Down the rabbit hole with private equity

There are rabbit holes and there are rabbit holes and one of the largest and darkest of all of them is the one in which resides the dark art of private equity. Other than everybody who ever gets involved in it apparently coming out very rich indeed, little is known and for its own reasons little is talked about. It is of course not all Harry Potter, Hogwarts and Platform 9 ¾. It’s not magic.

There are in essence two very distinct branches of private equity. There are some private equity firms which might be prone to buying out small and medium enterprises when, for example, the founder and principal wishes to pull the parachute and retire. Owner-managed businesses tend to be a little bit quirky as they have developed and thrived around the owner’s idiosyncrasies and eccentricities. Trade sales can be risky and the number of cases when acquirers of what looked like a perfectly fine company discover that integrating the operations of the business that they have just bought is going to prove to be far more difficult and costly than had been anticipated. Due diligence if performed by accountants can prove that the numbers add up, but assessing the culture is not within the remit. This is where some of the smaller private equity partnerships come in. They take out the owner, tidy up the business, introduce a business vocabulary that is more generally understood and eventually undertake the trade sale themselves.

And then there are the big guys with the multi-billion-dollar public fund raisings which have made their investors some decent money over the past few decades, and which have catapulted their own principals into the financial stratosphere. In the vein of discretion being the greater part of valour, I shall desist from naming names, although I trust that most readers will be conversive with the identity of some of the firms in question.

I was in my early 30s before I made the transition from corporate banking to investment banking. I had taken my first baby steps in the bond market on the buy-side when working for a trade finance house, Trade finance was all about understanding the ins and outs of sovereign risk and of pricing that risk accordingly. We then found to our amazement that bond markets were pricing off-beat risk far cheaper than we were, despite the default risk in publicly issued bonds being significantly lower than on trade finance transactions. I add at this point that the likes of Spain, Portugal and Finland were in the 1980s and into the 1990s still traded as fairly weird and mysterious. The former two had only joined the EU in 1986 and were still finding their post-dictatorship feet while the latter didn’t even become a member until 1995. The USSR still existed, and the Berlin Wall didn’t fall until November of 1989.

This was an age before the internet and when even a Bloomberg on the desk was a rare luxury. Pricing of assets was idiosyncratic and finding two markets which entirely differently priced what was fundamentally the same risk was not unusual. In 1988, I was sent on my first trip to the Irving Trust mothership in New York and it was there that I bought and read a copy of Connie Bruck’s blockbusting “The Predators’ Ball” which revealed to this innocent guy who thought himself to be the cat that had found the cream for trading in US Treasuries, German Bunds and some AAA and AA rated corporate bonds, how much more was going on out there.

The Predators’ Ball tells the story of the very real rise and fall of the house of Drexel Burnam and of Michael Milken, the junk bond king. Milken had perfected the art of raising finance for corporate raiders. In 1987, the raiders had come to Hollywood and in the movie Wall Street the characters of Gordon Gekko and Bud Fox were painted as the ugly side of the leveraged finance business. Gekko’s most famous line, the one which still haunts the Street, is “Greed is good”. Bruck’s book brings together all the key characters of the free-wheeling buy-out rage.

The raiders were ubiquitous and nowhere more evidently than in the epic takeover battle for the tobacco giant R.J.Reynolds, RJR. As the tobacco industry was coming under ever greater pressure, RJR took the defensive step of diversifying and by merging with the food giant Nabisco. The merger did neither business any good. It didn’t take complex maths to work out that the whole was trading at a discount to the value of the sum of the parts. The solution was simple. Buy out and break up. F Ross Johnson, RJR’s CEO, was amongst the first to act and with a syndicate of financiers attempted to take the company private. A bidding war ensued which in the end was won by the partnership of Kohlberg Kravis Roberts.  The Reynolds trade proved that there was no limit to the size of company which could be raided. The gloves-off fight for control of RJR was captured in the 1989 book “Barbarians at the Gate”.

The corporate raiders’ model was in essence quite simple. Work out the brake-up value of a business. Then raise the money to bid for all the shares of the company and take it private. Leverage the trade to the ying yangs and pay the price required to get enough cash on board. Then make sure all the components have been flogged off before the crippling cost of the borrowing has chewed up the economics. Pay back the lenders as soon as possible and pocket the rest. The world was fascinated by the raiders, mostly larger than life risk takers. Jimmy Goldsmith, father to Zach, was one of the gang. Then there were Meshulam Riklis, Carl Icahn, Ronald Perelman, T Boone Pickens, of course Henry Kravis, Kirk Kerkorian and many more including Nelson Peltz, now father-in-law to Brooklyn, eldest son to David and Victoria Beckham.   

