naked capitalism

The New York Times has a good update on the progress, or more accurately, lack thereof, in the efforts to return to normalcy in the credit markets. The story highlights the fact that the securitization markets, to the extent they are operating, are heavily dependent on government intervention and it does not appear likely that they will function at their present level if support were withdrawn:

The continued disarray in debt-securitization markets, which in recent years were the source of roughly 60 percent of all credit in the United States, is making loans scarce and threatening to slow the economic recovery. Many of these markets are operating only because the government is propping them up.

But now the Federal Reserve has put these markets on notice that it plans to withdraw its support for them. Policy makers hope private investors will return to the markets, which imploded during the financial crisis….

“Given the imperative for securitization markets to fuel bank lending, we won’t have meaningful economic growth until securitization markets are re-established,” said Joseph R. Mason, a professor of banking at Louisiana State University…

Enormous swaths of this so-called shadow banking system remain paralyzed. Depending on the type of loan, certain securitization markets have fallen 40 to 100 percent.

A once-thriving private market in securities backed by home mortgages has collapsed, from $744 billion in 2005, at the peak of the housing boom, to $8 billion during the first half of this year.

The market for securities backed by commercial real estate loans is in worse shape. No new securities of this type have been issued in two years.

“The securitization markets are dead,” said Robert J. Shiller, the Yale University economist and housing expert who predicted the subprime collapse. The government is supporting them, he said, but it’s unclear what will happen when it extricates itself. “We’re stuck,” he said.

What is intriguing about these comments is the tacit assumption that we have to go back to status quo ante, of having a significant amount of loans on-sold into credit markets rather than retained on bank balance sheets. Yet we have seen the superficial appeal of that system comes at considerable cost. Securitization allows for more “efficient” banking, in the sense that banks can operate with far less equity than if they conducted banking the old-fashioned way, by holding the loans they originate.

But this prized efficiency comes at high social cost. First, the idea that these loans were really off balance sheet in many cases was spurious. For some types of conduits, like credit card trusts and SIVs, banks did intervene when the supposed off balance sheet vehicles got in trouble. Indeed, credit card receivables could not have been off-loaded absent parent support. So the supposed efficiency gain was phony; the banks were simply using off balance sheet vehicles as a way to run with less equity than they actually should have had, but the regulators accepted the charade and looked the other way.

Second, as we know, securitization reduces the incentives to do proper borrower assessment and even worse, means no one is monitoring the borrower on an ongoing basis. There is no good substitute for traditional credit screening. The idea that simple metrics are an adequate proxy for credit assessment and local knowledge is utter rubbish. A banker who is a member of the community can factor in qualitiative considerations in (how stable is the employer for whom the prospective borrower is working? Is the local economy improving or weakening?) that get lost in simple minded scoring systems. And for corporate borrowers, the lender is the only party in a position to obtain non-public information that will allow for a better assessment of the lending risk. That is not to say these procedures are perfect; they aren’t, but they are better than what we have experimented with over the last 20 years.

As a result of the first two failings, we have the third problem: the public covertly and overtly has provided greater backstops to securitized credit than the traditional sort. We had Fannie and Freddie and Ginnie making the first wave of mortgage securitizations possible, and after those became well accepted, banks pushed into private (meaning non-government-backstopped) securitizations. But when a fair portion of them ran into trouble, the loans could not be restructured (increasing the social cost) and the banks that were exposed (by holding securitized mortgages, or warehoused mortgages due to be securitized) wound up being rescued. So the now greater level of support to the banking system is not a mere unfortunate side effect of the credit bubble, but a direct result of securitization, a process that leads to an undercapitalized banking system and a degradation of the lending process.

It is also noteworthy that the article fails to mention the fix proposed by the Obama administration, of having the originator retain 5% of the deals they on-sell. That is simply too low a percentage to change behavior. And a hold-back high enough to make a difference (probably at least 25%) will mean banks will have to hold more capital and will thus undermine the efficiency gains that are the raison d’etre of securitization.

Before the contraction entered the near-meltdown phase (fall 2008), central bankers appeared to have some willingness to have banks go back to a more old-fashioned model, even though it implied financial firms would have to raise massive amount of equity. Dizard depicted this line of thinking as wildly unrealistic, but it is noteworthy that is was the tacit plan until the wheels started coming off the financial system:

Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning….

The US banks and dealers are through the first quarter [of 2008], and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower…

It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters. That way, there is no credit crunch, according to the model. A credit crunch, in Fed chairman Ben Bernanke’s own language, is: “A significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers.” ( The Credit Crunch , Brookings Institution, 1991) That means you can have a decline in the demand for credit as part of a business cycle without a “crunch”.

Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a Washington Mutual recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.

All of it? I do not think so. The private equity people have other ideas. To raise anything like the bank capital the Fed and the other authorities such as the Treasury want, it would be necessary to have a series of road shows for the investing public that would be the size of theme parks. That could be done with difficulty and with great dilution for shareholders and, more seriously, career damage for senior management. The Fed itself would have to be a co-sponsor in some form.

