Price on LBO Loans Falling Due to Pressure From Iceland Liquidations

Banks stuck with unsold inventory of LBO loans have maintained a fair degree of market discipline, attempting to offload the paper at favorable prices and engaging in financing the sales rather than taking bigger haircuts so as to avoid further writedowns of still-unsold paper.

The sale of LBO paper held by Iceland's failed banks and hedge funds is expected, particularly in this tight credit environment, to fetch much lower offers than banks are using to mark similar paper. That will lead to further writedowns.

From Bloomberg:

The value of high-risk, high-yield loans slumped amid speculation more than 1 billion euros ($1.4 billion) of debt being sold includes assets seized from Iceland's banks.

Brokers sent details of loans used to fund leveraged buyouts for sale to investors and traders, according to four people who saw the lists.

``There are several bid lists of leveraged loans circulating,'' said Louis Gargour, chief investment officer at London-based hedge fund LNG Capital, who is setting up a distressed debt fund. ``One is from an Icelandic bank and two are from leveraged hedge funds.''...

``There are going to be more and more leveraged loans being sold off by a variety of different investors in the coming days and weeks,'' said Charlotte Conlan, head of leveraged syndication at BNP Paribas SA in London. This ``will inevitably have a knock- on effect on the mark-to-market for the rest of the loan investor community,'' she said.

Troubled LBO Loans Nearly Triple

The other shoe, as in real economy symptoms of the credit crunch, are starting to show up. One that was widely anticipated was rising default rates in private equity loans. This last cycle was particularly overheated, with not only the predictable peak-of-cycle high prices, which therefore implies high debt levels to make the private equity return calculus work, but also unprecedented lax terms, the poster child being "cov light" deals. Corporate bonds and loan agreements typically contain covenants, which require the company to meet certain requirements, such as a minimum net worth, a certain interest coverage (ie earnings as a multiple of interest charges), restrictions on taking on more debt. Thus if a company's condition deteriorates, the bank can use the violation of covenants to force a restructuring of the loan.

Because many companies took on heavy debt loads, and more than half the companies are rated junk (in the vast majority of cases not due to downgrades as much as high levels of debt at the time of a private equity deal). Many observers wondered how things would play out in these cov light deals when companies started to run aground, Looks like we are about to find out. And Nouriel Roubini anticipates that junk bond defaults will reach an all time high. Leveraged loans ought to track that performance closely.

From the Financial Times (hat tip reader John):

The percentage of large syndicated US loans rated as problematic has nearly tripled in the last year, highlighting the damage done by the lax underwriting standards of the private equity boom, ...

The annual federal “shared national credits” survey - which examines credit committments of more than $20m held by three or more banks - found that $373.4bn of such loans faced actual or potential difficulties at the end of the second quarter.

That was an increase of $259.3bn from the total of “criticised” loans during the previous year. Such problem credits accounted for 13.4 per cent of the total held by lenders in the US, up from 5 per cent the previous year, the survey showed.

The report by banking regulators including the Federal Reserve said many of the loans in the “criticised” category could migrate to more severe classifications, suggested default risk is increasing.

So-callled “classified” credits - rated as substandard, doubtful, or loss-making by the regulators - rose 128 per cent to $163.1bn, or 5.8 per cent of the total, up from 3.1 per cent in 2007.

”These portfolios are cyclical in nature and do track the general economy,” said Joseph Evers, deputy comptroller at the Office of the Comptroller of the Currency, one of the four regulators who conducted the examinations. “We may see criticised loans are increasing for a while and top out before getting better.”

Mr Evers said that similar patterns were seen during previous period of economic stress including the early part of the decade and the late 1980s and early 1990s.

The report criticised the underwriting standards that prevailed during the private equity boom. ”Examiners found an inordinate volume of syndicated loans with weak underwriting characteristics,” it said.

“The most commonly cited types of structurally weak underwriting were liberal repyament terms, repayment dependent on refinancing or recapitalisation, and non-existent or weak loan covenants.”

Here is the link to a joint Federal Reserve/OCC press release on the report. A juicy tidbit (click to enlarge):



From the text, providing a definition of SNC:

The volume of Shared National Credits (SNC),2 loan commitments of $20 million or more and held by three or more federally supervised institutions, rose 22.6 percent to $2.8 trillion, and the volume of criticized credits increased to $373.4 billion, or 13.4 percent of the SNC portfolio, according to the 2008 SNC review results released today by federal bank and thrift regulators.

TPG Makes Concession to Facilitate WaMu Raising Capital

The Wall Street Journal reports that TPG, which invested over $7 billion in the nation's largest thrift, Washington Mutual, late last year. gave a waiver which would facilitate an investment or sale.

WaMu earlier was reported to be considering selling branches and deposits, but how viable the remaining business (credit cards, plus the mortgage assets) is an open question. Various banks have been interested in the past, but it isn't clear who if anyone might step forward now.

From the Wall Street Journal::

Seattle-based WaMu, weighed down by a deteriorating balance sheet tied to its vast mortgage portfolio, has received interest from Wells Fargo & Co. and Citigroup Inc., these people said.

In the case of Citigroup, the bank this week preliminarily discussed a possible deal involving WaMu but isn't likely to proceed, according to a person familiar with the matter,,,,

At this point, WaMu isn't engaged in advanced negotiations with prospective bidders and it isn't clear that the company will pursue an outright sale, they said.

Goldman Sachs, which has been advising WaMu for months, is now aggressively reaching out to interested parties, said one person familiar with the matter. Another potential suitor is J.P. Morgan Chase & Co., which made an unsuccessful bid for WaMu earlier this year. Other parties may also be interested....

Those efforts moved forward yesterday when private-equity firm TPG (formerly called Texas Pacific Group), which led a $7 billion capital infusion into WaMu in April, let drop a provision that provided downside protection to its investment.

