The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis
By Joshua Kosman
Hardcover, 288 pages
List Price: $26.95
Note: Charts have been omitted from this excerpt.
It is late 2011, months before President Barack Obama will run for reelection. The U.S. economy is gradually recovering from four years of hovering on the brink of disaster. Banks are lending money again, at least to strong companies, and employment is stabilizing.
President Obama has finally begun to breathe a bit more easily, when the secretary of the Treasury walks into his office one day.
"You better sit down," the secretary says. "I've got bad news. First Data, the largest merchant credit card processor, has defaulted on $22 billion in loans. Clear Channel Communications, which owns more than twelve hundred radio stations, is on the brink. The other credit tsunami that we knew was out there has begun."
The Treasury secretary is talking about private equity. It's not the private-equity firms themselves but the companies they own that are defaulting. During the boom years of 2001--7, private investors bought thousands of U.S. companies. They did it by having the acquired companies take on enormous loans using the same cheap credit that fueled the housing boom. That debt is now starting to come due.
"Considering what we have already been through, how bad can it be?" Obama asks.
"Well," says the Treasury secretary, "PE firms own companies that employ about 7.5 million Americans. Half of those companies, with 3.75 million workers, will collapse between 2012 and 2015. Assuming that those businesses file for bankruptcy and fire only 50 percent of their workers, that leaves 1.875 million out of jobs.
"To put that in perspective, Mr. President, NAFTA caused the displacement of fewer than 1 million workers, and only a slightly higher 2.6 million people lost jobs in 2008 when the recession took hold.
"A spike in unemployment will mean more people will lose their homes in foreclosure, and the resulting nosedive in consumer spending will threaten other businesses. The bankruptcies will also hit the banks that have financed LBOs and the hedge funds, pensions, and insurers who have bought many of those loans from them."
"Is this bigger than the subprime crisis?"
"It is similar in size to the subprime meltdown. In 2007, there were $1.3 trillion of outstanding subprime mortgages. As a result of leveraged buyouts, U.S. companies owe about $1 trillion.
"Sir, we are on the verge of the Next Great Credit Crisis."
Obama is no longer smiling.
The picture painted by the Treasury secretary in this imaginary scene, as dire as it is, is not total fantasy, nor is it a worse-case scenario. There are people in the financial world, including the head of restructuring at one of the biggest banks, who predict this outcome. Some knowledgeable observers say the carnage will start sooner. In December 2008, the Boston Consulting Group, which advises PE firms, predicted that almost 50 percent of PE-owned companies would probably default on their debt by the end of 2011. It also believed there would be significant restructuring at these companies leading to massive cost cuts and difficult layoffs.
A rain of defaults is already starting. From January 1 through October 31, 2009, 175 American companies defaulted on their debt. That is almost double the number for all of 2008. Half of those companies have been involved in transactions with PE firms at some point in their corporate life, according to the Standard & Poor's rating agency.
The tsunami of credit defaults described by the imaginary Treasury secretary is not inevitable. If the U.S. economy manages to recover from the credit crisis that began in the mortgage markets in 2007 before the big PE debts come due, more of the PE-owned companies will be able to refinance their debt. In that case, we won't see a full 50 percent of them go under. Although if history is any guide, many of them will collapse anyhow, regardless of any easing in the credit markets, thanks to the greed and grossly shortsighted management policies of their private-equity owners.
First a little primer on how private-equity firms operate. Private equity firms buy businesses the way that homebuyers acquire houses. They make a down payment and finance the rest. The financings are structured like balloon mortgages, with big payments due at some point in the future. The critical difference, however, is that while homeowners pay the mortgages on their houses, PE firms have the businesses they buy take out the loans, making them responsible for repayment. They typically try to resell the company or take it public before the loans come due.
Played out within reasonable limits regarding the amount of the debt, the strength of the acquired company, and the continuation of some threshold level of investment to maintain that strength, it's a strategy that can offer big payoffs. But private-equity players are quintessential Wall Streeters whose grasp of the concept of reasonable limits is quite limited. For them, the whole purpose of doing business is to make money, so if a strategy works, each success is just an encouragement to raise the ante and be a bit more daring next time.
So here's why buyouts done from 2003 to 2008 could soon sink our economy. In the early years of the latest private-equity boom (there have been others before), the PE strategy worked well. The PE firms were gambling they could buy low and sell high, and for a while, they were right. If a firm bought a business in a 2002 LBO and the business's earnings grew just at the rate of the overall U.S. gross domestic product, the PE firm could sell the business in early 2007 and get its money back 3.4 times over.