Quietly arranged deals, first with sovereign wealth funds, then with private equity partnerships, are not enough. It is a bit like attacking militias in Basra without adequate forces or preparation. Some investors might throw down their arms and defect to the short-selling side.

Another way large banks are de-leveraging is to hive off assets, such as the $12bn of leveraged financing commitments Citibank laid off on a group of private equity funds, at a discount to the original price. The problem there is that while Citi is providing what a distressed homeowner would call “seller financing”, it is a lot less than the leverage available if the commitments were to be funded on Citi’s own books, or on the books of other banks. Multiply that $12bn by a raft of other deal announcements and you have the “leftward shift” Mr Bernanke referred to. Maybe more than one shift, come to think of it.

Readers no doubt also remember that that $7 billion recapitalization of WaMu was a very unhappy experience for the private equity investors who ponied up the money.

But now that we are only (according to the IMF) 60% of the way through the losses that US banks will realize thanks to the crisis, it will be hard simply to bring the banks back to a dim resemblance of pre-crisis levels of equity after the writeoffs are factored in. The additional capital needed for on-balance sheet lending seems an impossible goal. Yet there seems to be no realistic plan for bringing back the securitization markets, which is what has to happen for a restoration of status quo ante. And some question the wisdom of that goal. From Marshall Auerback:

….the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Unfortunately, ideas like this are simply unacceptable right now. The path of least resistance is to find a way to declare victory, which in this case will be to continue to prop up the securitization markets while somehow claiming they are operating on their own.

The New York Times tonight features a generally very good piece, “Buyout Firms Profited as a Company’s Debt Soared,” by Julie Creswell that falls short in one important respect: it fails to call a prevalent and destructive practice of private equity firms by its proper name.

PE firms in the risk-blind environment preceding the credit crunch got into the habit of producing good to stellar returns by modifying their usual formula. The traditional model was to buy companies with a ton of debt, then improving their bottom line by a combination of partial asset stripping (selling off ancillary operations), cost cutting, and once a blue moon, actually doing something to improve operational performance. Then the company would be sold, either privately, usually to a corporation, or taken public.

But the PE firms found a much easier approach: just pile on more and more debt, and pay themselves a special dividend. No need to do any work, just keep borrowing until you had recouped your investment and then some. And that way you did not need to care how the company fared. If you destroyed the business, it was of no mind to you and your investors. Other saps were left holding the carcass.

George Akerlof and Paul Romer called that activity looting in a famous 1993 paper and depicted it as criminal:

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations….

Our description of a looting strategy amounts to a sophisticated version of having a limited liability corporation borrow money, pay it into the private account of the owner, and then default on its debt…

First, limited liability gives the owners of a corporation the potential to exploit lenders. Second, if debt contracts let this happen, owners will intentionally drive a solvent firm bankrupt. Third, when the owners of a firm drive it bankrupt, they can cause great social harm, just as looters in a riot cause total losses that are far greater than the private gains they capture.

This version wasn’t sophisticated. It was done in broad daylight. The Akerlof/Romer article describes how looting occurred (among other places) in Chile and in the US during the savings and loan crisis. But the New York Times article is robbed of its punch by its inability (due to Grey Lady conventions) or reluctance to call this form of chicanery what it is, a fraud perpetrated on society as a whole.

From the New York Times:

For most of the 133 years since its founding in a small city in Wisconsin, the Simmons Bedding Company enjoyed an illustrious history….

Simmons says it will soon file for bankruptcy protection, as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money.

For many of the company’s investors, the sale will be a disaster. Its bondholders alone stand to lose more than $575 million. The company’s downfall has also devastated employees like Noble Rogers, who worked for 22 years at Simmons, most of that time at a factory outside Atlanta. He is one of 1,000 employees — more than one-quarter of the work force — laid off last year.

But Thomas H. Lee Partners of Boston has not only escaped unscathed, it has made a profit. The investment firm, which bought Simmons in 2003, has pocketed around $77 million in profit, even as the company’s fortunes have declined. THL collected hundreds of millions of dollars from the company in the form of special dividends. It also paid itself millions more in fees, first for buying the company, then for helping run it. Last year, the firm even gave itself a small raise.

Wall Street investment banks also cashed in. They collected millions for helping to arrange the takeovers and for selling the bonds that made those deals possible. All told, the various private equity owners have made around $750 million in profits from Simmons over the years.

A result: THL was guaranteed a profit regardless of how Simmons performed. It did not matter that the company was left owing far more than it was worth, just as many people profited from the mortgage business while many homeowners found themselves underwater.

