Private money (cont.)
With all due respect for the industry's executional moxie, the main reason private equity has an edge these days is its ability to load up balance sheets with cheap debt. (You literally have to go back to before World War I to find a time when credit spreads were this narrow.)
"While we remain focused on earning most of our returns through growth and operational improvements, many of the large deals of the past few years rely mainly on leverage," says Bill Ford, CEO of General Atlantic, which has $12 billion under management.
GE's Immelt seconds that emotion. Of the 30 or so buyout deals he looks at each year, he told the Financial Times in November, "the vast majority only add value through financial rather than operational improvements." Immelt added that if he were to order any of GE's top managers to nearly double profits in three years - and allow them to then "drop the reins" - "almost any of them could do it."
Other seasoned observers also fret that a newly fervid trading mentality among private-equity players - bringing an LBO company back to public markets faster than the more normal five- to seven-year time frame; more deals done by flipping companies among PE firms rather than going public; and above all, the industry's growing penchant for taking out profits as fast as possible through leveraged "dividend recaps" and excessive management fees - offers disturbing confirmation that the engine is overheating.
"How will private-equity firms continue to make money by just flipping and flipping and flipping?" asked Warren Buffett at Berkshire Hathaway's annual meeting last May. "They'll make it on fees, fees, fees."
Where do we go from here?
In many ways we have been here before - two decades ago. In 1988, LBOs accounted for nearly one-third of all M&A in the U.S., more than the industry's share last year. In today's dollars, KKR's 1989 takeout of RJR Nabisco would be worth just over $50 billion, which makes it still the real-dollar champ. Croesus-like riches? In 1987, Mike Milken earned $550 million in salary and bonuses for his labors at Drexel Burnham - in inflation-adjusted currency that's nearly $1 billion.
The last good time ended not with a bang but with a mattress. In August 1989, right before the junk bond market first seized up, First Boston extended a $500 million bridge loan to a New York buyout firm that was taking a company called Ohio Mattress (now known as Sealy) private. When First Boston tried to unload its temporary bridge on the usual suspects, the buyers, unnerved by rising interest rates and the collapse of the main market maker, Drexel Burnham, balked. Liquidity went overnight from a virtual Niagara Falls to a veritable Sahara. First Boston was stuck with its loan, developed its own financial woes, and ultimately was subsumed by Credit Suisse. The deal became known as the "burning bed."
Not such a riveting story, really, except for this little footnote. In May 1990, nine months after the bed first caught fire, one business magazine - not this one - concluded that "the lessons of Ohio Mattress won't be forgotten."
Actually, they pretty much have been.
What happens next in the debt and derivatives markets may have the biggest influence on how the latest boom ends. Here are some relevant data. Few of the individual megadeals today are as heavily leveraged as KKR was. But at more than $1.3 trillion, leveraged loans outstanding in the U.S. are at an all-time high and headed higher. The same is true for high-yield debt, securitized mortgages, collateralized debt obligations - you name it. While default rates are at record lows, credit quality by almost every measure has deteriorated: Debt-to-Ebitda ratios are where they were before the last downturn and rising; 55% of new leveraged loans are rated B+ or lower, also a record.
To Wilbur Ross, who's made a fortune timing the distressed debt market right, it points one way: to "a very big escalation in defaults." Hovering over everything is the mind-blowing expansion of the global credit derivatives market, up from nowhere five years ago to $25 trillion - and headed toward $30 trillion.
"How and when it happens I can't tell you," says prominent short-seller Jim Chanos. "But there's a train wreck coming."
None of the railroad owners will go that far, but they will admit that this whole fee thing is getting out of control, that there's too much deal flipping, that the risks are rising as they expand into foreign lands, that these days it's all too much about leverage, and that "the best time to sell is when the sun is shining," as one private equiteer told me. So, while private equity may well be an even bigger force when we look back from 2012, you might not want to bank on it.
On that note, let's check in with a man who made his hay while the sun was shining: namely, Mr. Sam Zell. Zell, the CEO and chairman of Equity Office Properties, has an impressive track record when it comes to calling the market's twists and turns. It's less widely known that he is also on record in a more creative format: Every New Year he sends his friends elaborate modernistic music boxes that play parody versions of songs conveying his current economic outlook.
In January 2000, for example, his gadget featured a kid staring at a naked emperor sitting atop a stack of Wall Street Journals, while a Paul Simon sound-alike crooned, "I'd like to help you all get rich at 23/There must be 50 ways to make a billion & /Just add a dot-com, Tom,/Front your name with an 'e,' Lee/Start auctioning toys, Roy & " and so it went. And what was Sam's message in January 2006, months before a bidding war put $900 million in his pocket? A music box that featured a B.J. Thomas sound-alike crooning along to "Raindrops Keep Fallin' on My Head." The last verse concludes:
"Capital keeps rainin' on my head/So much is out there that the world is out of whack/When will we see balance back?/It's gonna be a long time till returns meet expectations./We need to be/Prepared for slim annuities."
So by all means, cue the trumpets. But let's hold the parade for private equity until we see just how well it copes when the next hard rain finally falls.