The Reynolds trade opened the flood gates. The leverage buy-out merchants rebranded themselves as private equity and with the promise of untold riches went out to raise buy-out funds from institutional investors who were keen to get their fingers on part of the action. As so-called private equity investors, the raiders who forty years ago were the most hated men on the planet had pulled off the stunt of not only being wolves in sheep’s clothing but of convincing pension funds and charities that they are in fact sheep. The swashbuckling pirates morphed into the friendly captains of peaceful cruise liners.

In a rising stock market and in an environment of near-free money, leveraged buyouts are as good as shooting fish in a barrel. In the heyday of Drexel Burnham and of Michael Milken, the raiders would have been happy to be able to borrow anything as long as three-year money and at less than double digit margins. As interest rates have fallen and as desperate demand for yield has encouraged investors into ever-higher credit risk, the new corporate raiders, now successfully resprayed and rebranded as private equity, have been ringing the till.

And the dirty little secret is the special dividend. Once the deal is closed and the debt raised, a so-called special divined is commonly disbursed to the buyers. This in part repays them their investment in the equity purchase and as such shifts the burden of risk further onto the debtholders. I personally recall a case, although I fail to remember the exact deal, when the special dividend paid out actually exceeded the portion of the purchase price put up by the private equity firm. That in fact meant that the private equity guys had taken back all the money they had had at risk. They owned the equity for free. Thus, the were set to benefit from all of the upside of the deal while the debtholders carried all the risk on the downside.

Private equity, and far be it from me to tar all firms and all deals with the same brush, is not an equity game. It’s a debt game, the economics of which are driven by the cost of money. The Milken funded raiders of old needed to be fleet of foot and able to dispose of the assets at a profit before, as noted above, the cost of borrowing killed them off. With money cheap and stock markets rising, time was no longer of the essence. The private equity firms could buy and hold for as long as they wanted and, if the so chose, simply wait for the stock market to have risen enough for them to refloat the business at a profit and without having done anything to add value. No need to find underperforming conglomerates and cleverly break them up. Just buy any business, fund it with cheap money and then sell it back to the market as was. Repay the debt and bank the cheque. Happy days.

The deeply symbiotic relationship between the leveraged loan market and the private equity space is rarely highlighted although as volatile equity markets can no longer be guaranteed to lift the deal and the cost of borrowed money has shot up, shooting-fish-in-a-barrel private equity transactions have become a thing of the past. Increasingly over the past 30 years, the declining cost of borrowing has been used to create a smoke and mirrors environment around equities. Whether by way of borrowing to fund corporate share buy backs or, in the case of private equity, to buy all the shares at once yield hungry lenders have been there to make it all possible.

As it is institution investors’ obligation to meet their liabilities with the lowest possible quantum of risk, so rising underlying interest rates have also relieved their need to pile on credit risk at whatever the return might be on offer. As they now shun unnecessary credit exposure and as demand for higher margin assets shrinks, so borrowers need to offer higher spreads in order to attract what money is still there. Private equity is hit with the double whammy of both a higher cost of underlying borrowing and competition to pay more attractive risk premiums. Gradually, the model of sitting patiently and waiting for the market to take one out of the trade has ceased to work.

Private equity, the poster child of three decades of cheap money and ballooning asset prices, is beginning to look frighteningly like Warren Buffett’s legendary swimmer without shorts. As with all fashionable asset classes, the first in and the first out will be the billionaires. The rest will be left wondering why they missed the point and whether their decision to jump on the moving train had been such a good one. I am reminded of my former boss when I myself was involved in structured credit products. At the age of 32, he was a Managing Director and coining it. I once asked him how he had chosen this line of business to which he replied that he had at the end of his graduate training programme asked which was the newest and least popular line of business and had chosen to take the risk on the unknown. Twenty years later he is one of the big dogs on Wall Street.

The ultimate show of an era ending is the way in which the US short seller Hindenburg Research has focused on Carl Icahn’s Icahn Enterprises which basically still lives by the principles of the raiders of old. Highly leveraged and hurting, Icahn’s share price has halved since May 1 , and Hindenburg has restated its desire to remain short.

Time maybe for the current crop of graduates to consider private equity, at least for the while, as a busted flush. I’m no longer in the banking world and I have no clue of what next big gig will be, but I can assure you that its out there somewhere waiting for clever and courageous young people to turn over the rock and see what’s hidden underneath. 

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