The fact that Citigroup, which has been hammered by tens of billions of dollars in losses over the past year, is now considered in a position of relative strength in the banking industry underscores the dramatic upheaval taking place on Wall Street.

Value of Lehman Ex Asset Management Business May Be Negative

According to reports in the New York Times and Wall Street Journal, Lehman is shopping its asset management business, which includes Neuberger Berman (purchased for $2.6 billion in 2003), its private client brokers, and Lehman Brothers Asset Management.

Now look at the valuation of the asset management business versus Lehman as a whole. From the New York Times:

There has been widespread speculation that Lehman was contemplating a sale of Neuberger Berman, whose value is estimated by analysts to vary from less than $7 billion to as high as $13 billion (Lehman’s entire market capitalization is about $10.5 billion).

Connect the dots. The stock market is saying that the value of current Lehman operations ex the asset management business is close to zero, or maybe even negative (which would hold if liabilities exceed the value of the remaining assets). Note that the Journal story puts a narrower value on the asset management operations, $8 to $10 billion.

Of course, the deal-minded would contend otherwise, that Lehman is in effect suffering from a conglomerate discount, and as can happen with public companies, the breakup value is higher than the public market price. If that were true, Lehman should sell its asset management business in toto and use the proceeds to take the rest of the firm private.

A more curious disparity between the two pieces is the spin they put on Lehman's sales activities. Both articles say the firm has sent letters to possible buyers last week. But there was a marked difference in how each paper characterized the move. First, from the Journal:

As it tries to overcome mounting losses on soured mortgage-related assets, Lehman has begun circulating a detailed book of financial information about the investment-management unit to a group that includes private-equity firms Carlyle Group, Hellman & Friedman LLC and General Atlantic LLC, people familiar with the situation said. Blackstone Group LP also has expressed interest in the business in recent weeks, other people familiar with the process said.

Sending out an offering memo means the business is for sale, period. That does not mean a deal will go through; the offers may be deemed to be inadequate. However, oddly, the New York Times article gives an entirely different report on the state of play:

Lehman Brothers, the troubled investment bank, is considering the sale of all or part of its prized money management division to private equity firms...

Lehman sent letters last week to a number of financial companies, including private equity firms like Kohlberg, Kravis & Roberts, J. C. Flowers, the Blackstone Group, the Carlyle Group and Apollo Management, to test interest in its money management division, according to several people briefed on its contents.

The letter, a so-called memorandum of understanding, did not put a value on the division. It said that interested parties could bid for all or some of the pieces but encouraged bidders to make an offer for the whole business.... Lehman’s current talks with private equity are an attempt to put price tags on Neuberger and other pieces of its asset management unit, which should provide flexibility for Lehman executives when they sit down to review third-quarter earnings and calculate if they need to raise capital.

This gives the impression that Lehman is price-shopping to get inputs as to whether it should sell all or part of the operations or not. The reason I doubt this interpretation is you don't circulate "detailed" information to buyers casually. First, the process of shopping a company is time consuming and rattles employees and often leads to defections (although in this case, with Lehman's stock at such lousy levels, the Neuberger principals are believed to be on board with this move). Second, the prospective buyers are all major clients. It would be ill advised to jerk them around.

However, another oddity is the buyer list. Why, for instance, are no Japanese banks included? They are cash-rich, keenly aware of the advantage that confers to them now, (I was at a closing party of sorts for a large loan that one Japanese bank that the borrower, a big financial firm I guarantee you heard of, said European and US banks simply were not doing) and looking for equity investments.

A crude rule of thumb in M&A is that having another bidder in the mix will add 10% to the sales price. That's why, unless there is a need for secrecy or speed, businesses for sale are shopped widely. So the fact that the buyer list includes only private equity firms seems unduly narrow. The Times does offer a possible explanation: "At the same time, many bidders are not interested in buying the whole business because it does not fit with their own model." Many, if not all of the firms already being solicited apparently see this as a strategic purchase, not a portfolio investment. But again, that fact would seem to favor possible buyers with fewer conflicts in terms of existing operations, like the Japanese.

Of course, the assumption may be that now that the sale has been de facto announced in the Times and Journal that other interested parties will contact Lehman.

The Times also indicates that a sale of the entire business may not be viable:

....one of the complications to any potential sale of Lehman’s investment management business is that ratings agencies could determine that the division or its parts are too important to Lehman’s business to sell.

and quotes analysts like Richard Bove of Ladenberg Thalmann that would prefer that 20% of the fund management operations be sold in a public offering

NewSpeak Watch: What Does "Sale" Mean? (LBO Loan Edition)

Ah, how distant early 2007 seems. Remember how the private equity business was going gangbusters, M&A was at record levels, and no deal was too big to get done. Then the credit markets hit the wall, leaving a lot of investment banks holding LBO debt that they hadn't sold (the most common mechanism had been collateralized loan obligations.

But then the clouds parted and banks reported that they were selling the LBO debt that had been crudding up their balance sheets, admittedly at a loss. Everyone agreed that this was a Good Thing, that the banks were putting their problems behind them.

Of course, there was the inconvenient fact that some, perhaps many, of these so-called sales were in fact financed, but few appeared inclined to question the sunny view that progress was being made.

The Financial Times has unearthed some juicy details of the terms of these financings. In particular, the amount of the loan relative to the nominal amount of the sale is, shall we say, impressive.

To review typical terms:

Loan was sold for 85 cents on the dollar

Sale was 80% financed. This means that the sale proceeds were a mere 20% of the discounted amount; the rest of the loan balance is contingent on whether the loan performs (ie, the buyer takes the first loss, which is equal to the cash paid; the FT isn't explicit, but it appears further losses result in a dollar for dollar reduction in the loan balance).

