Elon Musk Buying Twitter May Be The Worst Deal Of All Time

Elon Musk buying Twitter is shaping up to be the worst buyout deal in history. It may go down as the biggest train wreck Wall Street has ever seen.

The transaction violates every rule of the leveraged buyout business. Red flags are flying high enough to be seen from the classic Corvette that Elon launched into space a few years ago. The deal may cost Elon Musk the bulk of his fortune, wipe out his co-investors, and collapse Twitter as a company.

Now, I'm a fan of Elon Musk- or at least his public persona. But investing is a serious business. When it comes to buying stocks, Michael Corleone put it best: "It's not personal, Sonny. It's just business."

Both Twitter and Elon Musk are products of the "new economy." They sprang from the technology sector headquartered in Silicon Valley where fortunes are made overnight and rules don't seem to apply (least of all, the laws of economics.)

But the leveraged buyout business is a very old business- an established sector of the financial markets. It was pioneered in the 1960's and came of age in the roaring “Greed is Good” decade of the 1980s. The leveraged buyout (or LBO) has strict rules for success and harsh penalties for failure.

(If you've ever taken out a mortgage to buy a house, you have done an LBO- because the principal is the same. You use a little bit of equity and a lot of debt to buy an asset of value. Before you sign on the dotted line you calculate your finances very carefully. To pay off that debt, you watch every penny and pray nothing goes wrong- such as losing your job- so you can meet the monthly debt payments.)

The Twitter deal is the second-largest LBO in history. Yet it seems based on almost zero due diligence- not even five minutes of number crunching. Reckless deals like this always end in tears.

LBO Rule #1: Don't Overpay

The first rule of a successful LBO is the same as every other investment: don't overpay. If you pay too much at the time of purchase, the deal is already a failure- a "dead man walking." Elon violated this cardinal rule.

Savvy investors could see that Elon's bid was a farce the moment he made it. He offered $54.20 a share (get it? $4.20, or 420, the slang code for marijuana that has been a running joke in Elon's business endeavors.)

In a business where every penny is calculated carefully, making a bid just because it coincides with an internet meme is the height of recklessness. How would you like it if you were buying a house valued at $200,000 but your real estate broker put in an offer of $204,200, just to be cute? That's essentially what Elon did- and investors will rue his cleverness with every monthly debt repayment.

Leaving aside the cute number, Elon grossly overpaid on an absolute basis. Twitter as a company does not make any money. Recently it has shown an EPS (earnings per share) of 25 cents, but before that, it operated deep in the red.

(This is actually the dirty little secret of tech darling companies: none of them make any money! Ebay, Amazon, Lyft, and other tech companies adjacent to the social media space all have negative EPS.)

Investors buy into these tech money pits based on a story- a fable that some fine day in the future, they will start spinning cashflow. This is the same mindset that every pyramid scheme has operated on since the beginning of time: your hard earned money today, in exchange for the promise of unlimited riches tomorrow.

Twitter also fails the "build vs. buy" test. Elon is paying $44 billion for Twitter. For a fraction of that- say, one billion dollars- he could have built a brand new, state of the art social media company. A social media company with a fresh start, not burdened by legacy systems, and incorporating the latest functionality as found on newer apps such as Tik Tok and Instagram. With Elon's star power, attracting users to this new company would have been a breeze. Instead, Elon bought a 20 year old company with legacy systems that burns cash like plane crash survivors in the Andes trying to stay warm.

LBO Rule #2: Only Buy Income Generating Assets

The second rule of successful LBO investing is to only buy assets that reliably generate income. The basic principal of an LBO uses low-cost debt to purchase assets that generate a higher yield. You issue bonds at 5% to buy a company that generates a 10% annual return. The more stable those assets are, the better. Ideally the assets are "hard assets" such as factories and real estate. Employees may come and go, but hard assets will still keep churning out a return.

We have already seen that Twitter doesn't generate any income of note. More worryingly, it does not have the assets to do so. Twitter is basically a room full of servers- a glorified data farm. Its "assets" (such as they are) go up and down the elevator every day: the employees who run it.

But what of Twitter's brand identity- isn't that an asset? Not really. In the tech space, brand identities come and go. Facebook just changed to Meta, for no apparent reason. Google changed its name to Alphabet. If the two largest companies in tech can change their names without a murmur of concern, it means that brand identity in the tech space is ephemeral at best.

Nor does Twitter benefit from user loyalty. Most users are not that fond of Twitter- they use it despite the company management, not because of it. When Instagram came along in the mid 2010's, millions of users jumped ship from Twitter and never looked back. The same for Tik Tok. If a new social media app came along today, it could put Twitter out of business overnight. A thousand tech-savvy young people around the world are laboring in their dorm rooms and loft apartments to create the next big thing in social networking. If just one of them succeeds, Twitter is out of business- for good.

It's true that the majority of funds to purchase Twitter are equity, not debt. Elon and his group of co-investors are putting up three-quarters of the purchase price in equity. With lower debt levels, the debt repayment schedule will be less onerous than found in many LBO's. Still, that leaves around $10 billion in new debt. Twitter's debt ratio will increase from around 3x to around 9x- a huge debt burden for a company that barely generates enough cash to keep the lights on.

Fortunately, the investor syndicate that Elon has corralled into the deal are all billionaires who should know what they are doing: people like Larry Ellison, founder of Oracle, and Prince Alwaleed of Saudi Arabia. Nobody will cry if they get served up short in the Twitter deal (and many will secretly enjoy it.) No pension funds or other public money is going into the deal- which could cause significant pain for members of the public when the deal goes belly-up.

Why is Elon doing the Twitter deal?

A back of the envelope analysis shows that Elon's Twitter deal does not make much sense from a financial standpoint. Hopes for the deal to work out seem to rely on an intangible "Elon factor," the idea that Elon will be able to increase the value of Twitter due to his innate skills. However, this generalized reliance on Elon is very different from how most LBO's have been handled. Usually, the strategy for value creation is laid out well in advance, down to the last detail: The costs to be cut, the divisions to be sold off, the operations to be improved are all mapped out carefully for co-investors to inspect (after signing an NDA, of course).

None of this has taken place. Elon himself has not outlined any value-creating strategies for Twitter. And any changes he makes to Twitter have an equal chance of backfiring. Users are fickle. If Elon starts charging for services or otherwise changing how the Twitter platform operates, it may cause users to bolt to one of the many alternative platforms such as Gab or TruthSocial.

I wish Elon the best. For better or worse, Twitter has functioned as the de facto public square in America for over a decade. It's a place where ideas are shared and news travels fast. If Elon handles the purchase of Twitter well, he could improve the free flow of information in America- an undeniable public good- and make himself and his investors a lot of money. If he bungles it, he could preside over the collapse of Twitter and the destruction of tens of billions of dollars of investor capital- as well as his reputation as a tech wunderkid who never misses.