After months of negotiations, Elon Musk finalized his acquisition of Twitter on Oct. 27. The price? A whopping $44 billion.
Of the purchase price, Musk coughed-up $25 billion which he raised from the sale of his Tesla stocks. Another $7.1 in cash was provided by a group of investors including Sequoia Capital, Andreessen Horowitz, Larry Ellison, and Saudi Prince Alwaleed bin Talal Al Saud. The balance of $13 billion was sourced from lender banks through a leverage buyout deal (LBO). This was the largest LBO deal of a technology company in history.
For those unaware, an LBO is a deal commonly used to take a public company private. In an LBO, the buyer (Musk) is not the borrower of the $13 billion but rather, the acquired company (Twitter) is. So instead of pledging Musk’s own assets to guarantee the loan, it is Twitter’s publicly listed stocks that serves as collateral.
An LBO works to Musk’s favor in three ways. First, using borrowed funds preserves Musk’s personal liquidity position. Second, he gets to acquire Twitter without surrendering his personal assets as collateral. Third, interest payments are borne by Twitter and booked as an expense. It lowers Twitter’s taxable income.
The risks to the lender banks are enormous considering Twitter has not turned a profit in eight out of 10 years. This is why interest rates for this deal were sky high, reportedly at 15%. So, to minimize their risk, lender banks subdivided their exposure and re-sold the Twitter loan in the form of bonds. Say Bank ABC has a $1 billion exposure. It sold 10 bonds at $100 million each at an attractive interest rate of 10%. Asset Management Firms would buy these bonds for its high yields.
In this manner, Bank ABC gets to raise the entire $1 billion without shelling-out its own money. It also earns a cool 5% interest in the process. For their part, Asset Management Firms are happy with their higher-than-usual bond yield. Everybody makes money — everybody is happy.
But there are problems.
The deal was inked before it was clear that the US and Europe will be facing a deep recession next year. This has not been factored into the equation.
Last year, Twitter booked a net cash flow of $630 million wherein its interest expense amounted to only $50 million. With its new $13-billion debt load resulting from the LBO, Twitter is now saddled with interest expense amounting to nearly $2 billion, way above its net cash flow last year. Twitter’s cash reserves of $6 billion prior to the buy-out are also running low. All these will lead Twitter (and Musk) to a liquidity crisis.
Musk had no choice but to downsize to cut cost. At least 3,500 of Twitter’s 7,000 workforce were laid off. The lay-off included critical executives who have relationships with advertisers. Twitter derives 90% of its revenues through advertising sales and many have started to stop advertising on the platform. Among those who pulled-out were Volkswagen, General Mills, and Pfizer. So now, Twitter revenues are in freefall.
Dwindling liquidity means that Musk must also cut spending on research & development, advertising, and innovation. This is a problem as Musk must find ways to combat fake accounts and find new ways to manage content.
To raise revenues, Musk launched Twitter Blue, a premium subscription service that elevates conversations on Twitter. A subscription fee of $8 is charged to those who opt-in to the premium service. The program was a flop with dismal subscriptions.
Twitter needs more money to stay alive and roll-out new innovations. But finding new investors is proving difficult, what with the poor economics of the company. Exacerbating matters is how tech firms have lost favor among investors. Facebook stocks, for instance, have lost 70% of value this year alone.
Given Musk’s net worth of $220 billion, many say he could easily cover Twitter’s cash requirements. He could also take-out some of Twitter’s debts to reduce its interest expense load. But there is a problem — most of Musk’s wealth is tied-up in the stocks of Tesla and its value has already plunged by 40% this year alone.
Twitter is also a mature business model that faces slow growth. And unlike a property or manufacturing concern, it is bereft of large fixed assets like land and machinery to offer as collateral to banks.
The avalanche of bad developments at Twitter has caused the market to panic. As a result, debtor banks are unable to sell the bonds at full value. They are now selling them at a 40% discount.
If banks sell the bonds at only 60% of their value, they must shell-out $400 million (for every $1 billion) of their own money to fill the loan. However, they must still pay the bond holders a 10% return on the $100 million principal. So, they must pay $10 million in interest for $60 million received. That is a 16.66% interest rate. If the banks are only earning 15% from the loan, they effectively lose 1.66% of the principal per annum. That is on the assumption that they are able to sell the bond in the first place. Twitter bonds are now classified as “junk.”
This is the state of Twitter as of the first week of December.
It’s a slippery slope for Musk as the odds are stacked against him. At this point, we cannot factor-out the possibility of Twitter going belly-up unless fresh funds are infused. One can imagine the anxiety the lender banks and private investors are experiencing considering their $13-billion exposure.
But then, we must never underestimate Musk. Recall how naysayers said he would never make money manufacturing electric cars. And how critics said he could never launch hundreds of satellites to provide cellular service through Space-X. Tesla and Space-X are among the most valuable companies today.
We hope that Musk’s genius prevails against Twitter’s enormous problems. This is a developing story that will unravel next month.
Andrew J. Masigan is an economist
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Twitter @aj_masigan