The interest on the loan is at less than market rates. In economic terms, that means the bank got even less than the mere 20% cash amount (you'd need to reduce that amount by the value of the discount on the financing)

I suspect this item will not get the attention it warrants. It's another illustration of the fact that much of the supposed improvement in the credit markets is a function of smoke and mirrors and unprecedented central bank interventions.

From the Financial Times:

Citigroup and Deutsche Bank are still retaining some of the risk from billions of dollars in loans backing leveraged buy-out deals that they have sold in recent months to private equity firms...

This year, banks including Citi, Deutsche and Royal Bank of Scotland have sold $25-30bn in buy-out loans to three private equity firms – Apollo; Blackstone, through its GSO Capital arm; and TPG...

Deutsche Bank acknowledged that it retained exposure to the original loans, but said that any further losses would be negligible.

For the bank to book more losses, it said, the old loans would have to drop to about 65 cents on the dollar – a calculation reflecting the 15 per cent writedown on the sales and the 20 cents on the dollar invested by private equity.

Of course, even if companies default or file for chapter 11 bankruptcy protection, lenders usually get some money back. In the bankruptcies this year, lenders have recovered an average of up to 60 cents on the dollar – less than in earlier economic cycles.

While that loss recovery factoid is no doubt accurate, Nouriel Roubini maintains that loss recoveries for corporate bankruptcies in a growing economy are 60-70 cents on the dollar, but in a recession, when defaults and bankruptcies rise, recoveries fall to 30-40 cents. So in a downturn, the exposure to loss on these supposedly sold loans is significant.

Back to the FT:

In a regulatory filing, Citi said its loan sales “substantially mitigate the company’s risk related to these transferred loans”, implying it retained some risk. The bank said it hedged retained risk by buying derivatives called total-return swaps but it declined to say how much it has paid for the instruments.

Analysts say such hedges can be expensive – sometimes costing more than the position being hedged. They say banks can be willing to pay so much because it is easier to tell shareholders they spent money on hedges than to report loan losses.

Goldman Raising $10 Billion Fund to Invest in LBOs

I must be missing something here.

Not too long ago, Goldman was wiling to act as a principal in LBO financings for deals the firm did and would then syndicate the deal. Now admittedly that was the sign of a bull market peak, that an investment bank would take that sort of risk, but bear with me.

The last cycle, when banks quit doing bridge loans, things reverted to the old model of deals going slower (not being done at all in the LBO workout phase) and reverting to a more-or-less a traditional loan syndication model. One of the implications is that possible syndicate members look at each deal and decide whether they want in or not.

According to the Financial Times, Goldman has raised $10 billion for a fund to invest in LBO debt. That means on a blind basis. This vehicle could be a decent opportunity, except the FT article indicates that the fund will invest in Goldman's deals. The motivation for this risky lending originally was to get a leg up in winning lucrative M&A mandates with private equity firms and other financial buyers.

That is a patently foolish idea from an investor perspective. This arrangement has conflict of interest and adverse selection written all over it. Yet Goldman is apparently close to closing on a pretty sizable fund.

Another data point that the credit market is a long way from bottom. Too many people are eagerly bottom fishing. We have not hit the repudiation phase.

From the Financial Times:

Goldman Sachs has raised a $10bn fund to invest in loans backing leveraged buy-outs, taking advantage of a gap in the financing markets created by the credit crisis.

The fund will buy senior loans, so-called because they are paid off before other debts. It comes in addition to an existing $20bn Goldman fund that invests in “mezzanine” debts, which are paid after the senior debt.

Between the two funds, Goldman can now commit to financing sizeable deals itself without having to go through the long and sometimes painful process of recruiting outside investors for the debt.

During the buy-out boom that ended last year, loans for leveraged deals were often pooled and used to back complex securities, called collateralised loan obligations, that were sold to investors. The CLO business has collapsed during the credit turmoil of the past year.

Recent private equity deals have offered lenders better terms than were the norm in the boom years – when powerful private equity firms benefited from such Wall Street innovations as “covenant-lite” and “payment-in-kind” loans, the latter enabling borrowers to pay interest with paper instead of cash.

Goldman’s latest fund is an example of the accelerating convergence between private equity and debt investing. Goldman’s new loan fund will operate under its private equity arm, with money from Goldman’s clients as well as the bank and its partners.

While other private equity firms and investment banks have debt funds, none approach the scale of Goldman’s funds.

Blackstone has bought debt house GSO to give itself enhanced capability to finance purchases of companies such as Weather Channel. Other buy-out firms, such as Kohlberg Kravis Roberts and TPG, are developing the capability to invest both in debt generally and finance their own deals.

While Goldman’s new fund has not officially completed its fundraising, its head, Tom Connolly, is already involved in deals.

He is looking at providing the senior debt for the sale of a manufacturing company with an enterprise value of $2bn, according to people familiar with the transaction.

Mr Connolly has been in charge of Goldman’s leveraged financing in the US and brings relations with the leading buy-out firms to his new assignment.

Blackstone Uses Own Hedge Fund As Stuffee for Its LBO Debt

When I read this Bloomberg story, "Blackstone Risks Hedge Funds' Return as LBO Lending Evaporates," my first reaction was "conflict of interest". My second was "lawsuit". Everyone casts a blind eye at arrangements like this until the returns falter.

My third was that everyone interview seemed extremely reluctant to say anything critical of Blackstone. That says the sources either have the highest respect for the firm's professionalism or do not want to alienate a possible meal ticket. You be the judge.

From Bloomberg:

When Blackstone Group LP, the world's biggest buyout firm, was pursuing the takeover of the Weather Channel cable network earlier this month with General Electric Co. and Bain Capital LLC, Wall Street balked at providing financing.

So the New York-based company turned to GSO Capital Partners LP, the hedge-fund manager it acquired in March, to pull off the largest U.S. leveraged buyout this year.