Yves here. While the NYT does not use our preferred terminology, it does correctly connect the dots between this sort of looting and the mortgage industry variant. Back to the story:

From my experience, none of the private equity firms were building a brand for the future,” said Robert Hellyer, Simmons’s former president, who worked for several of the private equity buyers before being asked to leave the company in 2005. “Plus, the mind-set was, since the money was practically free, why not leverage the company to the maximum?”…

A disproportionate number of the companies that were acquired during that frenzy are now struggling with the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some form this year were either owned at one time or are still controlled by private equity firms, according to analysts at Standard & Poor’s.

Yves again. Of course, the article offers the hollow defenses of Thomas Lee, that the company was a casualty of the downturn. But that reasoning is spurious. Companies need reserves for bad times, in the form of cash on hand and spare borrowing capacity. PE firms, by contrast, hollowed out their charges, assuring failure if not very much went wrong. And in the real world of commerce, things go wrong all the time.

Expect more wreckage, and expect the perps to get off scot free.

Nassim Nicholas Taleb of Black Swan fame predicts that a stock market decline of 20% would take down a lot of private equity firms along with it. Note that Nouriel Roubini predicted a fall of that level when stocks were a tad lower than today.

The grim view is confirmed by a BCG study that said that many P/E firms could fail as their portfolio companies defaulted.

If this were to come to pass, it’s a no-brainer to think the firm’s principals would be in the dole queue for bailout money.

From Bloomberg:

Private-equity firms may follow banks into failure should U.S. stocks extend their worst rout since the Great Depression, said Nassim Nicholas Taleb, author of the best- selling finance book “The Black Swan.”…

The Standard & Poor’s 500 Index has dropped 4.7 percent this year following a 38 percent plunge in 2008 that was the worst in 71 years. Blackstone Group LP, manager of the world’s largest buyout fund, fell 78 percent since the end of 2007.

“Banks are being bailed out, and private-equity firms are going to go next,” Taleb said in an interview with Bloomberg Radio. “These people in a bull market look like geniuses. And now they don’t look that intelligent, and it’s going to get a lot worse for them. If the S&P goes down 20 percent from here, what will happen to private equity firms? They’re all under water.”

As many as 40 of the biggest 100 buyout firms may collapse by 2011 as their debt-strapped assets default, according to a 2008 report by Boston Consulting Group Inc., which didn’t identify the firms in its study.

We’ve read off and on speculation that Chrysler might not make it, even assuming a less punitive attitude towards carmakers under the Obama regime. It’s hard to justify government subsidies when a wealthy owner, Cerberus, is refusing to open its checkbook. And Chrysler’s number three status makes it the least problematic to shrink or liqidate.

Cerberus has no doubt thought this through many chess moves further out than I have, and appears close to hiving off large pieces of the struggling automaker, From Reuters:

Chrysler is in talks to sell key assets to Renault-Nissan and auto supplier Magna as it rushes to restructure after taking $4 billion in U.S. government loans, according to people with knowledge of the discussions.

The string of potential deals would deepen ties between Chrysler LLC and two of its key current partners but could also mark the end of the struggling No. 3 U.S. automaker as an independent venture…

The present round of talks with Renault-Nissan gathered momentum in recent weeks and has included discussions about a deal to sell Chrysler’s iconic Jeep brand, according to three people with knowledge of the talks.

Renault-Nissan, an alliance headed by Carlos Ghosn, has been looking to clarify whether a deal to acquire assets from Chrysler would jeopardize the company’s access to U.S. government funding, one of those familiar with the talks said…

Chrysler has also discussed selling its assembly plant in Belvidere, Illinois, to Canadian auto supplier Magna in exchange for long-term production contracts, according to the three people familiar with the automaker’s talks.

In a separate set of deals, Chrysler is also looking to sell the tooling and other assets related to its PT Cruiser model, the three said.

OK, you gotta help me. Private equity is basically levered equity. Yes, the claim to add value in various ways, but many academic studies question that theory. The big source of profits is leverage and financial engineering. Neither of those approaches were spectacularly successful in any sector I can think of in 2008.

In addition, many PE firms have companies in their portfolio that are in a world of hurt right now, due to a combination of fundamentals that fell off a cliff, high debt loads, and in many cases, debt maturing in the next year or so.

So how can PE companies (on average) possibly report returns that are better than equity averages last year? It strains credulity. Leverage cuts both ways, and it most certainly would not, in most cases, have done PE owned firms much good last year.

And making the expected mere 20-30% losses (versus public market declines of more like 40%) comes when PE firms are held to more rigorous standards in valuing their holdings. That alone should have a return-depressing effect.

To its credit, the Financial Times article does say the losses could be considerably worse than the rumored level.

From the Financial Times:

Private equity firms will in the next few weeks send their investors grim letters telling them just how much – or little – the companies they invested in are worth today, with many executives saying the reported fall in value will be 20-30 per cent.

According to regulations that are applied this year for the first time, private equity firms are required to value their companies at what they would be worth in the market today rather than merely disclose the original cost of the investment.

