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Recap Rerun: Short Memories, Missing Regulation

While defaults rise and growing numbers of private-equity backed companies continue their march to bankruptcy (though not necessarily losses for the funds which marched them there), the "creative" financial devices which helped fuel the buyout boom appear poised for a comeback.

"Dividend recapitalizations" (taking on new debt to return cash to the buyout fund), "covenant light" (credit without conditions) and PIK loans (payment in kind, or funding debt by issuing new debt), among the presumed victims of the financial meltdown, are again being actively encouraged by Wall Street.

According to Bloomberg, writing on December 1, "Private-equity firms are returning to the high-yield, high- risk, debt market for acquisitions and dividend payouts little more than a year after Lehman Brothers Holdings Inc. failed and the global default rate for speculative-grade companies rose to the highest since the Great Depression." The article quotes JPMorgan Chase's head of leveraged loan sales saying head “Investors are thirsty for new names and product. They’re tired of shopping in the same aisles in the secondary market.”

Not only has buyout activity rebounded, so has the size of the deals. In the IUF sectors, for example, these include: KKR's acquisition from AB InBev of Oriental Brewery Co (USD 1.8 billion) and InBev's amusement unit for USD 2.7 billion); CVC's acquisition of AB InBev's Eastern and Central European operations for USD 2.2 billion (and a possible additional 800 million.; and Blackstone-owned Pinnacle Foods' USD 1.3 billion purchase of US frozen food maker Birds with just 300 million in equity.

These are of course far from the megabuyouts thrown up at the height of the LBO bubble, like the highly leveraged 2007 USD 45 billion buyout of energy group TXU (now Energy Future Holdings) by KKR., TPG and Goldman Sachs. (The size of that deal, according to the company's chief financial officer, has been considerably underestimated. The record 45 billion price tag should be revised upwards to 48 billion to take account of the existing debt on the company's books. Since the buyout, according to the CFO in an interview with the internet news site The Deal, the company has put an additional 3 billion in debt on its books by "paying the interest on several billion dollars of pay-in-kind toggle bonds by issuing more bonds instead of paying cash.")

Toggle bonds gave the buyout houses the option of paying off debt in cash or through new debt (payment in kind, PIK). According to a Financial Times article of December 2, "The techniques fell into disrepute during the financial crisis because they were based to varying degrees on the same rosy expectations that encouraged companies and consumers to assume what proved to be crippling levels of debt." Another instrument was the "covenant light", or virtually condition-free, loan to grease the buyout and allow the funds to take out cash post buyout by borrowing more (dividend recapitalization).

The disrepute, if such it was, was short-lived: covenant light, recaps, and highly leveraged deals are all back. USD 900 million of the debt used to fund the Birds Eye acquisition was covenant light, and the price was at a high ratio relative to cash flow.

While that deal was being finalized, according to the same FT article, "Wall Street witnessed the first Pik toggle deal since the crisis - a $250m financing for JohnsonDiversey, a cleaning services company. Meanwhile, several dividend-recap attempts have been mounted, including one involving the Booz Allen Hamilton consultancy, which is arranging $350m in loans that is likely to help pay a $550m dividend to Carlyle, its private equity owner. Tops Friendly Markets, a grocery chain, was using about a third of a $300m bond to pay a dividend to its owners, Morgan Stanley Private Equity, a Morgan Stanley executive said. Goodman Global, a maker of heating and cooling systems, has approached lenders seeking permission to use older borrowings to pay its owners - including Hellman & Friedman - a $115m dividend, according to the Standard & Poor's leveraged commentary and data division."

Bloomberg data shows US banks putting together USD 38.3 billion in high-yield,.high risk debt since September for buyouts and dividend payments, "more than in each of the previous three quarters."

A Wall Street Journal blog of November 20 quoted Paul Salem of Providence Equity Partners saying they had "recently received an offer of five times leverage from banks to do a dividend recapitalization, adding, 'Boy, memories are short.'"

The return of the recap and PIK loans and the rebound in the junk bond market are being ascribed to record low interest rates leading to "overheated" credit markets. Cheap money, however, can express itself in a variety of ways, depending on the wider environment. If the buyout funds and their banks are starting to party like it's 2006, and financing for real investment is systematically shunned in favor of speculation, it is the result of post Lehman political failure. Nowhere has a even a single significant regulatory measure been introduced to reduce the scope of highly leveraged finance, including private equity buyouts.

The call for action in the IUF's 2007 Workers' Guide to Private Equity Buyouts, written at the height of the boom, remains as pressing as ever:

The leveraged buyout boom in the US in the 1980s crashed to a halt because of movements in interest rates and the stock market which were unfavorable to the buyout business. Some of the funds went bankrupt, others reduced their profile and their activity. Today they're back with a vengeance, and global in their attack. The damage of the 1980s, however, cannot be undone – companies were ravaged and thousands of unionized jobs were scrapped. While some junk bond dealers went to jail, nothing significant was done in the way of regulation to prevent a recurrence – and that is the essential lesson. Workers – and society as a whole – cannot simply wait for the current cycle to run its course, as financial authorities and private analysts are increasingly predicting it soon will.

The cycle ran its course, leaving in its wake far greater damage than the first round. If anything has been learned, it should be that we can't afford to go another round.