As many of you are aware, as I have left the evidence hanging in my prior post, I may have been underestimating the extent to which we were on the precipice of a total financial markets meltdown.  We now can say with certainty that there will be no  Wall Street bulge bracket investment banks in the “new paradigm” since Goldman Sachs and Morgan Stanley are now money centered banks, having undergone a charter conversion, likely bowing to the pressure of federal regulators  While we all contemplate a future of Goldman Sachs ATMs, I thought we would talk about something really important related to the demise of Lehman Brothers — what will happen to  Lehman Brothers Merchant Banking’s (LBMB) pending investment in SRAM Corporation (SRAM)? Inquiring minds want to know.

For those of you who are avid cyclist or Tour De France devotees, you are likely to be familiar with Chicago based SRAM; after all Lance rides it.  For those of you who are not close with their bicycle or fans of Bob Roll and Phil Ligget, let me explain.  Launched in 1987, today SRAM is a manufacturer of bicycle components, shifting systems and wheels under the SRAM, RockShox, Avid, Truvativ, and Zipp brands.  The $500 million sales company is now the second largest components manufacturer and one of the hottest companies in the global bicycle components industry, historically dominated by Shimano, Inc. and its smaller foil Campagnolo S.r.l. (better known as “Campy”).  While most die hard roadies are Campy flag waivers, most American cyclists ride Shimano as it offers a broad range of shifting systems that are easier to maintain.  SRAM has successfulyl injected itself into the equation over the past 5 years, growing 15% – 20% annually, and bridging into the Tour De France world with Team Astana and Sauiner Duval-Scott through its SRAM Red product line.  I believe Alberto Contador rode SRAM Red to the Tour De France crown in 2007.  In November 2007, it celebrated another milestone when it bought Zipp Speed Weaponry, one of the hottest makers of aerodynamic wheel products for the road and triathlon bike communities.

Net net SRAM is “cool” to bike geeks worldwide.  So mouths were agape when, on August 6, 2008, SRAM announced that it was selling a 40% stake in the company LBMB.  The money will go for research and development, acquisitions, and $2 million annually for 5 years for a bicycle advocacy program.  The company actively sought a strategic financial investor who could help support its forward growth.  While no financial terms were disclosed, LBMB generally invests in companies with more than $10 million of trailing EBITDA, enterprise values as high as $600 million and writes equity checks between $25 – $100 million.   Shimano, while much larger and more diversified, trades at 1.4x Trailing Twelve Months (TTM) Revenues and 7.1x TTM EBITDA.  Shimano enjoys EBITDA margins of nearly 20%.  Under no mathematical applications of Shimano’s multiples can we get SRAM into LBMB’s valuation range absent a healthy amount of leverage not seen recently.   Its profitability must dwarf that of its larger rival who possess significant economies of scale and scope.  No matter, we can assume it received a premium valuation due to its strong growth, forward prospects, and brand value.  J.P. Morgan advised SRAM on the deal, which was expected to close in late September or early October according to the press release.

As you are likely to be aware, a strange thing happened on the way out of the wedding chapel — the groom checked in to bankruptcy.  While the demise of Lehman Brothers was well documented, LBMB appears poised to be kept intact, assuming a buyer can be found.  Although an affiliate of Lehman Brothers, LBMB isn’t likely to be impaired by the bankruptcy filing except in the sense that Lehman itself won’t be serving as a limited partner of any future funds and the business unit could be sold for the benefit of Lehman’s creditors.  Once a company goes into bankruptcy its creditors receive first claim on its assets after certain employee preferences has been paid.  The bankruptcy custodians of Lehman Brothers appear to be engaged in an orderly sale of assets.  LBMB is likely the prized piece of Lehman remaining after Barclays and Nomura Securities have picked the investment banking bones clean.  LBMB could be the subject of a management buyout backed by a private equity investor.

While the future of LBMB hangs in the balance, the first words out of SRAM were that the bankruptcy would not impact the closing of the deal.  SRAM co-founder and president Stan Day noted that LBMB was a separate entity, in tact, financially sound, and had nothing to do with the transactions that led to the peril at the parent company.   Four days later on the eve of Interbike, Day was singing a slightly different tune — that the bankruptcy, while again not caused in any way by LBMB, may result in a delay or the demise of its deal with LBMB.  Day was quick to point out that SRAM was financially sound and did not have to do the deal with LBMB or anyone.  However, he noted that if the deal fell through they could consider a new financial partner at some point in the future.

I expect that SRAM will wait until all of the dust settles and see where LBMB lands.  Expect the new owners of LBMB to be a private equity firm, which will make for a very interesting management dynamic (they will need Chinese walls for their Chinese walls).  At that point SRAM will determine if its in their best interest to close, assuming terms and conditions are still in tact.   However, as time goes on, those terms and conditions are likely to require amendment, which may scuttle the transaction.  There is a significant repricing of risk going on in the market as a result of the meltdown in the financial markets.  At some point LBMB will have to ask themselves does the deal still merit the valuation put on it previously.  There may be penalties if they walk away, but it doesn’t seem like it was that sort of deal.  If it does walk away that will have future implications (though walking away from deals has become a new pastime for the mega funds).  And what of the banks that are lending money into the deal, are they still in tact (this assumes this is a levered transaction, which it may not be)?  So many questions, so few answers.  It’s like the circle of life.  Either way SRAM will still be the best shifting system on the market…at least until Shimano electronic shifting is available for the masses.

Ride safe my brothers and sisters.

/bryan