Attracted by these rich returns, PE firms began to do more and more deals. KKR (Kohlberg Kravis Roberts & Co.) cofounder Henry Kravis announced in May 2007 that private equity was on the threshold of a golden age. PE firms, which in 2003 led buyouts of U.S. businesses that totaled $57 billion, just three years later, in 2006, quadrupled that figure to rack up $219 billion in LBOs. Buyouts in 2007 jumped to a staggering $486 billion. There was a feeding frenzy as PE firms gobbled up companies ranging from telephone firm Alltel to hotel chain Hilton.
Banks like Citigroup, which underwrote loans to finance the buyouts, loved the business. They collected fees on the overall balance of the loans they made and then resold more than 80 percent of the loans to the same hedge funds and insurance companies that were buying up subprime mortgages. As banks were reselling more of their loans, they were also relaxing lending standards.
By 2007, PE firms were paying earnings multiples that on average had risen 45 percent since 2000. And the amount of cash PE firms were putting down to buy businesses was actually falling from 38 percent in 2000 to only 33 percent in 2007. It had become possible for PE firms to arrange loans for publicly traded companies at higher earnings multiples than those businesses were trading at in the public markets.
Kohlberg Kravis Roberts and TPG Capital (formerly the Texas Pacific Group) announced plans in February 2007 to lead the biggest buyout ever — a $44 billion acquisition of Texas utility TXU Energy. KKR and TPG wanted the deal despite the fact that there was little chance TXU could ever repay the loans it was taking on to fund the buyout.
When Texas Republican state senator Troy Fraser said he believed KKR was overpaying by a considerable amount, the buyers had former U.S. secretary of state and Houston resident James Baker press their case for approval.
Baker told the Fort Worth and Greater Dallas Chambers of Commerce he was lobbying for the deal because the PE firms were not going to build the dirty-coal plants TXU was planning to construct and because they were buying TXU in a way that was economically responsible in that they had agreed to cut electric prices for TXU customers and freeze them until at least September 2008. There was little talk about what TXU might have to do after that or how it would repay its loans.
In fall 2007, TXU shareholders met to consider the sale. Protesters from ACORN (Association of Community Organizations for Reform Now), which advocates for low- and moderate-income families, gathered outside the Adam's Mark Hotel (now the Sheraton Dallas). Many wore red T-shirts with flyers taped to their backs reading "KKR and TPG are throwing $24 billion in debt on my back. Vote no on the buyout."
Still, shareholders owning 74 percent of the stock voted for the deal because the $69.25 share price offered a 28 percent premium over where the stock was trading a month before the buyout was announced. Soon after the shareholder vote, the U.S. Nuclear Regulatory Commission gave its approval. It was a perfect emperor's- new-clothes deal; its fundamental economics were pure fantasy, but that was an issue no one addressed.
A mutual-fund manager said he bought some TXU — now renamed Energy Future Holdings (EFH) — debt, believing that regulators concerned about global warming would stop the building of new coal plants. This would cause electricity prices to rise and improve profits to the point where it could refinance. Instead, electricity prices unexpectedly fell. For the year ending December 31, 2008, when subtracting a one-time accounting expense, EFH lost $900 million from continuing operations. If it had not have had to make $4.9 billion in interest payments it would have been profitable. Moody's Investors Service in February 2009 said it was concerned EFH might not be able to pay its $43 billion in debt, about $20 billion of which was coming due in 2014.
Leveraged buyouts increased in both size and number during this decade, and the KKRs of the world have become more powerful than the biggest American corporations. KKR itself in 2008 owned or co-owned companies that employed 855,000 people, which made it effectively America's second biggest employer, behind Walmart. In fact, five PE firms were among the ten biggest U.S. employers.
As long as the PE firms could refinance, or turn around and sell off their holdings before the biggest loan payments came due, spectacular flameout bankruptcies could be avoided. But even without the financial meltdown in mid-2007 that made financing almost impossible, there was another time bomb ticking: PE owners' short-term management practices cripple businesses, so eventually a significant number of them become noncompetitive and die.
Because the strategy of PE firms is to sell their businesses within several years, they focus on quick, short-term gains and give little consideration to long-term performance.
The LBO playbook is full of tactics for raising short-term cash. One is to cut costs by lowering customer service. Clayton, Dubilier & Rice did this from 1996 through 2004, when its company Kinko's got such a bad reputation for ignoring customers that comedian Dave Chappelle did a nationally televised skit spoofing the chain. Another is to raise prices, as when KKR-owned Masonite charged Home Depot so much for its doors during the housing boom that it eventually lost much of the Home Depot account and went bankrupt.
PE firms also starve companies of operating and human capital. They reduce 3.6 percent more jobs than peers during their first two years of ownership. Then there are companies like Energy Future Holdings that cut back on capital spending and research and development. When EFH finishes building the three plants it is required to construct by 2010, it will not have the money to add more capacity. EFH may move from losing money to being slightly profitable, but even this improvement would mean that there will still be no extra money for building new environmentally friendly plants or paying its principal.