By some calculations, the actual losses could far exceed 30 per cent, since many of these companies were bought and taken private at the peak of the financial frenzy. In many deals – particularly ones struck in 2006 and 2007 – private equity firms paid a 25 per cent premium to public market levels to take their targets private.

They then put massive amounts of debt money into their companies, suggesting the drop in value should be more like 60 per cent, some industry experts estimate.

With public markets down about 40 per cent, the equity may well be worthless today – save for the fact that the private equity firms have years to try to restructure and restore value to their companies.

Once year-end figures are known, many cash strapped investors, themselves reeling from losses, are likely to put more pressure on private equity firms to refrain from doing deals that would require them to write more big cheques.

These investors are also expected to dump more of their private equity holdings in the secondary market.

In the dot-com bust, investors demanded that venture capital firms reduce the size of their funds (my recollection the shrinkage was on the order of 50%), which a dramatic reversal of fortune for the funds, since most tried to cover their overheads and salaries with the management fee (the 2% of the typical “2 and 20″ formula). And of course, in that environment, upside fees were pretty much non-existent. Most business don’t cope well with a 50% cut in what they took to be annuity revenues (and more like a 90+% fall in top line when upside fees are included)

In more normal times, when a company faces the risk of bankruptcy but believes it has a viable business, it files for Chapter 11 and works out a deal with its various creditors. To keep functioning (and paying its lawyers) while the court proceedings are in motion, large companies have resorted to debtor-in-possession financing. The DIP financing is senior to all outstanding debt, and is generally a low-risk, high return money spinner (the reason it can be both is that it takes quite a bit of skill to be in the business, since hard asset lending types need to ascertain whether, if the company is forced to liquidate, whether the DIP can be repaid).

Despite its attractiveness to banks, DIP financing has gone into a hard winter, with one of its biggest providers, General Electric, withdrawing from the market. Many have argued that the dearth of DIP financing will mean that more companies will not be able to use Chapter 11 and will instead liquidate, leading to more job losses than in previous downturns.

A Reuters story points to a different method of adaptation: companies filing for bankruptcy before they are really bankrupt, with some cash left in the till, with the hopes of being able to complete a Chapter 11 restructuring. The story indicates that banks may be willing to extend limited non-DIP financing with this approach (particularly secured financing). But a Morgan Stanley report on these adaptations suggested that they were a far less than ideal solution, and by implication, many companies would not be able to resort to it.

From Reuters:

The bankruptcy of newspaper publisher Tribune Co and potential filing by Nortel Networks Corp reflect the increasing difficulty of accessing loans in bankruptcy, which may cause companies to preemptively file for protection, Morgan Stanley said.

Tribune filed for Chapter 11 bankruptcy protection…Instead of securing a debtor-in-possession (DIP) loan, which has traditionally been made to fund a company as it reorganizes in bankruptcy, the company reached an alternative financing deal with Barclays Capital.

This includes a $50 million letter of credit and continued use of a $300 million trade receivables facility it had made with Barclays in July. It has a $225 million balance on the facility.

“Tribune’s filing is telling, and what concerns us is that constraints on DIP financing will only worsen as the cycle wears on,” Morgan Stanley analysts said on Friday in a report….

“The most telling evidence of the challenging DIP financing environment is that companies with significant cash levels are contemplating preemptive bankruptcy (Nortel is an example) as a means to continue to function in a DIP-less bankruptcy backdrop,” Morgan Stanley added….

The popularity in recent years of companies taking out loans that were secured against their assets also complicates securing a DIP loan, as the companies are left with fewer unencumbered assets to pledge against the loan, Morgan Stanley said.

“This is yet another example of the unintended consequences of the proliferation in leveraged loans and securitization over the past few years,” the bank said.

Bankruptcy proceedings may also be more contentious than previously as corporate lenders have shifted away from banks to hedge funds and other investors.

“The holders of paper heading into bankruptcy are very different in this cycle relative to history,” Morgan Stanley said.

“The involvement of hedge funds and Collateralised Loan Obligations (CLOs) shapes our expectation that the bankruptcy process will be contentious relative to the clubby democratic-type negotiations involving commercial banks’ workout groups of the past,” the bank added.

The Morgan Stanley characterization of hedge funds is way too polite. Bank creditors are pros, they understand a deal is better than no deal, and know from experience how far they can push most structures. Hedge funds are, by their incentive structure, very short-term oriented and (generally) have no interest in a fair deal, but in securing the most for themselves. Too many parties like that at the table can often result in acrimonious negotiations and a failure to come to agreement, which is usually the worst outcome.

Yet another credit crunch casualty: venture capital firms, and potentially, their portfolio companies. The Wall Street Journal reports that VCs are seeing an increasing number of rebuffs, some borne of necessity, when they hit up their limited partners for dough (reader note: investors in private equity and venture capital funds do not remit the full amount committed at the closing of the fund, so these “capital calls” were contemplated in the partnership agreements).

