" /> The IUF's Private Equity Buyout Watch: April 2008 Archives

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April 11, 2008

Locusts into Vultures 2: Funds in $12.5 Billion Debt Buyback Deal

Desperate to move off the books over USD 43 billion in leveraged loans - loans it couldn't securitize and unload when the global credit crisis hit - Citigroup has found the ideal buyer: the private equity firms whose buyouts generated the loans.

Apollo, TPG and Blackstone are reported to be close to a deal to buy USD 12.5 billion in "distressed" buyout debt, at the bargain price of what the New York Times has identified as "in the mid-80 cents on the dollar." This is lower than the USD 87 cents identified as the average trading price by a special Credit Suisse index, but more than the 70-80 cents that many other buyout loans are currently trading at.

Much of the debt comes from the buyout funds' own deals, including the Apollo/TPG Harrah's buyout, the largest private equity casino deal ever. According to the Times article of April 9, "Loans that supported buyouts by other private equity firms, like the takeover of First Data by KKR, are also expected to be included in the package", with Apollo buying half the debt and Blacksone/TPG splitting the rest.

Virtually all sizeable private equity firms have been successfully raising multi-billion dollar funds since the early days of the crisis to speculate in LBO debt. Leon Black of Apollo told the annual super Return Conference in Germany in February "You can get equity-type returns from debt instruments that may be a better play than pure equity right now, where you can't get leverage."

According to the April DowJones Private Equity Analyst, reporting on KKR's plans to soon launch a leveraged debt hedge fund, "All of the biggest buyout firms soon will be active in hedge funds, either directly or through joint ventures. But smaller players such as H.I.G. Capital Management, New Mountain Capital LLC and Quadrangle Group are looking for a piece of the action, too – albeit more quietly. Unlike the big guys, who are mostly answering investor demand for a ‘onestop shop’ for alternative investments, the mid-market players are simply seeking to put information garnered in the course of everyday due diligence and portfolio management to work in new and creative ways. There are many ideas and potential investments that arise during the course of our business that fall outside of our views of a PE fund,” said Kevin Callaghan, managing director of mid-market buyout firm Berkshire Partners, which occasionally takes stakes in publicly traded companies. “How can we take those ideas and put them to work?”

According to the same Dow Jones report, US private equity firms raised almost one third more money in the first quarter this year than in the same period in 2007 - USD 58.5 billion vs. 44.9 last year. Fundraising for buyouts, however, fell sharply as a percentage of overall fundraising - USD 27.6 billion in 32 funds, as against 35.2 billion in 34 funds in 2007.

As noted in an article on this site published on October 1,2007, "The emergence of massive funds specializing in LBO debt (one hedge fund has already raised USD 7 billion) raises fundamental regulatory issues. The investment banks who have been collecting the fees and securitizing and peddling the debt to fund buyouts now find themselves unable to offload it, except at a heavy discount, to the very funds whose buyouts created the debt in the first place. Picking up heavily discounted buyout debt could bring massive rewards to funds who lost out in bidding wars which drove purchase prices to ludicrous earnings multiples – and leave them in possession of the company in the event of a default. All the classic conflict of interest issues raised by the buyout process are magnified and intensified here."

April 10, 2008

IUF at the European Parliament Highlights Dangers, Risks of Private Equity Buyouts

The IUF gave evidence of the destructive impact of private equity buyouts at a public hearing on hedge funds and private equity organized by the European Parliament's Committee on Economic and Monetary Affairs in Brussels on April 8. In addition to describing the impact on jobs and working conditions, the IUF emphasized the dangers of high levels of LBO debt in the context of the current global economic crisis.

"The total volume of buyout deals for 2006 has been estimated as high as 725 billion USD", the IUF said. "2007 was set to surpass that, until the credit crunch froze the big deals. Financial deregulation made it possible for the banks which funded the buyouts to offload their risk through a whole new breed of credit instruments which were largely unregulated. We were presented with wonderful innovations like 'covenant lite', 'toggle loans', PIK notes and so on – all basically instruments for funding debt through more debt. Debt was piled onto the books of the portfolio companies, and securitized debt was diffused through the financial universe, in fact so widely diffused that probably no one in this room can provide a plausible estimate of the outstanding volume of LBO debt, the forms in which it exists, or who owns it. In this respect it is no different than the loans which were packaged and repackaged on the basis of subprime mortgages. The total volume is somewhere in the trillions." The presentation concluded with a call for re-regulation of global financial markets.

