Private Equity's Traffic Jam in the Bond Market

Four score and seven months ago, the U.S. stock markets peaked and began to fall. They fell for a long time thereafter, and have only recovered this past spring, measured by the numerical value of stock market indexes. Adjusted for inflation, they still haven't recovered. During the late 1990's, the managements of many companies became fabulously wealthy by going public. With the end of the dot com boom, the allure of becoming a public company faded. While many companies continue to go public today, and enjoy the benefits (and burdens) of being public, a lot of the recent action for management has been taking their companies private.

To go private, management usually teams up with one or more investors (typically a private equity firm), borrows a large pile of cash, and buys out the public shareholders. Management and the private equity firm invest a comparatively small amount of money, but hold the stock of the newly privatized (so to speak) company. With the public shareholders out of the picture, management can have a larger stake in the company than before. They work to make the company more efficient and profitable, sell off unwanted lines of business, and do other things that may be easier once they're outside the glare of the quarterly reporting process and those pesky stock market analysts. Then, after one, two, three or however many years, they take the company public again, presumably at a big profit to themselves and their private equity backers.

Skeptics might point out that public stockholders don't share in the big pinata at the end of the process. And the employees may suffer a round of layoffs or two, and maybe some cutbacks on health and retirement benefits. But the human interest side of the story doesn't change the fact that the numbers for these deals have been very good for management and the private equity firms. As discussed one of our earlier blogs, a private equity firm bought Hertz from Ford in 2005 and brought it public about a year later, getting something like a 200% return. http://blogger.uncleleosden.com/2007/07/bond-market-tremors-hit-private-equity.html.
That sure beats savings bonds.

Because of the relatively small capital investment by the private equity firm and management, going private transactions require financing--a lot of it, as in billions--mostly to take out the public shareholders. A lot of public companies now trade at average to above average multiples of earnings, measured by historical standards. So it costs quite a bit of dinero to buy one. This isn't like 1982, when you could buy a public company, do a sale and leaseback of the parking lot next to corporate headquarters, and pay off the acquisition debt.

The financing for private equity deals generally came from institutional investors that bought bonds issued as part of the going private transaction. Until recently, raising the financing wasn't hard. The industrialized world was awash in cash, and big investment banks would line up to provide financing. The banks would promise to find investors to buy the millions or billions of dollars of bonds needed for the deal. They agreed that, if they failed, they'd pony up the money themselves (through an arrangement called a "bridge loan"). The fact that they might also get advisory fees, underwriting fees and perhaps other compensation for their participation in these deals probably wasn't entirely unrelated to their willingness to commit to provide these potentially enormous bridge loans.

The banks didn't really want to make bridge loans, since with a bridge loan, a large part of the risks of failure of the private equity deal would fall on them, instead of on bond holders. However, for a while, finding bond investors was fairly close to shooting fish in a barrel, with a shotgun. Bond investors were a dime a dozen, and so eager to invest they'd agree to deals where they'd have less than normal protection (so-called "covenant-lite" bonds). They even invested in deals where the borrowing company could avoid paying interest by issuing additional debt to the bond holder. In other words, the borrower would provide another promise to pay instead of cash on the barrel head. Even though they might not have much protection, bond investors still lined up to play in the private equity sand lot.

The private equity deals exemplify a process on Wall Street of structuring transactions so that risk is transferred to passive investors while rewards are concentrated on the deal makers. The public stockholders would be eased out of the picture, so that the jelly beans wouldn't have to be shared with them. New financing for the company would consist mostly of debt. Classic B-school analysis would tell you that when debt is readily available and cheap, you make more doubloons for yourself by using debt instead of equity to capitalize your company. The people in the private equity firms are very good at this kind of arithmetic. Reduce the amount of equity capital, concentrate equity ownership in the hands of management and their new best friends at the private equity firm, and finance the rest of the venture with debt. The cost of most of the capital (i.e., the debt part) is low, so the profits that accrue to the holders of the equity are leveraged. And if the transaction should fail, your equity investment would be relatively small and much or most of the loss would likely fall on the bond holders.

In essence, the going private deals largely separated risk from reward. The arithmetic of going private deals had an irresistible logic for management and the private equity firms, because they could get concentrated, low risk and leveraged rewards, while the bond holders were served rice and beans. Vast herds of bond investors abounded, and investment banks easily drove them into corrals and branded them with any deal the private equity firms wanted to do.

Consequently, going private deals were done early and often, over breakfast, lunch, dinner, and in-between meal snacks. Even though stock market price-earnings multiples were relatively high, as long as the debt was cheap, you might as well take the concentrated, low risk, leveraged profits while you could. A pipeline, almost assembly line, of deals was created, with transactions queuing up for their turn at securing financing in the debt markets. Stock market prices rose, as if every public company in the nation thought that it would be the target of the next deal.

