NY Times: Battle of the Bands: Citigroup Is Up Next

Published: February 6, 2010

AFTER the Grammy Awards last Sunday, the stars came out for EMI’s party at the W Hollywood Hotel. The country music hunk Keith Urban arrived with his wife, Nicole Kidman. Katy (“I Kissed a Girl”) Perry sparkled in a form-fitting dress that would become gossip fodder on the Internet. There were also rappers (Cypress Hill), guitar heroes (Slash and Dave Navarro) and a coffeehouse darling (Norah Jones).

The chief executive of Terra Firma, Guy Hands, whose acquisition of EMI prior to the credit bust has been costly.

There was one person, however, whose absence was conspicuous at the soirée: Guy Hands, the chairman of Terra Firma, the British private equity firm that bought EMI, the music publishing and recording company, for what it now says was $8 billion at the peak of the credit bubble in 2007.

Mr. Hands was once a mainstay at such glitzy affairs, happy to pose for pictures with the likes of Ms. Perry. Now, he is less eager to be seen at those events because, by his own acknowledgment, the EMI acquisition has been a disaster for his firm and his investors.

As soon as Terra Firma took control, Mr. Hands spoke publicly about the need to drastically reduce artist advances at EMI and immediately alienated some of the storied company’s most famous acts. Radiohead and the Rolling Stones departed. Lily Allen, a major star in England, told the British press, “I hate Terra Firma.”

“I don’t think he appreciated how sensitive and unpredictable artists can be,” says Bill Werde, editorial director of Billboard. “It seemed to me at the time that he looked at artists like just another asset — like the company’s distribution channel or its music publishing company.”

But the real clash has been between Mr. Hands and Citigroup, the bank that financed the EMI acquisition and many other Terra Firma deals. Terra Firma used only $3 billion of its investors’ cash to buy the music company; it borrowed the remaining $5.2 billion from Citi. Why was Terra Firma’s lender so generous? The bank thought it could later offload this debt by selling it in smaller chunks to other investors.

Then reality intruded. Before the deal closed in August 2007, the credit market froze — leaving Citi holding a vast bag of debt that it designated as “substandard.” The transaction offered yet another example of the kind of promiscuous lending that forced the government to rescue Citi the next year.

Two and a half years later, EMI’s results are improving. The company says its revenue for the most recent fiscal year, ended last March, was $2.4 billion, an increase of 7.4 percent from the previous year. Last week, “Need You Now,” the new album by EMI’s breakout country music act, Lady Antebellum, topped the Billboard 200.

Even so, the company still had a net loss of $1.6 billion during the fiscal year, and it still isn’t generating enough cash to cover the debt that was larded onto EMI’s books to finance Mr. Hands’s takeover. In the last 17 months, Terra Firma has breached loan covenants on its EMI debt five times and has had to inject nearly $150 million into the ailing company to stave off default.

Mr. Hands tried restructuring his deal with Citi, but the talks broke down in October. People familiar with the discussions, who requested anonymity because the talks are confidential, say Citi believes that Terra Firma’s equity in EMI is worthless and that the firm should hand over the company to the bank.

Mr. Hands, who declined to be interviewed, doesn’t give up so easily. He hired David Boies, who is to the legal profession what Bono is to arena rock, to do battle with Citi. In December, Terra Firma sued Citi in New York State Supreme Court, accusing the bank of defrauding the private equity firm. The suit, which has been moved to federal court in Manhattan, highlights the dual role Citi played in the transaction as both an adviser to EMI’s former management on the sale and Terra Firm’s lender — a common practice in the private equity boom.

No matter the outcome, the lawsuit has illuminated the relationship between Citi and Britain’s most famous private equity investor. After a string of successful deals together, the investor and his bankers plunged into a catastrophic deal that is emblematic of the credit boom’s excesses.

Terra Firma’s lawyers say David Wormsley, one of Citi’s top London dealmakers, didn’t inform Mr. Hands in the final hours of a bidding war for EMI that Terra Firma’s only rival, Cerberus Capital Management, had dropped out. Instead, the complaint says, Mr. Wormsley urged Mr. Hands to offer an inflated price for EMI.

Mr. Boies and his team say the Citi executive’s alleged failure to convey that fact was “at minimum, negligent, and fell below the standard to be expected of a reasonably competent investment banker in Mr. Wormsley’s position.”

A Citi spokeswoman, Danielle Romero-Apsilos, denies the lawsuit’s claims. “We believe this suit is without merit, and we will defend ourselves vigorously,” she said, declining to comment further. Citi’s lawyers at Paul, Weiss, Rifkind, Wharton & Garrison argue that the case should be heard in Britain, where many of the events in Terra Firma’s complaint transpired.

This could complicate matters for Mr. Hands. Last year, he moved to Guernsey, a tax haven in the Channel Islands, and can therefore spend only a limited amount of time on British soil. Not surprisingly, his lawyers counter that Terra Firma and Citi had plenty of dealings in New York, Citi’s base.

Some people in the industry say Terra Firma’s suit is merely a negotiating ploy meant to recoup part of its EMI investment and to avoid reputational damage that would make it harder for the firm to raise money in the future.

