By the early 2000s, the tiny company known as PC’s Limited — originally started in Michael Dell’s dorm room — had been reincorporated as Dell Inc, and the company had prevailed against IBM and Compaq in the personal computer wars of the 80s and 90s. Dell was now a publicly traded company. Michael himself had stepped aside as company CEO for a brief period, from 2004 to 2007, about the same time the entire PC industry started sliding sideways. Dell writes of this period in his autobiography Play Nice But Win (all emphasis mine):
“... if there was blame to be laid for [the late 2005] revenue loss, I (as Chairman) shared it. But it quickly became apparent in late 2005 that the underperformance wasn’t an anomaly: Dell was beginning to hit serious headwinds. For one thing, our competitors were getting smarter. Companies like Hewlett-Packard, Acer, and Lenovo, companies we’d always soundly defeated with our build-to-order model, had gone back into their cave and figured out how to duplicate many of our supply chain innovations. Meanwhile, build-to-order itself, so effective at addressing the many combinations and permutations of desktop computers, lost its advantage as the industry shifted from desktops to less easily customized notebooks. Customers were starting to focus more on services and solutions as value transitioned from the fundamental client product, the PC and related peripherals, to software, servers, and the data center.
It took us a little bit longer than we would have liked to figure all this out.
And then there was a Dell plus that was subtly turning into a minus: for a few years we’d been prioritizing profit over growth and share, and a company’s success is always a balance between those three. Our profits were strong in the 2000s, but now our share was eroding. And that can be a slippery slope.”
Notice the two highlighted bits: what Dell was essentially saying was that the company had priced its products expensively, right about the same time there was a change in the demand-side of their industry. This was bad.
Dell’s response was to go on an acquisition spree. Over the next few years, the company bought a large number of smaller companies, investing in a shift to ‘software, services, servers, and the data centre’.
Wall Street analysts and the broader press didn’t buy it. In July 2012, Dell found himself explaining his company on stage to Fortune editor in chief Andy Serwer. Serwer pulled up a polling question on the screen behind them: “Last year desktops and laptops accounted for 54% of Dell’s revenue, down from 61% in 2008. How big will Dell’s PC business be in five years?”
Dell describes what happened next (all emphasis mine):
Possible answers were: (a) 50–54 percent (about same as today); (b) 40–50 percent; and (c) 39 percent or less. Choice C got the most votes by far.
The correct answer was A.
I told Andy that with all due respect to his poll, a better way to think about the question of our PC business vis-à-vis our other businesses was in terms of revenue and profit. Let’s say (I said) you sell a billion dollars’ worth of PCs, versus a billion dollars’ worth of software: those two transactions would have very different characteristics in terms of free cash flow and margin. Therein lay some of the difficulty in looking at Dell strictly from a revenue standpoint. Our business mix was definitely shifting, I repeated, hoping the message was starting to sink in.
I believed passionately in everything I told Andy at Aspen. And in the days, weeks, and months that followed, the business press kept pushing the narrative that Dell equaled PC, and the PC was dying.
And our stock continued to swoon.
I’ll freely admit that some part of me smarted at seeing our share price sink so low. The company had my name on it; after my family, it meant everything to me. But my wiser side saw an opportunity for the company. Back in 2010 I bought a big block of Dell stock in the open market, confident that the share price would rise. (There are very stringent rules about when and how an insider like me can buy or sell our stock: soon, but not too soon, after quarterly earnings have been announced. Needless to say, I followed them.) Yet it also occurred to me that if I—with help from others, of course—could buy back all the stock, our transformation as a company could proceed without the tyranny, the ever-ticking shot clock, of a quarterly earnings report. Going private would open up the possibility of dramatically accelerating the growth of the company and allow us to have a far greater impact in the world.
