With over USD 1 trillion in buyout-related junk bonds coming due by 2014 and private equity-owned companies under severe cash strain, the battle is on in a war of position beyond bondholders and debt holders with claims on equity. The private equity funds - whose buyout strategy consisted of reducing their own equity stake to an absolute minimum in doing the deals - are now seeking to amass equity claims (which would leave them in control of what's left or could be extracted) in preference to those with a shot at cash in the event of company bankruptcy.
"Some debt exchanges are transferring wealth from bondholders, who are taking losses, to equity investors, who benefit when debt is extinguished", notes an April 17 Reuters article.
One way to measure the intensity of the combat is by the volume of "exchanged debt" changing hands in refinancing operations as the buyout funds trade old debt for new to position themselves for default/bankruptcy. According to Professor Edward Altman of New York University, quoted by Reuters in the April 17 article, distressed debt exchanges in 2008 totaled nearly USD 30 billion - or double the total value of the previous 24 years combined!
"The new twist", observes Reuters, "is that debt exchanges are becoming more coercive, meaning that bondholders participate not to receive benefits such as higher coupons but out of fear of harm if they hold out. In these kinds of exchanges, investors who swap their debt are often bumped higher in the capital structure, weakening the holdouts’ claim on a company’s assets if it goes bankrupt."
This is precisely what has been happening at Harrah's, the world's largest casino complex owned by TPG and Apollo. The funds have been buying up second-lien notes for 37 cents on the dollar, but have faced revolt on the part of bondholders anxious to secure the best possible deal when bankruptcy comes. (In addition to scooping up its own debt, Harrah's in late May issued USD 1.375 billion of notes paying 11.75% to pay down debt arising from the 2008 leveraged buyout. According to data from Bloomberg, "Speculative-grade companies, rated below Baa3 by Moody’s Investors Service and lower than BBB- by S&P, have sold $43 billion of junk bonds this year, 34 percent more than in the same period of 2008, according to Bloomberg data." So in the middle of an ongoing "credit crisis", junk bonds are flooding the market!)
Harrah's has also announced a USD 500 million cost-cutting program, which together with the refinancing pressure will translate into immediate pressure on workers and their contracts.
Bondholders at Freescale Semiconductor, the chipmaker taken private in December 2006 by a Blackstone-led private equity consortium including Carlyle, Permira and TPG, have recently sued the company, claiming its exchange program "unjustly enriched" noteholders who swapped "nearly worthless" notes for a loan backed by company assets as collateral. The lawsuit claims "The noteholders will have a substantially better chance of recovery if Freescale files for bankruptcy."
The consequences of the heavy leverage in the Freescale buyout were accurately identified by Business Week's April 3,2008 "When a Buyout Goes Bad", which called the deal "one of the ugliest buyouts in history.", noting that the debt burden would cripple capital expenditure and investment in R&D in the highly competitive and volatile technology sector.
"Freescale has no plans to lay off employees or sell or otherwise dispose of its facilities", according to the company's filing with the Securities and Exchange Commission which announced the buyout. By the end of last year the company had laid off some 2,500 employees - 10% of the global workforce. For workers, the ugly buyout gets even uglier.
Lenders are also pushing back at Clear Channel Communications, taken private in 2008 by Bain Capital and THL. According to the New York Post of May 22, "Only nine months after private-equity firms THL Partners and Bain Capital bought the radio and billboard giant in a $27 billion leveraged buyout, the two firms this week reached out to Clear Channel's largest senior lenders to propose a debt exchange and were roundly rejected by at least two lenders, who sources said had little interest in the proposal." The Post quotes one of the lenders who "said he might fare better forcing the company into bankruptcy than accepting a debt swap".
Clear Channel - whose private equity owners had to take legal action against the banks to force them to finance one of the last of the giant buyouts deal as the credit crisis deepened - has already had to lay off 1,850 employeees on its short march to bankruptcy. Now the battle over refinancing will determine how many workers are left in what remains of the company and how the debt holders dispose of its assets. The lesson for unions is that debt matters: how much debt and what kind of debt are on a company's books are crucial issues for unions defending workers' jobs and working conditions.
When the family sold the business to Nabisco in 1992, Stella D'Oro had 3 bakeries across the US with 575 employees and annual sales of 65 million dollars. But the 1990's were the decade which crystallized "shareholder value", the pressure to deliver constantly rising dividends and share prices. Fixed investment was increasingly viewed as a liability rather than an asset. Cash flow began to be diverted away from productive investment to finance dividends and share buybacks. Despite healthy earnings, companies began to borrow heavily to pay out even more cash to shareholders. From third quarter 2004 to third quarter 2008, the companies in the Standard & Poors 500 spent 2.6 trillion dollars on dividends and share buybacks - on $2.4 trillion in earnings. Whole or partial product lines - including profitable operations - were sold off and rotated through a succession of owners.