The article mentions in passing that VCs suffered from missed capital calls in the dot-bomb era. Private equity funds did as well. I recall a partner in a PE fund of fund saying that nearly half the money committed to PE then was from wealthy individuals, many of them from Wall Street, and a large percentage of them was missing capital calls).

This then begs the question raised in an earlier post, on endowments selling their PE holdings, even though they are taking very big discounts to get out. Some readers suggested that they wanted to escape capital calls, particularly since the money was almost certain to be going to replace maturing debt (many of the recent deals had been done with a large component of short-term funding, and a fair bit is maturing now, just as interest rates for junk credits are super high). Given the high cost of exit, and the fact (as the article describes), some high profile investors, such as Calpers, are adopting the “just say no” approach to capital calls, why aren’t endowments doing the same? Are the endowments insufficiently tough-minded?

Indeed the Financial Times tells us the reverse side of this story, namely, that investors are ganging up on PE firms and telling them to forget about the idea of getting more money from them. This too parallels the VC experience in the dot-com bust, when funds were (effectively) told to shrink because the money crowd did not want to be putting more money into tech during a recession/post Y2K downturn.

From the Financial Times:

Some of the world’s biggest buy-out groups are coming under pressure from cash-strapped investors to reduce their commitments after Permira’s unprecedented offer to let its backers off the hook for €1.5bn.

Those most at risk are funds with poor records…

….private equity bosses have long boasted they have money locked up for a decade.

But now investors are turning the screw to discuss renegotiating the terms of these previously rock solid commitments…

But today many investors in private equity funds are considering something akin to a buyer’s strike. While most pension funds – the bulk of the money for private equity – say they have no trouble meeting calls for money, endowments and foundations have been hit by losses and some may no longer be able to afford to write cheques they promised.

From the Wall Street Journal:

From pension funds to rich individuals to once-deep-pocketed financial institutions now in desperate shape, this year’s plunging markets have made it much harder for some investors to come up with the money they promised to invest in venture-capital funds…The funds typically collect on investor commitments through periodic “capital calls.”

In October, Washington Mutual Inc. skipped a $700,000 capital call from a fund called Financial Technology Ventures Fund III…In late September, WaMu missed a $30,000 capital call to another fund, Arch Venture Fund V….

Defaults can cause venture capitalists to run out of money to keep start-ups alive.

Some venture capitalists are concerned that the fallout from defaults will be more prolonged this time because there are so few deep pockets around. During the tech bust, Storm Ventures, a venture-capital firm in Menlo Park, Calif., was able to sell the stakes of individual investors who couldn’t meet their commitments to institutions, which still had plenty of cash on hand.

Now, though, “there is distress” spread widely among all types of investors, says Sanjay Subhedar, a Storm managing director…

“In all likelihood, a number of institutional investors will not honor capital calls,” predicts Cynthia Steer, a consultant at Rogerscasey. While doing so could break legal agreements, there are few precedents for venture-capital and private-equity funds suing their investors, since they need to maintain long-term relationships with the investment community.

A year ago, major endowments, like Yale, Harvard, and Princeton were seen as the ne plus ultra of sophisticated private investors, regularly posting 20%+ annual returns. Now they are dumping big chunks of their private equity holdings at distressed prices. What gives?

The reason this is odd is that the last thing you want to sell in a bad market is an illiquid asset. Even in good times, you take a discount for liquidity (dunno what current benchmarks are, but in the stone ages, the discount for valuation purpose for privately placed, unregistered securities was assumed to be 20% to 40%. But the current environment is much more like my childhood in the securities industry, so that might not be a bad starting point.). Consider art. In bad times, top paintings suffer least, but the second tier goes for very little, and a lot simply does not sell. Ditto other collectables and estate jewelry.

So why are so many endowments all running for the hills with private equity now? It was a no-brainer as soon as the leveraged loan markets froze as of last August, leaving investment banks with lots of unsold inventory, that the PE industry was going into a sustained downturn. Investment banks bridging loans is a firm-wrecking strategy and a clear sign of a frothy market (the practice was last seen circa 1989 and eliminated bulge bracket investment bank First Boston as an independent player). The big PE firms has done a monstrous volume of deals in 2006 and valuations were rich. Despite the common perception that a public offering is the exit strategy for PE deals, other PE firms more often than realized will buy operations from another PE firm’s deal, and whole companies are sometimes traded. So an important buyer group is lost, which limits exits and lowers prices in aggregate.

And there are powerful synergies between PE deals and public equity valuations. Again, in the heady 2006-early 2007 period. PE firms were bidding for unprecedentedly large firms. and were sufficiently active so as to provide a boost to general equity valuations. In 1987, in the months before the crash, one major Wall Street firm (for the life of me, I cannot recall which one) attributed 75% of the increase in market averages over the last year to M&A activity. In those days, so-called “financial buyers” aka LBO funds, were more active than strategic buyers.

