Fortune Magazine
by Bethany McLean

Sallie Mae: Who'll get schooled?

Lessons from what was to be the biggest financial services LBO.

By Bethany McLean, Fortune editor-at-large

(Fortune Magazine) -- Aren't supersmart people oh-so-seductive? They've figured out all the angles - haven't they? But sometimes even the supersmarts could use a little schooling.

Here's a textbook example: the $26 billion buyout of student-loan giant SLM Corp., (Charts, Fortune 500) or Sallie Mae. In April 2007 a consortium led by J.C. Flowers, which included Bank of America and J.P. Morgan, offered to buy Sallie Mae for $60 a share - an almost 50% premium to Sallie's pre-deal price. It was heralded as the largest ever LBO of a financial services company, and commentators predicted that it would put financial companies in play too.

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Sallie's chairman Al Lord is suing for a $900 million breakup fee.

But here we are, six months later, and the vaunted deal is mired in mudslinging, a clash of mammoth egos, and a lawsuit in Delaware Chancery Court.

The agreement stunned the market when it was announced. There's a reason why LBOs of financial services firms don't happen. You need to borrow money to do the deal - some $16 billion, in this case - and you need to borrow money to run the business - billions more.

In other words, you are at the mercy of the credit markets. But last spring cash was cheap, and most people assumed that Christopher Flowers, the intellectual, chess-playing head of J.C. Flowers who masterminded the deal, knew what he was doing.

Flowers, a former Goldman Sachs partner who made his name and his fortune with the 2000 purchase of the Long Term Credit Bank of Japan (now called Shinsei), is regarded as a financial genius. Getting J.P. Morgan (Charts, Fortune 500) and Bank of America (Charts, Fortune 500) to be equity investors, as well as suppliers of debt, seemed like a perfect package, a work of - well, genius.

The deal was stunning for another reason. Sallie's profits depend more on the whims of Congress than on anyone's business acumen, because Congress determines the profitability of loans that are made under the Federal Family Education Loan Program, or FFELP. Such loans make up 84% of Sallie's portfolio.

Under Al Lord, Sallie's combative chairman, the company lavished its lobbying love on Republicans. For many years the business was a gold mine. But Democrats have long resented Sallie's supersized profits, and even President Bush's budget last February proposed slashing lender subsidies. It was clear that Washington was a major risk, but most onlookers assumed that Flowers and his crew knew something they didn't.

"Some of the savviest minds on Wall Street believe that even in the face of a congressional debate over subsidies, there is room for a 50% premium," said Charles Gabriel, an analyst at Prudential, when the deal was announced.

But Flowers didn't have it figured out. It appears he was making two big, simple bets. One was that the financing environment would stay friendly. The other was that Sallie would be able to use its lobbying clout to forestall the most painful cuts to its profits, and that the buyers would be able to make billions off the backs of taxpayers.

Wrong! Twice! The credit markets have seized up. Even if Flowers wanted to twist the arms of his bankers to go ahead with the deal, he couldn't twist very hard - because he needs their equity too. Then, in September, President Bush signed legislation that cuts subsidies by even more than his budget had proposed. Things could get worse: Hillary Clinton says she wants to abolish the guarantee of lenders' profits.

As it became clear that they'd placed bad bets, the buyers tried to retrade the deal. In October they offered Sallie $50 a share, plus warrants of uncertain value, in place of the $60. They cited a clause in the contract that allows them to walk away in the event of a "material adverse event," ironically called MAE, in Sallie's business. The buyers contend that the change in the financing environment, plus the new legislation, constitute just that. Sallie, for its part, insists that the buyers signed up for those risks.

It's possible that Flowers and his crew put the MAE in place to give themselves an out in precisely this set of circumstances. If so, they underestimated their opponent. Instead of accepting the reduced price, Lord kicked and screamed and filed a lawsuit seeking a $900 million breakup fee. The banks can eat that easily, but if Flowers has to pay his $450 million share, his firm will suffer.

Maybe the real lesson here is that even supersmart people need to go back to school. If Flowers has to pay the breakup fee and can't afford class, maybe he can call Sallie for a loan.  Top of page