“It sounds to me like a textbook case of a private equity firm that bet the ranch, and now it has buyer’s remorse” says Paul Povel, a finance professor at the University of Houston who has studied Mr. Hands’s industry.

Jonathan H. Sherman, a Boies, Schiller & Flexner partner and Terra Firma’s chief litigator in the case, dismisses that notion. “At the heart of this case is an allegation as serious as it is simple,” Mr. Sherman says. Citi, he says, “induced Terra Firma to invest $3 billion by manufacturing the appearance of competition in an auction when it knew the auction was a bust. That is fraud.”

IN Britain, Guy Hands is a financial rock star. He has amassed a tidy fortune by snapping up undervalued assets like British pubs, European movie theaters and roadside concession stands in Germany and wringing cash out of them after borrowing the money he needed to buy them.

Along the way, he became the British equivalent of the Blackstone Group’s founder, Stephen A. Schwarzman. Mr. Hands owns a 12th-century estate in Tuscany, where he produces wine and olive oil. He has an enormous collection of karaoke records, and, on at least one occasion, has belted out “My Way” after an exhausting day of deal-making.

Citi played a key role in Mr. Hands’s ascent, with Mr. Wormsley bringing him some of his best deals. According to several people familiar with the dealings of Terra Firma and Citi, Mr. Hands’s other close contact at the bank was Michael S. Klein, a rising star who would become the head of Citi’s investment banking operation and was in a position to help arrange financing for these transactions.

Mr. Wormsley and Mr. Klein declined to be interviewed for this article.

The three men enjoyed one another’s company. According to people familiar with their extracurricular activities, Mr. Wormsley regularly took Mr. Hands and his wife, Julia, to the opera in London. Mr. Hands reciprocated by making his Italian vineyard available for the 40th birthday party of Mr. Wormsley’s wife, Vicky. For his part, Mr. Klein invited Mr. Hands and his wife, Julie, to his 40th birthday on Barbados.

So not surprisingly, according to the suit, Mr. Hands listened intently when Mr. Wormsley called him in November 2006 to tell him another company was for sale: EMI. And EMI seemed to fit the mold Mr. Hands preferred: a troubled enterprise with untapped value.

One of the company’s founders, Emile Berliner, invented the disk phonograph record in 1887. Over the years, EMI became a force in the music industry. In 1955, it bought Capitol, the American company whose roster included Frank Sinatra; . the company signed the Beatles seven years later.

EMI’s publishing division, meanwhile, amassed copyrights to songs from “Over the Rainbow” to ones made famous by Kanye West and Beyoncé.

EMI seemed to lose its momentum in 2001 after its Virgin Records unit unfurled a bomb: Mariah Carey’s album “Glitter,” which did so poorly that the company had to pay the singer $28 million to sever its relationship with her.

“After that, it was all about, ‘Have you hit your numbers this week?,’ ” says Ted Cohen, a former EMI senior vice president who now runs a consulting business. “I think they just took their eyes off the ball when it came to the creative side of the business.”

EMI’s weaknesses became abundantly clear in the last decade, when the industry was shaken by music piracy and declining CD sales. Unlike all but one of its rivals, the Warner Music Group, it was a standalone, publicly traded music company. In 2005, EMI’s stock tumbled when it revealed that forthcoming albums from its hit bands, Coldplay and Gorillaz, wouldn’t arrive on schedule.

This prompted it to seek an acquirer the next year. In strolled Mr. Hands — right behind a number of his rivals, including Cerberus; JPMorgan Chase’s buyout unit, One Equity Partners; and the Fortress Investment Group, all of which submitted preliminary bids for EMI in April 2007.

IN conversations recounted in court documents, Mr. Hands told Mr. Wormsley that he would need Citi’s backing for an EMI bid because he was coming in on his rivals’ heels.

According to the lawsuit, Mr. Wormsley alerted Citi’s debt team and, shortly thereafter, Mr. Klein sent Terra Firma’s founder an e-mail saying he was “personally involved” in getting the deal underwritten.

EMI then told its suitors that they would have to present their final offers on a Monday in May 2007. One Equity and Fortress dropped out. Terra Firma’s lawyers say Cerberus abandoned its hunt the day before the meeting. Cerberus declined to comment. The lawyers contend, however, that Mr. Wormsley prodded Mr. Hands until early Monday morning, telling him he needed to submit a high number if he didn’t want to lose EMI to his firm’s American rival.

“Citi’s representations to Terra Firma were knowingly false” Terra Firma’s lawyers said in their complaint.

Once Terra Firma submitted its binding offer for EMI, however, there was still a two-month closing period, during which the financial world began to unravel. While it would be another year before Wall Street approached an outright breakdown, the debt markets went into a coma as traders realized the severity of the subprime mortgage crisis (which Citi had played a pivotal role in fomenting.)

It soon became clear that Citi wouldn’t be able to syndicate the billions in debt it took on to do the deal. It also meant that Terra Firma would have difficulty refinancing or raising more money in the future.

