Why the private equity bubble is bursting

Loans will go bad, deals will be canceled, fortunes will be lost. The sudden end of cheap financing is wreaking havoc on the buyout market, says Fortune's Shawn Tully.

By Shawn Tully, Fortune editor-at-large

(Fortune Magazine) -- Michael Psaros is ready to pounce. Perched in his office atop Manhattan's MetLife Building, with its sweeping views of Central Park and photos of the sun-splashed Greek isle of Chios, home of his forebears, the 40-year-old is convinced that the spreading wreckage in the buyout world will serve up the best deals of his life.

Psaros is a managing partner of KPS Capital Partners, a firm that specializes in buying and rebuilding troubled industrial companies. A contrarian with a keen eye for market trends, he sold eight of his 11 companies as he watched the private equity frenzy mount over the past 14 months. "The prices were incredible," marvels Psaros. "The market is completely out of touch with economic reality." Now he's poised to move back in. KPS just raised $1.2 billion to buy companies that, Psaros reckons, LBO shops and lenders will jettison at desperate, distressed prices. "It always turns on a dime," he says. "All of a sudden you can feel the fear."

With the closing of the Chrysler deal, the (very) private equity shop is poised to succeed or fail very publicly, say Fortune's Katie Benner and Geoff Colvin. (more)

It's looking more and more as if the private equity phenomenon was a classic Wall Street bubble. It brought unprecedented riches to investment banks, minted a flashy new generation of billionaire Masters of the Universe, and bestowed a magical aura on leveraged-buyout specialists like Carlyle and Kohlberg Kravis Roberts. And now the bubble's bursting. Loans will go bad, deals will be canceled, fortunes will be lost. We're witnessing the unwinding of the whole dynamic that propelled the stock market (not to mention Manhattan real estate prices) to record highs.

Alarm bells are ringing. Since mid-July, worries about risky debt have helped drive the S&P 500 down by 6%, wiping out about two-thirds of this year's gains. At least one big hedge fund, Sowood Capital Management, run by a former member of the team that steered Harvard's endowment, has gone bust. And banks have been unable to syndicate loans financing several high-profile buyouts, including those of Chrysler, First Data and ServiceMaster.

The bursting of the bubble will inflict broad damage. The cascade of private equity deals will slow to a trickle - and the firms that vastly overpaid for their targets at the peak of the frenzy in the past two years - when, by the way, most of the deals were done - will deliver extremely low returns to the pension funds, university endowments, and wealthy families that invested in them in recent years.

Second, investors in high-yield debt will suffer. The worst victims will be hedge funds that kept the good times rolling by buying the riskiest junk bonds and bank debt, often on margin - the strategy that sank Sowood, which saw 50% of its assets evaporate in the meltdown.

The suffering won't be confined to the professionals or the wealthy. Ordinary investors who have money in corporate or high-yield bond mutual funds will feel the pain. And so will stock market investors. Until recently many stocks benefited from a takeover premium - it seemed that virtually any company in any sector, from gaming to hotels to retail to software, could be bought at a royal price by a leveraged-buyout specialist like KKR or Blackstone (Charts). Suddenly the buzz, and the takeover premiums, have vanished. Especially hard hit are the players heavily touted as LBO targets. In just three weeks Corinthian Colleges (Charts) has dropped 16%, Martha Stewart (Charts) is down 25%, and Radio-Shack (Charts, Fortune 500) has plunged 30%.

The seeds of its own destruction

The private equity saga follows the timeless template of financial frenzies. Its roots go back to the bursting of the tech and telecom bubble in 2000, which saw stock prices decline 40% and threatened to pull the economy into recession. In response, the Federal Reserve pushed interest rates to rock-bottom lows to keep the economy humming. And hum it did. While stocks stagnated, the economy and corporate profits kept chugging along.

The combination of low interest rates, depressed stock prices, and rising corporate profits created ideal conditions for private equity firms to flourish. Using dollops of cash and bushels of debt, they were able to snap up solid companies on the cheap - in 2002 buyout prices averaged just four times cash flow (defined as earnings before interest, taxes, depreciation, and amortization, or Ebitda). In a typical deal a private equity shop would borrow about 70% of the purchase price (those loans go on the acquired company's balance sheet, often doubling or tripling its debt load).

