By Purav Bhandare, Carta Ryan, Corey Sullivan and Gleb Kuznetsov (University of Queensland); Ivan Chung and Kevin Lee (Hong Kong University of Science and Technology)
Overview of the deal
Acquirer: Bain Capital or Cyrus Capital Partners
Target: Virgin Australia
Estimated Enterprise Value: A$3.5bn – A$4.0bn
Administration Date: 04/21/2020
Acquirer Advisors: Bain Capital advised by Goldman Sachs, Cyrus Capital Partners advised by McGrathNicol
Target Administrator: Deloitte advised by Houlihan Lokey and Morgan Stanley
Seven years of consecutive losses combined with the impact of COVID-19 forced Australia's second-largest airline, Virgin Australia, into voluntary administration on the 21st of April, 2020. In 2019 Virgin held just over 30% of domestic market share. After the first auction, Deloitte shortlisted four parties for the auction's second round: Bain Capital, BGH Capital, Indigo Partners, and Cyrus Capital Partners.
Company Details (Target - Virgin Australia)
Virgin Australia began services in 2000 as Virgin Blue, a cheaper alternative to Qantas Airways Ltd and Ansett Australia who were, at the time, dominators of the Australian airline industry. However, Ansett entered administration in 2001, primarily due to an inefficient fleet, and was liquidated in 2002. In 2011, CEO John Borghetti relaunched Virgin Blue as Virgin Australia and began re-shaping the company's business model to become a serious competitor to Qantas. In doing so, Virgin's preceding reputation as the young, low-cost carrier (LCC) was replaced with a focus on targeting corporate and business customers by introducing expensive lounges and other services, while making losses.
Founded in: 2000
Headquartered in: Brisbane, QLD, Australia
CEO: Paul Scurrah
Number of Employees: 10,620
Market Cap: A$726m
LTM Revenue: A$5,874m
LTM EBITDA: A$458m
LTM EV/Revenue: 0.84x
LTM EV/EBITDA: 10.72x
As an operational overview, in FY2019 Virgin Australia reported a loss of A$315.4m, stating that subdued economic conditions, higher fuel prices, and a weaker Australian dollar negatively affected their performance. Paul Scurrah replaced John Borghetti as CEO in Feb 2019, who introduced several strategic initiatives:
Deferring Capex by restructuring the order of Boeing 737 MAX aircrafts
Reducing capacity by 1.5% due to subdued market conditions
Organisational rightsizing program - reduction of 750 corporate and head office roles, lowering costs by A$75m annually
Renegotiating key contracts such as aircraft leases, maintenance agreements, etc., targeting A$50m in cost savings annually
Nonetheless, the global imposition of mass travel restrictions globally finally pushed Virgin over the edge; after seven years of consecutive losses totalling A$1.9b from FY2013 to FY2019, Virgin Australia has finally entered voluntary administration.
"The government is not going to bail out five large foreign shareholders with deep pockets who together own 90 per cent of this airline"
– Josh Frydenberg, Treasurer of Australia
Shortly after announcing the voluntary administration, over 20 bidders were interested in acquiring Virgin, all of which were granted access to Virgin’s data room, with non-binding indicative offers due on the 15th of May. Shortly after that, Deloitte selected four bidders and on the 25th of May, narrowed the list down to just two bidders: Bain and Cyrus.
BGH Capital is an Australia-based Private Equity firm, whose first Capital Fund raised A$2.6bn in May of 2018, making it the largest ANZ-focused private equity fund currently deploying capital. BGH’s proposed operating model involved drastically decreasing operations for several years, something which Deloitte’s Administrator and the Australian Council of Trade Unions did not agree with. Based in the U.S., Indigo Partners is a private equity fund, specialising in air-transportation investments, particularly in the establishment of low-cost carriers worldwide. Currently, the firm’s portfolio companies consist of Frontier Airlines, JetSMART, Wizz Air, and others.