Blackstone can't wait for banks, stuck with almost $100 billion of debt from earlier LBOs, to start lending again. Instead, it's pushing deeper into deal financing with GSO. The strategy may hurt the hedge-fund unit's returns -- some approaching 40 percent -- if slowing economies lead companies taken private by Blackstone to default on their debt.

``The question is: Do you lose your objectivity when you do something so close to home?'' said Paul Schaye, managing director of New York-based Chestnut Hill Partners, which helps LBO funds identify investments. ``The lines get blurred in terms of who's doing what and it raises questions as to what is truly arms-length.''....

``It's a great time to do financing'' because banks and investors are charging too much, said Daniel Fuss, manager of the $18 billion Loomis Sayles Bond Fund....

Blackstone must rely more on non-buyout businesses such as restructuring advice and hedge funds as private-equity fees plunge...

In a presentation to the Indiana Public Employees' Retirement Fund in April, GSO said 14 investments made since 2005 have produced an internal rate of return of 38 percent....

In addition to loans, GSO is buying debt issued as part of leveraged buyouts, a business Blackstone was pursuing before the GSO purchase. Blackstone raised $1.3 billion to invest in distressed debt securities through a separate fund.

Such deals are especially attractive for buyout firms, which are snapping up LBO debt trading at less than 90 cents on the dollar in some cases. Since the debt often is associated with transactions researched by the firms' dealmakers, the distressed funds can make fast, informed decisions....

``This is a good price for the private-equity firm,'' said Matthew Wilcox, an analyst at KDP investment Advisors Inc. in Montpelier, Vermont. ``Its an absolute mess for the banks. It's tough for them to sell the debt at a lower price.''

Still, the strategy may increase Blackstone's risk if those companies falter because it means the firm and investors may hold both equity and debt in a single deal.

The number of companies with high-yield or high-risk debt that fail to make interest payments probably will triple within the next 12 months to 6.3 percent, according to Moody's Investors Service in New York. The pace of defaults would have been even faster were it not for loose loan covenants that allow many distressed issuers the ability to avoid defaulting.

That "failure to pay" figure looks awfully optimistic, although the real crunch may not hit until later in 2009 (note the Bloomberg language is inconsistent; failure to pay interest is a matter of fact; whether that constitutes an event of default depends on the provisions of the deal. Thus the number who fail to pay interest will be larger than the number that can be declared to be in default by virtue of permissive lending agreements).

In the last two recessions, junk bond defaults peaked at over 15% per Nouriel Roubini. More than half the bonds outstanding are rated junk, so one would assume that an average based on the number of bonds would show a peak of over 7% (although a weighted average might come in lower). And by all accounts, this downturn is likely to be nastier than average. Defaults recently have been well below norms, but that is part has been due to the ease of refinancing, which is no longer operative.

Update: The paragraph above was corrected per a reader's comment. Roubini had apparently been referring to junk bond defaults in the presentation mentioned, since he compared the peak default rate to a historical default rate of 3.8%, which is the historical default rate for junk bonds, not corporate bonds as a whole. Even so, the 15% figure does look a tad generous. Several sources say junk bond peak defaults in the 1990 recession was around 12%; Fitch reported a junk bond default rate of 12.9% in the 2001 recession. That is less than 15%, however.

Commodities Spike, Scarce Credit Hitting LBO Companies Hard

The Financial Times reports on a new, troubling credit crunch phenomenon. Companies carrying a lot of LBO-related borrowings walk a tightrope since the high debt burden gives them little room for error.

But in this downturn features an unanticipated rises in raw materials, plus in some cases, cuts in credit facilities that were important buffers. The combination may lead to an unprecedented level of defaults in LBOs.

In past credit cycles, junk bond default rates peaked at a bit over 15%. But original issue junk bonds were the invention of Michael Milken; prior to him, the only junk bonds were investment grade companies that fell on hard times. The 1990-1991 recession, which followed another corporate buyout binge, was a short, sharp contraction without commodities price pressure. The painful early 1980s slump had both high commodities prices and punitive interest rates, but corporate balance sheets showed much lower gearing than today.

Another departure form the early 1990s: overlevered companies with sound businesses could typically restructure their debt. The FT suggests that companies whacked by input price rises and a funding crisis may wind up being shuttered, which means that aggressive financing won't hurt only the private equity firms who concocted the deal, but employees and communities as well.

From the Financial Times:

Progressive Moulded Products has become the latest motor parts company to file for Chapter 11 bankruptcy protection,.... Thomas H. Lee is expected to see its $200m investment go to zero while Goldman, which provided a slug of junior, mezzanine debt is also likely to lose everything...

But Progressive’s troubles are not simply those of a private equity-owned firm with too much debt accrued in happier days so that its owners could pay themselves dividends. Instead, Progressive is a victim of the lethal combination of tight credit and rising oil prices. Progressive, which makes plastic injection moulding systems for Detroit’s big three carmakers is one of many parts companies caught in the vice of higher costs and lower sales.

“This is a company that deserved to live,” says one person involved in the restructuring process. “Anyone buying commodities is running out of money and today there is no breathing space for companies if they can’t get credit."...

The rise in oil prices has struck with increasing severity in the past two quarters. Even two months ago, the industry was forecasting vehicle sales of 15m. Today, that figure has been slashed to 12.5m. The very speed of this change in economic circumstances combined with the contraction in credit means that companies have far less flexibility in avoiding bankruptcy court.

That suggests a new stage in the credit crunch. “Companies are running out of cash because of higher costs and the banks are cancelling revolvers wherever they can,” those close to the restructuring said. Moreover, in the absence of financing, the chances are far greater that a company might be forced to enter into a fire sale of assets.

Progressive had been close to a restructuring out of bankruptcy court...In recent weeks, the banks and bondholders had agreed to recapitalise Progressive and reduce its debt burden. But the agreement fell apart when the carmakers refused to pay in advance for parts because they, too, are in trouble, people familiar with the matter say.

