During and right after the mortgage crisis some were talking about the commercial crash and how that would soon hit. At the time I thought, in a tunnel vision sort of way, Commercial Real Estate, which could be partially true but that would not even be considered the medium banana. To get a sense of where the next credit problem is festering, think Private Equity(PE) Firms. The crash is likely to happen because of Leveraged BuyOuts that have put many well-known companies in serious debt. This excerpt is from “The Buyout of America”, a book by Josh Kosman:
It is late 2011 months before President 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 1200 radio stations is on the brink. The other credit tsunami that we knew was out there has begun”…….
“Considering what we have already been through, how bad can it be?” asks Obama “Well”, says the Treasury Secratary, “PE firms own companies that employ nearly 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 higer 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 LBO’s 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 crisis 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”
President Obama is no longer smiling.
This picture painted by the Treasury Secretary is not total fantasy, nor is it worst-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 knowledgable observers predict the carnage will start sooner.
So, how will these Private Equity firms contribute to such a scenario? PE firms buy companies with other people’s money by structuring the acquisitions like mortgages, but not quite like the average American would take out a mortgage. PE firms have the company they are buying take out the loan for the acquisitions, making the company responsible for re-payment. The PE puts down cash equal to 30 to 40% of the purchase price and the acquired company borrows the rest in what is termed as a Leveraged Buy Out(LBO). From 2000 to 2007 PE’s bought firms that employed nearly 10% of the private sector(10 million people). These loans taken out by the companies have balloon payments due 6-8 years down the line. In the meantime, the PE manages the company and because there is little risk to them, they do not manage for long term success, they usually will turn around and sell the company five years down the line. But while they are managing the company, they are also collecting management fees. They are always looking for ways to cut costs and they usually do so by downsizing, selling off divisions, replacing current management, cutting back on customer service, raising prices and turning up production with fewer employees and cutting corners on the finished product. With these cost cutting measures, they could re-invest back into the company, but they use those cost cutting measures instead to bring up the value of the company. When they sell, it is not because they have actually brought up the market value by investing and growing the company, but rather by cutting back. They manage to satisfy short term greed, not long term survival.
To give you an example of what could happen in a worst case scenario, Mervyn’s and Linens n Things were both LBO’s and both have filed for Bankruptcy and liquidated within the past few years. With Mervyns the PE was only really interested in their real estate holdings. When they started managing the first thing they did was to split the company, retail side and real estate side. For many years Mervyns had succeeded because of their real estate holdings. After the LBO, the retail side was barely solvent. They had assets of $674mm and liabilities of $664 mm and were left with negative capital unable to pay debts of $22mm. On the real estate side they borrowed $800 mm and increased the pressure on the retail side by raising rents to market value in order to pay back the loan. Rents went from $80mm to $172mm and they closed 33% of the stores. In the meantime, the PE took dividends and distributions of $400mm (which was taken away from the original loan). The retail side tried to obtain financing to work out of the BK but could not secure because they no longer had the real estate to back the loan. When Mervyns closed their doors in 2008, they let go approximately 18,000 workers with no severance and no vacation pay. Mervyns could have survived if not for the rental increases. The PE responsible for all this and who took no losses was Sun Capital Partners. Apollo Management did the LBO for Linens n Things. They received $15mm in transaction fees, plus $2mm per year management fees. In the space of 2 years, LNT filed bankruptcy closing 589 stores and letting 17,500 employees go.
You are probably asking why a company would do this and why the banks would loan the money on these acquisitions. The banks, just like in the subprime crisis, lent the money because they knew they were going to package the loans up(80%) and sell to another buyer down the line while collecting the fees for the exorbitant loans. The tax loopholes that make this damaging activity possible have never been closed. The company can treat the debt similar to capital expenditures – as an expense deducted from profits through depreciation tax schedules, greatly reducing their tax burden. In an ideal situation, the company could use that savings to pay down the loan but new management is usually brought in to run the company and it does not happen. In general the PE will also look at the company as “parts more valuable than the sum of the whole” and sell off piece by piece.