In hindsight, Terra Firma could have exited the deal before it was completed, and there were opportunities to do just that. According to people familiar with the closing process, Cerberus approached Terra Firma with an offer to put equity into EMI, which would have reduced the British firm’s investment. Terra Firma, however, has a policy of not doing “club deals” with other private equity firms. So it spurned Cerberus’s advances.

Citi could also have shut down the deal altogether but chose otherwise. A person with knowledge of Citi’s deliberations, who requested anonymity because of the litigation, says the bank was fearful of losing its standing with private equity borrowers if it abandoned a longstanding client like Terra Firma. So Citi stayed in.

In a sworn statement filed last week, Mr. Hands said Mr. Klein arranged for him to meet with Charles Prince, then Citi’s chief executive, to discuss the deal in New York five days before the closing. Shortly afterward, Mr. Hands said, Mr. Klein set up a telephone call between Terra Firma’s founder and Edgar Bronfman Jr., C.E.O. of the Warner Music Group.

Mr. Hands said in his statement that he made the call to Mr. Bronfman because he eventually wanted to merge EMI with Warner Music. Warner Music declined to comment, and Mr. Prince could not be reached for comment.

Even before Mr. Hands completed the acquisition of EMI, cracks in the Terra Firma-Citi relationship were already beginning to show — including some frosty closing meetings in New York, where Citi tightened the covenants on Terra Firma’s debt. Nevertheless, Mr. Hands remained confident. Even if Terra Firma violated its covenants, it could avoid default by injecting more equity into the company. Terra Firma raised $200 million from investors like the Canadian Pension Plan and set it aside for this purpose.

The music industry has a long, tortured history of treating outsiders roughly. (Think of the animosity directed at the former NBC president Andy Lack when he took over SonyBMG.)

But Mr. Hands was a fairly sharp-elbowed guy himself. He granted autonomy to EMI’s profitable music publishing business. But as soon as the deal closed in 2007, he inserted himself into the day-to-day operations of the recorded music division, eliciting a hue and cry from artists and their managers about heavy-handedness.

That didn’t stop Mr. Hands. He cut the recorded music division’s payroll of 4,500 by a third, bolstering EMI’s cash flow. Still, hopes for a 51 percent increase in digital music sales — a key element in Mr. Hands’s turnaround plan— didn’t materialize.

EMI’s hit-making apparatus, meanwhile, remained moribund. According to Nielsen SoundScan, EMI had only one album — “Viva la Vida” by Coldplay — in the annual Top 10 in the United States in 2008. As a result, sales and profits plummeted, and by the end of 2008, Terra Firma had written down its EMI investment by 90 percent.

MR. HANDS, meanwhile, relinquished his managerial duties at EMI to Elio Leoni-Sceti, a former brand manager for Reckitt Benckiser, the consumer products company with brands like Mop & Glo, French’s Mustard and Lysol. Mr. Leoni-Sceti had no previous music experience before taking the job. But according to Billboard’s Mr. Werde, he is a less polarizing figure than Terra Firma’s founder, and has done a surprisingly good job of repositioning the company.

“What EMI and Terra Firma need more than anything is time,” says Jon Cohen, a music promoter who is working with Mr. Leoni-Sceti’s team. “They are under so much pressure with all that debt.”

But time may be running out. In a recent corporate filing, Terra Firma says it has exhausted all but $15 million of a $200 million financing line it had created to resolve covenant violations. The company is trying to raise $188 million to avoid defaulting on its next covenant test in March.

All of this lent a sense of urgency to Mr. Hands’s attempts to restructure the company’s debt. But he is no longer dealing with some of his old mates at Citi. Mr. Klein left in 2008 after a management shakeup caused by the bank’s near-collapse. Mr. Wormsley remains at Citi.

Indeed, until talks fell apart in September, Mr. Hands sat across the table from bankers interested in one thing: getting Citi’s money back. He offered to put $1.6 billion into EMI if Citi wrote down that amount. That would have left Terra Firma in control of a company with a more manageable debt-to-equity ratio.

Citi’s position was that Terra Firma’s equity in the company was worthless and that Mr. Hands should therefore just hand over the company in exchange for a small percentage of the upside if the bank could later sell it.

Richard X. Bove, a banking analyst at Rochdale Securities, says Citi has written down nearly all of its EMI debt. “I think they think they have a pretty good chance at getting something back now,” Mr. Bove says.

There would be no shortage of bidders for EMI Publishing, which has remained healthy through all the turmoil. As for the recorded music division, there is one likely buyer: Warner Music. In December, Richard Greenfield, a media analyst at Pali Research, wrote that Warner Music was “hoarding cash” in the hope of doing just that sometime in the coming year. In short, it could be Citi that sells EMI to Warner instead of Terra Firma, which would be a cruel irony for Mr. Hands.

Then again, it’s unlikely that either Terra Firma or EMI will emerge from their mutual woes without feeling more pain. Claire Enders, a London-based media analyst who has followed the deal closely, says that there is no other way it could have ended.

“For Terra Firma, it was ego,” she says. “Citigroup did not want to be the one that brought the party to an end. But this was the pin coming out of the private equity balloon. After that, it went poof.”

Posted by Ted • Saturday, February 6, 2010 .