Without support from the carmakers themselves, these other interests were reluctant to make more concessions. A strike at American Axle, another parts maker, slowed production at many plants, putting further pressure on both sides.

The demise of Progressive will come as bad news to lenders who provided junior debt in other deals, expecting to get money back.

“It was fiction to believe that if you provided second lien debt, you were protected,” says the head of restructuring at one investment boutique. “Enterprise values are collapsing.”

Fed Considering Relaxing Rules on Private Equity Investment in Banks

We've mentioned from time to time the Fed's fantasy that banks could recapitalize in short order. John Dizard of the Financial Times has been the most blunt in describing the disconnect between the central bank's wishes and reality:

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.

While the fact that Qatar stumped up for the recent Barclay's fundraising was a relief, it was the exception that proves the rule that sovereign wealth funds have become decidedly cool on financial firm investments, having been badly burned in their first round of fundraising.

The Fed seems to be coming to the realization that it needs a Plan B, but (from what we see in public), its ideas still appear to be in the realm of wishful thinking. The central bank is considering relaxing rules on bank ownership so as to facilitate private equity investment. That sounds well and good, but the reason that most PR firms steer clear isn't simply the investment rules, but the fact that they are also wary of investing in regulated entities, since those pesky rules can change unfavorably at short notice.

From the Wall Street Journal:

In a move that could facilitate the flow of capital to cash-strapped banks, the Federal Reserve is considering steps to make it easier for private-equity firms and others to invest in banks, according to regulators and other people familiar with the matter...

Until now, tough federal rules have often served as an obstacle that prevented private-equity firms from pumping much cash into struggling lenders. The Fed and other banking regulators are wary of unregulated entities exerting control over banks. The result is that, with a small handful of recent exceptions, buyout firms have steered clear of bank investments.....

Fed officials recently have met with big buyout firms – including J.C. Flowers & Co., Carlyle Group, Kohlberg Kravis Roberts & Co. and Warburg Pincus – and banking lawyers to discuss the obstacles, according to people familiar with the matter. Among other things, the Fed has been trying to determine if private-equity firms are seeking more board representation than is currently permitted in bank deals, one person said.

The Fed isn't expected to take a completely hands-off approach that some private equity firms might prefer. Still, even tangential changes could be significant, potentially opening the door to an influx of private-equity capital, industry experts say.

Under federal law, to own more than 24.9% of a bank, an entity must register as a bank holding company, which is subject to heavy regulation and can be forced to serve as a "source of strength" for the bank. Ownership of more than 9.9% of a bank also subjects the entity to regulatory scrutiny to ensure that it isn't controlling – or even influencing – the bank's operations.

The Fed can't change those laws, but it has wiggle room in how it interprets them.

Even if the some PE firms do have signs of interest (the Warburg Pincus investment in MBIA illustrates that optimism can outweigh common sense), those players have aggressive return on equity targets. Yet this is a time when, due to a drive for more regulation and stronger equity bases at financial firms, that ROEs going forward are certain to be lower than their pre-bust levels. Yes, an investor can get in cheap and benefit from buying at the bottom of a cycle, but the broader point is that industry trends are moving against equity investors in banks. You have to have a good deal of confidence and skill to sail into such strong headwinds.

Blackstone Chief Calls Credit Recovery "Eye of the Hurricane"

Blackstone President Tony James said it may be premature to label the credit crisis over, although he did point to improving conditions in the market for LBO-related debt.

However, one also has to wonder whether this call is to lower expectations for Blackstone's performance, given the firm's dreadful first quarter results. Oddly, Bloomberg reports the the alternative investment shop lost $66.5 million in the first quarter, and cited a company statement. Yet the 8-K filing today, which includes a detailed discussion of first quarter results, says:

Economic Net Income for the First Quarter 2008 was a Loss of $(93.6) million reflecting a reduction in carrying value of investments.

GAAP Net Loss of $(246.7) million reflecting transaction related (including non-cash charges of $940.0 million) costs of $952.5 million offset by Non-Controlling Interests of $799.4 million.

Looking through the statement, nowhere do a see either a $66.5 million figure for losses, nor do I see the 12 cents a share deficit that the article cited (the release shows (page 6 and elsewhere):

Net Loss Per Common Unit, Basic and Diluted $ (0.97 )

What gives?
From Bloomberg:

Blackstone Group LP President Tony James said banks are mistaken if they think credit markets have begun a sustained recovery.

``It's not clear to me if it's a permanent upswing as I think many of the banks are saying or the eye of the hurricane,'' James told reporters on a conference call today.

High-yield, high-risk loan prices have climbed from a low of 86.3 cents on the dollar in February to 92.42 cents after banks whittled down a backlog of buyout debt to less than $100 billion from more than $300 billion last year, James said. Banks still must find a way to sell loans and bonds backing the takeovers of telephone company BCE Inc. and Clear Channel Communications Inc.

Private equity firms Bain Capital LLC and Thomas H. Lee Partners LP, which are buying Clear Channel, had sued Citigroup Inc. and five other banks for trying to back out of financing the deal. San Antonio-based Clear Channel, the largest U.S. radio broadcaster, said this week it settled the legal fight by agreeing to a reduced buyout price of $17.9 billion, 8.2 percent less than the Boston-based buyout firms agreed to pay last year.

``The Clear Channel deal moving forward was a blow to the banks,'' James said on the call, noting credit prices have moved down two or three points since the legal fight ended. ``The next big event will be BCE, which is even bigger than Clear Channel.''...

Banks are willing to lend for acquisitions, though ``I would not call it aggressive but they are open for business,'' James said. ``It's got materially better,'' he said.

"Citi allows loan ‘cherry picking’"

As told in the Financial Times, LBO groups interested in buying leveraged loans on offer from Citi are able to select the assets they want, rather than buy pieces of the package, as Citi had planned.