Beatrice, who owned Samsonite, Tropicana, Peter Pan PB, Avis, Swift, Wesson and CocaCola bottling plants was broken up in just such a transaction. Because the principle for the loans for these acquisitions are not due until between 2012 and 2104 and most issued bonds due in several years rather than pay the interest, underfunded pensions that are counting on PE firms to save them are going to be in bigger trouble than they are now. In 2006 when speciality retailers, Burlington, Michaels and PETCO took out such loans, Moody’s gave them a B2 rating which means “assurance of loan compliance over any long period of time might be small.” They said these companies would probably not be able to pay the loans within 1000 years let alone 6-8. For another example of an LBO gone wrong, go to Wiki and take a look at MGM Studios. Prior to reading this book, I would have looked at their recent troubles and thought, “Boy are they mismanaging things”. But that is not the case, the PE is the one who is mismanaging things and a grand old tradition in Hollywood is being eaten up piece by piece. Warner Records, founders of Atlantic, Electra and Warner have also been the subject of an LBO and have seen the company broken up. First Data Resurces was also taken private and as a result have taken on $22b in debt. While they have not made major changes yet, there are rumors already that their Dallas offices will soon be shuttered(see link below), moving the operations from Dallas to Omaha, their biggest facility. I have been to the Dallas facility and they employ alot of people. They have their own campus just outside of downtown Dallas. The Hugo Boss factory in Ohio is scheduled for closure at the end of April, another LBO. This closure will put approximately 375 more workers on the unemployment line. Danny Glover brought attention to their plight at the Oscars and encouraged a boycott of the Hugo Boss label.
As with the sub-prime problem, the PE firms have also spread out to Britian and Europe so if a crash comes, it is going to pretty much be global, not localized to the United States. Banks, although they have sold most of the loans, will suffer. Hedge funds that invested heavily in LBO financing will suffer as well as CLO(Collateralized Loan Obligations), investers who took insurance will lose. Purchasers of the even more derivitive vehicles built out of CLO’s will also lose. Sound familiar? It should, it is a miror of the sub-prime crash.
As is the case with most financial issues, it is almost impossible to correctly predict a crash as day to day so many things can happen to change the financial standing of any company, however if half of the total owed by these companies only causes a small tsunami, the workers and communities affected will not fare well. Nor will our fragile economy so soon after the mortgage crisis. People in the business of Private Equity firms will not be hurt except for their reputations and their are some pretty big players who are either now or have been in the business. Some of the players are and have been: Mitt Romney(Bain Capital), David Rubenstein(Carlyle Group), Goldman Sachs, Ray Kravis(Kohlberg Kravis Roberts), Cerberus(John Snow/Treasury Sec/Clinton) and others. Some of the companies involved in LBO’s: General Motors Acceptance Corp, Hertz, Michaels, PETCO, TXU(Texas) Energy, Sealy and Simmons Mattress Co, Hugo Boss, Burlington(Coat Factory), Warner Records, MGM, Mervyns, Linens n Things, General Instrument, Hospital Corp of America, Spire Healthcare, Vanguard Health Systems, Iasis Healthcare, Capella Healthcare, Ardent Health Services, Essent Healthcare, Hilton Hotels, Alltel, Clear Channel Communications, Harrah’s Entertainment, Kinder Morgan(pipelines). And if you are looking for the banks who participated, they are the same villians as in the mortgage crash, BofA, Citi, JPMorgan Chase, Goldman Sachs, Credit Suisse, Deutsche Bank. In fact, Wells Fargo may have been brought in by default because Wachovia is in the mix and Merrill Lynch could bring more exposure to BofA.
If you know what you are looking for, you can find many articles and commentaries on this potential looming crisis, I have provided a head start below. I certainly do not wish this tragedy on any of us or the companies involved, but it is better to be forewarned than to be surprised. It is also better to educate yourself on these issues, I know it will change how I look at businesses being bought and sold and who I put my trust in for the future, it would, and should, factor into decisions in the employment search of any individual.
The Buyout of America, Josh Kosman(it is a surprisingly easy read for a financial industry book)
Pension Funds waiting for payoff on equity
Buyout of America Website
Just reading this article on “Crooks and Liars” and considering that the cards started to tumble around the world’s financial institutions with the Lehman Brothers, I found this “alter ego” company story very scary. I wondered if this practice can ever really be stopped with new and tougher regulations or even stiff penalties. Perhaps they will just find others ways to defraud and bamboozle investors.
There is no will in the US to stop this, I think that is clear. I am not sure what it will take for the American people to stand up and say ENOUGH. Thanks for the link, I am going to read it now……back later.
Does this surprise you about Lehman?