As for the two remaining bidders, Bain and Cyrus are currently focused on completing their final bids, due on the 22nd of June. Both bids must consider a variety of factors with the ultimate goal of winning over administrator Deloitte and the ACTU (Australian Council of Trade Unions), who are representing the airline’s 9,000 workers owed entitlements and control a key portion of creditor votes. Below is a brief overview of the remaining bidders:
Founded in: 1984
Headquartered in: Boston, USA
Co-Chairmen: Josh Bekenstein, Stephen Pagliuca
AUM: Approximately US$105bn
The private equity arm of Bain Capital invests across different sectors and geographical locations. Bain Capital invested in Virgin Voyages, a cruise line based in the Caribbean Sea, in 2014 as a joint venture with the Virgin Group. The group also owns and operates Trans Maldivian Airways, a seaplane airline, as a part of its portfolio.
Bain Capital believes that its previous experience will help establish the airline in between its LCC past as Virgin Blue and the current full-service Virgin Australia. Nonetheless, the Transport Workers Union has raised concerns about Bain’s historical approach of cutting jobs and their treatment of worker redundancies in previous ventures such as Toys R Us.
Domestic flights will be prioritised first, with tourist routes likely to be the first to be re-opened. Bain was sceptical about international flight prospects, alluding to the possibility that the firm will only be re-launching international services in several years if the market has adequately recovered. Jayne Hrdlicka, the former head of Qantas’ budget airline Jetstar, is advising Bain’s bid and is a potential candidate for running Virgin, contingent on the success of their proposal.
Cyrus Capital Partners LP
Founded in: 1999
Headquartered in: New York, USA
Managing Partner: Stephen Freidheim
AUM: Approximately US$4bn
Cyrus Capital Partners is a US Private Equity firm, which has historically made significant investments in the airline industry. They have close ties to Richard Branson, having invested in Virgin America in 2005 before the company was sold to Alaska Airlines for US$2.6 billion in 2016. Recently, they were an investor in the British regional carrier FlyBe, which was one of the first airlines to collapse following COVID-19 and is currently in administration.
Cyrus Capital is proposing to keep Virgin running as a full-service international carrier that will continue to compete with Qantas. Some domestic flights and older aircraft models will be reduced in quantity, while a newer, more fuel-efficient fleet will be established over the next five years. The majority of the leased aircraft will also be returned. Cyrus believes that a more efficient approach in the fleet selection, route selection, and a broader focus on customer service, as opposed to the company’s budget airline roots, will pave the way to a resurrected and profitable Virgin.
Part of the 4-person team leading Cyrus’s bid includes a former director of Virgin America for eight years and a former CEO of Virgin Group North America.
Projections and Assumptions
Cumulative operating losses and a filing for administration have made Virgin an attractive target given that before COVID-19, the airline had strategic plans in place to reduce the piling A$6.8bn of debt on the company’s balance sheet owed to 10,000 creditors; 9,000 of which are Virgin employees due entitlements. Understanding the rationale behind acquiring Virgin centres around the feasibility of reducing debt while continuing to operate in a post-COVID-19 environment. Bain and Cyrus have both opted for relatively different operating models, as discussed in the bidder overview. Nonetheless, job cuts and route culling are still widely seen as inevitable under either Bain or Cyrus’ ownership, though both funds are steering clear of returning Virgin to its ultra-low-cost roots.
Acquiring Virgin Australia would complement either fund's portfolio and build on existing expertise, with both having previously taken stakes in troubled airlines. No matter the owner or operating model, Virgin will have a considerably difficult time competing against Qantas given the current macroeconomic environment. The road to a normal-operating Virgin is a long one; consumer research has suggested that Australians expect it to be between 18-21 months before they are flying as much as they did before the COVID-19 pandemic.
Avoiding Virgin's ultra-low-cost roots, as proposed in both Bain and Cyrus' operating models, may hurt in the short run, given that Qantas is in a strong position to undercut airfares. Qantas' CEO Alan Joyce has already publicised the idea of offering heavily discounted domestic prices to stimulate demand. If either Bain or Cyrus chooses to match this pricing structure, it will impose considerable pressure on both bidders to have sufficient resources to cover a higher rate of cash burn – something that is not ideal considering Virgin's A$6.8 billion debt pile and slow re-introduction to the Australian market. Nonetheless, the Australian Competition and Consumer Commission (ACCC) can only do so much in ensuring that Qantas does not engage in anti-competitive behaviour such as periodic predatory pricing.
