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