Lehman Brothers Investment Management Director George Herbert Walker IV dismissed the proposal, going so far as to actually apologize to other members of the Lehman Brothers executive committee for the idea of bonus reduction having been suggested. He wrote, “Sorry team. I am not sure what’s in the water at Neuberger Berman. I’m embarrassed and I apologize.”
Quite honestly Sue, when it comes to greedy people never having enough money to satisfy them, nothing surprises me anymore.
That this would be the only thing to embarrass Mr. Walker is sickening to say the least, but surprising no, these people would try to squeeze blood out of a stone. I personally believe the bonus practice should be scrapped altogether unless it is a remuneration for a regular employee for outstanding work or effort.
Sue, I am so impressed by your grasp of this, and your ability to try to explain it to someone like me
It sounds like another part of the deal. The original loan was ostensibly to sell the business. The commercial real estate piece you are referring to must be a special added bonus for all of us to eat if the government steps in. The only deal I read about, specific to real estate, was Mervyns. If these companies were taking equity out of the buildings they owned, then the problem may be much bigger than I wrote about or it could be another crisis coming down the pipe……whoa until all of us. Your explanation from Elizabeth Warren makes it sound much worse than just the buy out plans.
AdLib, in three amazing paragraphs, you wrote a most inspired and hopeful vision for an American future re: business. In case anyone missed it:
Cheers Kes! Sue (and you) inspired me to build on this, check out my new companion article to Sue’s which proposes putting this to a vote by the people, starting in CA, through the proposition process.
Let me know what you think.
On my way over to your article right now.
Yes, that is beautifully stated for sure.
I agree with AdLib this is a brillant piece.
Thanks, most of the knowledge for this piece came from the book I read. I never am able to get through a book on financial issues in less than a week or two. This one I finished, and took notes, in a little over 24 hours. Prior to reading the book, I would probably not even look past the Bankruptcy filing of a company to really determine what was behind it. You can bet I will be watching closer now. I also never thought of it in terms of employment, but anyone who wants long-term employment should take heed.
Brilliant article, Sue!
What doesn’t come as a surprise is that the mercenary logic of hedge funds and such who bought companies to slice them up and flip at a profit were decimating and destroying the integrity of everything they touched, killing the golden goose that is. It follows that, as with the derivatives crash, someone would finally be holding the hot potato when it exploded.
What is worrisome is that this era of corporate psychopathy could come crashing down on the heels of a slow recovery from the related economic crash.
Putting all of this in perspective, America was and continues to be raped by corporate capitalism and unregulated financial entities. And they have and will continue to get away with it until or unless the American public comes together and stands against corporate America with laws, rules and a different economic system.
If this crash occurs along with commercial real estate and possibly another wave of home foreclosures, if the average American is out of work and losing their homes and jobs, might they then demand and vote to change this failing capitalist model of our economy?
I don’t know. Looking at the teabaggers, what is dismaying is that people’s anger can be so easily re-directed from the rapist to the policeman for not stopping the rapist.
And my desire for a different economic system is not one that is unrecognizable but one in which corporations are not people nor have the rights of one, where corporations are redefined as having a split responsibility to the investors AND employees AND society, where bonuses are directly connected to success on all of the three responsibilities above, where CEO salaries are capped to a reasonable percentage of the average employee’s, where workers are free to unionize, where investment entities are tightly regulated and forbidden from dealings that could be detrimental to the nation’s economy and/or the long term viability of a business.
Yes, this would be very intrusive government control of our corporate and economic system. Just as most other nations practice. We’ve seen the destruction of our economy and democracy that an unregulated, self-correcting free market brings, that experiment is over and has failed.
It’s time to join the rest of the world in an economic system that can be sustained without consigning 99% of Americans to a declining standard of living that in the end, would be just a small step above if not near corporate servitude and poverty.
I contacted my financial advisor yesterday to insure we are not vested in any stocks representing this activity. Generally he told me he never will advise individual investors toward these picks.
There is so much wrong with Wall Street and our “free market” system. In reality it is a free system, at least to the movers and shakers who are making their money.
What really gets me is that none seem to have any conscience. It is like they are out to make the money and screw the rest. But you are right. Part of my reasoning for covering this is to get people angry. Until the American people do get angry and rise up, we will continue to be raped.
All of the regulators are like foxes guarding the henhouse. Since at least the 80’s no one has taken their jobs seriously and in late 90’s these people were given free reign to do what they want. Yet people continue to support them and in the case of teabaggers actually lick their boots while traveling around the country on a corporate provided bus.
