Monday 23 October 2017

Two deals too far

From Riverdeep to mountain high, he's seen it all. But can he survive his toughest challenge?

This week's news of a major financial restructuring at EMPG, which will see existing shareholders virtually wiped out, confirms suspicions that boss Barry O'Callaghan massively overpaid for acquisitions in 2006 and 2007.

Wednesday's statement by EMPG, revealing that it was in discussions with its bankers, to whom it owes at least $6.6bn (e4.5bn -- EMPG reports its results in US dollars), about a possible financial restructuring will have confirmed its shareholders' worst fears.

Despite the honeyed words about "putting the business on a sound financial footing", the news for EMPG shareholders is grim. In essence, the firm's creditors are taking control of the company.

While the good news is that the restructuring ensures EMPG's survival -- with its debts falling to about $2.5bn from a peak of $8bn and an additional $600m-$700m of fresh capital being injected into the company -- the bad news is that the existing shareholders, including O'Callaghan who has a 20.5pc stake in the company, will be wiped out.

This week's debacle marks the first serious setback for O'Callaghan, who has up to now been the golden boy of Irish business. In his more than 10 years in charge of EMPG, he transformed a small Irish software company into the world's biggest publisher of educational material.


Still only 40, O'Callaghan hails from Mitchelstown in north Co Cork.

The son of the local doctor, he was educated at the Jesuit-run Clongowes, the super-elite school which has also produced Ryanair boss Michael O'Leary and former Taoiseach John Bruton.

After Clongowes he studied law at Trinity. After graduating he moved to London and worked for a number of investment banks including Morgan Stanley, Smith Barney and Credit Suisse First Boston (CSFB). It was while he was with CSFB that the young O'Callaghan caught the eye of Pat McDonagh, Ireland's most successful software entrepreneur.

In 1995 McDonagh had founded his latest software company Riverdeep and, four years later, was looking to float the company on the NASDAQ market.

McDonagh appointed O'Callaghan, who had yet to reach his 30th birthday, chief executive of Riverdeep in advance of the flotation. With the internet share mania approaching its peak, Riverdeep initially did very well, with the company's share price trebling on the first day's trading in March 2000.

Unfortunately that was about as good as it got. The internet bubble burst shortly after flotation and by the end of 2000 the Riverdeep share price was down more than 60pc from its peak.

While the timing of the Riverdeep flotation might have been a tad unfortunate, the timing of O'Callaghan's next move was spot on. With the shares languishing below the flotation price, he and McDonagh took the company private for just $349m in 2003. O'Callaghan called the bottom of the market brilliantly. Three years later Riverdeep was valued at €1.2bn.

Unfortunately, while the timing of the take-private may have been impeccable, the same couldn't be said about his next two deals. In October 2006, O'Callaghan agreed to pay $3.4bn for US publisher Houghton Mifflin.

Double or quits

Less than a year later, he went double or quits and acquired another US publisher, Harcourt Education, from Reed Elsevier for a further $4bn.

Not alone was the timing of these two deals highly suspect, the fact that O'Callaghan chose to fund them largely through debt, with EMPG's (as Riverdeep had been renamed after the Harcourt takeover) borrowings peaking at a massive $8bn.

The attraction of using such high levels of debt is that even a small increase in EMPG's value would benefit the shareholders, chief among them O'Callaghan with a then 38pc stake, disproportionately.

However, in fairness to O'Callaghan, he did put his money where his mouth was, investing an estimated $200m in the company in 2006. Other Irish investors in EMPG were private clients of Davy Stockbrokers, who ponied up a total of €170m in 2006 and 2007.

Within a month of the announcement of the Harcourt deal in July 2007, the credit crunch struck.

Suddenly leverage didn't seem so smart any more. According to O'Callaghan, EMPG's value, including its debts, has halved over the past two years.

With the company borrowings having made up almost 90pc enterprise value (debt plus equity) at the top of the market, this leaves the lenders facing a nasty write-down and completely wipes out the shareholders.

Even before the onset of the credit crunch, there were clear signs that not everyone agreed with the path O'Callaghan had mapped out for the company.

In 2006, McDonagh, who had already taken €45m out of the company in 2005, sold his shareholding to O'Callaghan for over €95m.

While O'Callaghan is adamant that McDonagh's departure from the company was amicable and that the two men remain friends, the sight of a canny investor like McDonagh taking his money off the table, should have served as a warning signal.

Another warning sign was the decision of Riverdeep's then auditors, Ernst & Young, to resign in February 2007, alleging that the company had made "incorrect representations" about a "material contract".

While O'Callaghan responded by stating that the disputed contract had resulted in an "immaterial adjustment" to its results, the resignation of an auditor rarely bodes well for a company.

Within two years of the Harcourt takeover, with the credit crunch showing no sign of easing, EMPG was forced to restructure its debts in mid-2009. It persuaded its lenders to convert $1bn of borrowings into equity. This diluted the existing shareholders by about 45pc, reducing O'Callaghan's shareholding to 20.5pc.

Harsh and all as the 2009 haircut was for shareholders, it quickly became obvious that it wasn't enough. Reed Elsevier, which had received $300m of EMPG shares as part of the Harcourt deal in 2007, announced that it was writing down their value by 95pc.

So where do EMPG and O'Callaghan go from here? While O'Callaghan has been at pains to stress that the company is still trading well, it is widely believed that its 2009 earnings before interest, taxation, depreciation and amortisation, were down on 2008's $750m figure.

Will the new owners keep the company together or will they attempt to sell it off piecemeal? Even if they decide to stick with the house O'Callaghan built, will they retain the Corkman's services? He has, after all, cost them serious money.

In the short term, O'Callaghan is probably safe. John Paulson, the hedge fund manager who made several billion dollars betting that US house prices would fall, is one of the largest holders of EMPG bonds. He was positively gushing about O'Callaghan this week, speaking of his "great admiration" for him and his management team.

Counting against O'Callaghan is the widespread feeling that the former corporate financier is better at assembling companies than actually running them. Speaking of the Houghton Mifflin deal in 2006 he described it as "too good an opportunity to miss". Those EMPG shareholders who have now lost their entire investment might beg to differ.

The new owners of EMPG need O'Callaghan to ensure a smooth transition.

After that his future looks a lot less certain. With Paulson now calling the shots at EMPG, don't be surprised if, after a suitably decent interval, O'Callaghan moves on from the company he created.

Irish Independent

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