Funny that no one attempted a similar analysis in 2006. but of course, the sell-side analysts then were more into “sell” and less into “analysis” than their predecessors.

That is a very long winded way of saying that if one were to have taken a jaundiced view of things, M&A bear markets tend to be protracted and nasty, and deal values plunge at those times, If you thought you might need to lighten up, the time was a year ago. Even then you would have taken an ugly haircut, but off a a much better valuation.

But were any of these endowments in 1980s LBO funds? Doubtful. KKR did a great job of cultivating public pension funds, but for the most part, the first generation LBO firms did not attract a lot of institutional money. Remember, they were raiders and did hostile deals. The current version is much more white shoe. So few lived through that period, and even those endowments that had LBO investments back then almost assuredly have no institutional memory.

So with that long preamble, the problem is the stated reasons for selling these private equity positions do not add up,. We will get to my nefarious theories in due course. But let’s start with the background and party line.

From Bloomberg:

A push by the richest U.S. universities to unload their stakes in private-equity funds is flooding the market, driving down prices for the world’s best- known buyout firms.

Investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion, may increase so-called secondary sales of private-equity funds to more than $100 billion during the next year, overwhelming available pools of capital. Interests in funds managed by KKR & Co., Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent, according to people familiar with the sales.

Crippled financial firms such as American International Group Inc. and bankrupt Lehman Brothers Holdings Inc. are joining strapped endowments such as the ones at Columbia University in New York and Duke University in Durham, North Carolina, in trying to sell private-equity stakes…

“There’s a huge supply-demand imbalance,” said David De Weese, a general partner at Paul Capital Partners in New York, which manages $6.6 billion. As much as 10 percent of the world’s $1.2 trillion of private-equity interests may change hands next year in the so-called secondary market, up from an average turnover of about 1 percent….

Officials at Harvard are in talks to sell $1.5 billion of limited-partnership holdings in leveraged buyout funds, including one run by Boston-based Bain Capital LLC, according to a person briefed on the situation. Harvard and other endowments have suffered lower returns this year and face further writedowns on their private-equity stakes when the funds report their third- quarter valuations…..

Yves here. Apologies for the detail, but you need to get specific to parse properly.

Ahem, This is a year when every asset class is down (Treasuries are not an asset class) globally, only three stock markets are up (one was Ecuador) and Harvard is yanking out money because “returns are down”? That implies returns are positive. If that was true through end of second quarter, the relative performance was great and they’d be making a mistake to sell given the illiquidity discount.

The only logical explanation is that the investors don’t trust the valuations. Are PE firms carrying investments at book value that really ought to be written down? A quote later in the piece provides indirect confirmation:

Blackstone Group LP, whose $21.7 billion buyout fund is the industry’s largest, wrote down the value of its holdings by about 7.5 percent in the third quarter, the New York-based firm told investors last month when it reported results.

Back again to the story:

“Shares of KKR Private Equity Investors LP, which invests in KKR’s funds and trades on Euronext Amsterdam, lost about 25 percent of their value during the third quarter. Blackstone shares lost about 13 percent of their value during that period….

The endowments want to pare private-equity holdings to free up cash for new investments and to reduce the number of managers they have to monitor

Yves here, If you believe that, I have a bridge I’d like to sell you. Back to the article:

The California Public Employees’ Retirement System, the largest U.S. public pension fund, has sold private-equity partnerships and opted instead to invest in secondary funds. Calpers, based in Sacramento, disclosed last month that it has disposed of $2 billion of private-equity partnerships this year…..

So Calpers got this right, They dumped when times were relatively good, and are now buying back pieces at somewhat lower prices (the same downdraft they would have suffered, more or less, had they stayed as long as they were) at the 50% plus “all sellers, no buyers” discount on offer now. Sweet.

Back to the piece:

Also squeezing limited partners is the so-called denominator effect. With the Standard & Poor’s 500 Index down 39 percent this year, institutional investors’ public equity holdings are suffering. When the value of those holdings (the denominator) is lower, the percentage of the overall pool devoted to private equity (the numerator) rises, pushing the percentage of illiquid asset classes like private equity too high….

This is where mechanically administered portfolio allocation rules wreak havoc. We have entered a highly volatile period. Valuations at any quarter end can reflect a recent, and very short lived burst of optimism or pessimism. Didn’t program trading teach us that defaulting to rules about when and how much to sell wasn’t a great idea in wild markets? For instance:

Sales will be driven next year by institutions such as New York-based Lehman, which filed for bankruptcy in September and had more than $1 billion invested in private-equity funds. AIG, which must repay a $60 billion federal loan, has about $28 billion in alternative assets, including private-equity stakes…

Also helping drive down the price of private-equity assets is a lag in reporting compared with publicly traded companies. Since June, the last quarter for which many of the firms’ values have been calculated, the S&P 500 has dropped almost 30 percent.

