WSJ: Blackstone's World of Cash

Will the private equity party -- this week's Blackstone IPO is icing on the cake -- end with a bang or a whimper? Let's recall that on Friday, Oct. 13, 1989, the almost $7 billion employee-led buyout of United Airlines fell through, a bookend on a wild 1980s of junk bond-led takeovers. The Dow dropped 190 points that day, almost 7%. That's 1000 points today. Ouch. Could it happen again?

Sure. The money involved here ain't small potatoes. Private equity funds raised $221 billion last year, up from $33 billion 10 years ago. There are now over 170 private equity funds with more than $1 billion in assets. The value of deals done last year was $475 billion, up from $37 billion five years ago. Most of it was taking public companies private -- Equity Office, HCA, Harrah's Clear Channel and on and on.

What's fueling the boom? With the Dow over 13,000, it's not like there's lots of cheap companies just begging to be bought and turned around. Rather, the world has been awash in cash. The money supply has been growing like a weed at the same time that the federal deficit is shrinking -- $148.5 billion through the first eight months of budget year, down 34% from last year. As our trade deficit with China grows, they keep buying our long-term bonds. Add to that the Japanese carry trade (borrow in Japan at negligible interest rates and invest elsewhere), and you get distortions -- especially from fixed income investors such as banks, insurance companies, pension funds and hedge funds, all chasing higher yields.

The biggest beneficiary has been private equity funds. They buy companies by putting up some cash and then borrow the rest. Their borrowing costs, which show up in the spread between their rates and 10-year Treasuries, have been at historic lows. Anything less than four percentage points is a gift. It bottomed recently at 2.4 percentage points. That's a ridiculously low hurdle to jump over to justify a buyout. Plus, Wall Street has created a huge business in credit swaps and derivatives to help more money flow into private equity deals. So everything has been in play. Environmentally challenged electricity generator Texas Utilities? Sure. Dying auto maker Chrysler? Why not?

The dirty little secret is that private equity investors really aren't all that good. They take mediocre investments with lackluster growth but steady cash flow and add leverage to amplify the returns.

One great move we saw from the PE crowd is Hertz: Immediately after investing, borrow $1 billion and pay it out as a dividend to the investing group so they can get their money out. All of a sudden, management is focused and will do anything to maintain or increase cash flow. Here's the usual list: Cut spending, workers, offices, factories and advertising, and with tech companies now in play, cut R&D, their lifeblood. Don't mistake financial engineering for company building.

Damage the franchise? No matter. It's still lucrative. Buyout firm KKR and friends paid $6 billion for Toys 'R' Us two years ago. They should change the name of private equity to Fees 'R' Us. Besides the same 1%-2% management fee and 20% of the upside carried interest that hedge funds and venture funds charge for the money under management, private equity heaps it on. There are transaction fees for doing the deal in the first place (Hertz was bought for $4.37 billion plus debt and incurred "transaction fees and expenses of $439 million"), monitoring fees to keep tabs on their investment (Toys 'R' Us pays $15 million a year to its investors), consulting fees, investment banking fees and even termination fees when the company is flipped back to public investors. Why not accounting fees to keep track of all these fees?

This booty often goes to the general partners of the fund, not the pension funds and university endowments' limited partners who invest in the funds.

Is there an economic purpose to all this? Sure, someone has to squeeze efficiencies out of lackluster businesses. But couldn't management of public companies do this in the first place? Excuses of Sarbox and public market scrutiny or demand for short term quarterly results ring a little hollow. It's just more lucrative to do the high risk, high wire act of going private, borrowing until they'll lend no more and load companies with debt up to their eyeballs.

Borrowers chasing yield tend to forget about the risks. Late in the last buyout cycle, just before the UAL deal blew up, deals were being done with PIKs, payment in kind bonds. Rather than interest payments in cash, lenders just received more of the same bonds. These were sold with a straight face, mainly to Japanese banks whose aging managers wanted one more bonus before retiring.

Well they're ba-ack! With names like Covenant-Lite and PIK toggle, these debt instruments are designed to help companies by suspending cash payments when times get tough and are being sold to hedge funds which book profits now. So much for discipline on either side.

Tomorrow, the stock of private equity king Blackstone Group, with $88 billion in assets, starts trading in the public markets. Forget the irony of a firm that takes companies private going public itself -- or the paradox that only accredited investors can get into Blackstone's fund, but any ordinary schmo can invest in the risky stock. It will be a hit. The Senate's Baucus-Grassley shakedown bill aims to take their own fees by taxing publicly held PE companies at the corporate 35% rate instead of 15%. Perversely, Blackstone could just load up with debt to avoid the higher taxes, adding risk.

