After the buyout boom: The bust?

[EJ]

After the buyout boom: The bust?
December 18, 2006 (Jessica Seid Dickler, CNNMoney.com)

A string of deals led by private equity firms will push buyouts to record levels this year. But if things turn sour, look out.

The merger machine's rolling full steam ahead, and private equity investors are playing a bigger role than ever before - a trend that's likely to carry into 2007.

But some investors and merger experts are starting to worry that the slew of deal-making could come to a nasty end, especially if slower economic growth or a recession make it harder for companies to deal with the debt that's often involved in today's buyout deals.

AntiSpin: Add to the two generally acknowledged guarantees in life, death and taxes, a third: recessions after a massive speculative bubble has collapsed. And if we get a recession next year, as we've pointed out before, a bunch of uneconomical PE buy-outs will become even more uneconomical. It's not unlike the post tech stock bubble, except rather than the venture capital (VC) money drying up that's needed to keep uneconomical businesses running that were started during the boom, companies will be left trying to make huge principle and interest payments on debt.

"It's still going like a house afire," said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth's Tuck School of Business.

I expect the PE market will be on fire in a year or two the way the housing market is in some areas today.

The risk, he and others said, is that a downturn in the economy could upset the applecart.

"If the debt markets have a crisis of confidence and there is a real turndown of the economy we could see a dramatic pullback," Blaydon remarked. "We know there will be a pullback, we just don't know when that is going to happen."

When, not if. We agree with Dean Baker at the Center for Economic and Policy Research who expects a recession no later than Q1 2008.

Of the $1.4 trillion in total U.S. merger deals announced so far this year, Blackstone Group, Kohlberg Kravis Roberts & Co. and other buyout firms account for about $370 billion, or 26 percent, of the total. That's not just a record in dollar terms but is more than twice the amount of private equity deals for all of 2005, according to Thomson Financial.

Sounds like a blow-off to me, especially since friends in private equity were claiming that the debt markets driving PE were "out of control" two years ago.

But there are two other scenarios that could cripple the buyout market: a recession or another pickup in inflation, which could lead to higher interest rates - and rising payments for companies that have been acquired and loaded up with debt.

How about both? If a recession in the U.S. reduces the return on U.S. assets relative to others, foreign demand for them will decline. That reduces demand for dollars. That can lead to rising import prices that increase inflation pressure. Existing foreign holders of U.S. debt will want to be compensated for the increased inflation risk with higher interest rates. Higher rates will slow the economy further, reduce foreign demand for U.S. assets. And so on. The question is, when does the collapsing housing bubble get the ball rolling?

"There's an endless appetite for credit now, and that's kind of scary," said one high-yield investment manager. "It's all liquidity-driven. Every day something else [another buyout deal] is being announced. It's a question of when the music stops."

I was told "soon" two years ago. The PE bubble goes on in typical bubble fashion, like a bad acid trip. Speaking of acid, will LSD come back in the next recession? Or coke? Or something new? Crime, especially in the neighborhoods where ugly lending practices have been tolerated by regulators for the past nine years and foreclosures are on the rise, has already arrived.

If the economy gets bad enough, that could hurt corporate cash flow, and highly leveraged companies in particular could have trouble meeting debt payments.

Debtholders would face a jump in defaults by borrowers, and that could spark a wave of selling in the debt markets - or leave a lot of investors owning things they didn't want to own.

"In general, the average hedge fund certainly doesn't have the ability to manage a company in default," said Jay Ritter, a professor of finance at the University of Florida who specializes in corporate finance.

"It's a recipe for disaster," according to Justin Hillenbrand, a principal with private equity firm Monomoy Capital Partners, referring to a wave of new investors getting stuck with assets they don't want to own if there's a downturn. "That's the bigger concern than the huge run-up in private equity deals."

PE firms can restructure deals, take their medicine and move on, but many hedge funds will fold. I'm guessing 600 or so. But I have seen credible predictions in excess of 4000, or half the USIPs currently in operation.

