We spoke with 7 insiders about IBM's $34 billion Red Hat takeover — here's how the biggest software deal of all time came together (IBM)

Ginny Rometty

IBM's planned acquisition of Red Hat for $34 billion is the result of a relationship between the two tech companies that stretches over 20 years.
When the deal closes, it'll be the largest software deal ever.
We talked to seven people close to the deal to learn how it all came together.

IBM's acquisition of Red Hat was 20 years in the making, but it was a month-long whirlwind courtship that sparked the announcement of the largest software deal ever.

The two tech companies began a collaboration to develop and grow Linux, the open-source software, in the 1990s. That partnership culminated in Sunday's announcement, in which IBM said it intended to purchase Red Hat, the world's biggest Linux company, for about $34 billion.

The deal couldn't have happened without an April lunch between IBM CEO Ginny Rometty and Red Hat chief executive Jim Whitehurst, according to remarks the IBM chief gave earlier this week. That meal sparked further talks between the two technology companies that culminated in IBM buying Red Hat for $190 a share.

If the acquisition goes through, it will be IBM's biggest deal ever and one that will instantly catapult it into the top ranks of cloud providers, a fast-growing industry that's long been the domain of Amazon and Microsoft.

Details of the talks were described to Business Insider by seven people familiar with the transaction who asked not to be named because they weren't authorized to speak to the press. An IBM spokesman declined to comment and a Red Hat spokeswoman could not be reached.

Expanding a partnership

A month after sharing that meal, Rometty and Whitehurst announced in May that they would be expanding their partnership further and help clients speed up their adoption of the hybrid cloud platform — technology that stitches together the company's own storage solutions with those offered by third parties.

"Jim and I share the same strategic vision and we have complimentary capabilities," Rometty said on an investor call earlier this week. The partnership announced in May "gave us really great confidence. We were testing that, could we go capture this and unlock this for both of us?" she said. "So that's really what led to this."

The strategy is classic IBM, tiptoeing into a potential acquisition by first finding ways to partner with the target, to test out the compatibility issues, sound out customers, and explore what a tie-up might mean, according to people with knowledge of the firm's history and techniques.

It also occurred largely without the help of investment bankers.

It was only after IBM's management team decided to formally explore a deal with Red Hat that they began to sign up outside advisers for help on valuation, negotiating strategy, financing, and investor relations, the people said. Many firms engage bankers at the beginning of the deal process, whereas large firms like IBM employ highly skilled corporate development teams to do the early work. Plus, the two executives knew each other well.

A potential tie-up

As the May partnership progressed successfully, IBM began to mull a potential tie-up.

After Labor Day, the tech giant moved swiftly, signing up Goldman Sachs, which would work closely with Lazard bankers already retained by IBM, according to people with knowledge of the transaction. Goldman's Alison Mass, the head of the bank's financial and strategic investors group, used her long-standing relationship with IBM to help advise on the deal, alongside Goldman's cohead of M&A, Michael Carr, and tech banker Colin Ryan, the people said. Lazard bankers Alex Stern and John Gnuse led their team.

Over the following week or two, the advisers got to work helping IBM's management team develop a strategy for approaching Red Hat, and for informing the tech firm's board of directors, the people said.

Armed with information from her own corporate development office and outside advisers, Rometty was ready for the next regularly scheduled board meeting, set for the week of September 24 in New York, the people said. By the time it concluded that Wednesday, IBM's board had given its approval to move forward with a potential deal.

Board approval

With the go-ahead, IBM called Jennifer Nason, JPMorgan's global chairman of investment banking, to begin financing discussions, according to one of the people. Rometty also called JPMorgan's CEO Jamie Dimon to give him the news. Initially, the tech giant thought it might need a bridge loan for the entire transaction cost, a request JPMorgan couldn't meet by itself. The bank asked Goldman Sachs to chip in.

JPMorgan scrambled a team to begin thinking about the bridge financing, a short-term loan used by a company until it can sell bonds or raise more permanent funding, the people said. The firm would also offer advice on how to communicate the deal to IBM's investor base among other items. Global M&A cohead Chris Ventresca helped lead its team.

The following day, Rometty met with Whitehurst face-to-face to discuss a deal. They met in New York City, on neutral ground away from each other's offices, according to three of the people. For a deal this large, the two sides felt it was important to meet in person, two of the people said. At that meeting, Rometty gave Whitehurst a written indication of IBM's interest, they said.

The Red Hat CEO informed his board, which convened a meeting to evaluate the offer and move forward with talks, one of the people said. The firm reached out to potential partners, asking longtime banker Guggenheim Partners to act as the lead. Morgan Stanley, which helped sell GitHub to Microsoft earlier this year, was brought in for its relationships and transaction experience with other potential suitors such as Google, Amazon, and Microsoft, according to one of the people.

Secret talks

The talks were a closely guarded secret. Even at IBM, which has been known to use hundreds of people to conduct due diligence on a deal, the team was small, numbering less than a few dozen, according to one of the people. Advisers kept their teams lean, considering the amount of work needed to get done.

Everyone referred to the two firms by code names. The tech giant, known historically as Big Blue, went by the secret name of Indigo, while Red Hat was known as Socrates.

As deal talks heated up, IBM and its advisers backed away from using financing for the entire purchase price, believing it would be more prudent to use cash on hand and other sources of liquidity to cover a portion, according to multiple people. The firm reduced the financing to $20 billion, the people said.

At the original size, JPMorgan needed a partner and agreed to split the financing 70-30 with Goldman Sachs, the people said. The two firms kept that agreement even when the size of the loan shrank to an amount that JPMorgan could have handled on its own. Ultimately, the bank provided $14 billion and Goldman contributed $6 billion, the people said.

In deals where secrecy is prized, keeping the number of financing banks to a minimum is critical. Lawyers at Paul Weiss advised IBM, while lawyers at Skadden Arps worked for Red Hat.

As IBM and Red Hat continued to negotiate, the target's advisers checked in with other big tech firms to see if they might be interested in a deal worth more than IBM's offer, one of the people said. One of those firms was Google, according to reporting from CNBC. Those talks and others ultimately went nowhere.

The big announcement

And so on Sunday, October 28, IBM announced it was paying $190 a share for Red Hat.

That was a 63% premium over Red Hat's closing price of $116.68 on Friday. Shares of Red Hat traded upward of $175 in June, but disappointing earnings combined with a volatile market to drive the price sharply lower.

For Rometty, the deal promises to be transformative and instantly establish her firm as a serious player in cloud computing. For Whitehurst, the deal represented what would be a 60% premium to its stock price last Friday, though the valuation was set earlier in the month when Red Hat's stock was trading higher, according to two people with knowledge of the talks. And anyway, valuation is seldom tied to the spot price, they said.

For many of the bankers and lawyers, the deal was the culmination of years of working with IBM, one of the first technology firms that has recently tried to reboot its strategy after a slump in revenue.

It was also a potential payday. The deal could mean as much as $115 million in fees for the bankers, according to Jeffrey Nassof, the director of the consulting firm Freeman & Co.

Guggenheim and Morgan Stanley, Red Hat's advisers, are set to split an estimated $50 million to $70 million in fees for working on the deal, while IBM's advisers — JPMorgan Chase, Goldman Sachs, and Lazard — are expected to split an estimated $35 million to $45 million, Nassof said. Those figures don't include financing.

The deal, subject to approval from Red Hat's shareholders, is expected to close in the second half of 2019.

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