For many workers, the process ends with the sale of orphan brands, manufacturing sites and services to a private equity fund. From 2000 through 2007, some 3,000 US companies with a value of over one trillion dollars were acquired by private equity funds through leveraged buyouts relying on massive debt to finance the deals.
RJR-Nabisco was taken private by KKR for 31 billion dollars in the 1989 leveraged buyout memorialized in the book (and later movie) “Barbarians At The Gate." KKR couldn't build the Stella D'Oro brand or the company's other products: they were too busy scrambling to meet interest payments and get their cash out. The mega-LBO failed to yield the anticipated megaprofits, despite massive job cuts and plant closings. So RJR-Nabisco was dismembered; in 2002 Kraft bought Nabisco, and with it Stella D'Oro, originally with an eye on challenging other up-market bakery specialists.
With Nabisco reeling from the ongoing buyout damage, Kraft began by investing in new equipment and production lines in the Stella plant in Illinois. But Kraft succumbed to the pressure for "shareholder value". The company abandoned its investment, scrapped the newly updated plant, and sold on the remaining Stella operation.
The shrinking process under Kraft left Stella D’oro with one plant and annual sales of roughly $30 million. Shortly after the Stella sale, Kraft announced a 23% increase in quarterly earnings and the elimination of an unspecified 8,000 jobs worldwide. Financial analysts were pleased: Kraft was finally getting serious.
Kraft sold Stella D'Oro in 2006 to a private equity house, Brynwood Partners. No one outside of a narrow investor circle knows the sale price or the terms of the sale. Because private equity firms are exempted from disclosure requirements, the public - including the Stella D'Oro workers and their union, Local 50 of the BCTGM (the Bakery, Confectionery, Tobacco Workers & Grain Millers International Union) - know nothing about the financial situation at the company that was once their collective bargaining counterpart. They can't know how much debt went into the deal, though they can assume it was a healthy portion of the purchase price. They can't know the rates of interest or who holds the paper. They can't know who invested in the Brynwood fund that did the deal (like all private equity investors, Brynwood Partners' fundraising is staggered in cycles).
They can't know the business plan, but they have to assume that the company books, as with every leveraged buyout, are guided by a single imperative: cash in, interest out. And they can only assume that Brynwood Partners' motivation in buying the bakery that used to be their workplace was to pay down the debt, get their money out early and sell it off as soon as possible to another investor. Brynwood's investors would expect nothing less.
The first attack on working conditions at Stella D'Oro was indirect: management replaced the union distribution company with "independent contractors" working for inferior pay. Then when the production workers' union contract ran out in July 2008, Brynwood put its first and "final offer" on the bargaining table: wages for most workers would be cut by a dollar an hour over the next five years. That meant that workers earning $18 an hour today would be making $13 in 2013. The company's first and only negotiating proposal also included stiff additional health care premiums, the elimination of Saturday pay, the elimination of paid sick leave and reduced holidays and vacation time. Under the contract proposal, nearly every Stella D'Oro worker would be considerably worse off at the end of the contract.
When the company refused to budge, the union felt it had no choice but to go on strike - and the members have been walking the picket line every day since August 13 last year. Since then, the union has received three communications from management. Soon after the walkout, union members were informed that they were being replaced by "permanent replacements", with no right to reinstatement. A letter in December informed that nearly half the positions had been "permanently replaced." And management has come up with a modification to its contract proposals: replacing the company pension plan with a 401k stock ownership plan (hardly an enticing prospect these days).
The Stella D'Oro workers are determined to defend their wages, benefits and dignity, and they've continued to walk the line. No one has broken ranks, and they've received support from other unions, community activists, and borough and state political representatives. Union members recently turned out in force for a demo at Brynwood Partners's Greenwich, Connecticut headquarters, chanting "No contract - no cookies!" But they're up against a tough adversary, and the current legal framework for industrial relations and collective bargaining is not in their favour. It's been decades since workers saw anything resembling strong government sanctions for “surface bargaining”. While management has clearly shown less than good faith, there have been no consequences for delivering ultimatums rather than seeking joint solutions through the collective bargaining process.
The federal government’s National Labor Relations Board recently issued a complaint, validating the union’s charge that Brynwood had not bargained in good faith. But given the broken status of US labor law, justice from the legal system could take years to achieve, if ever.
“We have never had serious negotiations with Brynwood,” according to local union President Joyce Alston." The Stella D'Oro workers are at pains to emphasize that they're not asking for more. Given the dire state of the economy, most would be happy to keep what they have.
The dispute at Stella D'Oro is much more than a routine conflict over wages involving a union intent on defending members' living standards and a hard-nosed management struggling with a tough economic climate. At the heart of the conflict is the huge burden of debt weighing down the balance sheets of companies taken private through an LBO.