Rumors last month that the buyout firms KKR and Texas Pacific Group would buy Home Depot (Charts) for $100 billion - which would be the biggest leveraged buyout in history - underscore the possibility that next year no company, and no sector, will be immune from the wave of buyouts.

Famous last words. By mid 2008, all companies and sectors will be as immune from the wave of PE leveraged buyouts as pets.com is immune today from receiving VC funding.

[akrowne]

Re: After the buyout boom: The bust?

"Money drying up for some investors in buyout firms"

"The value of private equity-backed buyouts this year doubled to $602.4 billion from last year, according to Dealogic, on 1,912 deals.

At the same time, the value of their exits is down 23 percent to $176.8 billion. The number of exits, which include selling to other buyers or public offerings, is down 24 percent to 698, Dealogic says."

That seems to me like a problematic asymmetry. The interesting question is: when private equity goes broke, who is left holding the bag? We know some of the answer: public pension funds. How about bank financiers? Anyone have any hard stats on how deep they're in it?

[DemonD]

Re: After the buyout boom: The bust?

Okay, I read this article, and agree with it's main thrusts. I take umbrage with some of your comments though Eric. As much as I respect your opinions, I think you are saying some things that are a little distorted here.

AntiSpin: Add to the two generally acknowledged guarantees in life, death and taxes, a third: recessions after a massive speculative bubble has collapsed. And if we get a recession next year, as we've pointed out before, a bunch of uneconomical PE buy-outs will become even more uneconomical. It's not unlike the post tech stock bubble, except rather than the venture capital (VC) money drying up that's needed to keep uneconomical businesses running that were started during the boom, companies will be left trying to make huge principle and interest payments on debt.

Okay, first thing's first. The word "uneconomical." I know you are a macro guy, and I like looking at the fundamentals of any deal. On this, I truly believe any single deal you need to look at on a micro level. One of the LBO's today was for Harrah's, which is a wildly successful company with incredible growth potential both domestically and internationally. While I do shake my head at some of the deals that have been done recently, there have been a lot of PE acquisitions that have made a lot of sense on fundamental levels. A good example from earlier in the year was the PE buyout of Kinder-Morgan.

Are there bad or "uneconomical" deals? Sure. These two below are headscratchers:

Among the bigger deals announced, pharmacy benefits manager Express Scripts Inc. said it was offering to buy rival Caremark RX for about $26 billion. Realogy Corp., which owns the Coldwell Banker real estate franchise, said it agreed to be acquired by private equity firm Apollo Group for about $6.65 billion.

"Uneconomical?" Maybe. These are certainly risky deals. However, both Caremark and Realogy are earnings-positive companies. They are not dot-com earnings-negative money pits. Buying Realogy though seems to me to be like a huge reach.

I expect the PE market will be on fire in a year or two the way the housing market is in some areas today.

Ouch. Not a good link to try to drive home the point. I understand you might be trying to be humerous with that link, but this has nothing to do with economics. A pyromaniac will set fire to something, just because it happens to be in a mountain community away from big cities of commerce does not make it applicable.

Of the $1.4 trillion in total U.S. merger deals announced so far this year, Blackstone Group, Kohlberg Kravis Roberts & Co. and other buyout firms account for about $370 billion, or 26 percent, of the total. That's not just a record in dollar terms but is more than twice the amount of private equity deals for all of 2005, according to Thomson Financial.
Sounds like a blow-off to me, especially since friends in private equity were claiming that the debt markets driving PE were "out of control" two years ago.

EJ, I'm not going to pretend to understand how megadeal M&A and LBO things work. But from what I understand, most of these deals are LBO's where the acquiring company uses the equity in the company they are buying to take the company private. I'm sure this is a high-risk, high-reward type thing. KKR has been around a long time, and they have made a lot lot of money in the past few decades. I'm not saying they are always right (if I remember right they lost a lot of money with rjr/nabisco LBO from the late 80's). But last I checked, interest rates all around the world are still very low, despite the fed doing what they are doing. And weren't you talking about M3 exploding recently? The liquidity is coming from somewhere.

