Private Equity Leaders: Seeing the Big Picture

In my earlier posts on Blackstone and KKR, I made it pretty clear that their steps - going public and creating lower risk, lower return investments - are a foreshadowing of what's to come: namely, a much tougher environment for private equity.

These difficulties will emanate from several sources, principally:

Less friendly debt markets (both higher rates and tougher terms);

Fewer attractive buy-out candidates;

Too much liquidity across the alternative investment landscape (PE, HF and large VCs); and

Greater regulatory scrutiny.

No sooner did I write this that I read about Apollo's pushing the limits on issuer-friendly debt terms. Based upon what I've seen, it is starting to feel like the late 1980's in the leveraged debt markets. Now remember, I was around back then, and it was crazy, man. This from the WSJ:

Strong demand for bonds, particularly those offering extra yield, has created the right environment for such offerings (those exclusively used to fund dividends), with investors more concerned with return than a company's cash flow. After all, financing a dividend payment does little to improve a company's operations, yet the added debt leaves bondholders more vulnerable to potential losses.

Apollo financed that dividend with a high-yielding pay-in-kind "toggle" debt, a new twist on the PIK notes popularized in the 1980s that allows a company to pay interest in either cash or additional debt. These notes began popping up with greater frequency in the fall, starting as a way to finance giant leveraged buyouts and later championed by Apollo as a way to pay dividends.

This is a bad, bad thing. Too much liquidity can cause perverse decision-making, and the brash and brainy private equity financiers are only too willing to take advantage of this market anomaly (that is, the inadequately-priced risk that is willingly underwritten by sheep-like investors awash in cash). Leon "Pizza the Hut" Black knows this. Stephen Schwartzman knows this. David Rubenstein knows this. Henry Kravis knows this. They all know this. They are making hay while the sun is shining, especially when they see mounting clouds on the horizon. So Henry is buying PIPEs. Steve is going pubic. What is next?

This from William Conway, Co-founder of Carlyle, as reported in Dailyii.com and taken from a note that was supposedly sent from Bill to his peers at Carlyle. Please note my comments in bold capitals:

Conway warned that the cheap debt private equity firms have been thriving on is likely to be history in the not-too-distant future, saying, "The longer it lasts, the worse it will be when it ends." Conway, directing his memo to his p.e. peers at Carlyle, stated, "Frankly, there is so much liquidity in the world financial system, that lenders are making very risky credit decisions. This debt has enabled us to do transactions that were previously unimaginable, and has resulted in generally higher exist multiples than entry multiples." When Conway says "us," he literally means deals involving his own firm, including the $15 billion buyout of Hertz and the $18 billion Freescale deal. In preparation for the eventual fall, Conway offered three recommendations:

--"If the excess liquidity ended tomorrow, I would want as much flexibility as possible – are our covenants loose enough? Have we hedged against a share upward move in rates? Can we draw down on our revolving credit loan facilities?" he asked. SEE LEON BLACK, APOLLO

--"Second, liquidity has led to a significant reduction in risk premiums – most investors in most asset classes are not being paid for the risk being taken. Our strategy should evolve to take lower risk deals and earn lower returns." SEE HENRY KRAVIS, KKR

-"Third, we should redouble our focus on deals with downside protection – asset coverage, multiple and early exit paths, strategic partners, government protection, consumer needs, controllable capital expenditures and defensible market positions," he said. SEE PRIVATE EQUITY, ORIGINAL BUSINESS MODEL

If I've said it once I've said it a thousand times - watch these guys. Because unlike many of us, they are seeing the big picture. The institutional debt investor is myopically focused on deploying their cash and spreading risk around different credits (even when, say, it is best to keep some money in cash because it offers the best risk/return trade-off?), while the IPO investor is also interested in participating in the New New Thing and finding another name in which to deploy capital (notwithstanding trifling considerations like, say, valuation?).

These are all signs of things to come, friends. Eyes wide open, ok?

Comments

[Amit Chokshi]

All old news as far as dividend refinancings, these things have been going on with as much, if not more, frequency since 2004. In some cases within a week of the original buyout a sponsor would do a quick dividend recap (see the PanAmSat deal). The LBO guys are smart, if there are stupid buyers that are yield hungry then who cares. It's no different than the late 90s as well, this cycle happens all the time, you'll see it again. In the 90s LBO guys got caught financing a ton of telecom and media deals which blew up on them. Same thing will happen but in the mean time it's just a cycle that's impossible to stop.

You think the M&A, leveraged finance, and high yield bank group heads are going to say we think it's getting toppy? They're compensation is based on beating last years #s so they'll continue to sell these deals as aggressively as possible and compete with other banks by underwriting more paper with looser covenants to rake in the fees. If you look at any number of these mega deals and you're the banker with the relationship with the big sponsors and you pass on a deal because it's a bad credit, you think you'll look like a hero in front of the group head when it's year end and they say why weren't we on this x billion dollar deal?

It's always easy to judge this ex post when a few deals blow up and credit markets tighen but in the mean time, from the banker/underwriter's view, they miss out on hundreds of millions of dollars in fees and a lot of lost goodwill with some of the most profitable clients.