This was the Capital side of business expertise at work again. With the benefit of hindsight, we now know that Dell was right — taking the company private gave its operators the freedom to adapt to a rapidly changing industry. (This is a fancy way of saying that Dell, Inc spent a lot more money on acquisitions and expansion: resulting in lumpy free cash flow, which meant earnings volatility that public market shareholders would have absolutely hated.) But to do this, Michael Dell needed to find backers to purchase the entirety of Dell Inc’s outstanding stock; as rich as he was, he couldn’t possibly purchase all of it alone. In a way, the shape of the problem here was similar to Lee Walker and the Austin banks: in order to do business his way, Dell had to find a sufficiently large pool of capital, and he had to convince that pool of capital that there were profits in going with his plan.
This he accomplished with the help of Silver Lake Partners, a major private equity firm. The structure of the deal is what is known as a ‘leveraged buyout’, or LBO: Silver Lake would loan the money to Dell, Inc, which would use it to purchase all of its outstanding stock. Like with most LBOs, the debt would sit on Dell’s books, and Dell would have to pay it down — along with the interest — over a few years. To be clear, this was risky. If Michael Dell’s plan hadn’t pan out the way he saw it, the company could well default on its debt. But Dell thought that it was a reasonable bet to make. Years later, in a Forbes article, Dell said that “it didn’t feel that risky to me ...” Skeptics, he insisted, had missed the big picture: the corporation gushed cash and sat on plenty of valuable software assets it could sell if the worst came to pass. And the financing available was cheap. “If you have this savings glut, capital is inexpensive and there’s tons of cash on your balance sheet, it’s hard to make your equity more valuable,” Dell said. “If you flip the equation, it’s not conventional wisdom to say, ‘Hey, let’s have a tech company with lots of debt.’ ... [But] with predictable cash flows, it’s a winning strategy.”
The go-private itself took place over a couple of months. It became a hugely dramatic affair. Carl Icahn bought into the stock and began attacking Dell in the press (and eventually, in court); the company’s board went about soliciting competitive bids to force Michael and Silver Lake to increase their bid — about what’d you expect a good board to do. The only problem was that nobody wanted to buy Dell — just about everyone else thought that Dell’s future was in the PC market, and that the PC market was dead. I’m going to skip over this phase of the story; I merely want to point out that Dell knew such a move was possible, and was lucky enough (or skilled enough!) to pull it off once he put the company in play.
What I want to focus on was Dell’s merger with EMC, just two years after the deal concluded. This, more than taking Dell private, is a phenomenal demonstration of Capital expertise.
To set this story up, it helps to understand EMC’s position in the enterprise data market at the time, along with its relationship to Dell and to Dell’s competitors. Founded in 1979, EMC had grown to be the world leader in networked information storage systems circa 2016. Their big product was a powerful hardware-software data storage array named Symmetrix, and it was predominantly used by enterprise-class corporations — the top hundred to two hundred companies in the world. If you were in the Fortune 100 and you ran your own servers, chances were good you were storing all of your company data in an EMC product.
Dell and EMC had a long-term partnership by this point: in 2001, the companies entered into a strategic alliance. Dell would sell EMC machines as part of its enterprise engagements, and EMC agreed to use Dell servers inside their storage systems. More importantly, through Dell, EMC had a sales channel that targeted companies smaller than the top 100/200 enterprises. This helped it against NetApp, its primary competitor, who had developed sales capabilities targeting smaller enterprises. It also took Dell off the table as a competitor — since such an alliance prevented Dell from working with NetApp.
In 2004, EMC bought virtualisation startup VMware. Three years later they took it public, floating 19% on the New York Stock Exchange and reducing their ownership to 81%. VMWare’s product offering was so compelling that by the mid-2000s, if you worked in a company that had servers and weren’t using virtualisation, you were ‘totally doing it wrong’. Consequently, VMWare’s stock was taking off like wildfire.
EMC’s CEO was a man named Joe Tucci. He was a veteran of the computer industry — Michael Dell had first met Tucci when Tucci was Chairman and CEO of Wang Laboratories in 1994. At the time of the proposed merger, Tucci could see storm clouds on the horizon:
Whilst EMC owned 81% of VMware, a high growth company and a beneficiary of the nascent switch to cloud, Tucci knew that there would be choppy waters ahead. Tucci and Dell had had conversations about EMC’s future: Tucci believed that it wasn’t a great idea to be a storage company without also operating a server company over the long term, given changing industry dynamics.