I rarely take issue with the FT, but in this case, particularly in its choice of headline, the pink paper is being far too kind to Citi. A more accurate description would go something like: "Unable to attract sufficient interest in the $12 billion of loans it is trying to unload, Citigroup had no choice but to relent and allow the LBO firms to pick and choose among the loans. It's a foregone conclusion that the big bank will be left with the worst assets."

One of the oldest rules of dealmaking is that everything can be solved by price. It's surprising that Citi couldn't or wouldn't lower its price sufficiently to attract offers for interests in the entire pool. As the FT story indicates, there is a lot of competing product, which puts Citi at a disadvantage. In addition, the bank appears to have parameters for how much it is willing to lose on certain types of deals. But is this any more sensible than a homeowner who refuses to sell a house for less than he thinks it is worth, even when the market has moved away from that price?

When funds or trading entities need to raise cash, they almost inevitably wind up selling their best holdings first. If they are lucky, they can right themselves without lowering the quality of their portfolio too much. Nevertheless, it's a bad sign that Citi is taking steps that smack of desperation in such a public way.

From the Financial Times:

Citigroup is allowing private equity groups bidding for up to $12bn of its leveraged loans to cherry-pick from a wide range of assets with different prices and credit ratings – a move that could complicate Citi’s efforts to clean up its balance sheet.

People close to the situation said that, rather than selling the loans as a block, Citi was asking buy-out firms including Apollo, TPG and Blackstone to choose from a menu of leveraged loans used to fund at least seven major buy-out deals...

People familiar with the sale said private equity groups were likely to focus on loans linked to deals they knew well, while steering clear of those that were perceived as troubled or unlikely to recover. As a result, Citi might end up selling less than the $12bn it had originally targeted, they added.

News of Citi’s piecemeal approach comes as it emerged that Deutsche Bank has been trying to sell parts of its €36bn ($56bn) portfolio in leveraged loans to private equity groups since August.

Last year, the US unit of Credit Suisse sold off $20bn of its buyout financing. Goldman Sachs also has sold off large chunks of its portfolio of leveraged loans.

People close to the situation said that Deutsche was in discussions to sell €5-6bn of loans to Apollo Management, one of the most aggressive buyers of distressed debt, and Blackstone Group in a deal that involves the use of borrowed money from Deutsche Bank.

Thomas Lee: No Big LBOs for at Least a Year

Thomas Lee, one of the greybeards of the private equity business, predicted the absence of very large acquisitions for at the next year due to the deep freeze in the securtization market. The top tier of deals depended on funding via collateralized loan obligations, which Lee does not see returning any time soon.

From MarketWatch:

Big leveraged buyouts won't return for at least a year because the complex structured products and investors that supported such deals have disappeared, said Thomas H. Lee, president of private-equity firm Lee Equity Partners LLC, at a conference on Tuesday.

Still, there's plenty of money for medium-sized buyouts, partly because loans used to pay for such acquisitions are usually kept on firms' balance sheets and not securitized, Lee said in speech at an Institutional Investor conference in San Francisco.

The LBO boom of 2006 and the first half of 2007 was fueled by the increased use of collateralized loan obligations (CLOs), Lee said. Leveraged loans used to pay for LBOs were wrapped up in these structured products, which were then chopped into slices and sold to institutional investors such as pension funds.

Roughly $100 billion of CLOs were sold in 2006 and about $58 billion were issued in the first half of 2007, according to Standard & Poor's Leveraged Commentary & Data. But when the credit crunch hit in the summer, issuance ground to a halt.

Banks had come to rely on CLOs, Lee said on Tuesday. In 2001, banks were putting roughly 10% of their leveraged loans into these vehicles. But by 2007, that had surged to about 70%, Lee noted.

This expanded the availability of credit beyond the balance sheets of traditional lenders like banks. But now that the natural buyers of CLOs, such as pension funds, have pulled back, such financing is gone, Lee said.

"The large-scale LBO market isn't coming back soon. Maybe for a year or more," Lee said. "There's no money for the large transactions."

"Will the natural buyer return to the CLO market? I'm not so sure," he added.

However, the market for LBOs valued between roughly $500 million and $1 billion is still healthy. That's because the financing for these deals doesn't relying on CLOs, Lee said.

TPG to Invest $5 Billion in Wamu

Private equity funds (except for specialists like Chris Flowers) seldom make investments in banks, and for good reason. They are regulated businesses with complex, integrated overhead structures that don't lend themselves to the sort of cost cutting and breakups that are easy ways for LBO firms to unlock value.

On the one hand, with sovereign wealth funds turning a cold shoulder to requests for further cash from strained financial firms, the recapitalization of the banking industry will have to come largely from domestic sources, so the TPG move in theory is a positive development. On the other hand, if like the SWF, they have merely acquired the right to lose money, TPG and any "me too" deals could be the last private sector hurrah before banks start resorting to more desperate measures (dividend cuts, asset sales despite the weak market for banking businesses, rights offerings).

If I were in TPG's shoes, I'd wait for banks to hive off large businesses. These are easier to evaluate and (for them to be saleable) would have to have only a limited direct exposure to the mortgage crisis.

I anticipate TPG will come to regret this deal.

From the Wall Street Journal:

Private-equity firm TPG and other investors are close to a deal to invest $5 billion in Washington Mutual Inc., people familiar with the matter said Sunday.

The injection of new capital would allow the country's largest savings and loan to ease its pressing capital requirements, the people said, amid punishing losses from the national mortgage crisis. But it would substantially dilute current WaMu shareholders, who have already lost 74% of their investment over the past year. WaMu's market capitalization on Friday was just under $9 billion, after its shares dropped 11% that day.....

While banking regulators were likely apprised of WaMu's plans, the government was not directly involved in forging a deal as in the recent purchase of Bear Stearns Cos., say people familiar with the matter.

