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Dell Will Issue a Lot of Not-Quite-Stock to Pay for EMC

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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How should you think about Dell's acquisition of VMware? I mean, Dell is acquiring EMC, and that is reasonably straightforward, as these things go. There are oddities, mostly to do with the debt financing of the deal. But, basically, it's a big levered deal, combining "the industry’s leading innovators in digital transformation, software-defined data center, hybrid cloud, converged infrastructure, mobile and security." Fine, sure, makes total sense.

But Dell is also acquiring VMware. Sort of! VMware is a separate public company, but EMC owns about 81 percent of it, and controls about 97 percent of its votes. So by acquiring EMC, Dell is also acquiring control of VMware. But then it is giving 65 percent of VMware back to EMC's shareholders. Again, though: Sort of! It is actually giving them a tracking stock that references VMware. 

The tracking stock will be a publicly registered, exchange-traded, share of common stock in Dell's holding company, which will thereby go public just over two years after going private in a cloud of acrimony. But these shares will not have the same rights as other Dell shares (which are mostly owned by Michael Dell and his private-equity backers at Silver Lake). For one thing, Dell and Silver Lake will have 10 times as many votes per share as the tracking stock, so they will retain firm control of the company. And the tracking shares' economic rights will be based on the performance of VMware, not the rest of Dell/EMC. In particular, Dell can swap the tracking shares for shares of VMware whenever it wants, and if Dell sells its VMware stake, it will give the proceeds to the tracking stock shareholders, though it can choose whether to do that in cash or Dell stock or various other ways.  If you squint, the tracking shares look sort of like the economic equivalent of VMware shares, but you have to squint pretty hard. They're sort of VMware shares filtered through Dell's discretion to do whatever it wants with them. "They’re kind of a ‘trust-me’ security," says one analyst.

But if you do squint, the diagram looks sort of like this :

Why would Dell do this convoluted thing? I think there are two possible answers, which are:

  1. Dell doesn't want VMware, but needs to acquire it as part of the EMC deal, and so is trying to acquire it as little as possible.
  2. Dell does want VMware, but can't acquire it as part of the EMC deal, and so is trying to acquire it as much as possible.

I find that a pleasing opposition, though I suspect that both theories are kind of true.

Theory 1 is that Dell doesn't want to own VMware. On this theory, Dell and EMC belong together, but VMware belongs apart, as its own separate company. I am unable to evaluate that theory because I honestly cannot figure out what any of these companies do. I mean, I'm aware that I have like nine Dell laptops lying around my apartment somewhere. But "digital transformation, software-defined data center, hybrid cloud, converged infrastructure, mobile and security" are all completely beyond me. So Dell does some stuff, and EMC does some stuff, and VMware does some stuff, and clearly it makes sense to someone to combine the Dell stuff with the EMC stuff, but whether the VMware stuff belongs in the same box as the other stuff is an utter mystery to me.

But there is some support for the theory that it belongs in a different box. Most notably: A year ago, Elliott Management, a big EMC shareholder, was pushing EMC to spin off VMware. As Elliott said :

EMC and VMware now compete: Both EMC and VMware have grown and are now competing against one another, confusing customers, employees, Street analysts and shareholders.

Also me, I am also confused.

Anyway, on this theory, the right thing to do would be for Dell to just buy EMC, spin off (some or all of) the VMware stake to EMC's shareholders (as Elliott demanded last year) and keep the rest.

Except that Dell can't actually do that, because the tax bill would be prohibitive. "EMC paid $635 million for VMware in 2004," and the stake is now worth about $24 billion.  If EMC just sold those shares for $24 billion, it would have a tax bill of about $8 billion.  Now EMC could spin off the VMware shares to shareholders without paying those taxes. And EMC could sell itself to Dell without paying those taxes. But it can't do bothIf it does both of those transactions together, or within two years of each other, then the majesty of the tax code says that it has to come up with the $8 billion tax bill. I do not pretend to be able to explain the logic behind this distinction, but here's a footnote anyway. The point is that EMC has to choose, spin-off or merger, and it seems to have chosen merger.

Obviously the tracking stock is sort of convoluted and not popular among VMware shareholders: "The stock's kind of taking a big hit because of the (deal's) stupid structure," says one analyst. But for EMC shareholders, this structure doesn't look all that stupid: It is saving them $8 billion of corporate taxes. In some ways, the VMware tracking stock is analogous to Yahoo's Aabaco spin-off: EMC (Yahoo) could just give its VMware (Alibaba) shares to its shareholders directly, but doing it in a convoluted way saves, or at least defers, billions of dollars of taxes.  When you think about it, Aabaco is kind of a tracking stock for Alibaba.

So that's Theory 1: EMC shareholders want a VMware spinoff, and Dell wants to give it to them, but the tax code requires that VMware be spun off only in virtual, tracking-stock form. 

Theory 2, on the other hand, is that Dell wants to own VMware and is only reluctantly giving part of its equity back to the public. Why would it do that? One possible reason -- call it Theory 2(a) -- is that EMC shareholders really want to keep the upside in VMware and are unwilling to sell it to Dell for cash. Dell wants VMware, EMC shareholders want VMware, and the only way to bridge the gap is to give some of VMware to Dell and the rest to the shareholders.