A leveraged buyout is at best a highly fragile construction. When a company's books are swamped with debt, a rise in interest rates, an increase in raw material prices or even a slight consumer downturn can sink it. It is now estimated that up to one-half of all the companies owned by private equity funds could soon be looking at bankruptcy. Default rates are on the rise, and a number of private-equity owned restaurants, retail chains and manufacturers have already had to close their doors.
Outstanding LBO debt is a ticking time bomb in the debt markets. Like the sub-prime debt, it has been sliced, diced, securitized and "warehoused" in obscure corners of the financial universe that are only now coming to light. Buyout debt the banks couldn't move off their books when the meltdown came is weighing down their balance sheets, further aggravating the crisis in the financial sector.
The Obama administration is now proposing that private equity fund bosses' earnings be taxed at a higher rate. Considering that KKR's owners took in 1.3 billion in profits in 2007, at the peak of the LBO bubble, and that they probably pay a lower rate on their earnings (taxed at the present low rate as capital gains) than the Stella D'Oro workers, it's a welcome proposal, and a timely one. But it doesn't address the tax break at the heart of the buyout model, which is the unlimited deductibility of interest for business tax, not the low rate of taxation on personal income for the buyout chiefs.
This massive regulatory subsidy, which encourages financial pillage while costing taxpayers billions of dollars in lost public revenue, is an open invitation to poison the books. As long as company balance sheets are forced to assume the burden of their own buyout and saddled with colossal debts, workers like those at Stella D'Oro will be forced to pay the price.
Stella D'Oro is a classic example of a profitable company which has been drained and shrunk in the quest for quick gains and then turned over to the financial markets to leverage out the last bit of cash.
There was talk about cleaning up the fallout from the 1980's LBO boom in the early days of the Clinton administration. It soon got sidelined by the savings and loan crisis - and financial markets were progressively deregulated to facilitate the use of increasing amounts of debt to drive profits to new heights. So when conditions were ripe - from roughly 2000 to mid 2007, when the credit crunch began to bite - we had LBO boom number 2. The funds had changed their name to the friendlier sounding "private equity", but the mechanisms were the same.
The acquisitions were now global, the buyouts were bigger, the leverage greater, and the damage will be far wider than anything seen in the 1980s, which for many workers were a disaster.
Politicians and ordinary citizens have finally woken up to the damage unleashed by highly leveraged financial instruments. Regulatory proposals are lagging behind. The Obama administration should take action now - because working Americans can’t stand many more Stella D’Oros.
Under the terms of today’s agreement, Carlyle will adopt Cuomo’s Public Pension Fund Code of Conduct. The code of conduct bans investment firms from hiring, utilizing, or compensating placement agents, lobbyists, or other third-party intermediaries to communicate or interact with public pension funds to obtain investments. To avoid pay-to-play schemes, the Code prohibits investment firms (and their principals, agents, employees and family members) from doing business with a public pension fund for two years after the firm makes a campaign contribution to an elected or appointed official who can influence the fund’s investment decisions. This provision would also bar all firms currently doing business with the pension fund from making such campaign contributions. Investment firms must also disclose any conflicts of interest to public pension fund officials or law enforcement authorities, to increase transparency and avoid abuse of the fund for personal gain.
As a part of the agreement, Carlyle will pay $20 million to the State of New York to resolve its role in the Attorney General’s ongoing investigation into corruption at the CRF.
The Attorney General’s investigation revealed that in 2003, Carlyle, at the suggestion of a partner, retained Henry (“Hank”) Morris, the chief political aide to then Comptroller Alan Hevesi, as a placement agent to help obtain investments from the CRF. Prior to retaining Morris, Carlyle had experienced limited success in obtaining investments from CRF. However, after retaining Morris, Carlyle obtained approximately $730,000,000 in total investment commitments from CRF in Carlyle funds and Carlyle/Riverstone funds. In exchange, Carlyle paid Searle & Company, the broker-dealer associated with Morris, nearly $13,000,000.
Searle then paid the lion’s share of placement fees received from Carlyle to PB Placement, LLC, a shell company controlled by Morris. Unbeknownst to Carlyle, Morris had allegedly entered into a fee-splitting arrangement to pay Wissman half of all these fees. The investment commitments made by CRF and the related fees paid to Searle and others included:
A $150,000,000 commitment to Carlyle/Riverstone Global Energy & Power Fund II, L.P. made in November of 2003 for which Searle was paid $3,000,000 in fees, $1,425,000 of which went to PB Placement and $1,500,000 of which went to Wissman;
A $100,000,000 commitment to Carlyle Realty Partners IV-A, LP made in April of 2005 for which Searle was paid $1,250,000 in fees, $1,187,500 of which went to PB Placement;
A 80,000,000 Euro commitment to Carlyle Europe Real Estate Partners II, L.P. made in September of 2005, for which Searle was paid $1,158,382 in fees $1,098,160 of which went to PB Placement;
A $350,000,000 commitment to Carlyle/Riverstone Global Energy & Power Fund III, L.P. made in October of 2005 for which Searle was paid $7,000,000 in fees, $3,325,000 of which went to PB Placement and $3,500,000 of which went to Wissman; and
A $30,000,000 commitment to Carlyle/Riverstone Renewable Energy Infrastructure Fund I, L.P. through CRF’s fund-of-fund, The Hudson River Fund II, L.P. made in December of 2005 for which Searle received $600,000 in fees, $285,000 of which went to PB Placement and $300,000 of which went to Wissman.