Paul Singer, the founder of legendary activist hedge fund Elliott Capital Management, had taken up a large EMC position and was pressing the company for a merger.
Tucci himself was in his late 60s, and had delayed retirement multiple times. He did not yet have a clear successor. Merging with a strong partner would allow Tucci to step down, secure in the knowledge that he had left EMC with good hands. But as much as Tucci liked Dell, and Dell liked Tucci, the final decision lay with EMC’s board of directors. The company was, after all, publicly traded.
EMC’s initial bid for a merger was with Hewlett-Packard. Under CEO Meg Whitman, negotiations between the two companies went well enough over the course of 2014 — about the same time Dell was busy with the going private. By the end of the year both companies had a handshake deal: HP would let EMC shareholders trade their shares for HP shares on a one-to-one basis. But at the last minute, the folk at HP reneged; saying, in effect, “our stock should be at a five percent premium to your stock because we’ve got a better business.” EMC’s board felt betrayed by this last minute change and scuttled the idea.
Two years later, Michael Dell was becoming increasingly convinced that a Dell and EMC combination would be killer. Dell had made a play for EMC during the 2008 financial crisis, but couldn’t make the deal work. By this time, Dell Inc was doing wonderfully as a result of the go-private: the company was gaining market share and paying down debt at a rate that was faster than originally expected. It had also fully committed to the enterprise services, enterprise software and the server and data centre markets that Dell had talked up pre-buyout. These were the same target markets that EMC excelled at.
In fact, EMC was a triple threat. It was the enterprise leader in data storage systems. It owned VMware. And it owned Pivotal, a software development company that was spun out of the two, that had created a platform to develop cloud software.
If Dell could merge with EMC, Michael believed that the combined company would have an unrivalled edge:
It seemed like a natural progression for us. Not only did our alliance with EMC go way back; it was also a rare opportunity in that EMC and VMware were the clear Number Ones in their industry segments. As I mentioned, it’s very hard to dramatically change the share position of a company, so buying a number two or Number Five business (which are the ones that are usually for sale) was a much more difficult way to succeed. Usually, number one businesses aren’t for sale, or the price is exorbitant, or they are part of an even larger company that isn’t acquirable.
I was thrilled by the idea of combining Dell with EMC and VMware, and Egon [Durban, of Silver Lake] felt the same way. It would be a merger of unprecedented size, one that would immediately create the world’s premier company in IT infrastructure, with the best products and technology and the greatest scale. And it would fit our (Dell’s and EMC’s) customers’ needs perfectly.
There was only one small issue: Dell couldn’t afford it. More specifically, Dell couldn’t afford the 81% of VMware that EMC still owned. Since the price of VMware was determined by its public market valuation, and since VMware was still growing like a weed, the valuation was simply too rich for any combination of equity and debt Dell’s team could anticipate putting together.
Dell, Joe Tucci, Egon Durban, Bill Green (an EMC board member and former Accenture CEO), and EMC EVP of corporate strategy Harry You gathered for a meeting in Dell’s house in Austin on April 3rd 2015. Like Dell, the EMC executives were becoming increasingly convinced that there were major competitive advantages to tie the two companies together. But they still couldn’t see a way around their financing problem.
After the meeting, Durban and You flew back to California. It was during this flight that You had a flash of insight. “There’s something else we could try,” he said.
You whipped out a napkin and started drawing. He revealed that EMC had studied issuing its remaining 81% stake in VMware as a ‘tracking stock’ — a somewhat obscure, publicly traded financial instrument that gave investors exposure to the performance of a specific subsidiary of the company, without the parent company giving up control. You had visited John Malone for advice when looking into this plan, since Malone was a master of the instrument.