Part of the problem is the same storyline is being applied to disparate players (in terms of size and immediate need for cash).

I suspect the reality for some funds is that they need to sell for straightforward operational reasons. Maybe it;s portfolio allocation rules, maybe it’s point of view that equities will rebound sooner (and perhaps may also be paying decent dividends.

But how could these supposedly savvy players not anticipated a PE drought, particularly since they coincide with equity bear markets? It seems the real problem is these supposedly conservative investors took on way too much risk.

We’ve noted from time to time that one of the many reasons this downturn will prove to be exceptionally bad is not just that corporate defaults are likely to equal, if not exceed, past post-war peaks. Two new factors are at work that will hurt junk bond holders.

First, many of the recent leveraged buyout deals, and thus a considerable portion of junk bonds outstanding, were cov-lite. That means when a company starts to deteriorate, the creditors lack their customary ability to renegotiate the debt and require restrictions on operations. Many analysts believe that the result will be that those companies will enter bankruptcy in worse shape than they would have if the creditors had been riding herd on them. That in turn will lower the recovery amount.

Second, debtor in possession financing has dried up. DIP enables companies to continue to fund ongoing expenses while working through the Chapter 11 process. A lack of DIP financing means that companies that might have been saved via Chapter 11 will be forced into liquidation. That in many cases will again lead to lower recoveries (the assumption behind Chapter 11, after all, is that a lot of companies are worth more alive than dead).

From the Financial Times:

Average yields on US junk bonds have topped 20 per cent for the first time amid rising concerns about a protracted recession and a wave of corporate defaults.

The spike in yields could have a dramatic impact on economic activity, making new debt prohibitively expensive for companies with credit ratings below investment grade. Such junk-bond issuers account for 17 per cent of the S&P 500 and nearly half the corporate bond market, according to Standard & Poor’s…

The yield on the benchmark Merrill Lynch US High-Yield index hit 20.81 on Wednesday after climbing to 20.27 per cent on Tuesday. Before Tuesday, the previous high for the index was 18.66 per cent in January 1991. The risk premium, or spread over comparable Treasury securities, is close to double what it was in 1991, when Treasuries were yielding more than 8 per cent.

Risk premiums on bonds with ratings below investment grade have hit new highs repeatedly in recent months as the credit crunch has grown worse.

Some long-term bonds issued by General Motors, one of the biggest non-investment grade issuers, have been yielding more than 50 per cent.

The latest surge in rates reflected ongoing uncertainty over a bail-out of GM and other US carmakers.

Investors were also rattled by last week’s announcement by Hank Paulson, US Treasury secretary, that the government had decided against buying toxic assets as part of its $700bn troubled asset relief programme.

The rise in yields comes as debt markets are trying to cope with a flood of forced selling by hedge funds and other investors seeking cash to meet demands for redemptions. Banks are also selling assets as they reduce their risk profiles.

In Europe, the market has not seen a large syndicated bond offering from a junk rated issuer since the summer of 2007.

A story by Andrew Ross Sorkin and Michael de la Merced, “Debt Linked to Huge Buyouts Is Tightening the Economic Vise,” covers the fact that private equity deals, which as a matter of course feature high leverage, are starting to hit the wall as the economy sours. This is hardly surprising; it’s happened in past downturns.

The story does a workmanlike job in providing details on some of the companies now in trouble, yet stunningly omits a couple of key details, namely, that the fact that many of these deals had so-called cov-lite debt, plus the fact that DIP (debtor in possesion) financing is now almost impossible to obtain. DIP financing is often necessary to help companies keep making payments as they go through the Chapter 11 process. With DIP financing scarce, lot of these deals are likely to end up not in Chapter 11, but as Chapter 7 liquidations, causing vastly more damage than past LBO hangovers. These the omissions are striking given that Sorkin covers the deal beat on a daily basis.

First, some of the key bits of the NY Times article:

Private equity firms embarked on one of the biggest spending sprees in corporate history for nearly three years, using borrowed money to gobble up huge swaths of industries and some of the biggest names — Neiman Marcus, Metro-Goldwyn-Mayer and Toys “R” Us.

Linens ’n Things, a big retailer owned by the private equity firm Apollo Management, filed for bankruptcy protection this year.
The new owners then saddled the companies with the billions of dollars of debt used to buy them. But now many of the loans and bonds sold to finance the deals are about to come due at the worst possible time….

Yves here. The notion that LBO debt issued in the last three years (which is when the bulk of the deals were done) is maturing now does not sound at all right. LBO debt usually has a longer maturity. Is this misleading drafting, or are the problems of a small subset of deals being conflated with others facing the market?

Back to the article:

If history is any guide, the worst may be yet to come. Steven N. Kaplan, a professor at University of Chicago Graduate School of Business, found that nearly 30 percent of all big public-to-private deals made from 1986 to 1989 defaulted. Afterward, private equity players were called to testify before Congress, and movies like “Wall Street” and “Other People’s Money” depicted financiers as greedy criminals…..