In fact, in spite of the most recent troubles, the SEC remains quiet on the subject. It is criminal IMHO
It is exactly like that. It is how hedge funds and banks operate. They gut the businesses they buy to profit from then put lipstick on the pig to sell it for more money than they paid for it.
The whole point of doing business this way is to plunder a company which naturally weakens it and harms employees, then hope someone else will buy it and own it when the spit and bailing wire comes apart.
It is a fact, this can’t continue endlessly without a long term or permamnently collapsed society with 1% of haves and 99% of have-nots.
What’s frustrating is that the people who should be most hostile towards corporations have been so easily duped by them to blame government for everything.
Then again, if they were bright and used reason to make decisions, they wouldn’t be teabaggers.
x2 The “none seem to have a conscience” is absolutely at the bottom of all of it.
What do you get when you add No Conscience and Greed together? Greedy Republicans with no conscience.
Yeah– exactly. The Gordon Gekko business model.
Except in the end Bud Fox screwed Gekko, even though his tactics were no better than everything he and Gekko had done on Wall Street.
This is intense!
I was just driving past one of the ’empty’ Mervyns today.
The giant marque letters are now gone
but the shadows where they were, looked liked ghosts.
We used to take the kids there.
It’s been empty for more then a year now.
If that land is so valuable,
Why is it empty?
I hope Obama can put this
kind of info into something the public can understand.
I feel the PE firms & banks depend on peoples eyes glazing over.
The more complex and confusing, the better for them.
People will give up trying to understand and buy into
the simple info being pumped into their
psyche from the beck palin charlatans.
If Obama can get ahead of this
and get the public behind him
I’ll say he walks on water.
that is one of the things I am glad hit the PE. Because of the economic crisis, they are having a hard time filling those buildings………..and you are right about the banks and investment houses. Funny thing is alot of the brokers on the street were not financial wizards, they were giving their buy/sell advisories based on the analyst’s research in the firms. Some of that research could have been as old as one year. This guy’s book was very easy to read and understand.
I am not sure Obama will get ahead of this, he would have to warn people of something that could be damaging to the companies that are involved that are solvent for now. Of course he could turn his talk to “sensible financial decisions” that would give him some extra credibility but until these companies default there is not much he can say, except preach financial sense to the public.
Great article, Sue. Of the many articles I’ve read in recent years, I think this has got to be the most frightening. (Far more frightening than Osama bin laden). This is where unfettered capitalism leads, the great Invisible Hand that so many conservatives are so smitten with. Unfettered capitalism is unfettered greed.
This may seem a bit of a stretch to those who don’t read as much history as I read, but I always remember what happened to the buffalo. The Americans came along and couldn’t just hunt for as much buffalo as they needed at the moment. They had to hunt down and destroy ALL the buffalo, just because they could.
Thanks, it scared me enough to let others know the potential risk.
As to your second paragraph, I can see where you would make the metaphor, very astute.
Sue, wonderfully researched, excellent — if scary — article.
One very small correction — not that it really matters — but Cerberus is headed by John Snow, former Treasury Secretary appointed by Bush II, rather than Clinton. Tony Snow was the Press Secretary under Bush II, who lost his battle with cancer, having resigned his post shortly before. The only reason I know this is because John Snow is a die-hard Republican from this area, who made his earlier fortune in CSX railroad systems. “Home town boy makes bad” sort of thing.
Do you get the impression that there’s anything that can head off this potential collapse? Surely, even though it’s been in the works for years, this will be another thing that will be blamed on President Obama!
You are right, I corrected from Tony to John. As to your question, not unless the holders of that debt want to forgive it. Even if the companies file BK it will put a strain on the systems because as is the case in a liquidation, creditors have to line up for any recovery. In addition, the author of the book said that payments on the US debt are going to come due, the government will not be in a position to bail them out, nor should they. It is just a rotten shame that the PE’s will get away with their riches in tact. Just remember the name Mitt Romney in case he runs for president.
One more reason not to vote for Romney, Sue. Not that I was seriously considering it; but I’m sure there are quite a number of tea party types who could be led in that direction… baaaaah….baaaah…..
Kes but now you have the information to combat their talking points. It is going to come up along the line unless the Dems are plain stupid or in the shark tank themselves.
Right you are, Sue. This was really a terrific article on a subject that not many people are aware of. I know I wasn’t! Thanks for this and all that you do here.