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Go On, Give That Man in the Suit a Guitar

Wall Street Journal, 09.14.02
Martin Peers and Jennifer Ordonez

Ailing Music Industry May Have Rescuers in Investment Bankers

Saviors have emerged from nowhere to transform the music industry before -- Elvis, the Beatles, the inventor of the compact disc. Now, with the business hitting its lowest note in years, it may be investment bankers' turn.

The industry's blues are deep: including digital downloads and other forms of music piracy, increasingly narrow radio play lists and album sales that so far this year are down 11%. This year is likely to trump 2001 as the most dismal for music sales in a decade. Executives say they aren't expecting things to get better soon.

But all this spells opportunity to some Wall Street deal makers. At least three of the five big music companies could potentially be put in play as takeover candidates in the next year: Vivendi Universal's Universal Music Group, EMI Group PLC and Bertelsmann AG's BMG.

At the same time, the regulatory climate may be warming toward a deal. Attempts by EMI in the past couple of years to merge with both BMG and AOL Time Warner Inc.'s Warner Music were stymied by regulatory opposition in Europe. But in recent months, there have been signs that European regulators may be loosening their tough stance against mergers. The attitude of U.S. regulators, no pushovers themselves, remains uncertain.

While cobbling together deals with rival music companies is still a long shot -- many of the big media companies are strapped for cash -- the private-equity firms such as leveraged-buyout players are another option. Despite the problems bedeviling the music companies, they continue to generate rich cash flow -- a big attraction for private-equity firms that rely on debt to fund acquisitions.

Blackstone Group already has put a toe in the water by buying Columbia House, the music club, from AOL Time Warner and Sony Corp. earlier this year. In recent weeks, various private-equity firms, including Kohlberg Kravis Roberts & Co. and Thomas H. Lee Partners, met with Edgar Bronfman Jr., vice chairman of Vivendi, to discuss a possible buyout of Universal Music. Representatives of both KKR and Thomas H. Lee declined to comment.

Talks so far have cooled, but the restructuring of Vivendi has a long way to go. And former BMG Chief Executive Strauss Zelnick, who last year took control of a Japanese music company with backing from a private-equity firm, Ripplewood Holdings, is on the prowl for acquisitions in the U.S. or Europe.

"This is a terrific time to invest," says Mr. Zelnick. "It's still a $36 billion world-wide market." Although the absence of big hit records has kept buyers out of stores, hurting sales of older albums as well as newer releases, Mr. Zelnick says he believes piracy eventually will be tamed and that when big new stars appear, sales will rebound.

"It's a good investment," says Thomas D. Mottola, chairman and chief executive of Sony Corp.'s Sony Music Entertainment: "Anyone with half a brain can see this is a giant opportunity."

But it isn't without risks. "The problem is that it's the kind of investment that if it doesn't work out it's not that you have disappointing returns -- it's that you have no returns," says Jonathan Nelson, president of Providence Equity Partners, a Rhode Island private-equity firm that invests in the media and communications industry. "On the other hand if an investor can figure out how these issues will be resolved, it could be an opportune time to invest in the music business."

Wall Street executives say a range of private-equity firms are taking a look at the industry, despite wariness about its prospects. "We are thinking about it," says an executive at one firm, noting that persuading banks to lend money for a music deal could still be a difficult proposition. Indeed, an industry veteran who has talked with several firms about the industry says interest is "real, but it's thin ... It's very situation-[specific] and management-specific."

At the top of everyone's shopping list is Universal Music, considered the most attractive because it has the biggest market share by far, nearly 30% in the U.S. Several weeks ago, as Vivendi was trying to arrange bank financing to avoid a cash crisis, Vivendi's Mr. Bronfman met with numerous private-equity firms to try to line up backing for the purchase of Universal Music, say people familiar with the situation. Mr. Bronfman found a receptive audience, but he didn't pursue a deal.

Mr. Bronfman initiated the talks to ensure Vivendi had an alternative if it couldn't easily resolve its financial problems, says a person familiar with the situation. In the end, Vivendi resolved its immediate financial crisis with a new credit line, and Vivendi's new chairman, Jean-Rene Fourtou, has reckoned that music is more valuable if kept together with the company's film and television properties, say people familiar with the situation.

But Mr. Fourtou's attitude may reflect pessimism about the price Universal Music would fetch. Industry executives say private-equity firms will likely pay between $6 billion and $7 billion for the firm, well below what the former Seagram Co. paid for the assets before Seagram was acquired by Vivendi.

The situation could still change, however. Vivendi is expected to create a new entertainment arm that it will take public, likely headed by Barry Diller, the media power broker who oversees most of Vivendi's entertainment businesses already. But Mr. Diller is lukewarm about whether to include Universal Music in the new company, say people close to the situation. Given the size of the music business, including it in a bigger company would likely depress the company's stock-market valuation. Still, if someone lobbed in a $10 billion bid, Vivendi probably would sell, say industry executives. Vivendi declined to comment.

Other possible deals could involve Bertelsmann's BMG and EMI. Bertelsmann's chief executive, Gunter Thielen, has committed the company to keeping BMG and even expanding it. But he is sticking with Bertelsmann's insistence that BMG lift its profit margins. One industry executive says Bertelsmann could still decide to get out of music. But BMG has some awkward baggage: It has to spend more than $2 billion for independent company Zomba, a deal forced on Bertelsmann as a result of an option held by Zomba's controlling shareholder, Clive Calder. Unfortunately for Bertelsmann, Mr. Calder exercised the option as Zomba's performance was declining. Some in the industry expect consolidation among BMG's labels once the Zomba deal is resolved. BMG declined to comment.

As for EMI, companies such as AOL have never given up hope of renewing past deals. AOL Chief Executive Richard Parsons recently indicated his continuing interest if a deal could be found. The 2000 proposed merger of Warner Music and EMI's music businesses shelved by regulatory opposition involved the payment of about $1 billion by AOL for control of the combined music operations. Right now AOL is looking to reduce debt and likely wouldn't want to do any deal that involved any significant spending.

Still, industry executives continue to ponder various possibilities for EMI, including a leveraged-buyout firm buying its Virgin Records label at least in Europe, where it is very big, making acquisition of the rest of EMI easier for companies like Warner. EMI declined to comment. But the specter of the Internet still looms. "The music industry has got to resolve the piracy issue," says Joseph Ravitch, a senior media banker at Goldman Sachs Group Inc. "Until that happens, the economics of the business will be very uncertain."