May 11, 2010
Two decades ago, Drexel Burnham played the difficult hand it was dealt very poorly, partly because of the limitations of its management but also because few financial firms in the modern age had any experience dealing with such a challenge from the government.6 Goldman should study the Drexel matter carefully to determine the appropriate course of action in order to assure the best outcome for itself as well as for the financial system. Goldman would be far better served by settling this matter, and the government would be far better served by agreeing to settle rather than acting like it is dealing with organized crime and inflicting unnecessary systemic damage in a situation where it licensed and opened the casino and has now decided to come in after the fact and change the rules.
Goldman’s management will be distracted by its fight with the government, and embarrassing emails and other unsavory disclosures will continue to leak out into the press for the duration of the case. The optimal outcome would be one in which Goldman survives as a firm that is a beacon of ethics, transparency and fair dealing, a standard that its involvement in transactions like ABACUS strongly suggest the firm has allowed to lapse in recent years. Goldman would also be served by making a corporate decision to shift its business toward more productive activities in the future. Profits may suffer, but profits without principle are proving an empty accomplishment. If Goldman is fighting for the ideal that it was providing the marketplace with a useful product in ABACUS, it is tilting at windmills.
One of the more unfortunate byproducts of improving corporate credit markets is the ability of private equity firms to cover up their mistakes. It is unfortunate because it allows the private equity industry to continue to squander the nation’s institutional capital in unproductive investments while delivering poor risk-adjusted returns. The so-called “maturity mountain” rising up in 2012-14 is being rapidly chipped away by massive refinancings that allow buyout firms to extend the debt maturities on the portfolio companies for which they grossly overpaid during the height of the credit bubble.
The latest manifestation of private equity’s lack of value creation is a flurry of sales of portfolio companies among buyout firms. Deals in which both buyer and seller were private equity firms have risen to their highest level since 2006, according to Bloomberg News.7 Thus far in 2010, there have been 40 such deals; in 2006, there were 149 such deals. Recent deals have included TPG Capital’s $1.3 billion acquisition of American Tire Distributors Holdings Inc., the second time since 1999 that the tire company has been purchased by a buyout firm; Cerberus Capital Management LP’s $1.5 billion purchase of DynCorp International Inc.; and the $1.1 billion buyout of Sedgwick Claims Management Services by Stone Point Capital LLC and Hellman & Friedman LLC.
The process whereby one private equity firm sells a company to another private equity firm is one of the more noxious phenomena in today’s financial markets. Such transactions keep these companies enslaved by debt while the lion’s share of their cash flow is devoted to paying undeserved fees to their private equity sponsors and interest payments to their bankers and bondholders (principal is rarely repaid because these companies are generally incapable of growing after being starved of growth capital for so many years). These companies often end up in bankruptcy, like the manufacturer of Simmons mattresses, which has changed hands more than half a dozen times in recent years as it has been swapped among private equity firms like a bunch of baseball cards. Private equity firms are obviously desperate to generate “realization events” that allow them to return capital to unhappy investors and generate fees for their otherwise moribund businesses, which is one reason why these pointless transactions persist. Institutions are properly starting to question these types of transactions, a promising sign that investors are beginning to wake up to the disappointing reality of private equity.
Public pension funds
HCM read with great interest CALPERS’ announcement that it had reached an agreement with private equity firm Apollo Management8 that will lower that firm’s extortionate fees by $125 million over five years. We would have been more impressed, however, had CALPERS shown greater recognition of the fact that Apollo and other buyout firms with whom it is seeking similar accommodations are responsible for job losses, lower R&D expenses and other drains on economic productivity that ultimately harm the beneficiaries whose capital the giant pension fund invests. This was particularly disappointing in view of CALPERS adoption of a new policy to prohibit excessive rent increases and the involuntary displacement of low-income households in real estate in which it invests. This change in policy demonstrates that the pension giant is starting to awaken to the broader implications of its investment decisions. Investors need to understand that private equity is asking them to load a gun that is aimed at the heads of their own constituents.
Public pension funds also need to come to terms with the realities of the post-crash investment environment. Despite the impressive stock market and credit market recovery since the March 2009 lows, future returns are likely to be both volatile and modest. The large California pension funds are currently engaged in a debate with Stanford University’s Institute for Economic Policy Research, which published a study suggesting a more than $500 billion unfunded liability for California’s three largest pension funds – CALPERS, Calstrs and the University of California Retirement System.9 The three funds criticized the report in part due to the use of an expected return rate tied to 10-year Treasuries of 4.14 percent. This is far more conservative than the assumed rates of return used by the three large California funds, which range from 7.5 percent to 8.0 percent. Reasonable minds can disagree about the appropriate return target, but 7.5 to 8.0 percent is too high, particularly if these funds are going to continue to invest significant amounts of money in private equity and other strategies that have proven themselves to be highly overrated (see Chapter 5 of The Death of Capital for a detailed discussion of the fallacy of private equity returns). Public funds need to be realistic about the markets, and such realism should acknowledge that markets are going to have to contend with the fallout of the massive government stimulus that was required to prevent a replay of the Great Depression. Accordingly, expecting returns in the 7.5 to 8.0 percent range in a zero interest rate environment, or an environment in which zero interest rate policy is certain to be abandoned, is the opposite of realistic. Instead, it is likely to lead to investments in strategies that will be unduly risky. As such, they will involve illiquidity, leverage, concentration risk and other characteristics that led to catastrophic losses in the periodic market collapses that have scarred the investment landscape over the past two decades and most recently in 2007-2008.
