus, and One Equity, are all interested in paying something in the vicinity of $6 billion for the British music group EMI. The entry of significant private equity dollars indicates a major shift from as recently as March, when EMI rejected a $4.2 billion bid from Warner Music.

EMI is one of the world's largest music companies but the industry has faced difficulties adjusting to the presence of digital distribution and the resulting ease of stealing its product. While Napster has been vanquished and reincarnated within just a few years as a legitimate distribution channel, the development of countless clones with technology designed to avoid legal challenges indicates the ultimate weakness of the business.

Downloading music illegally is getting easier all the time, and the potential to download higher value products like movies is increasing the returns to mounting this diminishing learning curve. The music industry's attempts at digital rights management, or DRM, have been a titanic failure. In addition to failing to prevent any reasonably dedicated teenager from getting a hold of music, the whole process has had the effect of creating an adversarial relationship with customers.

EMI has been underperforming its industry over the past few years and has actually lost money in the last quarter. Given the profitability of the rest of the industry, even as it struggles with change, this indicates EMI's management is not up to the task of answering the digital challenge.

All of this clearly begs the question: "Why is EMI suddenly worth so much money?" The better question is: "Why would private equity firms be willing to pay significantly more than music industry insiders for the company?" The answer seems to be that music industry insiders are focusing on the unique value proposition of the underlying business while private equity gurus are more concerned with the balance sheet.

The music business may not be what it once was, but significant revenues are a certainty for the foreseeable future. At the same time, the recent spate of private equity firms engaging in leveraged buyouts across numerous industries with widely different businesses and risk profiles seems to indicate that relative to the price of capital, most publicly traded companies are insufficiently leveraged. EMI is a giant business that has lost its way. The company is losing ground, but that actually makes it a more compelling takeover target.

By taking a company with essentially no debt and leveraging it to the maximum, the Americans plan to take value stored in the enterprise itself and cash out quickly. EMI is slowly sinking, but it isn't drowning. A quick turnaround could net substantial returns on resale in five years when the company has returned to profitability.

Experts know their area of expertise and not much more. Music industry insiders see a floundering giant, but private equity sees untapped potential. Only time will tell if the money that private equity can squeeze out of a leveraged buyout will outweigh the loses at EMI's main business.