Private equity firms back out of Harman deal

NEW YORK (Reuters) - Harman International Industries Inc (HAR.N) said its private equity buyers are pulling out of their $8 billion buyout deal, a severe blow to the company whose shares fell more than 25 percent on Friday.

The audio equipment maker said that Kohlberg Kravis Roberts & Co LP and Goldman Sachs Group Inc's (GS.N) private equity arm believe a "material adverse change" occurred in Harman's business and that it breached the merger agreement.

Harman said in a one paragraph release that it disagrees such a change occurred and that it did not violate the buyout contract.

KKR and Goldman's decision not only impacts Harman, but could have broader repercussions for the firms and the leveraged buyout sector, as it comes at a sensitive time for the industry. The credit crunch has threatened to scuttle several leveraged buyout deals, forcing banks stuck with loans to renegotiate deals and straining relations among Wall Street, private equity buyers and the companies involved.

The crunch has caused investors, bankers and lawyers to scour merger agreements in search of ways for buyers to get out of deals, or sellers to keep them in tact.

"The world has changed," said Dan Fuss, vice chairman at Loomis Sayles in Boston, who helps oversee $77 billion in fixed-income assets. "In this current market, I don't know that the economics made sense anymore and so that caused it to fall apart. I strongly suspect a number of others are not going to make it."

But the Harman bail-out looks centered on the financial conditions of the company itself, not the lending agreement, and marks the first time in a two-year private equity acquisition frenzy that buyers walked out of a major deal.

Merger arbitrage traders and an analyst said among the hurdles Harman faced was rising inventories and declining cash flows and sales in the last few quarters. Traders also said questions surfaced recently about Harman's relationship with Daimler-Chrysler, a customer for its audio products.

Harman announced the buyout in April, in a deal that allowed shareholders to keep equity. The deal includes a break up fee of $225 million.

That KKR and Goldman are backing out of not just a deal, but an agreement that was supposed to bring in shareholders, does not help private equity's already roughed-up image, even if the firms prove they are within their rights according to the contract.

KKR, the firm credited with creating the LBO industry, filed to go public recently, attributing its success to the firm's "culture and values."

BACKING OUT

Harman shares dropped 24 percent to $85 on Friday after the Wall Street Journal and Reuters reported trouble with the deal.

Harman shares fell to $83 following its release after the market closed. Under the terms of the deal, Harman stockholders would have received $120 per share. The firms have not said what triggered the "material adverse change" claim.

One analyst said Harman's inventories in February were up 40 percent, while second-half sales expectations were for an 11 percent rise.

"When you've got inventories going through the roof, cash flows are going to get hit," said Alisa Guyer Galperin, an analyst covering Harman at independent research firm RiskMetrics Group.

The merger proxy does have language in it on pertaining the deal being threatened in the event of certain "material adverse" effects on Harman.

"The company either has to slow production, reduce prices, or have inventories remain at elevated levels, and that deteriorates your cash flow model," Galperin said, adding that personal navigation devices for cars were among the items sitting in the inventory.

Traders said on Friday that a great deal of attention was being paid to a filing showing that sales to DaimlerChrysler accounted for 25 percent of Harman's total consolidated net sales for the fiscal year ended June 30, 2007. Cerberus Capital recently bought Chrysler from Daimler.

While Harman says in the filing that loss of sales to the customer would have a "material adverse effect" on sales, there is no public indication that the relationship is in jeopardy.

Harman founder Sidney Harman owned about 5 percent of the company's stock at the time of the deal and committed to exchange half of his holdings for stub equity.

The Harman deal allowed Harman shareholders to own as much as 27 percent of the company after the buyout.

"There is no doubt it adds a deal of complexity, heightens the embarrassment, and makes the pain a little greater" should the deal fall apart, said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth University's Tuck School of Business.

(Additional reporting by Jennifer Ablan, Richard Leong and Mark McSherry)