PE firms would like to have us all think the reason they try so hard to raise earnings in their businesses is so that companies can use those profits to pay down the money they borrowed to finance their own acquisitions. But the records show that during the 2003--7 buyout rush, that wasn't generally the case.
Instead, they used the profits as a basis to borrow more money. The new loans, which were piled on top of the original debt taken on to finance the LBO, were used to issue dividends. The money from the loans went straight into the PE owners' pockets. The fourteen largest American PE firms declared dividends in more than 40 percent of the U.S. companies they acquired from 2002 through September 2006. Many of these eighty-three businesses are now in particularly precarious positions because they slashed budgets and then borrowed more money during the credit bubble.
If history is any indicator, there are rough times ahead. Junk bond king Michael Milken fueled a smaller buyout boom in the 1980s that ended with the savings-and-loan crisis and a mild 1990--91 recession. Of the twenty-five companies that from 1985 to 1989 borrowed $1 billion or more in junk bonds to finance their own LBOs, 52 percent, including wallboard maker National Gypsum, eventually collapsed. The biggest deal of that era was KKR's $30 billion buyout of RJR Nabisco, chronicled in Barbarians at the Gate, the bestselling book about greed gone berserk. KKR eventually traded half its shares in RJR for Borden Inc., and much of what Borden became went bankrupt.
A real possibility exists that KKR may soon hold the dubious distinction of driving both the biggest buyout of the 1980s, RJR/Borden, and the biggest one in this generation, TXU, into bankruptcy.
The coming buyout crash, like the mortgage meltdown, will have global dimensions. American and British private-equity firms since the 1980s have backed companies in England that employed about 20 percent of the private sector there. Multiples paid for those businesses this decade are even higher than for American companies. Jon Moulton, who heads British PE firm Alchemy Partners, concedes that many of the companies will struggle, but he diminishes the importance of the failures, predicting that the number of lost British jobs will be only in the hundreds of thousands, not the millions. "Now two hundred thousand to three hundred thousand jobs lost in the U.K. is a big deal, but it is not catastrophic," he said.
Of course, PE firms will be just fine if all these companies collapse. That's because most of them earn enough from the management fees they charge their investors and the companies to more than cover any losses. And that's not counting the huge dividends they haul in. Despite the credit crisis in 2009, PE firms were sitting on roughly $450 billion in unspent capital and itching for more deals.
PE firms — many of which are the ones about to cause the Next Great Credit Crisis — are trying to profit from the current one by buying distressed assets in the United States and Europe, like banks, mortgages, and corporate loans at deep discounts. During the recession, they cannot borrow much money to finance buyouts and therefore are seeking dislocations in the debt and equity markets where they believe a flood of sellers is causing assets to trade too cheaply. Mostly, this means they can appear to be saviors to governments, banks, and financial services institutions that are anxious to reduce liabilities. The U.S. government sees PE firms as part of the bank-rescue solution. It wants PE firms to partner alongside its $700 billion Troubled Asset Relief Program (TARP) bailout fund in buying troubled banks at relatively low prices.
All of this activity continues despite the likely collapse of half of the 3,188 American companies that PE firms bought from 2000 to 2008. If the credit markets remain restricted, the fall will be more dramatic. Many overburdened PE-owned companies will go under when their balloon debt payments come due, which in most cases will not happen until 2012 unless they break loan covenants first. Millions of jobs could be lost. If that happens, however, it will be because we have been living through at least five years of recession, so maybe, if there is a bright side, it will be that by then we will have learned how to live with financial disaster. But even if the credit markets reliquify and an era of relatively easy money returns, there is still a wave of bankruptcies coming. They will just occur over a longer time. It won't be a tsunami, only a hurricane.
These failures are going to occur because PE firms put their companies into crippling debt and, unlike entrepreneurs, who manage their businesses to succeed in the marketplace and grow, they manage their companies largely for short-term gains. They care about the futures of their PE firms but not about the viability of the companies they buy. So they make deep cuts in spending on current operations and on research to develop new products. They fire not only redundant workers but also many who are essential to producing competitive goods and providing customer service. They raise prices on noncompetitive goods to unsustainable levels. And they use the brief windows when they have nice-looking financial statements from the cost cutting to take on huge new loans to pay enormous dividends.
I believe the record shows that PE firms hurt their businesses competitively, limit their growth, cut jobs without reinvesting the savings, do not even generate good returns for their investors, and are about to cause the Next Great Credit Crisis. Leadership is needed to rally opposition to close the tax loopholes that make this very damaging activity possible.
Excerpted from The Buyout of America. Published by Portfolio. Copyright Josh Kosman, 2009.