In addition, soon after the CRF’s $150,000,000 investment in Carlyle/Riverstone Global Energy & Power Fund II, a principal of Riverstone — Carlyle’s joint venture partner — made an “investment” of $100,000 in Chooch, a film produced by the brother of then Chief Investment Officer to Comptroller Hevesi, David Loglisci. Carlyle was unaware of that investment and the investment was not disclosed to the CRF. Carlyle employees also made approximately $78,000 in campaign contributions to Comptroller Hevesi’s campaign between January 2005 and October 2006, some of which were solicited directly by Morris.
Several of the Carlyle investments are alleged as the basis for Martin Act and other charges in the 123-count indictment returned by the grand jury and filed by Cuomo’s office in March against Morris and Loglisci.
Carlyle is one of the world’s largest private equity firms, with over $85.5 billion under management. Carlyle manages 66 funds and operates out of offices in 20 countries in North America, Europe, Asia, Australia, the Middle East/North Africa and Latin America. Carlyle’s principal executive offices are located in Washington, D.C.
The California public employees pension fund CalPERS, the largest US public employees pension fund, in 2007 actually bought a direct 5% stake in Carlyle, alongside a 10% stake in Apollo Management (see Growing Pension Fund Stakes Feed PE Search for 'Permanent Money' on this site.
]]>The Wall Street Journal defines their role as performing "a variety of client services, such as crafting marketing materials and investor presentations -- or making introductions -- to help firms win coveted business that generates significant fees." As the buyout business has come under growing pressure to deliver the returns pension funds had been led to expect, the use of the agents has increased. "Use of placement agents has risen in recent years, as the hedge-fund and private-equity industries have grown. At the same time, declining profits and an exodus of investors amid the downturn has put pressure on firms to raise money, which can generate more business for placement agents. More than half of private-equity firms globally, or about 54%, used placement agents to close funds last year, compared to 40% in 2006, according to London-based research firm Preqin Ltd."
Carlyle Group is the largest and best know private equity fund to have been publicly named in the course of the investigation, which originally sought to determine whether some two dozen funds violated securities laws (in essence taking illegal kickbacks) in exchange for access to the New York City Employees Retirement System (NYCERS). NYCERS has investments with no less than 94 different buyout funeds – USD 1.9 billion of USD 30 billion in total investments.
According to its former executive director John Murphy, "NYCERS is in the dark as to what these investments are worth [today]." It goes without saying that they're worth a fraction of their notional value only a year ago.
New York State has now banned placement agents from access to state employees' pension funds. Meanwhile, the number of funds under investigation and the geographical scope are widening.
The IUF pointed this out in February ( The Commissioner, 'Transparency', and Codes of Conduct: the Last Refuge of a Scoundrel?), when the British and European VCAs and EU Internal Market Commissioner McCreevy tried promoting Walker-style "self-regulation in response to the European Parliament's September 2008 vote demanding comprehensive regulation of both private equity and hedge funds. Walker, quoted in the FT, now accuses Poul Nyrup Rasmussen, who heads the Party of European Socialists, of leading an "economic crusade" against private equity. We leave it to Mr. Walker to explain the meaning of "economic crusade". The fact is that the "crusade" seems to have caught on: the European Parliament voted by a cross-party majority of 526 to 82 to request the Commission to prepare comprehensive regulation.
To subvert the vote, McCreevy and the various Venture Capital Associations first tried to flog a recycled Code of Conduct. Now that it's clear the European Commission will have to do something more substantial, they've shifted to Plan B. Plan B itself is no secret: - it's set out in McCreevy's 2006 "Alternative Investment Expert Group's Report on Developing European Private Equity", authored by…members of the European Venture Capital Association (the Experts). That report called for expanding the operations of both private equity and hedge funds through a generalized EU regime patterned after the UK/Ireland "light touch" model. Far from reigning in private equity, it would establish a uniform basis for EU-wide operations. The EVCA adapted to the 2008 Europarliament vote by setting up a "Brussels Task Force" to identify areas where regulation would be acceptable, specify the precise conditions for implementation and fight all regulations which would interfere with the funds' key profit-generating mechanisms.
"There is a very real danger that private equity may get swept up in the general hardening of sentiment towards oversight of the financial services sector", declared the EVCA in its call to arms. The reports adopted by Parliament "call for measures including capital requirements; binding disclosure and transparency; controls on asset stripping and capital depletion and limits on directors' remuneration… The window of opportunity is closing fast."
