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Searching for answers at Yahoo!

by David Carey | Published December 13, 2011 at 9:56 AM

On the face of it, Yahoo! Inc.'s current effort to sell a 20% piece of itself to outside investors makes little sense. And depending on how it used the $4 billion to $5 billion in proceeds, it could harm existing shareholders.

Alas, that would be nothing new for Yahoo!. The capital-raising move follows a decade of disarray for the once-mighty internet giant. It has run through five CEOs in that span, ceding ground to innovative rivals like Google Inc. and Facebook Inc. After the board's indefensible spurning of Microsoft Corp.'s 2008 takeover bid of $33 a share, the stock tumbled into the teens. In September, after Carol Bartz's ouster as CEO, Yahoo! launched a "strategic review" and invited investor offers.

Two weeks ago, at least two groups bid for about a fifth of the company: one, made up of private equity firm Silver Lake, venture shop Andreessen Horowitz and Microsoft, reportedly offered about $16.60 a share; a competing offer from TPG Capital was slightly higher.

Yahoo! won't comment on its aims, but the nature of the proposals affords hints. In selling just a minority, Yahoo!'s leadership slate made up of chairman Roy Bostock and co-founders Jerry Yang and David Filo wouldn't give up control, as their rebuffing of Microsoft's 2008 bid showed they're loath to do. Moreover, a sale of 20% could be accomplished without shareholder approval.

For Yahoo! shareholders, though, the benefits of such a deal are hard to fathom. Not only would the investment dilute their stake, but the new group would pay considerably less per share than the "control premium" that an outright buyer would fork out. Sure, harnessing the wits of Marc Andreessen, a proven tech turnaround ace, could boost Yahoo!, but current stockholders would be paying a lot for such advice.

Dealmakers and bankers who have scrutinized Yahoo! are baffled by the move.

"Yahoo! doesn't need the money; it needs a change in direction," remarks a private equity executive. Says another: "I don't see much value to it. I'm mystified." A top M&A banker adds: "From a corporate finance standpoint, it's certainly not ideal. I think they'll try to dress it up and make it look like a 'strategic deal,' as evidence they are doing something."

Speculation abounds that Yahoo! has a further trick up its sleeve: namely, that it intends to use the investment proceeds, along with dollars raised in the debt markets, to finance a partial stock buyback. This scenario gained currency after a Wall Street Journal report in early November that Yahoo! was shopping a "leveraged recapitalization" idea. Under this plan, Yang and Filo, who together own nearly 10% of Yahoo, would use a buyback to shrink the public float and lift their and their PE allies' combined stake from 30% to more than 40%.

Latching on to the report, hedge fund manager Dan Loeb, a 5.2% owner who has called for Bostock's removal, fired off a letter to Yahoo!'s board in which he charged that the stratagem would only serve to "entrench management and transfer effective control without payment of a premium."

Whether or not that's Yahoo!'s agenda, it's abundantly clear that the investment options it's said to be weighing would not maximize shareholder value. To do so would require a change in ownership, either through a sale of the whole company or the split-off and sale of its constituent parts.

However, doing either would be exceedingly tough. An outright PE takeover of Yahoo!, whose market capitalization surpasses $19 billion, would require more than $10 billion of debt financing, an amount that may be beyond the reach of today's market. An alternative would be splitting Yahoo! into digestible chucks, by hiving off its valuable stakes in Chinese e-commerce company Alibaba Group Holding Inc. and in Yahoo! Japan. Its 40% stake in Alibaba has been valued as high as $14 billion, while its 35% share of Yahoo! Japan is worth several billion.

A split-off poses a major hurdle: because Yahoo!'s cost basis in both is quite low, a conventional sale would saddle it with a massive tax on the gain.

That hasn't deterred deep-pocketed PE players from finding ways to dispose of the holdings in tax-friendly ways, however. According to sources, Blackstone Group LP and Bain Capital LLC are trying to map out a deal with Alibaba and Japan's Softbank Corp., which owns large stakes in both Asian operations. Using a complex strategy known as a "cash-rich split-off," which would blunt the tax impact, the group would acquire Yahoo! outright, then sell the Asian holdings back to Alibaba and Yahoo! Japan's owners, which include Softbank.

That presumably would suit Alibaba CEO Jack Ma, who has been vocal in his desire to buy back Yahoo!'s stake in his company, but getting tax authorities to sign off on the arrangement may be difficult. Until they do, says a source, lining up bank financing for a whole-company takeover won't be possible. "This isn't something that can happen in a super-compressed time frame. It could take months."

Another possibility would be for Alibaba and Softbank to buy the Asian stakes outside the framework of a broader buyout, but that, too, presents major challenges.

However daunting the obstacles, it behooves Bostock and Yang to think outside the box and do right by Yahoo!'s shareholders. If they confine themselves to selling a minority stake to friendly investors -- or worse, push for a buyback to solidify their control -- they will court a shareholder revolt.

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