Finally Private Equity won the battle for Avaya

On Monday, private-equity firms Silver Lake and TPG Capital agreed to pay $17.50 in cash for each share of Basking Ridge, N.J.-based Avaya. The buyout represents a 28% premium above Avaya's closing price of $13.67 on May 25, the last day prior to initial reports about a potential sale. Other companies in the telecommunications-equipment industry, such as Cisco and Nortel, also showed an interest in acquiring Avaya, but the high price offered by TPG and Silver Lake pushed them to the sidelines. Analysts say those companies might eventually renew interest if TPG and Silver Lake succeed in making Avaya more profitable.

By going private, Avaya executives say they'll be able to move faster to improve the company and worry less about meeting the short-term concerns of public investors. Yet the acquisition does nothing to diminish competition in what's a very tough market. Avaya has been battling Cisco Systems Inc. for the right to supply corporate customers with Internet-based phone systems. Other major rivals include Nortel Networks Corp. and Siemens.

So, what did Silver Lake and TPG see in Avaya that was so attractive? If they can work their financial and operational magic again, the equity firms should be able to reinvigorate the company and perhaps resell it at a profit. However, such a process could take three years or longer. Avaya’s business is very complicated to manage, that’s why equity firms have asked senior management to stay on to run the company. But there will have to do some tough restructuring.

First, the new owners have to fix Avaya's lower margin and less predictable service business and reduce the company's 20,000-strong workforce, even though no major layoffs are expected. Secondly, Avaya has to continue to invest significantly to retain its leadership in the corporate phone market. Actually, competition is intensifying in this space as a lot of players are trying to get into it. Aside from operational issues, Avaya and its new owners need to figure out how to generate faster sales growth, boost market share and improve mid-single-digit profit margins. Stronger growth is expected because of an anticipated global upgrade cycle. Corporations want to combine separate phone and data networks into one system to trim costs and take advantage of the new features offered by Internet technology. Let’s see whether management is up and around for the monumental challenge.

Avaya: The Next M&A Target

The telecommunications company Avaya Inc. is in negotiations to sell a part or all of itself, in what may be the latest round of deal making in its industry. Among those interested are two rivals — Cisco Systems and Nortel Networks — and the equity buyout firm Silver Lake Partners. Avaya, based in Basking Ridge, N.J. and valued at $6.1 billion, has retained the investment bank Credit Suisse as an adviser. The company, the one-time business communications arm of Lucent Technologies, and before that AT&T, is one of the nation’s top makers of phone equipment, rivaling Cisco, Nortel and Alcatel-Lucent in providing Internet-based communications to corporations.

Of course, this is not a surprise. The telecommunications sector has proved mature for deals recently. Actually, there should be more consolidation in the telecom-equipment industry. The massive consolidation among telecom carriers in the last few years have left telecom-equipment space too crowded, with too many vendors chasing after too few deals. Smaller equipment makers such as Avaya have to do their own deals to compete with their bigger rivals. Last year, telecom equipment manufacturers Alcatel and Lucent merged in an $11.6 billion transaction. In addition, Western equipment makers are facing pressure from low-cost Asian manufacturers, as well as the growing size and purchasing power of a few large phone companies.

Why Avaya is an ideal target for private-equity firms? The company has $829Million in cash and no debt; it generates strong and stable cash flows combined with increasing profit margins. The company provides equipment that moves traditional phone systems onto integrated IP network platforms that provide voice, email, conference, IM and video communications. About half Avaya's revenue is derived from long-term service contracts, which ensures even more recurring cash flows.

So, why Nortel? First, a Nortel-Avaya deal would be consistent with Nortel’s strategy of increasing focus on enterprise and professional services. In a research report, UBS analyst Nikos Theosopoulos said buying Avaya would give Nortel 30% of the enterprise voice market, as well as more scale in the services business. However, I’m not sure Nortel is ready for such a big move. Despite the progress made by CEO Mike Zafirovski in restructuring the company, there is still plenty of more work to be done and operating costs to be reduced. An acquisition would definitely complicate the situation. On the other hand, Nortel has no choice but to move forward with the deal in order to compete with bigger equipment maker providers, such as Cisco Systems, Inc.

The way I see this potential deal is quite simple. Another big wave of consolidation is around the corner in the telecommunications industry. It doesn’t really matter if buyers will be private-equity firms or competitors. It is just the inevitable path for an industry that is becoming more mature.