Has it closed? Only the actual text of the draft Directive can tell us that. When the financial press reported in late March that the funds were preparing a response to the draft, the IUF asked McCreevy's office for a copy. We were informed that "It is our strict practice to refuse to provide privileged access to internal Commission documents because it is unethical and would leave us open to accusations of bias. Given the political sensitivities around the hedge fund/private equity file, we have been even more vigilant and attentive to this in the present instance."
So private equity has seen the (top secret, highly confidential) draft and is "horrified" that the disclosure requirements (and how much do they really disclose?) might apply to 500-600 private equity-owned portfolio companies, who just might have to provide some minimal information of relevance to government, their employees and public finance at a potential cost (according to Walker) of £25-30,000. It strains the imagination to think that private equity is aggressively lobbying for "protection" from accounting fees in London and Brussels.
What else is in the directive? Could all this be the prelude to a scenario in which the "soft-touch" 2006 McCreevy program is newly clothed in the language of regulation and a "horrified" private equity lobby screams that innovation and growth are being murdered by "crusaders"? If the Directive fails to meet the minimal objectives set out in the Report adopted by parliament, Eurosocialist and other MPs would presumably be obliged to denounce a piece of legislation which does little or nothing to protect the public from unregulated pools of speculative capital as requested in last year's vote. Commission President Barrosso would declare that if industry and the Socialists are equally up in arms the Directive must be doing something right. And Simon Walker would than announce, as he did in his February 1 Financial Times article, that private equity would reluctantly have to "bite the bullet" and comply.
Despite a massive number of amendments, the Rasmussen Report adopted by the European Parliament last year set out some basic policy objectives to be achieved through comprehensive regulation. The IUF cooperated on the elaboration of the Report at every stage, and the Report reflects many of the labour movement's fundamental concerns about private equity. To determine whether the proposed Directive meets those goals, and whether the fuss in the UK press isn't really a shadow play designed to once again frustrate serious regulation, the following questions should be put to Simon Walker:
Does the scope of the Directive apply to private equity funds, which are generally offshore, or only to fund managers domiciled in the EU? If the latter is the case, it is a non-starter, as it leaves intact the offshoring which is at the core of the regulatory and fiscal vacuum.
What is the threshold of applicability? In addition to the mega-buyout funds, the sector abounds in medium-sized to smallish investment funds owning companies with many thousands of employees. Are they exempt? Are small to medium portfolio companies covered?
What are the leverage requirements - will the Directive limit or halt the practice of buying out companies with limited equity and massive debt? Through what mechanisms?
What are the proposed rules on "asset stripping and capital depletion" - will the Directive stop the funds from paying off the initial buyout debt by selling off assets and pumping out dividends through piling new debt onto the portfolio companies?
What exactly is covered under disclosure requirements - the kind of nonsense which meets the UK Code of Conduct or detailed, comprehensive audited quarterly information on the situation of the funds and their portfolio companies? Is the Directive's touch sufficiently "light" that it would permit a private equity fund to say, as Blackstone recently told the US Securities and Exchange Commission, that "rates of return have no direct impact on our financials and therefore we question the relevance to our investors"? Or are the funds simply being exhorted to behave "honestly"?
What specific protections are applied to workers and trade unions under private equity ownership? What does the Directive require of private equity funds as employers?
A crumbling wall of leveraged debt is at the center of the current economic global meltdown. Private equity and hedge funds are part of the problem, not part of the solution, as Walker and McCreevy want us to believe.
"A half year has passed since the European Parliament voted for strong regulation of both private equity and hedge funds", says IUF general secretary Ron Oswald. "It's time to get the Directive out in the open, evaluate it in relation to what the Parliament thought they were voting for, and stop an orchestrated farce which would have us believe that the Commission tail is wagging the private equity dog."
]]>Investment funds that specialized in high-risk debt during the boom years - including the riskiest bits of LBO debt spliced into collatoralized loan obligations, or CLOs - are currently in freefall, contributing substantially to the trillions of dollars in losses for the global financial institutions. These losses have also hit buyout houses with dedicated operations speculating in junk-rated debt - like the massive losses at Blackstone resulting from their purchase of loans they bought in 2008 from Deutsche Bank. KKR's publicly listed KKR Financial Holdings LLC has seen its shares fall by 97%. KKR Financial was set up in 2004 to buy high-yield debt to finance buyouts.
In the first half of 2007, at the height of the buyout boom, CLOs bought close to two-thirds of the debt which financed the deals. The private equity houses set up these funds, earning additional money through fees they collected from investors who bought the paper which kept the buyout business moving. But CLO sales fell to USD 17 billion in 2008 from 100 billion in 2006, as investors ran away from securitized debt. According to JP Morgan, CLO bonds rated AA are trading at one quarter of face value. Standard & Poors says the riskiest bonds are trading at 10 cents on the dollar, and the number of borrowers with the lowest credit rating has doubled over the past year. Unsurprisingly, Bloomberg quotes Moody's senior credit officer as saying "The absence of new CLOs magnifies the chance companies won't be able to refinance debt."