I'm sure on a macro scale this is more worrisome than just a random abberration. But unless your "friends" are sitting next to the top execs at KKR, it's hard to take your claim here as anything more than random speculation without foundation (on a micro level).

"There's an endless appetite for credit now, and that's kind of scary," said one high-yield investment manager. "It's all liquidity-driven. Every day something else [another buyout deal] is being announced. It's a question of when the music stops."

I was told "soon" two years ago. The PE bubble goes on in typical bubble fashion, like a bad acid trip. Speaking of acid, will LSD come back in the next recession? Or coke? Or something new? Crime, especially in the neighborhoods where ugly lending practices have been tolerated by regulators for the past nine years and foreclosures are on the rise, has already arrived.

This statement, in my opinion, is at best mildly irresponsible and at worst, along with the link, completely disingenuous. The link between crime and money has not to do with the RE market, but more to do with the fact that the Bush tax cuts, economic policy, and domestic policies are quite possibly the absolute worst since quite possibly the 1800's. Research has shown time and again that the best way to prevent crime on a cost basis is community outreach projects and education, things like head start, police athletic league, community sports leagues, etc. etc. What is the first thing to go when we cut domestic programs? "Bleeding-heart liberal" programs like this. The No Child Left Behind Act has caused states to spend many more dollars with worsening results. Decreased tax rolls have cut into police and firefighter services. College tuition continues to rise way faster than inflation - thanks to the Republican administration.

One thing that economists seem to be averse to is the effects of politics and politicians on economics. Why is it so hard to say that the Clinton administration deserves a lot of the credit for the success of the prosperity of the 1990's, when they raised taxes on the rich and cut taxes on the middle class and poor (through extra grants and tax credits for education), and who balanced the budget by partially not going into all out wag-the-dog wars, and this redistributed wealth to the bottom rungs, and who made it a point to give local municipalities the opportunity to hire more police and support services? Why is it so hard for an economist to say that GW Bush is a complete idiot in an outright manner?

Some may argue that the US President doesn't have that much effect on our economy. I say that is BS. The US President has the BIGGEST effect on our economy. A great CEO will take a quality company and make sure it runs smoothly (see: William Weldon of JNJ). A great CEO will take a quality company that has been run down and bring it back to prominence (see: Mark Hurd of HP). A poor CEO will lie, cheat, and steal... and run his company into the ground (see: Enron, Worldcom, Adelphia, etc. etc.).

You make the argument that USA is a large company, USA Inc. If that is the case, then our President is our CEO. The only saving grace that our "company" has is that there are plenty of people sitting on the board of directors doing good things underneath our corrupt Presidential administration to make sure we don't fall into complete anarchy/default.

In any case, your point that it is the RE market causing crime is pretty much dead wrong from where I sit. Crime rising, in this case, is caused by a failure of the organization that is responsible for the safety of the populace. The economy right now is still booming. Crime and the economy go together when unemployment goes up. Unemployment is not an issue. The governance is.

PE firms can restructure deals, take their medicine and move on, but many hedge funds will fold. I'm guessing 600 or so. But I have seen credible predictions in excess of 4000, or half the USIPs currently in operation.

Rumors last month that the buyout firms KKR and Texas Pacific Group would buy Home Depot (Charts) for $100 billion - which would be the biggest leveraged buyout in history - underscore the possibility that next year no company, and no sector, will be immune from the wave of buyouts.

Famous last words. By mid 2008, all companies and sectors will be as immune from the wave of PE leveraged buyouts as pets.com is immune today from receiving VC funding.

