Facing the Music: When corporate restructuring leads to disappointing returns

The Thomas H. Lee Buyout of Warner Music

In her 2003 Grammy Award-winning song, “Cry,” Warner Music artist Faith Hill asked if her partner could “pretend that he was feeling some pain.” Nine months later, Warner employees were getting a preview of the pain that was going to come with the private equity buyout of their employer. “ Despite my personal fondness for the music business as well as for all of our wonderful managers and music group employees,” said the Time Warner CEO Dick Parsons, “I believe that this transaction is clearly in the best interests of our company's shareholders. ”

Paying $2.6 billion, just more than half of which was debt, a group led by the buyout firm Thomas H. Lee and including Bain Capital, needed to quickly find ways to cut expenses to cover the high cost of their deal, which closed in February 2004. Their plans for cost-cutting quickly became clear: consolidating divisions, laying off 20 percent of the workforce (1,000 employees), and ending contracts with nearly half of the artists on its roster. As a result of the cuts, Warner shaved $240 million off its expenses and reduced net losses for the year, although it was still losing more than $100 million a year.

Despite these losses, the private equity group quickly recouped some of its investment. In September of 2004 Warner Music returned $342 million to the investors and paid a dividend of $8 million on their preferred equity taken from existing cash. Two months later, the company took out a $700 million loan, financed with CCC+ junk bonds, of which $681 million was used to pay additional dividends to the investors and repurchase a significant portion of their common stock. At the same time, Warner Music faced a succession of subpoenas from then-New York Attorney General Elliott Spitzer as part of his investigation of payola schemes. Spitzer’s investigation led Warner Music to reach a settlement, in which it agreed to stop giving financial incentives and promotional items to radio stations and their employees in exchange for airtime. As part of the settlement, Warner Music admitted the payoffs were improper, and agreed to abide by a higher standard.

The next spring, 18 months after the buyout, Warner announced it was making an initial public offering, hoping to raise $750 million. Analysts and potential shareholders were underwhelmed by the offering; the offering range of $22–$24 per share ended up selling for just $16.40 per share. Some may have had little confidence in the long-term benefit of the quick cost-cutting by management, others may have been put-off by revelations in the initial filing that management had not fully addressed all the accounting problems identified when the company first went private. Public investors’ concerns have been borne out, as after nearly two years, the stock is still trading for virtually the same price at which the shares were offered in the IPO, during a period when the S&P 500 has gained more than 20 percent. According to an article in Forbes, the buyout partners made $3.2 billion on a $1.3 billion outlay in just a little more than a year—on a company that was losing money, and its good reputation.