So the buyout funds which turned their attention to buying back debt at the earlier stages of the crisis - and who've gotten badly burned because the market for debt continued to plunge - may have discovered a new tactic: buying back second-lien debt to position themselves for a major equity stake in their own bankrupt companies. According to another Bloomberg article of March 13, Apollo Management and TPG, having failed to refinance the massive debt falling due for their highly leveraged USD 30 billion 2008 buyout of casino complex Harrah's Entertainment, "Are buying debt to protect themselves should the world's biggest casino company fail. By amassing Harrah's debt, Apollo and TPG may be able to retain control of the company in a bankruptcy."
In a remarkable comment on the debt purchase, Bloomberg quotes a Harrah's spokesperson as saying "We're pleased that they continue to show confidence in our company."
Apollo and TPG know the game is probably up for Harrah's, and they're not indiscriminately buying just any bonds: they're loading up on second-lien debt, which, should the company fold, would give them a claim on equity, and thus continued control of the company they've leveraged to death (first-lien debt holders have the first shot at any cash).
Bloomberg: "Harrah's, which Moody's Investors Service included this week on a list of 283 U.S. companies considered the likeliest to default, is looking to swap 2.8 billion in bonds for new second-lien notes. As part of the exchange, Harrah's is also offering to buy back its old and new second-lien notes for 37 cents on the dollar in cash, which would allow Apollo and TPG to build a larger position in the securities."
Investors, including pension funds, who helped finance the Harrah's buyout, will of course continue to lose massively - as will Harrah's employees. As US bondholders lobby for a potential piece of government toxic asset relief, it is urgent that unions and public interest groups use this opportunity to highlight the financial pillage and massive conflicts of interest at the heart of the buyout business and its collapsing wall of paper.
In October 2008, the European Parliaments adopted (by a cross-party majority of 526 to 82) the report prepared by the Party of European Socialists (PES) on legislative regulation of private equity and hedge funds. The normal response would be for the Commission to develop concrete legislative proposals. McCreevy, however, is now maneuvering to subvert the Parliament's vote by promising private equity firms that they can avoid regulation by signing up to… codes of conduct. This was McCreevy's explicit message in a recent speech to the British Venture Capital Association (BVCA), and he appears to be working on it at EU-level.
Corporate codes of conduct, from Nike to Nestlé, have always been a move to escape from binding laws and regulations, either the elaboration of new ones or the effective implementation of existing ones. In the case of private equity, the mother of all codes is the one elaborated in the 2007 report of the UK Walker Commission, which was roundly criticized by unions at the time as an inadequate substitute for binding regulations. If McCreevy intends to again turn to the European Venture Capital Association to provide the cover for his assault on democracy, the February 1 Financial Times editorial by BVCA head Simon (not Sir David) Walker may provide more than a few clues. According to Walker, the buyout funds have to "keep marching down the path towards greater transparency" and "the regime of self-regulation" established by the 2007 report. The report, strictly speaking, establishes no regulations at all, but deals entirely with a limited number of disclosure issues in a limited number of areas for a limited number of funds - and in fact applies to a mere 56 of some 1,300 UK private equity-owned portfolio companies. Moreover, the "disclosures" are essentially useless. A quick trawl through the internet would supply more, and more relevant, information to workers and all citizens concerned with the impact of private equity on investment, employment and public finances.
Permira, Europe's largest buyout house, blazed "the path towards greater transparency" by publishing the UK's first Walker-compliant annual report. Here's what they have to say, for example, about the job they did on Danish telecommunications company TDC, which they took over as part of a private equity consortium of 5 of the biggest global buyout funds in a 2005 deal which was 80% debt-financed and took the company's debt to asset ratio up to 90%. Permira and the other funds then depleted the cash reserves, distributed the equivalent of half the company's assets to the new owners and top managers and eliminated thousands of jobs:
TDC has introduced substantial changes over the past two years including: i) significantly strengthening the management team; ii) successfully focusing the business on the core Danish operations through disposals of non synergistic assets outside the Nordics (Bite, One, Talkline); and iii) reorganising the company into a customer-centric organisation. In addition, TDC has developed a new corporate strategy and launched an extensive cost improvement and complexity reduction programme that is currently being implemented.
That's it. There's a generic picture of a mobile phone, the names of senior management, and the size of the total investment, but nothing about what really matters: the debt, how it was financed, who owns it, the evolving debt to equity ratio, how they've been taking their money out, the company's tax liabilities (or lack thereof), and so on. There is no information here of any relevance to a union involved in collective bargaining or anyone simply seeking to understand the impact of the buyout on the company, the sector or the country as a whole (unsurprisingly, TDC. is no longer a leader in wireless technology).