Dell continues in his autobiography:
What if, Harry said, we were to issue a new class of stock for VMware, one that didn’t reflect ownership in the business, but instead tracked the company’s performance? We could then sweeten the consideration paid to EMC stockholders in the deal by adding VMware tracking shares to their EMC shares. Egon was very excited by the idea—so much so that he and Harry started sketching out then and there—on the plane, on paper napkins—how a VMware tracking stock could work in a Dell-EMC combination.
And because we’d been collaborating on the idea steadily for six months, really working arm in arm as partners, Egon phoned me from his car the moment he landed and very excitedly told me about Harry You’s bolt from the blue.
Issuing a tracking stock would knock billions off EMC’s purchase price.
But now there was another problem. Dell’s advisors at JPMorgan Chase thought that that the total equity being put up in the deal wasn’t enough to support the debt that would be needed to complete the acquisition — even after the tracking stock. This was problematic. If banks were not willing to loan the money, Dell, Inc would have to raise mezzanine debt — a hybrid of debt and equity financing which, if things went badly, would allow the lender to convert the debt to equity. This was considerably more expensive and considerably less liquid than regular debt. At one point in the deal, it seemed like there was only one player who could provide the needed 10 billion dollars: Temasek, Singapore’s sovereign wealth fund. Temasek would almost certainly know its bargaining position, and extract a dear price for that cash.
In late August, Tucci, Green, You, Durban and Dell sat for dinner together in an out-of-the-way area of New Jersey. It was during this dinner that Durban had his flash of insight about the tracking stock. Dell writes:
Serious business was coming the next day, but that night the atmosphere around our table was friendly and fun. Maybe that’s what allowed The Idea to surface.
I remember we were all laughing about one thing and another, including the idea of walking into a bank, sitting down with some loan officer and saying, “I want to borrow $50 billion”—which was pretty much where we stood at that point, and it seemed kind of hilarious. But suddenly Egon looked serious for a moment and raised his index finger.
“So the bank says, ‘Okay, how are you going to pay us back?’ ” he said. “And we say, ‘Well, actually, we have a couple of ways to pay you back.’ ”
We all quieted down and listened.
“One is we have this thing called our ISG business, which is the combination of EMC’s storage, which has been around for thirty-plus years, and Dell’s server business, which is world leading. And then we have this thing called the PC business, which generates all this cash flow.
“Then,” he said, “we have this other thing called VMware. Even though we’re issuing a tracking stock, we have eighty-one percent of the actual common stock of VMware on our balance sheet. It trades on the New York Stock Exchange, and that VMware stock is worth around $40 billion (emphasis mine). But because after the merger we would have that eighty-one percent of VMware on our balance sheet, our equity in the company would be far greater than it would be without VMware included. So, Mr. or Ms. Banker, we actually have multiple ways to pay you back.”
Egon smiled. “And—this is the beautiful part—we really don’t need that expensive mezzanine debt with Temasek.”
If this sounds a little like having your cake and eating it too, that’s because it ... was. Effectively, VMware’s stock — the 81% that EMC held on its books — acted as collateral for the $50 billion dollars of debt Dell planned to raise. Meanwhile, the new tracking stock would be issued for 53% of that same VMware stake, saving $12 billion on the final purchasing price. Durban knew this argument — coupled with Dell’s track record — would fly with financiers. The tricky thing about creditworthiness is that creditworthiness exists where people believe it exists. And Durban and Dell had the standing to back it up.
And so it did: the arrangement turned out to be the capital structure that Dell used for the merger with EMC. The final structure included rolling over some of EMC’s existing investment-grade debt; more importantly, by making Durban’s argument about VMware, Dell was able to go to the rating agencies and get investment-grade tranche ratings, which in turn enabled them to tap the investment-grade debt market. This was the breakthrough that Dell needed — since the investment grade debt market ran much deeper, the group could increase the amount raised and lower the cost of available debt capital to the point where they no longer needed to raise any expensive preferred stock from Temasek.
The one remaining hurdle was to convince EMC’s board. This was done shortly after the fateful dinner. Dell writes:
On Wednesday morning, September 2, Egon and I went to the Times Square legal offices of Skadden Arps for what was arguably the biggest meeting of my professional life. It was put up or shut up time, the day that the EMC board was going to take a beady-eyed look at me and my company and decide if we were worthy to buy their company—and, no pressure, whether I was worthy to lead the whole shebang.
