Monday, November 3, 2008

New York Times: Debt Linked to Buyouts Tighten the Economic Vice

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Before the main story there is an excellent (but lengthy piece) in the New York Times 'From Midwest to MTA, Pain from Global Gamble' which outlines some examples of the interconnections of the global finance eco-system; and current fallout. It actually parallels the exact same situation many individuals in America were faced the past decade - facing a shortfall in budget people "got creative" to fill the gaps - and "enablers" were ready, willing, and able to sell them the product to get them there. Granted the enablers are paid on volume of transactions only so if they blow up after the fact - who cares? No different than mortgage brokers the past half decade. It's a long story but thought I'd highlight it since it shows you how even local school boards were taking this gamble to make up for holes in their budget. And why I have been saying for the past year, that next budget year for state's is going to be a disaster (look for federal bailouts there too starting next summer)
  • During the go-go investing years, school districts, transit agencies and other government entities were quick to jump into the global economy, hoping for fast gains to cover growing pension costs and budgets without raising taxes. Deals were arranged by armies of persuasive financiers who received big paydays.
  • But now, hundreds of cities and government agencies are facing economic turmoil. Far from being isolated examples, the Wisconsin schools and New York’s transportation system are among the many players in a financial fiasco that has ricocheted globally.

But the main story I want to focus on is private equity which were about 18 months ago the new golden children - masters of the universe; the best, the brightest, the new power brokers in our era of cheap credit and looking the other way while they load the companies they buy in debt while running off with huge paydays. So for their self interest they are effectively bogging down company after company and threatening the jobs of many in this country. The fallout will be even more apparent in the current credit situation. I still to this day, on principle alone, won't buy Burger King (BKC) stock based on this story I read in BusinessWeek a few years ago [BusinessWeek - April 10: Where's the Beef?] I'm not the only one [Nov 19: Cramer Goes off on Private Equity] The irony is the IPO of Blackstone (BX) effectively put in the "top" in private equity. But let's see how the credit crisis is affecting our friends...

  • Private equity firms embarked on one of the biggest spending sprees in corporate history for nearly three years, using borrowed money to gobble up huge swaths of industries and some of the biggest names — Neiman Marcus, Metro-Goldwyn-Mayer and Toys “R” Us. [That Mervyn's thing didn't work out too well - Jul 21: Add Mervyn's to our Growing Litany of Retailer's Heading to the Great Sunset]
  • The new owners then saddled the companies with the billions of dollars of debt used to buy them. But now many of the loans and bonds sold to finance the deals are about to come due at the worst possible time. So, like homeowners with an adjustable rate mortgage that just went up, some of private equity’s titans are facing a huge squeeze. And that is coming at the same time consumers are staying home with their wallets closed. “There’s absolutely going to be a lot of pain to go around,” said Josh Lerner, a professor of investment banking at Harvard Business School. “The big question is how apocalyptic it will be.”
  • Private equity firms, which are lightly regulated, use investors’ money to buy undervalued public companies and take them private. The difficulty of companies that have been acquired by private equity firms to get new credit could have enormous implications for the economy. People who work for companies owned by private equity firms could lose their jobs as firms cut costs to meet their debt obligations.
  • Pension funds and college endowments that invested their money into in these funds in recent years hoping for big returns are likely to suffer as well, and many of those investors could face a cash squeeze, as they are forced to hold onto their investments for years until the economy recovers.
  • When the economy was booming, the firms made huge profits by cutting costs at their new acquisitions, improving operations and then turning around and selling them. In 2007, at the height of the bubble, such deals totaled $796 billion, or more than 16 percent of the $4.83 trillion in all the deals made globally that year, according to data from Dealogic.
  • Firms like the Blackstone Group and Kohlberg Kravis Roberts & Company, faced an image problem at the height of the bubble for excessive compensation and beneficial tax treatment, but their returns were so high that even investors like pension funds were drawn in. Now these firms, built on enormous amounts of debt, are being forced to go back to the financial markets just as those markets have nearly frozen up.
  • If history is any guide, the worst may be yet to come. Steven N. Kaplan, a professor at University of Chicago Graduate School of Business, found that nearly 30 percent of all big public-to-private deals made from 1986 to 1989 defaulted. Many industry insiders and analysts contend that companies backed by private equity will not suffer nearly as much as those in the late 1980s because the firms pushed for better financing conditions that allow them to keep operating even if they cannot make their debt payments. Stephen A. Schwarzman, chairman of Blackstone Group, remains committed to the future of private equity. “The people rooting for the collapse of private equity are going to be disappointed,” he said. While some companies may find themselves in trouble, he said, many more will be able to ride out a downturn in the economy because of the less restrictive financing conditions that banks agreed to earlier
  • Shares of Blackstone are hovering at around $10, down from the $31 they were at when Blackstone went public in June 2007. (Fortress Investment Group, another big firm, is trading at $4.90 a share, down from its initial price of $35 in February 2007.)
  • Mr. Lerner, of the Harvard Business School, said that trouble among private equity firms would probably “precipitate hard questions about the compensation and fee structure” in the industry. The firms generally take fees of 2 percent of all money managed and 20 percent of profits. “I would not be surprised if they try to head off the criticism by returning capital,” he said.
  • The problem for the past deals is that many firms waded into economically sensitive sectors like retailing and restaurants. Firms like Apollo, Cerberus Capital Management and Sun Capital Partners purchased several troubled companies to turn around from 2004 through the first half of 2007. In the case of Linens ’n Things, a longtime also-ran to Bed, Bath & Beyond, Apollo knew that it had a tough job ahead of it, yet it still added heavy debt. Two months before Linens ’n Things was acquired, it reported $2.1 million in long-term debt; by Dec. 31, 2007, that amount had exploded to $855 million. (sounds identical to the Burger King story) We highlighted Linens n Things in [Apr 11: This Day in Bankruptcies - Another Airline and our First Major Retailer]
  • At the time, private equity firms assumed that they could refinance their portfolio companies’ debt cheaply. But many appear to have been blindsided by the size and severity of the credit market meltdown, which has left lenders unable or unwilling to provide more money. In what seems a worrisome trend, many bonds of private equity-backed companies have recently plummeted in value, signaling worries about their solvency.
  • The bonds issued by Harrah’s Entertainment, for example, were trading at 16.5 cents on the dollar, indicating investors’ belief that the company was drawing closer to a potential default. Harrah’s, too, was saddled with a lot of debt when it was taken private. A month before the completion of the Harrah’s takeover, the company reported $12.4 billion in long-term debt. By June 30, that figure had swollen to $23.9 billion. Harrah’s has already begun making selective staff cuts and has begun scaling back costs, even cutting back hours in its V.I.P. lounge and the complimentary rooms and meals for its best customers. (again the same pattern as Burger King)

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