On your first point above (just to let you know I'm not arguing for argument's sake), I tend to agree. There are a lot of scary macro factors out there right now. An LBO of Home Depot would be a repeat of the Nabisco/RJR LBO and would likely cause a lot of pain, and would be a bellweather that the late 80's are here again (if they haven't come already). I will say once again though, comparisons to the tech/VC bubble are just not accurate. I do not believe in comparing mega-cap largely profitable companies with speculative negative-earnings internet companies with no clear path to profitability. Continually evoking "pets.com" to me seems like an inflammatory attempt to get people's attention from something that is emotional and close to them; it is not a logical and relevant comparison.

I do believe in fundamental analysis though, and on that I can't disagree with your theories in general though EJ. I just think some of your comments in this article are inaccurate.


AK - I see your point in the follow up post. I can give two plausible explanations. One is that the PE's are doing a buy-and-hold approach. See Kinder-Morgan. There is nothing that says an individual or group can't buy a company and just pocket the profits of that company. The other is that the firms are working to increase the value of their investment, through traditional hack-n-slash and outsourcing measures, and installation of better management practices. That approach seems to be working for GM (who wasn't taken private, but was influenced enough by Kirk Kerkorian that many of it's tactics mimic PE value-building).

Taken as a whole, we could make the argument there is now a bubble in M&A. The amount of activity is quite alarming (fundamental micro factors notwithstanding).

A final thought... like all bubbles... could this one continue to grow? There seems to be an endless supply of money out there that wants to be put to some use by big institutions.

[EJ]

Re: After the buyout boom: The bust?

DemonD,
PE and USIPs picked up where the public markets left off. The problem is that rather than 100% equity as in the case of IPO and VC funding, these PE deals are often 30% equity and 70% debt. The risk is that a company that was cash flow positive with the interest and principle to pay on, for example, $1B in debt pre-LBO deal may not be cash flow positive in a recession when the company has $7B in debt post-LBO and needs $600M in cash flow just to cover the debt. These newly debt laden companies now have a lot less flexibility to deal with adverse economic conditions beyond their control, conditions that are growing more severe as the post-housing bust recession gets underway. In aggregate, the hangover from this boom is likely to be at least as severe as after the LBO boom of the 1980s.

Didn't mean to be glib on a topic you clearly have some passion for. To learn more, see the recent Washington Post story that explains, "A recent study in Chicago found that rising foreclosures, and attendant social dislocation, fuel increases in crime rates."

For some truly irresponsible commentary, see Twelve Days of Christmas Bust.

[Jim Nickerson]

Re: After the buyout boom: The bust?

In any case, your point that it is the RE market causing crime is pretty much dead wrong from where I sit. Crime rising, in this case, is caused by a failure of the organization that is responsible for the safety of the populace. The economy right now is still booming. Crime and the economy go together when unemployment goes up. Unemployment is not an issue. The governance is.

I saw the article yesterday that EJ referenced regarding increased crime and considered briefly posting comments on it with regard to it being a sign that perhaps there is a poorer segment of the population that is being squeezed to the point of turning to robbery. I decided that time will tell what is the case.

I believe the employment reports do not include those discouraged would-be workers who have given up seeking work. Perhaps there are numbers on how big that segment is.

Demon, I think you make a premise that crime rate is inversely proportioned to the number of law enforcement people available. I do not know if that is correct or not. If you have enough need to rob others, a lot of policemen being around does not relieve the need, it only makes committing robbery a bit harder, but I doubt impossible.

[EJ]

Re: After the buyout boom: The bust?

I saw the article yesterday that EJ referenced regarding increased crime and considered briefly posting comments on it with regard to it being a sign that perhaps there is a poorer segment of the population that is being squeezed to the point of turning to robbery. I decided that time will tell what is the case.

I believe the employment reports do not include those discouraged would-be workers who have given up seeking work. Perhaps there are numbers on how big that segment is.

Demon, I think you make a premise that crime rate is inversely proportioned to the number of law enforcement people available. I do not know if that is correct or not. If you have enough need to rob others, a lot of policemen being around does not relieve the need, it only makes committing robbery a bit harder, but I doubt impossible.