In 2004, Permira bought Spanish retailer DinoSol from Ahold for €895 million. To get their money out quickly, they launched a "sale and lease back" program in January 2005 which freed up cash for Permira but worsened the company's balance sheet and piled more debt on to the books, took on additional debt in November 2006, and in February 2007 took out more money through a €488m dividend recapitalization. This is what is driving developments at DinoSol. What does the report tell us?
The company is focused on defending and strengthening its competitive position in its core Canary Islands market while improving the performance of the firm’s mainland operations, aiming to increase both footfall and revenue per customer.
The "march down the path towards greater transparency" continues through the portfolio, but provides not a clue as to why many of these companies are staggering under their accumulated leverage and their debt is trading at severely "distressed" levels, a possible prelude to insolvency (of course this can and will be blamed on "unfavorable circumstances" in whose creation they had no part…). It's like reading an account of European history in the first half of the twentieth history which compresses two world wars and a devastating depression into a few lines celebrating a successful endeavor at "concentrating on core business". One eagerly awaits the next report's handling of the financial carnage at Pro-Sieben, Europe's biggest television broadcaster from which Permira and KKR sucked out a €270 million dividend last summer at a time when the company was struggling with €4 billion in debt and plunging deeper into the red.
Is this the "new tone" which McCreevy, following Simon Walker, intends to impose on private equity as "the course of action" to assure it of a "bright future"?
It is the meltdown in financial markets, not the "self-regulation" of the ludicrous Walker "code of conduct", which has put a temporary halt to pillage through leverage. What Walker and McCreevy are proposing on disclosure doesn't even come close to meeting existing requirements to which the funds should be held to account - and disclosure is only a small, if significant, part of the total regulatory program which is urgently needed.
Unions have not sufficiently emphasized the fact that strict disclosure requirements are well defined in relation to collective bargaining in existing legal instruments, including Conventions of the ILO (which have the force of international treaty law), the OECD Guidelines on Multinational Enterprises, and the ILO Tripartite Declaration on Multinational Enterprises. All of these stress the necessity of workers' access to full and complete information on the economic situation of the enterprise/company in order for "meaningful" negotiations to take place. .Since unions negotiating with a private equity portfolio company are essentially negotiating with a highly leveraged financial construction, this can only mean full disclosure of the details of the debt financing in addition to the kinds of information that unions have traditionally sought concerning revenue, investment, productivity etc. As Michael Gordon of Fidelity International wrote in a March 31, 2008 Financial Times editorial, "Private equity as we have come to know it is all about debt - lock, stock and sinking barrel."
]]>Blackstone and the other pe funds have been lobbying hard to shape the Obama administration's stimulus package, now headed for the Senate, to extract maximum benefit from possible tax relief provisions on cancelled debt.
]]> The Senate version (different from the one that just passed the House of Representatives) would allow companies which use cash to buy back their debt in 2009 and 2010 to defer tax liabilities on the operation until 2011, and then to pay it back over a number of years. The ultimate cost to US public revenue is estimated at around USD 26 billion.For US tax accounting purposes, savings on cancelled or reduced debt constitute taxable corporate income - an unwelcome liability at a time when the funds are desperately struggling with their sinking, heavily leveraged portfolio companies. Thus, for example, a pe-owned company which successfully exchanged one million dollars worth of debt for half a million in cash would owe tax on the 500,000 saved, which is treated as income. Taxed as income, it beats paying back interest plus principle, but it isn't easy to pull off, even with investors scrambling to save whatever they can.
In December 2008, for example, the TPG/Apollo-owned Harrah's Entertainment, the world's largest gaming corperation taken private for a premium price at the height of the LBO boom, reduced some of its debt by USD 1 billion. This was accomplished by persuading some bondholders to accept cash or swap existing debt for later maturing new bonds. Altogether, only a relatively small group of bondholders took up the offer. Harrah's continues to lose money and has USD 24 billion in long-term debt on its books, with 710 million due next year and 308 million due in 2011.
Bondholders have not only been reluctant to write off a significant chunk of their claims, some of have been fighting back, adding yet more litigation to the collapsing leveraged finance landscape. Apollo's attempt to refinance over USD 1 billion in debt at sinking real estate broker Realogy.(where interest payments on the buyout deal roughly equal annual revenue) was successfully challenged in the courts by investors holding senior debt (and therefore first to have a go at what's left of assets in the event of bankruptcy). Apollo had sought to exchange over 1 billion in outstanding bonds for new ones worth half as much. The lawsuit contended that the proposed swap would only "delay the inevitable failure of Realogy" and was essentially "fraudulent". The unsecured debt on offer, according to the suit, trading at less than 25% of its nominal value, "is all-but-worthless".
Early withdrawal, however, doesn't come cheap. Permira announced in December that investors could redeem their pledges by as much as 40% - but would continue to pay full management fees based on the original commitment and renounce 25% of any returns. Many pension funds had been attracted to private equity funds of funds as an alternative to locking investments into illiquid direct stakes in the buyout funds.