As currently envisioned, the $5 billion investment would be structured as both a common- and preferred-stock offering. The preferred stock could be converted into common shares in the future, subject to a shareholder vote. TPG -- formerly Texas Pacific Group -- is expected to maintain a "substantial minority holding" in WaMu, said one person familiar with the matter, though exact terms weren't clear. The amount is expected to fall under 25%, a threshold that would require TPG to register as a financial holding company under government rules.....

And there is the remaining question of whether a $5 billion investment will be enough to cover all the thrift's capital requirements in the future, especially if the mortgage-backed-securities market continues to deteriorate.

Declines in those securities have hit WaMu hard. The thrift reported a $1.87 billion loss in the fourth quarter that was fueled by a sharp increase in the reserve for loan-related losses. The company has been exposed to some of the hardest-hit housing markets in the U.S., including California and Florida. Problems have also spread to credit cards and other types of loans, meaning WaMu has been bracing for a steep rise in loan chargeoffs.

Private Equity: "Nothing More than a Clumsy Trick"

It's remarkable how otherwise sophisticated individuals want to believe in magic bullets. If they get a horrific illness, surely there must be a treatment somewhere that will restore them to health. Similarly, some investors know how to tease superior returns on a consistent basis out of highly efficient markets.

Now I am willing to accept that markets are not perfectly efficient, that there are individuals who can do very well year in, year out. But they probably are 1/10000th the number of the pretenders to the throne. And it's much easier to be really good if you are obsessive (which usually means anti-social) and manage comparatively small amounts of money. Yet the economics of money management is that profits are a function of the size of the fund. So the industry's return objectives will every and always conflict with superior results.

Michael Gordon, global head of institutional investment at Fidelity, argues in the Financial Times that private equity, more properly called its original name, leveraged buyouts, is a scam that used leverage to produce the illusion of winning performance (a recent post carried a similar argument about hedge funds).

I'll give the LBO crowd some credit it may not deserve. In theory, its business model could work, particularly now that the public market have gotten so short-term oriented as to impede the pursuit of prudent strategies. But the popularity of private equity (or one might say its aggressiveness in launching new funds) guaranteed that the economic benefits its professionals might add would be paid to the seller. Many academic studies have concluded that the big reason most corporate acquisitions fail (the estimates range from 60% to over 75%) is that the the value of any synergies winds up being paid to the sellers, With hypercompetitivenes in LBO land (mid-market deals routinely would attract 40 bids), it's easy to imagine a similar, or even more extreme, process taking place.

From the Financial Times:

So now we know. The boom in private equity, which was promoted as the superior business model, based on patient capital, superior management and an alignment of interests, was nothing more than a trick of financial engineering – and a clumsy one at that. The magic of leverage works both ways, as we are discovering.

Henry Kravis of Kohlberg Kravis Roberts is asking his investors to be patient after a bout of negative returns and writedowns, echoing the cries of Alan Bond and other entrepreneurs of earlier credit cycles. Hamilton James, Blackstone’s president, said at the Super Returns private equity conference on February 26: “We’re a proxy for the credit markets.” David Rubenstein, co-founder of Carlyle Group, recently asked whether “modest return” was a more apt name for private equity. He thinks it’s funny. It’s not.

As investors are increasingly bruised by the recognition that reality has once again triumphed over hope, the private equity barons are having to confess that the benefits of superior management, alignment of interest and, of course, the superior reward structure counted for very little.

Many of the private equity deals look no different from Yell and other highly leveraged public companies. As Warren Buffett notes, when the tide is going out, we find out who has been swimming without their shorts.

Sometimes a simple observation can prove an important point. In November 2006 Citibank published a research report that highlighted how private equity returns could be achieved by just leveraging basic stock market indices. It is a seminal note. “How do they do that?” asked the report, and then went on to provide the answer.

By leveraging the basic stock market indices by three to one, Citibank pointed out, returns could exceed even the best historical private equity returns. Never mind that as they were spellchecking the final version of the note, leverage on that season’s deals was reaching four to one and even five or six to one.

As Citibank pointed out, the private equity barons would always emphasise alpha over beta – their ability to outperform a market rather than merely ride the market wave – but it showed clearly that leveraged beta was where the returns were being generated.

Interestingly, a similar lesson could be being learnt in other asset classes.

Shaken but not stirred, the private equity barons are looking to move on. Dismayed and disillusioned western investors will not play ball. In the leveraged loan markets, assets have been marked down by a fifth, so 80 cents in the dollar is the new par. Thus the financial alchemists have turned to the huge pools of money available in the Middle East and Asia.

Guy Hands of Terra Firma believes they will enable the disintermediation of Wall Street and the City of London. Perhaps, but in what shape and form?

Does he really assume that these new investors will be as naive as many of the investors in some of the five- and six-times-levered private equity deals of the past three years? I would be surprised. Commentators have suggested that many state-backed funds are still in their infancy and thus do not have the experience and organisation to cope with “big debt investments”. That gives the private equity guys something of a problem.

Private equity as we have come to know it is all about debt – lock, stock and sinking barrel. There may have been better management and better incentive structures in the deals of recent years. But they really contribute nothing to the overall return when compared with the impact of the leverage in the capital structure.

So let us be candid. The deals of recent years are leveraged buy-outs. Let us give them their proper name. It is a shame that private equity has been degraded by misused financial engineering that was permitted by easy monetary policy and lax credit conditions. Moreover, the fact that these structures generated enormous management fees bears further questioning. These LBO deals and their business models were held up as superior in structure and therefore in worth. Massive fees were thus justified. That the market was happy to pay these for a simple leveraged structure that could have been assembled in a DIY fashion seems remarkable now.

In reality, private equity should not be about debt. Pure, properly capitalised private equity remains a wonderful business model. It should be able to prosper without recourse to cheap and easy finance.

