Deals

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

Blackstone Group LP is making a big investment in the cigarette industry on behalf of its clients. Don’t expect this deal to feature prominently in its corporate social responsibility literature any time soon.

Funds advised by the private equity firm on Wednesday agreed to buy Solvay SA's Acetow unit, a maker of cellulose acetate used in cigarette filters, for about $1.1 billion. The product is the second-largest component of cigarettes, and about 90 percent of sales are to the tobacco industry.

It is surprising to see a company like Blackstone going down this route. True, the investor describes its role as a responsible steward mainly in terms of making companies, and thereby economies, stronger. But Blackstone also calls itself a socially responsible investor and says it analyzes environmental, public health, safety and social issues for its investments. Cigarette ends don't obviously burnish those creds.

Spot The Difference
Solvay's radical reshaping of its portfolio has yet to deliver sustained outperformance versus peers
Source: Bloomberg

Still, the financial opportunity afforded by Solvay's disposal is just what private equity firms crave. This is a unit of a large corporate that had been neglected as the parent's strategy shifted elsewhere. The timing is helpful too. The Acetow business has had a difficult few years. Revenue has fallen by an average 9 percent annually since 2013 as Asian competition has intensified. That impact may be now easing. If so, Acetow offers Blackstone a slow-growth but predictable stream of cash for the coming five to seven years, the period private equity firms typically invest for.

According to Solvay, the sale price of 1 billion euros ($1.1 billion) amounts to seven times Ebitda, implying that could be about 142 million euros this year. Such a figure would be consistent with the business's reported 542 million euros of revenue of last year, assuming margins are roughly in line with the group's 26 percent.

Burning Out
Solvay has seen Acetow's sales decline 18 percent in two years
Source: Company reports

Suppose the unit can tolerate debt of five times Ebitda, or about 700 million euros, and the required equity check from Blackstone would be only 300 million euros. Even at LBO-style borrowing costs of roughly 6 percent, the annual interest bill would be less than 50 million euros -- very affordable.

Plus Blackstone can doubtless get margins up by running Acetow with more focus. There's also the chance to expand a division of the business that makes a high-performance wood, Accoya, used in window frames and decking. That would require some investment, but it may offer something more sustainable than cigarette ends.

The question is what the exit might be in five years. Another private equity firm may be less interested in buying the business if it thinks Blackstone has extracted all possible efficiencies. Trade buyers may be as unenthusiastic as they were this time to add further concentration to their industry. So an IPO may be the best option. But it's hard see to investors falling over themselves to buy a cigarette ends, especially as rising rates erode the defensive quality of tobacco stocks that has propelled them over the past decade.

Blackstone has its work cut out to build a more durable investment case before it thinks about selling.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Hughes in London at chughes89@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net