If Buffett can do it, why can’t I?

Private equity investors have long had difficulty doing deals in the US rail sector. Cezary Podkul dissects the reason why.

Offering to buy Burlington Northern Santa Fe – the largest rail carrier in the US by revenue – for $26.3 billion in cash and stock and negotiating a deal in a two-week time span, is no easy feat by any metric.

Indeed, it seems like the kind of deal only Warren Buffett could pull off.

Including Buffett’s existing stake in the company and $10 billion of assumed debt, it’s a $44 billion blockbuster transaction that would easily stand as the largest railroad deal in North America and possibly the world. And, by his own admission, it will be the largest deal for Buffett’s Berkshire Hathaway.

Warren Buffett

To be sure, private equity firms have been able to haul in big-ticket deals as well. The $45 billion takeover of Texas utility TXU by Kohlberg Kravis Roberts, TPG and Goldman Sachs is a case-in-point.

But could a KKR or a TPG or any private equity investor ever pull off a similar deal in the railroad sector?

InfrastructureInvestor posed a similar question to Matt Rose, Burlington’s chief executive officer, at an infrastructure conference last year. Surrounded by a throng of reporters after delivering a speech on the need for more investment in the US’ rail infrastructure, we asked him: would you ever consider partnering up with the $180 billion of infrastructure funds that are said to be out there waiting for deals?

In retrospect, his answer was quite telling: “We don't have a problem with access to capital”. Indeed, with Warren Buffett paying Rose courtesy calls while he’s in town on business, one can take him at his word.

“I don't think they [private equity firms] have a lower cost of capital once they buy a railroad,” Rose added, and asked whether infrastructure funds and can play a role investing in the US rail sector, he responded: “I don't.”

Why would the CEO of the US' largest railroad possibly think this? At first glance, one might be tempted just to chalk it up to the sheer scale of the capital required to pull off such a deal. For the largest of the US’ railroads, known as Class I carriers, the equity value alone would be in the tens of billions – especially if they return to their pre-September 2008 highs. So it would take massive amounts of debt for such a deal to become doable for a private equity firm. And, ironically, after the Lehman crash, just when Class Is finally became more affordable – Burlington was trading in the low $50s in March and Kansas City Southern could have been had at a bargain – the debt markets were shut.

But it’s more complicated than that. Granted, if you don’t have the money to buy a Burlington or a Union Pacific, there are more than 500 other railroads in North America you can set your sights on. They’re smaller, regional carriers known as Class II rail and tiny, often one or two-mile long spurs, connectors or switch lines known as Class III rails. But, contrary to what you might expect, they’re an equally difficult place to transact.

For one thing, their owners seldom want to sell. Many of the choicest Class IIs – the ones with the most connections to Class I carriers and regional monopolies on traffic – are controlled by the Class Is. The remainder belong to regional aggregators and independent family-owned holding companies that have little reason to give up their crown jewels. You can try, but chances are that, unless you’re willing to offer double-digit multiples, you’re not going to have much luck.

Class IIIs, on the other hand, do occasionally come up for sale. Families sometimes look to cash out and industrial owners, such as paper manufacturers, steel makers and other companies that gobbled up rail lines while vertically integrating, do occasionally look to monetise non-core assets. But when they do, the assets they’re selling tend not to be the choicest picks.

So really the only value to be had is through an aggregation play. And because finding adjacent properties to bolt-on is extremely hard, you’d more likely than not end up with a portfolio of disconnected spurs spread across various states, with little synergy and even less pricing power. That's not a very attractive value proposition to most private equity investors.

This does not mean, though, that it is all together impossible for them to invest in railroads. In June 2007, New York-based Fortress Investment Group won Florida East Coast Industries, owner of the Florida East Coast Railway, in an auction for $3.5 billion. In November 2006, Fortress also bought Class III aggregator RailAmerica for $1 billion – now again a public company.

But deals like these are few and far in between. So a better bet may be to invest in companies that service railroads, rather than the railroads themselves. Some private equity firms have already made that bet: in May 2008, Carlyle Infrastructure Partners, a $1.1 billion infrastructure fund managed by The Carlyle Group, acquired ITS Technology & Logistics, a company that generates 90 percent of its revenue from lifting containers on and off trains and trucks and maintaining related equipment.

Meanwhile, unless you’ve got the heft of Berkshire’s balance sheet, it’s probably best to skip a ride on Class I rail.