Commenting on December 19 on the impact on Permira of a potential investor flight, the UK Guardian wrote: "Sources close to the firm [Permira] said there would be little impact on its ability to buy distressed companies or those that fit its existing portfolio. Until yesterday, only 55% of the £11.1bn IV fund was invested, giving the firm continued access to funds. However, it is understood the firm is in constant talks with banks backing its funds, after a decade-long buying spree that added 180 companies to its portfolio. Banks often agreed to lend five or six times the total equity used by buyout firms in major deals, much of which needs to be refinanced after a period of three-to-five years. SVG's decision to cut its outstanding liability to the fund from £1.2bn to £343m will increase the proportion of bank debt and send a message to the banks that tougher times lie ahead."
]]>According to recent UK press reports, Premier's advisor Goldman Sachs is pushing them to opt for a "cornerstone" investor to inject hundreds of millions of pounds into the company, with private equity funds Bain Capital, Blackstone, Lion Capital and Permira mentioned as possible candidates. All of them are flush with uninvested capital.
Premier's debt stands at 9 times the company's current market capitalization and 4.5 times EBIDTA - which is to say, its financial structure is that of a leveraged buyout. Commenting on the 2006-2007 acquisitions in its 2007 annual report, Premier stated "We considered the majority of these businesses to be underleveraged in the existing business structure."
Premier was in fact owned by international private equity operators Hicks, Muse, Tate and Furst from 1999 until 2004, when it was listed on the London stock exchange. During that period Premier added to their portfolio castoffs from Nestlé (including Crosse & Blackwell, Branston Pickle and Chivers) and Unilever (Ambrosia) as well as cereal maker Weetabix (now with Lion Capital, who have loaded it with debt to reap dividend payments). When the dotcom/telecom bubble burst and Hicks, Muse Tate and Furst imploded, its European arm separated to form Lion Capital, now a major private equity investor in the UK food sector.
Premiere's massive debt stands as one measure of the imprint of leveraged finance on publicly listed companies. Another - the mirror image - is the prominence of high-ranking corporate food executives in the private equuity business. Lion Capital's web site "history", for example, informs us that "Javier Ferrán joined Lion Capital after a 20-year career at Bacardi, the last two years as the President and Chief Executive, and George Sewell joined Lion Capital after a 32-year career at Quaker Foods, the last nine years as the President of Quaker Foods Europe." Further, "In early 2007, Mohamed Elsarky joined Lion Capital following a 20-year career as a senior executive in the branded food sector, the last three years as the President of Northern Europe for United Biscuits. Also in early 2007, Mary Minnick joined Lion Capital following a 23-year career with The Coca-Cola Company, the last two years as the President of Marketing, Strategy and Innovation, with responsibility for strategic planning, marketing, all new product development, product quality, global advertising, media, packaging and equipment worldwide. These last two appointments further deepened Lion Capital's consumer expertise, which is unparalleled within other private equity houses." All part of financializing food…
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.
]]>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.
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.
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.
As in the retail sector (see e.g. the October 28 article on Carrefour below and
New Era in Litigation? Bankrupt US Retailer Charges PE Funds with Asset Stripping), one of the key goals of the funds' investment strategy is "unlocking value" through separation of the real estate and hotel operations. Earlier this year, Accor announced the sale of its Sofitel the Grand Amsterdam for €92 million. Accor will run the property on a 25 year "sale and management back" contract indexed to hotel revenue (though Accor keeps a 40% stake in the real estate vehicle which now owns the property). This type of contract (which transfers increased risk from the property fund to the hotel management, and ultimately to hotel workers) is increasingly replacing the "sale and lease back" arrangements under which the hotel chain sells the property and leases it back.
UK-based private equity fund 3i established 3I Quoted Private Equity (QPE) as a listed vehicle in June 2007 for the sole purpose of investing in publicly quoted companies, raising GBP 400 million (USD 746 million), of which it has since invested GBP 169 million. Establishing investment vehicles (listed or unlisted) to invest in listed companies certainly flatly contradicts the buyout funds' claim to represent a superior business model through the closer alignment of ownership and management interests, alleged relief from the pressures of short-termism etc. Pension funds and other institutional investors have also traditionally questioned the logic of paying 2% in up front fees and 20% of the profits for investing through a fund in listed companies, preferring to aim for the above-market returns promised through the leveraged buyout process. According to a recent Financial Times article, however, "31 YPE aims to double its investors' money over four years, equivalent to an annual net return of 16 per cent." The FT went on to note "But its shares have lost more than a third in a year to well below its net asset value…"
Private equity funds, like "activist" hedge funds investing in public companies, are structurally obliged to aggressively seek the maximum short-term extraction of cash through sell-offs and hyper dividends from their investment targets, for the simple reason that they have to beat the "hurdle rate" - the defined profit threshold below which they cannot extract their 20% of the profits.