Many industry insiders and analysts contend that companies backed by private equity will not suffer nearly as much as those in the late 1980s because the firms pushed for better financing conditions that allow them to keep operating even if they cannot make their debt payments.

This is the ONLY allusion to the cov-lite issue, and a very one-sided one at that.

Traditionally, bond deals (except for very short term deals with stellar credits) contained provisions called covenants. The borrower agreed to do certain things over the life of the bond. Typical sorts of covenants were minimum net worth, maintaining certain interest coverage ratios (as in net income had to be at least x times interest charges), not incurring any new debt senior to the bond offering.

If the issuer (the borrower) violated these covenants, the bondholders had the right to accelerate the debt (demand immediate repayment). That, of course, would not really happen, but it gave the creditors the ability to force the issuer to renegotiate the deal (at a minimum) and in more extreme cases, to restructure liabilities in a more encompassing fashion and push for operational changes (for instance, restrictions on capital expenditures until earnings or net worth reach a certain level). It gives the creditors a chance to intervene in a deteriorating situation and put the company on an even shorter leash.

Instead, look at what happens with no covenants, and stunningly, Sorkin and Merced present this as a plus:

For example, in an effort to save cash, six of Apollo’s portfolio companies, including Claire’s Stores, Harrah’s and Realogy, have announced this year that they will pay some of their bonds’ interest by issuing more debt.

So we have a company that is worried that it might run out of cash if it pays interest, so the answer is to borrow more money. Now admittedly, some debt renegotiations wind up in a similar place (interest payments are reduced but the foregone interest is added to principal), But current creditors can also structure a payment schedule (or payment triggers) specific to the company’s situation, and the terms of debt forgiveness from them might not be as onerous as that from new creditors (the initial group is motivated to try to save its original loan and not trash the company).

Sorkin and Merced fail to acknowledge the scenario that most foresee for cov-lite deals where the company starts to get into trouble. In the old days, the banks could apply the brakes and force restructurings, sometimes forestalling a bankruptcy filing, or alternatively, trying to steer the company towards Chapter 11 while there was still something there to save. Now, the company has no checks, and the private equity investors have every reason to carry on until the company defaults because it really has no more cash. That means it enters bankruptcy in a much more weakened state than if the banks had been able to intervene to try to protect their loans.

And the new wrinkle is debtor in possession financing is scarce, thanks in part to GE’s departure from that market, making it much harder for companies to avail themselves of Chapter 11 bankruptcies. As the Wall Street Journal explained last month:

Credit has gotten so tight in recent weeks that companies contemplating a bankruptcy filing can’t find the cash needed to get through the process.

This multibillion-dollar corner of the lending market — debtor-in-possession and exit financing — has been rocked by General Electric Co.’s recent, undisclosed decision to largely halt lending to companies in bankruptcy-court protection or near it, said several bankruptcy lawyers and financial advisers. GE is one of the world’s largest such lenders, last year doing $1.75 billion in restructuring loans.

Debtor-in-possession, or DIP, financing is essential for the lawyers, layoffs and other restructuring necessary for a company’s rebirth. Exit financing is used when a company “exits” reorganization. Banks have been eager to take part in this market because the loans are the first to be paid back and command high interest rates.

Without the lending lines, companies that would normally survive bankruptcy will have to quickly sell assets. Potential buyers may not be able to borrow either, meaning companies could be forced to liquidate immediately instead of working out their problems. That could cost tens of thousands of jobs across the economy….

“It is a struggle, a real struggle to find DIP financing,” said Jonathan Henes, bankruptcy attorney at Kirkland & Ellis LLP in New York. “In the old days, like early 2007, the banks would do an origination and syndication model, where hedge funds and [loan funds] would gobble up those loans, but they don’t have the capital. They are out.”

Data provider Dealogic estimates lenders provided $24.24 billion on 40 restructuring deals in 2008, a 38% increase from the $17.59 billion on 18 deals in 2007. Major banks do much of the work, with GE typically among the top five or 10 lenders each year. Despite the tight credit markets, DIP lending is up this year because of the overall increase in bankruptcy filings since 2007. Little has been done in the past few weeks.

Interest rates for bankruptcy financing have doubled to the London interbank offered rate plus 5% to 7% or higher, compared with Libor plus 2.5% last year, said Mr. Henes and others…

Several companies are trying to raise DIP financing in case they need to file for bankruptcy reorganization, but have struggled to find any takers, said bankruptcy observers.

In other words, there are good reasons to think that the typical cyclical overleveraged deal failures that the private equity foists upon the wider world on a regular basis will lead to even worse outcomes than usual. Yet Sorkin, who ought to know better, omits key details that would raise even more questions about the prospects for these investments. One can only wonder why.