The text of the presentation is available on the European Parliament website here .

April 01, 2008

Night of the LBO Dead

Linguistic innovation has grown apace with financial creativity in recent years. "Covenant lite" has morphed into "zombie", the term for what a Financial Times article of March 25 described as "companies with unsustainable financial structures but no triggers for the banks to force them to renegotiate."

Their debt is trading below the 80% which has become increasingly standard for leveraged loan paper, and the companies are now deemed to be worth less than what they owe. Banks who did the deals (or still have the debt on their books because they couldn't offload it when the credit crisis hit), and investors who bought the debt, in most cases have no ability to renegotiate the terms to salvage their investments: they were "covenant lite" or even no covenant at all.

The FT gives the examples of Spain's clothing retailer Cortefiel, Irish telecom company Eircom (into its second round of financial pillage) and Germany's plastics company Klöckner.

But there are more. Exactly how many more cannot be determined, any more than the securitized debt trail can be fully traced. One indication of the extent of the contagion is a recent report from Standard & Poors's which maps the corporate default threshold. According to the study, the number of "weakest links" - companies closest to default on their financial obligations - stood at 114 on March 10, with 93 of them in the US. In June 2007, the comparable number was 62, rising to 77 in December.

Of the 93 US "weakest links", over half were involved in private equity transactions. Standard & Poor's finds the results "not surprising", given that companies taken private through an LBO depend on taking on additional debt to deliver returns to investors. "The default risk exposure may be magnified this time around, because current market conditions have constrained the typical exit options afforded to sponsors", observe S&P. That is to say, the "exit" door is currently blocked, consigning the acquired companies to longer private equity ownership - a point emphasized by the IUF at the onset of the credit crisis.

Another recent study by FridsonVision, discussed in the Wall Street Journal on January 25, looked at 220 private equity deals between 2002 and 2007, and found the level of "distressed" debt to be 29%, including bonds and loans, compared with a level of 19% in the Merrill Lynch high yield index. The study also found widely varying levels of distressed debt between the various buyout firms, with Thomas H. Lee Partners (47%), Apollo Management (42%) and Bain Capital (42%) scoring at the top.

S&P and Moody's both predict a substantial increase in the default rates for LBO-related debt.

The Debenhams Deal: Autopsy of a Quick Flip

In 2003, Debenhams, a department store chain with 142 units in the UK and Ireland, was taken private by three private equity funds: CVC, TPG and Merrill Lynch Private Equity.

The buyout, accomplished with GBP 1.4 billion in debt and GBP 600 million in equity, was described in the IUF's A Workers' Guide to Private Equity Buyouts, as "financed by mortgaging the real estate on which Debenhams stores are situated, as well as loans made against the company’s assets. Through dividend recaps, company debt was increased to £1.9 billion to finance a dividend payout of £1.2 billion to the 3 private equity firms…With the £1.2 billion dividend alone the private equity firms doubled their money in just 30 months, leaving Debenham’s seriously indebted."

The story, however, doesn't stop there. Debenhams was relisted in May 2006 at a price of GBP195p per share. With the public offering, the buyout funds tripled their initial investment. Following the initial public offering, TPG retained 14 percent of the shares, CVC 9.7 and Merrill Lynch 8.5.

With over GBP 1 billion in debt still on the books, Debenhams has struggled, and has struggled even harder in the face of a consumer spending downturn. Merrill Lynch sold some 2-3 percent of its holding last year, and on March 26, 2008 sold its remaining shares - at 60p per share, for GBP 28.4 million, compared with the GBP 103 million it was valued at following the IPO. In a classic case of thieves falling out after the big haul, Merrill Lynch gave no warning of its plan to dump the shares to its erstwhile buyout partners - both of whom retain seats on the Debenhams board. According to the Financial times, the Merrill sale "came as a shock" to TPG and CVC.

The real lesson, buried in the FT article, is this: "Merrill - along with the other buy-out firms - has made a handsome return on the investment regardless of the share price performance following the float [our emphasis - IUF] The three private equity firms made more than three times their collective initial £600m equity investment in less than three years." Company shares fell by 17% immediately following Merrill Lynch's exit.

Now is a good time for someone - say, the UK Venture Capital Association, or TPG chief David Bonderman - to explain to Debenhams' workers the familiar virtues of a leveraged buyout: longterm investment, superior management and better alignment of the interests of management with investors.