With Qantas and Virgin cumulatively holding over 90% market share in the Australian Aviation industry, close monitoring by the ACCC will likely benefit Cyrus or Bain. It is likely that overall, ACCC Chair Rod Sims’ commitment to monitoring Qantas’ pricing, route capacity, and other behaviour in the re-birth of Virgin should help facilitate the transition to a fully operational Virgin.
The pandemic has plunged the airline industry into uncharted waters – resulting in unprecedented conditions that have caused numerous job cuts, tanking profits, and slumping demand.
Despite this, it seems that the airline industry cannot fall much further. This appears to be the primary long-term rationale for the interested parties, who are looking to capitalise on the current distressed state of the industry.
To tackle these headwinds and begin the long road to recovery, the Government has started regional state services, and mine-site fly in and fly out operations. The next step to recovery includes boosting domestic services, with the potential for some of the popular links to be subsidised by the Government. Fundamentally, demand for air travel will only improve when the Government announces that it is safe to do so and when the public regains confidence, which is analogous with consumer sentiment returning to pre-COVID levels. This is unlikely to occur until a viable vaccine is readily available to the general public.
Despite changes in the practices surrounding business technology, consensus regarding the long-term outlook for Airlines remains focused on the expansion of domestic services throughout the 'Golden Triangle' (Sydney-Melbourne-Brisbane flights) and capital city links, which would give airlines the capacity to steadily grow margins.
Following these initial stages, Australia will start opening its borders on a case by case basis. There may be no international carriers resuming services to Australia until next year when a vaccine is potentially released to the public. This is expected to be beneficial to both Qantas and Virgin as they will have the pick of their international routes. However, this is dependent on whether the winning bidder decides to resume international services.
The final stage of recovery is the “new normal”, which represents a medium to long- term period where pre-COVID demand drivers for aviation services can be used to forecast future activity. However, unlike the GFC and SARS, the scale of the crisis means that there could, in fact, be detrimental long-term impacts on both demand and supply fundamentals for the aviation industry.
Risks and Uncertainties
The most pressing risk is Virgin’s liquidity. Deloitte admitted that the carrier’s current cash balance would only be enough to last until the end of June. This has resulted in a very compressed timeline for the bidders to submit their indicative and final bids. The successful party will need to make an immediate and substantial cash injection; whilst Deloitte is currently looking for intermittent funding until a binding bid is finalised.
There are also concerns with the general outlook of the airline industry. While business travel is expected to play a critical role in Virgin’s recovery, there remains uncertainty with regards to the behavioural shift that has resulted from the "work from home" initiative, which has caused many corporations to evolve away from face-to-face meetings, potentially compressing business travel.
Further, when comparing the S&P 500 index with the S&P 500 airline index, the historical spread between the two has drastically widened in 2020, as shown in Graph 1. Such a variation in the spread represents a lack of investor confidence surrounding the recovery of the airline industry in general. If the winner of the bid focuses on shifting Virgin Australia closer to an LCC (low-cost carrier) model in the short-term, then the airline will be susceptible to additional regulations and added cost that is analogous with the social distancing laws enforced by Governments. The profitability of LCCs stems from the large number of customers that can fit on their aircraft; customers are expected to be averse to this shortly following the pandemic.
Graph: Spread and Multiplier between the S&P 500 and S&P Airlines Index (Capitaliq)
"We all witnessed the capacity war between Virgin and Qantas as Virgin slowly moved up the scale. I don't think that really helped anyone. It's premature to say whether we would retain a direct competitive presence in the higher-end market or whether we would be a little more nuanced and try and sub-segment the corporate market"
- Mike Murphy, MD APAC PE Bain Capital