It eased my nerves considerably that we had a friend with us: Jamie Dimon [the CEO of JPMorgan Chase].
A big meeting room, filled with EMC board members and management and bankers and lawyers, a video camera and speakerphones to include all who couldn’t be present: a couple dozen people waiting to hear what I had to say. I’d thought of the occasion as a job interview—I felt confident, but at the same time, well aware that there was a huge amount at stake.
The board had a lot of questions.
They wanted to understand our plans, and also see how things would change. They wanted to know how we would keep the VMware ecosystem independent. They wanted to know how we would continue the philanthropic and community involvement that EMC had at the core of its culture. I made my best pitch.
(...) An hour or so into the meeting, there was a momentary silence. Then one of the board members broke it with a question.
“This merger would add a lot to your job, and your job is already big,” he said. “We’re all kind of wondering how devoted to it you’re going to be able to be.”
“Look, this business has my name on it; it’s been my life,” I said. Then I smiled. “But also, those of you with kids will understand—my twins are grown up, they’re both off to college now—I have a lot of free time on my hands.”
This got a laugh. But once the room quieted down, another director gave me a serious look. “Do you have the money?” he asked. “We’re talking about a lot of money.”
Before I could say a word, Jamie spoke up.
“Yes,” he said. “They have the money.”
The board gave their approval. Interviewed later, Jamie Dimon said, of the deal: “No one in their right mind should question [Dell’s] commitment or his ability to fight and win. I sometimes make fun of people with credit models. It’s also about the character of the people you partner with. [Dell and Durban] are exceptional guys.”
There were more snags to get the deal done — including a second scrap with Carl Icahn — but Dell’s merger with EMC was finally completed on the 7th of September, 2016. At the time, the acquisition was the largest in the tech industry. It made Dell Technologies a powerhouse.
It also loaded the combined entity with $50 billion in debt, turning EMC from investment-grade to junk rated. Dell began paying down the debt almost immediately. Interviewed later, Dell’s CFO Tom Sweet explained that 90% of all of Dell’s considerable free cash flow went towards paying down its debt load during this period.
Dell and Silver Lake did one final move — a coup de grace that finished off this series of complex transactions. In the years after the merger, VMware’s stock rose by more than $50 billion in the public markets. In the words of journalist Antoine Gara, Dell and Durban decided to use the subsidiary ‘as an ATM’. They pulled out $14 billion from VMware’s coffers to buy out shareholders of the tracking stock. (Initially they only wanted to pay $9 billion, but activist investors Elliott Management and Carl Icahn made a large enough fuss that Dell and Silver Lake increased their offer to $14 billion, or 80 cents on the dollar). As part of this maneuver, Dell took his company public again, under the name Dell Technologies.
Dell Technologies’s initial share price stank. The market seemed to think that debt-heavy Dell was worth less than zero even after accounting for its ownership stake in VMware. Unfazed, Dell decided to do a full spinoff of the subsidiary. The market reacted to this offering in exactly the way he wanted: Dell Technologies shares soared, doubling in value and netting Dell $20 billion. Repeating his hat trick, Dell pulled out a further $9 billion from VMware as a condition for the spin off, using it to further pay down the parent company’s buyout debt.
The end result? Before the buyout, Dell owned a mere 15.6% of his company, shares worth less than $4 billion. After this multi-year series of manoeuvres, Dell owned 52% of Dell Technologies, and 42% of VMware. The company came out of this period completely restructured, targeting higher value enterprise and data centre segments. And the total value of Dell’s own holdings coming off the spin off was worth a cool ~$40 billion.
Sources
The primary source for this was Michael Dell’s autobiography Play Nice But Win.
Antoine Gara in Forbes: Deal Of The Century: How Michael Dell Turned His Declining PC Business Into A $40 Billion Windfall
Lee Walker’s autobiography: Imagination House.