No one can call a top, but there sure are signs of fatigue. With the Dow near all-time highs, prices aren't cheap. Lenders are feeling stretched and may dry up their bottomless pit of funding. Bank of America chief executive Ken Lewis suggested last week that "We need a little more sanity in a period in which everyone feels invincible."

Ten-year bonds have been backing up, with yields approaching 5.25%. This surely means money supply growth is slowing. The Chinese are making noises of slowing Treasury bond purchases. And usually what happens is that everyone remembers at the same time that cash flow is for suckers, and the flow can dry up fast.

If the economy slows, debt payments get tougher. PIKs won't be worth the paper they are printed on. Hedge funds will go chase something else. This is the stuff that sours credit cycles.

Maybe private equity deals will just slow down to a more reasonable pace. Yeah, right. These guys have raised big funds and are paid not to back off. More likely, some giant deal, Icarus Inc., will get its wings clipped, just like United. Then we get a 1000-point drop in a heartbeat.

On a happy note, the demise of buyouts in the late '80s led to a technology funding cycle that peaked a decade later. Something productive is sure to emerge after this buyout cycle as well. Keep some powder dry.

Mr. Kessler is an author and former hedge fund manager.

Comments

[Daniel]

Andy,

1) Smart money is short debt
2) Caveat emptor and scarce money for the average investor
3) This too shall pass

I am happy to hear that you accept that the trade deficit is being fueled by money expansion and not mere profitable enterprise arbitrage, aka offshoring manufacturing. While the USA is not the only culprit, we are definitely the most savvy of the short debt party. Literally, the sophisticated money is saying that debt is too cheap and they have established short positions in debt by borrowing.

As far as the risk, caveat emptor. The PE and elite HF managers can charge the fees they do because their access to capital markets is scarce and they are the gatekeepers to big money. If PE and HF managers are the only ones that can access massive debt, by default PE/HFs are the only market participants that can compete for buying large corporations.

People participate in the securities market for the opportunity of financial reward. Money is the incentive, everything else takes a distant back seat. Leveraging cash flow is like any other investing strategy, it is great until it isn't. Velocity profited from ridiculous technology company valuations and you and Fred were smart enough to acknowledge that by shutting the doors and taking profits. The leveraged cash flow opportunity will go away too, but will eventually present itself again.

Money supply contraction is the greatest threat to the domestic and global economy right now, it will be interesting to watch what unfolds. Regardless, it will be laughable when all of these companies hit the public markets again in 3-5 years. Executive compensation needs to be refined if you don't want to PE/HF players making the big fees, but then the executives are getting the big payouts. Paying the executives the big money is probably less expensive due to lack of investment banking fees times two for a round-trip PE deal...but executives making big money upsets the company lemmings.

Best wishes, when do we get Velocity Health Care Fund?

-Daniel

[Keoni]

Andy,

I'm fearful that you are correct in your analysis. And if so, the slaughter that may ensue could do significant damage to the average investors retirement plans once again.

Most of the external concerns are on the obvious and usual suspects: Iraq, China, Oil prices, Global Warming, Presidential elections, SOX, etc. But the "gilded age" excess being displayed by PE/HF types is enough to raise concern about the top of this new bubble and they are cashing out, is this the end of this new financial era?

IMHO.

Keoni

[Andrew Horowitz]

So, the private guys who make all of theor money doing privatizations are going public. As public has much more problems with requirements for transparency ala SarbOx. The rest are going private or thinking about relocating offshore. Hmmm... Interesting....

http://www.thedisciplinedinvestor.com/blog/2007/06/21/blackstone-ipo/

[Eric Pennington]

Brilliant insights...P.T. Barnum was right.

[Eric]

I agree with your comments. Our industry doesn't seem to have any institutional memory. The markets keep making the same mistakes over and over. I'm about finished with one of your books too. It was a good read.

[James Ramos]

As Andy pointed out in his book (yes the one about our prostates), there are still trends that will change our economy. Not that i am banking on our politians, but i am banking on (yes, us) scientists. Education, like healthcare, still needs more of that scale factor. the truth is that at my firm the best employees are not the ones with the best education, but the ones who want to advance the most (despite those who still cling on to thier useless CFA's CMT's, MBA'A). this is only possible in a society like ours where the education that we require is readily available in accesible formats. Things will change. Yes, slowly. But i'll tell you something, there is nothing like hiring someone with a fire burning in them, and there is nothing to stop them now when we can put the releveant information in front of them at zero cost.

all the best to us human beings,

James

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