In The Death of Capital, one of the regulatory changes I recommend is an absolute minimum level of bank capital of 10 percent. This level might even be too low, but it is far better than what current exists. This minimum level should be maintained at all times, not just at quarter ends or at certain measuring periods. The reason for such an approach was highlighted recently by a report from the Federal Reserve Bank of New York showing that major banks have been temporarily lowering their debt levels at the end of reporting periods and then significantly increasing them immediately thereafter. According to this report, 18 banks – including such corporate leaders as Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Citigroup Inc. – understated the debt levels used to fund securities trades by lowering them by an average of 42 percent at the end of each of the last five quarters. They then increased them sharply by the middle of the following quarter before lowering them again. The banks’ outstanding net repo borrowings (repos are overnight borrowings that these institutions use to finance their trading activities) at the end of each of the last five quarters turned out to be 42 percent lower than their peak borrowings during those quarters. HCM need not remind its readers that all of these institutions are now bank holding companies and that the three largest of them enjoy government guarantees of one sort or another on their deposits. HCM should point out that this type of activity is an age-old practice on Wall Street. Financial firms of all types – banks, hedge funds, whatever – have always dressed up their books for reporting dates. The question is whether such a practice should be allowed to continue in the wake of the financial crisis, or whether greater transparency and discipline should be enforced through regulatory reform. HCM believes the answer is a resounding yes, particularly if naked credit default swaps are not going to be banned.
Europe and the rating agencies
The rating agencies are ripping through Europe, downgrading first Greece, then Portugal and then Spain. The question remains why these intellectually and morally discredited businesses still exist, but HCM is tired of beating that dead horse. Once again, these self-appointed doyens of credit, who know less than nothing about credit, are showing up at the party too late and adding fuel to a fire that is already raging, making it that much more difficult for governments and central banks to make sound decisions about how to stabilize the situation. Greece was downgraded by Standard & Poor’s to BB+ from BBB+, Portugal was downgraded to A-, and Spain was lowered to AA. If the markets continue to allow the imprimatur of credit agencies to determine investment suitability, there is a genuine risk that these downgrades will inflict systemic damage. This would be, in the words of Karl Marx, both a tragedy and a farce. The world’s governments and central banks need to get their acts together immediately with respect to these organizations and develop a plan whereby they can no longer inflict damage without consequence.
HCM expects the European Union to end up doing what is necessary to insure that Greece and the other peripheral countries in the union do not drive off a cliff (or further highlight the impossibility of economic union without political union). As noted in these pages recently, there is no true periphery in an interconnected world, so Greece’s collapse should not be taken lightly. But it should be kept in perspective. Greece accounts for only 2.5 percent of the Eurozone’s GDP, and Portugal is even smaller. Spain is larger, but it is taking strong steps to address its budget woes. Greece’s €300 billion of debt is hardly insignificant, but it is manageable and is unlikely to reverse the strong recovery in U.S. credit markets unless a default is permitted to spread beyond the Aegean (and Iberian Peninsula). Policy makers have presumably learned something from the 2008 crisis and will be able to manage the current one. Investors should remain vigilant, however, just in case something unexpected happens.
Greece is no longer financeable on its own. After being downgraded by Standard & Poor’s on April 27, Greece’s credit default swap spreads traded at spreads of more than 800 basis points, and its two-year bonds traded at yields in the high teens. These are unsustainable levels, meaning that the country is effectively closed off from raising additional financing. Only a bailout will prevent an outright default, and a bailout will occur. The issue will come down to how much austerity will be inflicted on the Greek state, and whether other countries in similar straits will get the message.
Michael E. Lewitt
6 At least Drexel Burnham and Michael Milken were trying to make financing available to those who couldn’t previously access it – less than investment grade companies, including minority-owned companies and companies in emerging markets – while modern-day investment banks like Goldman Sachs do little along those lines.
7 Bloomberg News, “Bonderman Buys American Tire as Buyout Firms Trade at Boom Pace,” April 22, 2010.
8 It is a sure sign that credit markets are entering overheated territory when private equity firms like Apollo begin piling into the market. Bloomberg News reported that Apollo Global Management LLC dominated the high yield bond new issue market in April, accounting for more than 16 percent of the $24 billion raised through April 27. Among the Apollo portfolio companies issuing debt was Harrah’s Entertainment, which has already effectively defaulted by engaging in debt-for-debt exchanges that gave debt holders less than face value for their bonds. Harrah’s was one of the most overleveraged transactions completed during the credit bubble. As noted in last month’s issue of this publication, it beggars reason that investors continue to fund the deals of a private equity firm that has been a serial abuser of bondholders.
9 This discussion was triggered by an editorial in The Wall Street Journal on April 27, 2010, “The Pension Ticks Louder.”
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