This theory has some obvious evidence for it. In particular, Elliott, the activist shareholder that owns 2.2 percent of EMC, wanted to keep its exposure to VMware, and presumably the tracking stock will help win its support. From Elliott's statement:

Elliott is pleased to participate in VMware’s ongoing upside through the tracking stock, which will benefit from both meaningful synergies as part of Dell’s organization as well as far greater liquidity than VMware shares have today.

The tracking stock also has another, sillier gap-bridging function. The deal announcement assumed, "for illustrative purposes, a valuation for each share of tracking stock of $81.78, the intraday volume-weighted average price for VMware on Wednesday, October 7, 2015," to get to the headline deal price of $33.15 per EMC share. Of course, by the time of the announcement VMWare's stock was no longer at $81.78, and since the announcement it's fallen to $69.31, giving a deal value of about $31.74. But even that overstates the deal value, since there's no reason to assume that one share of tracking stock is worth as much as one share of actual VMware stock. With low voting rights and no direct claim on the VMware assets, it will probably trade at a discount. "We think that the tracking stock will trade at a 5 to 10 percent discount," says one analyst, and that honestly seems kind of generous.  Still: Dell gets to pay for part of the deal with a currency that it can, for headline purposes, plausibly overvalue. 

The other reason that Dell might be willing to part with some of VMware -- call it Theory 2(b) -- is that it can't afford to buy all of it. That is: Dell is buying EMC, a company that, including its VMware stake, is worth about $67 billion.  Dell's shareholders are putting up about $4 billion to do that.  Four billion dollars is not a lot to pay for a $67 billion company! Most of the rest of the money will come from "almost $50 billion in debt," and that is a lot of debt for a $67 billion company. It's so much debt that "EMC’s board continued to have questions about whether Dell and Silver Lake could afford a deal," so much debt that Jamie Dimon himself "showed up at an EMC board meeting around Labor Day to assure the company that Dell would get the financing it needed to complete an acquisition." 

When you have Jamie Dimon showing up in person to promise that a deal can get financed, that probably means that financing the deal is at the very outer limit of human achievement. But notice that $50 billion plus $4 billion does not equal $67 billion: Even after raising as much debt as could possibly be raised by humans, Dell still can't afford EMC. It still needs to come up with more than $13 billion from somewhere. And that somewhere is, more or less, EMC's shareholders, who are providing about $15 billion of equity financing -- about four times as much as Dell's private shareholders! -- by taking the VMware tracking stock.

This is of course common in mergers: When an acquirer can't afford to pay for a target in cash, it will often issue stock to pay for part of the purchase price. But Dell is oddly placed to do that, not only because it is not a public company and so doesn't have public stock to issue, but also because its whole strategy over the last two years has been more or less focused on avoiding public stockholders. "Privatization has unleashed the passion of our team members who have the freedom to focus first on innovating for customers in a way that was not always possible when striving to meet the quarterly demands of Wall Street," Michael Dell wrote last year

So the tracking stock is a perfect instrument. It does not exist currently as a public stock, but it references VMware, which is publicly traded, so it has a reasonably plausible public comparable to anchor its value and make it useful as a financing tool. It gives away only some of Dell's upside, with most of the company's earnings still belonging to Dell's very leveraged private-equity investors. It has limited voting rights, and pretty limited rights generally.  

Here is how Dell chief financial officer Tom Sweet described the tracking stock:

The combination of EMC and Dell, while maintaining a tracking start from VMware will make the company more competitive and enable to make investments for the long term. Unencumbered by the short term orientation of the public markets.

More along those lines:

The combination of Dell and EMC will create the world’s largest privately controlled, integrated technology company, the companies said. The structure of the deal, meanwhile, will "enable the business to make long-term investments without the pressure of quarterly results," said Egon Durban, a managing partner with investor Silver Lake, in a conference call Monday morning.

But of course New Dell will be a public company, with billions of dollars of publicly traded stock. It's just that that stock will be a weird second-class stock, with no real voting power and no claim on the bulk of the company's business. It is public stock for a company that doesn't like public stockholders, a company that will be publicly traded but will nonetheless remain free from the tyranny of quarterly results (and shareholder accountability). If Dell is going to return, reluctantly and by necessity, to the public stock markets, this is pretty much the perfect way to do it.

  1. Honestly, if you give up change of control protections for a little extra yield, this is what happens to you.

  2. The appraisal litigation isn't even over!

  3. See Sections 5.2(h) (voting), 5.2(m)(1) (exchange) and 5.2(m)(3) (sale of VMware) of the form of Fourth Amended and Restated Certificate of Incorporation of Denali Holding Inc. for these terms. Other documents related to the tracking stock:

    A by-law section protecting the tracking-stock shareholders.

    A "Tracking Stock Policy" for the board to consider.

    The merger agreement.