I'm on a conference call now with reps from the NAR and others. They expect 2.2 million mortage loans with a value of $164B will fail next year.

They are calling it a "national housing Katrina" and expect a major increase in vacancy rates, neighborhood decay, and crime.

More than 20% of subprime loans made since 2000 will end in foreclosure. The infamous "worst case" Houston housing market of the 1980s experienced a 15% foreclosure rate with 1 million homes abandoned. They are predicting a 2x worse problem.

25% of all loans made since 2000 were subprime.

More later...

[WDCRob]

Re: After the buyout boom: The bust?

25% of all loans made since 2000 were subprime.

So the NAR says 5% of all mortgages made since 2000 are expected to eventually default? If memory serves they aren't usually considered flinty-eyed realists. Could it be a lot worse?

Either way...I'm glad I waited to buy. I suspect my money will go a lot further in 2007/8 than it would have in 2003.

[DemonD]

Re: After the buyout boom: The bust?

I saw the article yesterday that EJ referenced regarding increased crime and considered briefly posting comments on it with regard to it being a sign that perhaps there is a poorer segment of the population that is being squeezed to the point of turning to robbery. I decided that time will tell what is the case.

I believe the employment reports do not include those discouraged would-be workers who have given up seeking work. Perhaps there are numbers on how big that segment is.

Demon, I think you make a premise that crime rate is inversely proportioned to the number of law enforcement people available. I do not know if that is correct or not. If you have enough need to rob others, a lot of policemen being around does not relieve the need, it only makes committing robbery a bit harder, but I doubt impossible.

Jim, if there is one thing we are not seeing or hearing, it's that people can't find a job. Maybe it's because i live in a city where the cost of living is so expensive that there are many low- to mid-level job openings, but I'm just not hearing or seeing employment bust news. Maybe this is due to poor biased national media? For every discouraged would-be worker who has left the job rolls, there are plenty of people undertaking entrepreneur type enterprises. Entrepreneurship has skyrocketed recently, and employment data doesn't reflect that either.

I'm not saying that in 6-18 months the economy will still be booming with plenty of jobs for all. I am saying that right now this is the case.

You also misread my opinion on crime rates and social services. It is not just police, but it is ALL social services available in communities. Youth intervention programs, youth groups, school activities, sports, Head Start, there's that program where poor kids get free breakfast at school, outreach programs, there's that one program in NYC where they take poor kids and take them out to the country and have them go to a horseriding camp each summer. Yes, I might sound like a bleeding heart liberal saying stuff like this, but the fact is that when you put kids in opportunities where they can learn and succeed, they are far less likely to become criminals. The uptick in violence is more as a result of the Bush Administration cutting these types of programs to finance tax cuts to the wealthiest 20% of the population, and now we are getting the "return" on these tax cuts as more violence and crime appears in places where community services have been discontinued.

The other part about law enforcement is also true too. California has been struggling to keep it's fire and law enforcement services staffed to necessary levels.

My argument is that even though home prices are hurting right now, the effect on the economy right now is negligible. In the future, it will become more apparent, and then we might see much larger increases in crime that may be associated with decreasing wealth effects. But right now all the blame lies squarely on the CEO of USA, Inc.

[bart]

Re: After the buyout boom: The bust?

I'm on a conference call now with reps from the NAR and others. They expect 2.2 million mortage loans with a value of $164B will fail next year.

...

More later...

Chalk me up for yet another jaw dropping moment. I never would have expected the NAR to be that forthcoming.

Thanks for the heads up.

[spunky]

Re: After the buyout boom: The bust?

CEO of USA Inc :confused:


Voodo Al, Helicopter Ben, daddy Bush ??????? You can cut and paste all the charts you want to, but the middle and lower incomes groups have been left behind. Why do you think the " Blue Dog Democrats " emerged ??? Sad the democratic party of my youth left the people