With that kind of leverage, even modest improvements in the company's profits generated huge returns for the private equity firms and their investors. In some cases, they paid themselves dividends that allowed them to recoup their entire investment within a year. And to top it off, they raked in huge fees from the companies for arranging the deals and the financing, as well as for managing the business. (The deals also got a boost from Uncle Sam. The interest on all that debt is tax-deductible, so the companies saw their tax bills drop drastically.) The math made the buyouts bulletproof. "The market was so good that dead people could have made money on LBO deals," says Chris Whalen, a managing director at Institutional Risk Analytics.

Like every mania, this one carried the seeds of its own destruction. The lure of easy riches drew new players, and the pace of dealmaking picked up. In 2005 there was a string of splendid deals at reasonable prices. For example, TPG (formerly Texas Pacific Group) and Warburg Pincus scooped up Neiman Marcus for $5.1 billion, and a group led by Clayton Dubilier & Rice, Carlyle, and Merrill Lynch paid $5.6 billion for Hertz (these prices don't include the existing debt of the targets).

As the good times rolled, the buyout binge took on a life of its own. The real craziness started in 2006. Dazzled by rich returns, investors threw more and more money at private equity firms. Flush with cash, the PE shops started pushing prices to unsustainable heights. The firms were not only making initial offers at big premiums over the target's current market value, but getting drawn into bidding wars that drove the prices and the premiums still higher. Last year Blackstone bid $16.4 billion for Free-scale Semiconductor - nearly a 30% premium to its market value, which had already been boosted by takeover talk. After KKR came into the picture, Blackstone had to sweeten its offer to $17.6 billion to prevail.

Shareholders of target companies soon figured out that they didn't have to accept the first bid that came along, no matter how rich it was. Last year Clear Channel shareholders rejected a 33% premium from Bain Capital and Thomas H. Lee for the radio group. The firms clinched the deal only after upping their offer by $800 million, to $19.3 billion. By early this year the average buyout price was clocking in at 15 times cash flow - nearly a fourfold increase from the 2002 level and matching the level reached just before the LBO market blew up in the late 1980s.

In another sure sign of froth, the firms traded companies to each other at ever higher prices instead of selling to corporate buyers. Blackstone recently sold Extended Stay Hotels to Lightstone Group for $8 billion, $6 billion more than Blackstone bought it for in 2004. And then came an unmistakable sign of a top: Private equity firm Blackstone went public (the stock is off 35% since its June debut), and others talked of following suit. Those plans are now on hold.

Paying higher prices meant borrowing more money; as debt levels grew, interest payments absorbed a bigger portion of cash flow, eliminating the margin of safety that made the earlier deals so compelling. In the recent $12.2 billion buyout of Univision, the Spanish-language TV network, interest payments on its $10 billion debt will eat up virtually all of the company's $760 million yearly cash flow. "Univision has good growth prospects," says John Puchalla, an analyst with Moody's, "but it will need both good performance and a strong economic environment to manage the huge debt load." The big leverage on recent deals practically guarantees that default rates on buyout loans will soar from the current rate of less than 1% to at least their historical average of 5% to 6%, and perhaps a lot higher.

'Because we can finance them'

Now we come to the other half of the buyout equation: the lenders. Buyout firms borrow through banks and by issuing junk bonds (in the name of the companies they're acquiring, of course). Among the key enablers of the buyout boom were investors searching for yield. With rates on supersafe Treasuries at historical lows in the early 2000s, the usual suspects - led by hedge funds and Asian and European banks - were happy to snap up all the high-yield debt the market could offer.

And they seemed blissfully insensitive to risk - even junk bonds rated a scary C were selling briskly, accounting for more than 25% of all LBO junk-bond issues earlier this year. "Bonds are usually downgraded to that rating when they're near default," says Mike Rowan, managing director for corporate finance at Moody's. "It's unusual to see new issues at that level." In fact, the last time C debt was issued to raise money was during the telecom bubble, and we all know how that ended.

It wasn't just junk-bond investors - banks drank the Kool-Aid too. The loan covenants, or conditions the banks imposed on borrowers, became far looser. These "covenant lite" credits frequently dispensed with traditional requirements that companies keep a comfortable cushion of cash flow to cover interest payments or else pay down debt. They also often allowed companies to borrow more money to pay interest, a feature in many deals, including Univision, that resembles the negative-amortization home loans (which allow homeowners to add unpaid interest to the principal) that juiced the mortgage market.