  4. Two notes:

    • For "Dell" read "Denali Holding," the Dell parent company, though I assume no one calls it that.
    • I say "(0% vote)" for the former EMC shareholders because they have no voting rights in VMware: Dell will own all of EMC's stake in VMware, and will be able to vote it however it wants. But the former EMC shareholders will have some voting rights in Dell (technically, Denali Holding), though the Michael Dell/Silver Lake shareholders will have 10 times as many votes relative to their economic interests.
  5. I mean, not, like, "mobile." I know what "mobile" is. I have an iPhone. But I'm pretty sure Dell didn't make it?

  6. Read the whole thing; there's a lot about "The Federation" and "EMC II." It's a strange company.

  7. That is, EMC owns about 43 million Class A and 300 million Class B VMware shares, out of totals of about 122 million and (exactly) 300 million, respectively. (The high-vote Class B shares don't trade.) Treating each share as being worth $69.31, today's Class A closing price, you get EMC's stake worth about $23.8 billion out of VMware's $29.3 billion total market cap.

  8. That is, $23.8 billion minus $635 million times a 35 percent top corporate tax rate

  9. Which it is doing! And Dell then keeps EMC's basis in the stock. See Section 5.21 of the merger agreement, which calls for the deal "to qualify as an exchange described in Section 351 of the Code." No gain or loss is recognized in a Section 351 exchange. 

  10. This comes from the "anti-Morris Trust rule," which forbids combining tax-free spinoffs with acquisitions of the parent or the spun-off company. Here's a summary:

    Specifically, under Section 355(e), known as the anti-Morris Trust rule, a corporation that distributes stock of a subsidiary to its shareholders in an otherwise tax-free spin-off recognizes a taxable gain if 50% or more of the vote or value of either the distributing corporation's stock or stock of the spun subsidiary is acquired as part of a plan that includes the spin-off. Section 355(e) considers such an acquisition occurring 2 years before or after the spin-off as "part of a plan". However, if it can be demonstrated that the acquisition and spin-off were not part of a plan, no such tax will be imposed.

    Here is Section 355(e). "Reduced to simpler terms, it prevents a spinoff or similar distribution from helping fund an acquisition," which is in effect what is going on here. 

  11. I don't know. I am inclined to attribute a part of the hit to merger arbitrage trading -- long EMC, short VMware, to capture the cash value of Dell's bid -- which would be true even in a total spinoff.

  12. One big difference is that EMC, unlike Yahoo, could spin off its VMware shares without a tax hit, because EMC controls at least 80 percent of VMware, unlike Yahoo, which controls only a minority of Alibaba. "Under Section 355, the parent must distribute 'control' of the spin-off company (generally, stock representing 80% of the voting power and 80% of each non-voting class of stock)" to qualify as a tax-free spinoff, so EMC, which has "control" of VMware, can qualify but Yahoo can't. EMC is blocked from doing a tax-free spin in connection with a merger, while Yahoo is blocked from doing one generally. ISN'T THIS STUFF GREAT?

  13. A related fact is that there's that other 19 percent of VMware that is held by VMware's own shareholders, outside of EMC. If Dell wanted 100 percent of the company, it would need to negotiate two mergers with related companies at the same time. Oy, the conflicts of interest! Oy, the lawsuits!

  14. Incidentally, note that Elliott now thinks that there will be "meaningful synergies" from the Dell/EMC/VMware combination, as opposed to the dis-synergies in the EMC/VMware combination that it complained about last year.

  15. For one thing, they're not tax equivalent, and you might worry about taxes on a near-term exchange of the tracking stock for VMware shares.

    For another thing, I mean, some dumb math:

    • EMC closed today at $27.55.
    • Dell's cash bid is $24.05.
    • At a zero discount rate, that values the tracking stock at $3.50 per EMC share, or $31.53 ($3.50 divided by 0.111) per VMware share.
    • So that's like a 55 percent discount!
    • Though obviously don't use a zero discount rate, there is closing risk, etc.

    Here is another five-to-10-percent estimate.

  16. That number is from the merger announcement and is probably lower based on today's stock prices, but close enough.

  17. I am actually not completely sure about the equity financing. Bloomberg cites "people with knowledge of the matter":

    As part of the $67 billion agreement announced Monday, Dell will also contribute about $3 billion in equity and Silver Lake Management, a co-owner, will put in about $1 billion, said the people, who asked not to be identified because the information is private.

    The deal announcement also includes new equity from Temasek, though Temasek is not mentioned as a financing source in the merger agreement (see Section 3.02(g)). But I figure about $4 billion from Dell equity investors is the right ballpark number.

  18. Note that the "almost $50 billion" includes some refinancing of existing Dell debt, so the actual need from EMC shareholders is more than $13 billion. My math is just 65 percent of EMC's $23.8 billion VMware stake, valued at today's closing price, is worth $15.4 billion. If you value it based on the $81.78 per share that Dell uses, you get about $18.2 billion.

  19. And a "corporate opportunities" policy that basically says Dell is free to take any VMware opportunities for the non-tracking shareholders.

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

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net