The IUF's Private Equity Buyout Watch

According to leveraged finance specialists gathered at the November 26 Debt Brief Europe conference in London (keynote theme: "Who will finance future deals?"), up to half of the companies taken private in the past three years face potentially serious problems with continuing to finance their debt.

The Wall Street Journal on December 1, reporting on the meeting, quoted the investment director at Japan's Nomura Mezzanine as describing "a black hole of economic morass." The WSJ described the situation in more prosaic terms, merely predicting "substantial casualties".

More concretely, Standard & Poors reports a 100% increase in the year to October 30 in companies breaching their bank loan covenants, requesting waivers from creditors "or related restructurings among speculative-grade industrial companies [i.e. LBOs]." Moody's Investors Services, according to the same WSJ article, "expects the five-year global high-yield default rate to more than triple to 35.1% from the current 10.2% by 2013.

In addition to the growing number of covenant breaches and outright defaults, the ticking time-bomb of so-called PIK (payment in kind) notes weighs over the LBO debt market. Covenant-lite loans (i.e. loans with few restrictions) were granted in abundance at the height of the LBO boom, allowing companies to skip interest payments by exercising an option to issue more bonds (the PIK notes), funding debt through more debt. According to Standard & Poors, the total volume of outstanding PIK bonds now stands at over USD 33 billion, most of it attached to leveraged buyout deals. At least 18 companies taken private have issued PIKs (including Harrah's Entertainment, US hospital chain HCA and Texas energy provider TXU, 3 of the biggest LBOs) - and not all companies have exercised their PIK options. PIK notes allow the portfolio companies to (temporarily) conserve cash but can hasten bankruptcy by adding to the accumulated debt burden while flooding collapsing debt markets with still more dubious paper.

HCA, for example, taken private for USD 33 billion in 2006 by KKR, Bain Capital and Merrill Lynch, carries USD 26 billion in debt on its books. With net income down dramatically compared with what it was in the year of the buyout, the company skipped a recent cash interest payment on a part of the senior loan, hoping to save an estimated USD 145 million each year by issuing PIK notes at over 10%. But the loans will add more debt each year than was saved by skipping the interest payment!

Unions representing workers in all these heavily indebted companies should be bracing for tough negotiations. Behind the traditional bargaining representative on the other side of the table now stands an intricate leveraged financial construction, requiring an expanded union bargaining agenda.

Posted on December 4, 2008 04:13 PM | Permalink

Until very recently public and private employee pension funds were loading up on private equity in a relentless drive for above-market returns.

Two of the biggest US public employee pension funds - California's CalPERS and the Washington State Investment Board - last year increased their overall allocation to private equity to a record 10 and 25%, respectively. CalPERS went a step further and bought direct stakes in Apollo Management, Carlyle, and Silver Lake Group (see see Growing Pension Fund Stakes Feed PE Search for 'Permanent Money on this site. Frozen out of the top league of established buyout funds, hundreds of pension funds worldwide arriving late on the scene competed frantically to invest in newer, smaller funds, which in turn fed the competition to close more and bigger buyout deals, at any price, as long as credit was cheap and regulation largely non-existent.

So strong was the pressure to invest - even as LBO defaults soared and the meltdown in the financial markets deepened - that the largest buyout funds had little difficulty in meeting their fundraising targets well into the financial meltdown, even closing out some funds early as recently as six months ago. With money pouring in and megabuyouts no longer on the investment map, pe funds were estimated to be sitting on some USD 450 billion in uninvested capital (up from USD 300 billion at the start of 2007) - on which pension funds were paying high "maintenance" fees.

A Financial Times article of November 23 now reports that some anxious investors are dumping these investments at a huge loss. But unlike hedge funds, which are less illiquid, private equity funds don't allow for easy exit. As a consequence, investors are forced to sell their shares in a growing secondary market. According to the article, "Investors in buy-out funds are so concerned private equity returns will slump in the years ahead that they are selling their commitments for as little as 30 per cent of their original value. Eighteen months ago, if such stakes were available at all, they generally traded at a premium."

"The sell-out from private equity funds," the article continues, " is gathering speed as pension funds, endowments and family offices realise these funds are likely to fall far short of original target returns. They are already reeling from losses in the stock market and on hedge fund investments.

"The collapse in valuations reflects growing concerns that many private equity-owned companies will implode as the economic contraction intensifies. Some of the largest deals, struck at the height of the private equity boom that ended in the spring of 2007, now look to be disastrous for the equity holders.

"Monte Brem, chief executive of StepStone, which acts on behalf of such investors, says he thinks it may make more sense to buy funds at a sharp discount in the secondary market rather than paying full price for stakes in new funds. Mr Brem is now considering buying stakes in the secondary market for his clients."

A November 30 Financial Times update states "Investors are likely to sell about $140bn in private equity investments - more than 10 percent of the total - in the next 18 months", with some analysts predicting even greater flight.

How many pension funds are now liquidating their investments at a huge loss after years of chasing alpha returns at the expense of jobs and the stability of the financial system? Unions should be asking their pension fund trustees.

Posted on December 1, 2008 03:04 PM | Permalink

US private equity funds fleeing a dismal buyout scene with piles of uninvested cash have received a shot in the arm from regulatory changes enacted on November 28 which could feed their appetite for acquiring banks. Investment funds were previously limited by federal regulations to a 25% stake in banks but were prevented from owning them. Now the US Office of the Comptroller of the Currency (OCC) has skirted this by creating a "shelf charter" which would permit non-bank investors to form a bank holding company to become eligible for bidding on a full ownership stake in failing banks. The funds, after acquiring all the stock, could then run the banks the way they run their portfolio companies - with no shareholders to stand in the way.

While the OCC's head counsel declared that "Not just anybody can come in and get a charter", one investment group - Hilltop Holdings, backed by three private equity funds - has already received the first charter.

Posted on December 1, 2008 12:25 PM | Permalink

The IUF and two Norwegian affiliates, the General Workers' Union Fellesforbundet and the Food and Allied Workers' union NNN, have publicly called on Norway's State Pension Fund to maintain existing restrictions on investing in private equity and hedge funds. The government fund, Norway's oil-funded sovereign wealth fund with some USD 300 billion in assets, does not currently invest in either private equity or hedge funds but maintains an ongoing discussion with regard to new investment classes. The fund is regarded as a standard-setter with regard to ethical investment, having disinvested from Wal-Mart (2006) in response to the company's record of labour and human rights violations, and more recently from mining giant Rio Tinto in response to the company's environmental destruction in Indonesia.

The letter, signed by the three organizations' general secretaries and sent to the Finance Ministry on November 29, outlines the risks to both investors and to the global financial system arising from heavily leveraged investments and stresses the destructive employment impact of private equity buyouts. Recalling the global standard-setting role of the Fund, the letter states: "Investment in private equity and hedge funds would take the State Pension Fund into areas which violate its basic principles, add to global financial instability, impact negatively on working people's lives and livelihoods and undermine the standard-setting role of the Fund. We strongly believe that opening even a limited percentage of the Fund's investments to these "alternative assets" would have a destructive impact globally.

"Any discussion of lifting the existing restrictions on investment in 'alternative assets' - which we understand to be ongoing - calls for extensive, wide-ranging public debate which can take into account the many-sided impact, today and tomorrow, of these investments."

The full text is available here.

Posted on December 1, 2008 10:42 AM | Permalink