Do banking crises come before and lead to recessions or do recessions come before and lead to banking crises?
This was the question I posed yesterday, before pointing out that one of the lessons of the Global Financial Crisis was that when ample credit is available, defaults drop to negligible levels. When defaults are negligible, there will be no shortage of credit.
One of the most egregious cases of a misjudgement of the credit cycle was that made by Chuck Prince, erstwhile Chairman and CEO of Citigroup. Now, we shall look at that misjudgement.
On 10 July, 2007, the Financial Times reported on a meeting it had held in Tokyo with City CEO Chuck Prince who had said that the party would end at some point but that there was so much liquidity in the market that it would not be disrupted by the emerging turmoil in the US subprime mortgages.
He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.
I’m sure that is not what Mr Prince will want to be remembered for but I’m afraid it is and will remain so for many years to come.
Coming back to 2007, Prince acknowledged that there were rumblings of discontent in the subprime and Alt-A mortgage space and, just to keep our feet on the ground, so there was also in the UK equivalent, the non-conforming mortgage market. I remember telling my two summer interns in August 2007 that I couldn’t see a future for them on the structured credit desk and helped both of them find roles in other departments for the following year. By the time my boss got to letting them know that he was not going to be making them an offer, I’d got them sorted. One eventually went to the buy-side and became a force in the rates space, the other is a senior credit trader at a “Tier One” firm in the City. I could see the end was nigh; the head of Citibank couldn’t.
The presence of ample liquidity is therefore maybe not the canary in the coalmine. That said, private equity and private debt work hand in hand. One provides the assets, the other buys them. They are making one another rich and who would want to be the one to toss the grenade into the fishpond? The ones who could would be the banks which are providing the bulk of the money to the private debt funds which in turn are funding the private equity deals which have – this is the industry’s dirty little secret – very little to do with equity and a hell of a lot to do with debt.
At peril of being accused of generalising, which is exactly what I am going to do, this is roughly how the private equity game is played.
The private equity folks look for undervalued companies. They find one and make an offer at a premium to the current share price. The stockholders, mostly equity fund managers, see a decent profit and cannot resist. The private equity people put up some of their own money and some from the funds that they manage. The rest they borrow as bridge finance from the banks. They now pay themselves a “special dividend” that effectively repays them most if not all of the capital they have put up themselves. They now own the equity for free. All the risk is with the creditors. They then issue bonds and loans that are bought by the private credit funds and by structured credit vehicles. All the upside is owned by the private equity group, all the downside by the creditors.
This is, as I noted, a dreadful generalisation which will attract great ire from the private equity community, but we also know that when we look in the mirror, we never seem that fat or that old. The best bit of the game is then to wait for stock markets to rise and then to re-float the business on the exchange. Given that the private equity firm owns all the stock with the rest funded by debt, the lenders get their money back and the partners in the private equity group make out like a bandit.
There are warning signs in the secondary market for private equity deals. The ability to refloat, even with stock markets at new highs, seem to be limited and firms are sitting on purchases that they do not appear to be able to unload. It has always seemed a bit incongruous that private equity firms buy and sell businesses to one another although, when it becomes clear that books need to be cleared if a new opportunity emerges, it is also clear that they have no alternative. There is, however, currently an extraordinary amount of activity afoot in the secondary market. It is suggested that as much as US$ 150 billion of deals will be traded in the secondary market this year, roughly 25% more than last year.
This is not only the result of stale deals being cleared but apparently there are also institutional investors such as pension funds which have been investors in the private equity firms’ buyout funds withdrawing their stakes.
The higher interest rate environment has not been kind to private equity – as I noted, it’s all about the availability of debt and the cost thereof – and returns to outside investors have been disappointing at best. It’s not without reason that the phrase was coined: “And where are all the customers’ yachts?”.
It is reckoned that up to US$ 3 trillion of transactions are sitting unsold on the books of buyout firms. That is likely because they cannot be either floated or sold in the secondary market at a profit or break-even. That said, secondary market prices have recovered in 2024 after a couple of grim years where the high cost of financing pushed secondary market prices down and down again. Having hit lows of close to 80 cents in the dollar in 2022 and 2023, they are now back to just a small discount. But that is still not what attracted outside investors to private equity and the sort of returns that were on offer when the industry began to go mainstream now look like a fading dream.
Too many buyout firms trying to make a living has arbitraged out much of the easy money and now, whether it admits to it or not, the sector is beginning to creak. Funds are raised but with nothing on which to deploy them, the best is to get something, anything, from someone else before investors start to ask for their money back. Please don’t get me wrong. I’m not trying to condemn the entire private equity industry. There are some very smart people doing some very smart things, but the age of free lunches is over and there are probably too many firms dancing around the edge of the stage hoping to get a speaking part.
I was particularly struck by one US pension fund manager who is quoted as having commented: “We have made many investments over the last 25 years in private equity and, unfortunately, a material proportion of them have not liquidated in an orderly fashion. And so we are taking the position that it might be time to get out of those positions through a secondary sale.”
Not all is well in the garden. To be fair, there are always some unhappy investors. Maybe his company’s choice of buyout funds was not the best. But what has become clear is that the private equity game is no longer working quite the way it had in the early days when Michael Milken had arranged the debt financing and when the like of Kohlberg Kravis Roberts, now just KKR, bought out R.J.Reynolds, the tobacco firm that had tried to diversify by acquiring the National Biscuit Company, Nabisco, and had ended up as an undervalued and underperforming conglomerate.
The Reynolds deal, immortalised in the 1989 book by Bryan Burrough and John Helyar, “Barbarians at the Gate”, was an epic battle to take the business private although once the price had been competitively driven up to US$ 25 billion there was nothing left and KKR eventually lost around three quarters of a billion dollars unwinding the trade.
The Reynolds deal set the stage for the following 25 years during which no company was too big or too expensive not to be had a rule cast over it by private equity firms. The largest ever deal was the 2007 acquisition by KKR – yes, them again – TPG and others of Energy Future Holdings for US$ 45 billion. In 2014, the company filed for bankruptcy. Say no more.
The question remains as to whether private equity is accretive to the economy as a whole. The PR guys will tell you that p/e seeks undervalued companies that are in need of a fresh management that can bring the company up to its perceived value. Sadly, that does nothing for the shareholders who still get bought out at a discount.
The value is extracted by the partners of the buyout firm and when that is done, all things being equal, they sell the business back to the public market at a higher price. And far too many deals have been done in order to get done and at a cost that leaves little to the imagination. They sit on the buyout firm’s books at the expense of the third party investors in the buyout fund while the partners will in many cases already have extracted their share of the funding whilst hanging onto their equity interest.
The private equity model was once great, but its pudding has been overegged and is now struggling. Whether it is here that we might end up with all sellers and no buyers remains to be seen but it was a one way market that broke the bank in 2008. There will be no repeat but as new forms of finance are developed, new forms of crashes are being programmed into the financial system. And will the Fed, the Bank of England and the ECB be there if private equity and private debt find themselves in trouble? Answers on a postcard please.
Banks making fortunes, graduates lining up to get their seat on the trading floor and markets priced to perfection in the knowledge that nothing can go wrong. As the legendary US Baseball coach Yogi Berra said: “Déja vu, all over again.”