Then, a funny thing happened on the way to the forum. Interest rates began to rise worldwide, especially for corporate debt. There are a lot of reasons for this, but it happened. And the rise in interest rates changed the profit-loss equation in private equity deals. Deals that could be successful with cheap credit might fail with more expensive credit. To make things worse, the private equity firms began to pay higher and higher prices for public companies, which meant taking on higher levels of debt to finance the deals. That only compounded the effect of rising interest rates. And, with large number of deals in the pipeline, bond investors began to pick and choose, looking for ones where the deck wasn't stacked quite so badly against them.

Next, a very ugly and evil troll named Subprime emerged from a swamp and stormed down Wall Street, stomping everyone in his path and consuming everything he stomped. The more he ate, the larger he grew. Subprime got bigger and bigger. Maids on Maiden Lane screamed for help. But the doyens of the markets trembled and dropped their bids, fleeing as fast as their limousines could navigate the treacherous pavement of the FDR Drive while desperately searching for any bridge across the East River that wasn't clogged with traffic. Subprime continued on his rampage, becoming even more gargantuan, and reached across oceans to consume a European bank or two and an Australian hedge fund. Many bond investors were also invested in the mortgage markets and learned that having a troll chew on your toes because you bought some risky investments might make you want to stay home and sip tea in the garden for a while.

Bond investors all of a sudden started to balk, and demand greater protection for their money. Greater protection for their money would mean less potential profit for the private equity guys and management. The private equity guys are no pushovers, and caving in to the demands of bond holders could reduce the potential amounts of their hard-won (well, maybe not so hard-won) profits. So the bond market stalemated. Bond investors and private equity firms couldn't agree on terms for bonds, so no bonds were sold. One recent example is a private equity acquisition of Chrysler by an outfit called Cerberus, which was left with no bond financing. Other examples are the acquisition of a British pharmacy chain called Alliance Boots and an acquisition of Allison Transmission (a GM subsidiary that makes car transmissions).

That meant the banks that made financing commitments to the private equity firms had to pony up bridge loans. Large amounts of them. The Chrysler deal involved something like $12 billion of debt, the Alliance Boots deal involved around $10 billion of debt and the Allison Transmission deal involved around $3 billion of debt. Press reports (Wall Street Journal, 7/26/07, P. A1) indicate that there are around $200 billion of deal debt that banks have committed to provide. If they can't find purchasers for the bonds, they'll have to fork over bridge loans themselves. As a result of this traffic jam in the bond market, the banks, who are the heart of the financial system, could find themselves sitting on a rather large pile of unexpected risk.

The private equity phenomenon is another manifestation of the financial markets' recent propensity to create unusually large amounts of risk. The going private transaction, as explained above, largely separates risk from reward. The private equity crew and management get the rewards, while the bond holders (or the banks, if they had to extend bridge loans) take most of the risk. The private equity guys could make truckloads of money by doing a large number of highly leveraged deals of the "heads I win, tails you lose" variety. And they did. Those deals now overhang the corporate debt market.

We've discussed in an earlier blog how the allocation of risk and reward in the mortgage markets, with the rewards concentrated the market pros if they write and underwrite high risk mortgages, led to the creation of a lot of bad mortgage loans that never should have been made. http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html. The impact of those bad loans now has the market sagging. The going private phenomenon has a similar separation of risk from reward, where the private equity firms are rewarded for doing highly leveraged and potentially risky deals without the risk to themselves of more than comparatively modest losses. In such a situation, it can only be expected that they would follow the scent of money and do a lot of those deals. The problems is that the risk of loss was transferred either to passive investors, or to the banking system. For the moment, the consequences now weigh on the banking system.

There must not be many people on Wall Street named Murphy, since Wall Street, despite a long history of panics, corrections and crashes, doesn't seem to understand that if something can go wrong, eventually it will. The fact that risk has shifted from away from oneself doesn't mean that the risk has been eliminated. Once financial risk is created, there is no way to eliminate it. It can be transferred to someone else, and then again to others. But it will always lurk somewhere. If a lot of financial risk is created, that means a lot of risk is lurking somewhere. A lot of risk can inflict a lot of pain, even if it is diffused. We are seeing this happen now with the massive losses in the mortgage markets.

No disasters have yet occurred in going private transactions. The banks that made bridge loans apparently have been able to handle the burden. But there is a serious traffic jam in the road to the bond market, and the banks' bridge loan exposure seems likely to rise. Will the private equity guys help the banks out by agreeing to take bonds with terms more favorable to the bond holders and therefore potentially less profitable for private equity? Well, remember the adage that if you want a friend on Wall Street, get a dog.

Maybe all this will just blow over. The U.S. and world economies are doing okay, and American consumers continue to do yeoman's duty at the mall. But now risk abounds, and more trolls may be stirring.

Personal Finance in the News: man receives 2,000 credit cards he didn't ask for. http://www.wtop.com/?nid=456&sid=1200699. No wonder there's a consumer credit problem.