Zombies Stalk Private Equity

Well. at least we have a new addition to the finance scene that isn't an acronym. A zombie deal is what happens when a LBO transaction with a cov-lite loan goes bad. Recall that "cov-lite" was a sign of how frothy lending conditions had gotten. Just think, a mere year ago, a private equity firm could borrow gobs of money and lenders would willingly abandon their traditional protection (covenants) that among other things, allowed them to declare an event of default and accelerate the principal (which in practice usually leads to penalties and/or a renegotiation of terms.

But now, these dodgy deals can't be forced into a restructuring or a bankruptcy (at least not by the bondholders).

Note that what appears to be a minority of private equity firms is trying to do right by the lenders, The Financial Times explains:

What do a Spanish clothing retailer, an Irish telecommunications group, a German maker of plastic packaging film and a French house-builder have in common?

They are all so-called “zombie” companies, bought by private equity in heavily leveraged deals shortly before the debt bubble burst last summer and now judged by investors to be worth less than they owe to creditors.

“These are zombies, companies with unsustainable financial structures but no triggers for the banks to force them to renegotiate,” says Edward Eyerman, head of European leveraged finance at Fitch.

They include: Cortefiel, the Spanish clothing vendor acquired by PAI, Permira and CVC in 2005; Eircom, the Irish telecoms group bought by Babcock & Brown in 2006; and Klöckner Pentaplast, the German plastic film maker sold to Blackstone last year.

Cortefiel’s senior bank debt was recently quoted at 67 per cent of its par value, suggesting that the equity owned by the private equity firms is worthless.

Klöckner and Eircom also have debt trading at discounts of 15-30 per cent to par.

Kaufman & Broad, the French house-builder in which PAI bought a majority stake in July 2007, is another case of a company bought at the peak of the market.

Shares in Kaufman & Broad have lost half their value since the deal amid a trading slump, while Calyon and Merrill Lynch have been unable to syndicate the €1.4bn ($2.1bn) of debt they issued to finance the bid, raising doubts about what value is left for PAI.

The list of companies in similar situations is long.

But their private equity owners mostly shrug off the problem, pointing out that often covenants on the debt are either very loose or non-existent, so they have time to wait for conditions to improve.

Paul Drake, Standard & Poor’s head of leverage finance and recovery in Europe, says: “Most private equity firms’ reaction when the market tanked last year was that it was not their problem.”

Mr Drake adds that banks’ loan recovery rates could fall if they are without the tools to rein in problem companies.

“There is no trigger to bring private equity to the table, so you have to ask if loss rates will be higher. That is a real risk,” he says.

Private equity firms may suffer if they end up owning “zombie” companies for longer, reducing their returns.

In a survey of 100 private equity executives, to be published Tuesday by Grant Thornton, more than half said they expected hold periods to lengthen.

Banks are looking for any opportunity to force “zombies” to renegotiate.

Some already have and in most cases private equity owners seem willing to inject more equity, such as Candover in Ontex, the Belgian nappy-maker, or Kohlberg Kravis Roberts in ATU, the German auto-repair company.

Most buy-out bosses say they would fight before letting a company default.

“We have 20 to 25 deals in our portfolio and really can’t afford to lose any of them,” says Martin Halusa, head of Apax Partners, at this month’s EVCA conference in Geneva.

Kurt Bjorklund, co-head of Permira, says he would “consider on a case-by-case basis whether it is a good incremental investment” before injecting more equity.

In the end, a private equity firm’s decision is likely to depend on many factors, such as how much equity they have taken out by refinancing, how much reputational damage it would suffer in case of default and whether it thinks the company can recover.

Banks Cut Unsold Buyout Loan Inventories

A bit of good news on the generally gloomy credit markets front: banks have managed to unload some of the LBO loans they have held on their balance sheets. Admittedly, however, they still have great deal more to place, nearly $130 billion of buyout debt. However, they have had to offer large discounts. Recent reports said that the loans had been marked typically at 88 cents on the dollar; these were sold at prices as low as 80 cents.

From Bloomberg:

U.S. banks have whittled their holdings of leveraged buyout loans to $129 billion from $163 billion at the beginning of the year by offering the debt at discounts, according to Bank of America Corp. analysts led by Jeffrey Rosenberg.

The decline is a ``ray of hope'' for banks amid a slump in credit markets and a slowing economy, said the Bank of America analysts led by Jeffrey Rosenberg. The firms also have $73.6 billion of high-yield bonds they need to sell, the analysts said.

Banks have been breaking ranks from their lending groups and offering their own pieces of the LBO loans at as little as 80 cents on the dollar to get the debt off their books. New York-based Lehman Brothers Holdings Inc. yesterday said it has reduced its LBO backlog by $6.1 billion to $17.8 billion since the beginning of the year, Goldman Sachs Group Inc. halved its holdings to $20 billion and Morgan Stanley reduced its pipeline by 20 percent.....

Goldman reduced its backlog of loans by $20 billion in the past quarter from $43 billion, chief financial officer David Viniar said on an investor call yesterday. The New York-based firm, which booked a loss of $1 billion on the loans, also added $4 billion of new commitments during the period.

Lehman, the fourth-biggest U.S. securities firm, booked losses of $500 million on leveraged loans last quarter, CFO Erin Callan said on a conference call with investors yesterday.

Morgan Stanley, the second-biggest U.S. securities firm, reduced its leveraged finance pipeline to $16 billion from $20 billion during the first quarter, CFO Colm Kelleher said in an interview today after the company reported first-quarter profit fell 42 percent.

Some of the same LBO firms that generated the debt in the first place are raising funds to buy it back at reduced prices. Blackstone raised a $1.4 billion fund last November to buy bank loans, and Leon Black's Apollo has bought $1 billion of distressed loans and bonds....

In addition to the buyout firms, traditional loan investors and hedge funds are also buying the debt.

Banks Advised to Renege on LBO Commitments

Ohh, the plot thi