Buyout Pacts That Backfire

Fixed prices to end joint ventures looked smart in the '90s. Now...Ouch!

Don Burrell was laughing all the way to the bank. Three months ago, he sold Burrell Colour Inc. in Crown Point, Ind., to Eastman Kodak Co. (EK ) for $62 million in cash. The imaging giant didn't have any choice: When Kodak teamed up with Burrell in 1999, it gave him the option to sell his share of the joint venture to Kodak at a fixed price. Now, Kodak is looking to unload the business and could lose money on it. "We don't want to own that," says Robert H. Brust, who joined Kodak as chief financial officer in 2000. "I have no idea why that was negotiated."

Brust got off lightly, but many of his peers are stuck with far bigger bills as they're forced to honor the costly corporate prenups they signed in happier days. Because the buyers don't control the timing of their divorce, the impact can be devastating. For instance, even though AOL Time Warner Inc. (AOL ) was drowning in red ink 18 months ago, it had to pay German media giant Bertelsmann $6.75 billion for its half-share in AOL Europe -- four times the unit's estimated value today. Bertelsmann made the same mistake: Last year, it took a $1.3 billion write-down of Zomba Records, Britney Spears's record company, which it had to buy out. And General Motors Corp. (GM ) is trying to wriggle out of a potentially disastrous deal that could compel it to swallow the 80% of Italy's tottering Fiat Auto that GM doesn't own -- along with its mountain of debt.

How did smart corporate execs get themselves into such jams? Think back to the late '90s, when companies were scurrying to grab a piece of what seemed to be promising growth markets, sometimes far from home. Savvy partners were only too glad to sign up -- in return for the right to sell out at some future date. The big boys agreed to the deals because they figured business would still be booming when it came time to pay. "A lot of negotiations looked at how things would play out on the upside," says Colin Blaydon, a management professor at the Amos Tuck School of Business Administration at Dartmouth College. "People didn't expect [the worst] to happen."

But it did, leaving companies scrambling to renegotiate deals, raise funds to honor them, or both. Under a 2000 agreement, troubled German insurance giant Allianz could have been forced to fork over around $2 billion on Mar. 31 to buy the 30% of the former PIMCO Advisors LP that it doesn't own from Pacific Life Insurance Co. Although the joint venture is thriving, Allianz (AZ ) could ill afford such a balloon payment because many of its other businesses have been pummeled by the stock market's dive. On Mar. 10, it renegotiated so that it could pay on the installment plan. Pacific Life can demand only $250 million a quarter for the next year, and the rest in a lump sum after that. Pacific Life says that, for now, it doesn't plan to sell.

Despite the pitfalls, joint ventures aren't about to disappear. In fact, they may become more popular because the alternatives -- mergers, acquisitions, or building from scratch -- are usually less successful. About 45% of joint ventures do work, says Harbir Singh, a management professor at the Wharton School. On the other hand, only a third of large mergers add shareholder value, according to a study by BusinessWeek and Boston Consulting Group last year.

Still, JV investors will bargain harder to make sure they're not left holding the bag. Already, more flexible contracts are being negotiated that spread the risk in the event of a breakup. Bankers cite some deals as good models, such as the one between Liberty Media (L ) and Comcast (CMCSK ) for their joint ownership of shopping channel QVC, and the News Corp. (NWS ) and Cablevision Systems (CVC ) joint ownership of regional Fox sports channels around the U.S. These pacts avoid traps such as fixed or minimum buyout prices, short payment periods, and strict payment options, such as cash only. "The best agreements try to avoid giving one party a loaded gun to point at the other," says Paul J. Taubman, a managing director at Morgan Stanley.

Bad deals can feel like a stickup. In the early '90s, phone giant AT&T (T ) began investing in a new Canadian long-distance company as the local market began opening to competition. By 1999, it owned 31% of the company, now called AT&T Canada, and planned to pick up the rest once the government lifted its 33% limit on foreign ownership. AT&T agreed to pay shareholders a price that would rise 4% a quarter starting in the third quarter of 2000. But Ottawa didn't lift the restrictions until 2002. By then, AT&T had taken on billions of debt in a rash of U.S. cable-TV acquisitions. It decided to buy the rest of AT&T Canada for $3.4 billion last year rather than wait as the price escalated, even as the company's value sank. So AT&T raised $2.25 billion in a stock offering in June, 2002 -- when its own shares were at an 11-year low and worth an eighth of what they had been at the time of the original deal. It borrowed to finance the rest. AT&T declines to comment.

GM's predicament may turn out to be even worse. In early 2000, it paid $2.4 billion for 20% of Fiat Auto. GM also gave Fiat Auto's parent, Fiat, the right to sell the rest to GM at the then market value in January, 2004. Already, GM has written off $2.2 billion of its initial payment. Bankers say Fiat Auto is in such a mess that not only is it worth almost nothing but would cost $5 billion to fix. Now, GM is dickering with Fiat and its bankers. One idea: GM would buy some of Fiat Auto's healthy operations, such as its sporty Alfa Romeo brand, at a premium for, say, $1 billion to get Fiat to drop its option. Says one banker: "GM is scared to death of Fiat." GM won't comment.

Of course, some deals can turn out well for the buyer -- if it can afford to pay. Verizon Communications (VZ ) and Vodafone Group PLC (VOD ), Europe's big telecom carrier, joined forces in 2000 to create Verizon Wireless, now the leading U.S. cellular carrier, with Vodafone taking a 45% stake. In June, Vodafone can start selling its share at market value for up to $10 billion and resume in 2005 until $20 billion-worth is sold. The entire stake is now worth about $28 billion, according to analyst Jeffrey Halpern at Sanford C. Bernstein & Co.

So far, Vodafone says it doesn't plan to sell -- but if it changes its mind, Verizon could be in a fix. It might have to pile on more debt (already heavy at nearly double its operating earnings), issue shares, or take Verizon Wireless public in a weak market. "This is a huge problem for Verizon," says Tim Horan, an analyst at CIBC World Markets. Verizon says it has the "financial flexibility" to buy the stake and "would be entirely comfortable" if Vodafone wants to sell.

And while Kodak may lose money on Burrell, it is gladly buying back a $100 million stake in Kodak China Co. from its Chinese partners. Says Brust: "It's a large, profitable venture for us." That's something too few joint-venture partners can still say.

By Faith Keenan in Boston, with David Welch in Detroit, Jane Black in New York, and David Fairlamb in Frankfurt

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