Private Equity Only Loves Virgin Australia for Its Loyalty

(Bloomberg Opinion) -- What could possibly attract Bain Capital about an airline that hardly ever generates cash? Loyalty is almost certain to be the answer.

Administrators for Virgin Australia Holdings Ltd. at Deloitte agreed to sell the second-ranked Australian airline to the private equity firm after it collapsed in April owing A$6.8 billion ($4.7 billion). In a sign of what a difficult path lies ahead of Bain, interest from 20 parties was ultimately whittled down to just two final bidders.

Airlines, with their vast capital expenditures, weak competitive positions, and already-heavy debt loads, aren’t the most obvious places for private equity to invest. Most firms look for businesses that can consistently throw off cash before returning to market at an enhanced valuation a few years later.

Virgin hardly fits that bill: The company has posted positive annual free cash flow just three times in two decades. It’s hard to see how a few years of business in the time of coronavirus is going to enhance its market value much. That’s particularly the case given that Qantas Airways Ltd., which spent much of the past decade demonstrating the power of its superior market share, has just strengthened its balance sheet through a capital raising.

There is, however, one part of Virgin that’s perennially attractive to private equity — its Velocity frequent-flier program. It’s not unusual for airlines to be essentially loyalty programs with wings — Qantas’s is often the most profitable part of the business, and Air Canada’s spun-off program Aimia Inc. mostly traded at a higher multiple than its former parent until it was bought back a few years ago.

Velocity has already been a winner for private equity. Affinity Equity Partners bought a 35% stake in the program in 2014 and sold it back last year at a A$2 billion valuation. That’s more than twice what it originally paid, and far more than the A$1.2 billion or so that the entire airline was worth before coronavirus struck, not to mention the zero value now put on Virgin Australia’s equity.

The biggest challenge for Bain will be what to do with the main bit of the business — but that’s not an impossible task. While details haven’t been released of what a post-insolvency Virgin will look like, you’d expect the administration process to bring an end to many of the asset impairments and interest expenses that have weighed so heavily on earnings in recent years, giving an opportunity to spruce it up for selling back to the market. Australia’s stock investors are famous for buying dog-eared companies from private equity and repenting at their leisure.

Bain has promised to “invest in and see closer integration” of the loyalty program and the core flying business, though it’s not clear that this amounts to a promise never to separate the two. Don’t be surprised if 18 months from now the next big IPO in Sydney is a seemingly-rejuvenated Virgin Australia, shorn of its lucrative loyalty program. Just don’t make the mistake of buying into it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

David Fickling is a Bloomberg Opinion columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

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