Sounds like fighting words to the Prince.  The Prince has stayed on the sidelines on the Clear Channel dispute until this point.  The buyout firms’ quick rejection of the arbitration offer from the syndicate of banks prove once again the Prince’s earlier argument (Wall Street’s Short Memory on Private Equity) about how much leverage sponsors have when it comes to negotiations on committed financings.  If a group of financial sponsors wants to get get a deal done then they have very few incentives to give concessions to the banks that committed financing.  The fact is the banks and the private equity firms are essentially engaged in a continuous multi-decision game and have relationships that negotiations will test.  However, given the short memory of Wall Street, it is unlikely that any buyout firm will see real repercussions in the future if it forces the banks to honor their commitments.  Provided the private equity firm has capital in the future to invest The Prince guarantees that there will be bankers willing to forget the past to get a deal done.  Any banker threatening in committed financing negotiations to not be as aggressive next time on terms or not show a sponsor a company first is probably full of it.  The sponsors know this.   

Let’s briefly review. The Clear Channel deal has been in the pipeline forever.  Since July of this summer the banks began to drag their heals and push back.  However, even before this point, the sponsors underwent a rather embarrassing battle with shareholders over what was a fair price.  This $26bn buyout secured roughly $19bn in bank loans and high yield debt from the syndicate of investment banks led by Citigroup.  The banks would have earned nearly $400m on the financing but the shutdown of the leveraged loan market this summer made syndicating the debt at a net profit impossible.  This deal was supposed to close months ago and would have closed a few week had the banks not put their foot down on a specific term that was a deal killer for the sponsors.  The sponsors quickly filed suit in New York and Texas with Clear Channel joining the Texas suit.  The banks petitioned to have the case moved to New York.  Today the banks said they were prepared to submit to the decision of an independent arbitrator and believed that the matter could be resolved within six weeks (see the text of the offer).  The buyout firms quickly refused the offer.  "We are ready to complete the deal to buy Clear Channel on terms consistent with the binding commitments the banks made nearly a year ago, and provided all the documentation needed to execute the funding, but the banks refused to sign," the private equity firms said.

This kind of reminds the Prince of when Merck tried a few cases to try to set a precedent for how large the settlement would have to be over Vioxx.  The banks are going in to this one hoping they can set a precedent which will allow them to wiggle out of other committed financings in this environment or at least limit the pain.  The thought process is something like there is a speeding truck heading towards us and its hood says BCE.

It is probably a good thing for the industry that the Clear Channel suit brought by the sponsors against the banks will go to court.  Hopefully, it will be tried in New York.  Having this case go to court will set a precedent for how the industry and the courts should treat committed financings.  In an ideal world the case would be argued and decided before other massive buyouts, like BCE, go through.  The financial sponsors have a better case in the Clear Channel suit and The Prince knows they are going to win if this suit goes to trial.  However, the decision will be more important as a precedent for future negotiations.  This is probably one of the most important cases in quite some time in terms of its potential to remake the relationship between the sponsors and the investment banks.  The reputations of all the parties involved in this case are on the line but the banks have the most to lose and the sponsors have the most to gain.  The private equity firms didn’t blink in this negotiation and it will make future negotiations much easier for sponsors as a whole when they win.  The hearing this Thursday in New York should be interesting. 

A few weeks ago Ken Moelis, former Drexel, DLJ, UBS rainmaking banker, was interviewed on Bloomberg about the leveraged loan market and the changes he expects to see at investment banks.  Few people are as well placed as Ken Moelis to make such forecasts and his commentary is fascinating.  He also answers questions about his new boutique, Moelis & Company, and its phenomenal recent performance.  He also throws some criticism at UBS, his former employer.  He criticizes the financial conglomerate model because lines of authority and decision making are difficult to discern.  The Prince knows that this news is slightly outdated but he does not think many people saw this interview.

Here is a link to the video that aired on April 9, 2008

On investment banking in general:

"Investment banking is an incredible business.  A very unique business in which you empower some very smart people to take unusual risks.  Almost no other business in the world allows you to empower people on a day-to-day basis to take risks."

On the leveraged loan market in response to John Mack’s rosy picture:

"To give John Mack his due, maybe we are in the 9th inning, but that means they shut the game down.  What you are really asking is when does the next game start and I think we may be in the 9th inning of the last game and we might have to wait a year before baseball season actually starts again.  Because there is no more backlog being created and there are no more commitments out there and so yeah we may be ending the crisis point in leverage credit but the floodgates will not open again for a long-time.  I think it takes a long time for these cycles to reappear; people learn lessons, boards of directors, risk managers.  It will happen again but it will probably be five to six year before we get anything like what we at 9 months ago."  

On private equity’s edge in the boom:

"There was a real arbitrage, I believe, going on between the public equity market, which was being pretty irrational, and the private finance market.  What really happened was the security that was being under priced was leverage.  It was being given away in too large size at too low rates.  And what a lot of the private equity firms were really doing, I’m not sure they thought about it this way, but they were using the arbitrage of cheap credit which allowed them to actually pay 25-30-40% more than public equity markets.  Because what we are finding out is the debt was giving them that ability by pricing themselves too low or too aggressively." 

On Moelis and Company’s edge and the M&A market without LBOs:

"First of all, let me defend us [Moelis and Company], because you said we don’t have a balance sheet and I was joking.  I think we now have the strongest balance sheet on Wall Street given what is going on.  I‘m not sure that anyone has what you would call a balance sheet anymore from the old definition.  The interesting part is that M&A, I think is going to be down but nothing like what were feeling like in New York because of the finanacial panic that we are seeing here.  The rest of the country is really not experiencing quite the same pressure that the financial are and I think you are seeing strategic deals come back.  We just put a company up for sale this week and we did get 20 bids from financial sponsors.  So I think if you have good product people will find a way to finance it and purchase these companies."

On the investment banking business:

"We are going down, we will be down 30 to maybe even 50 percent in the short run and I think the street got staffed up to support what was a slight bubble in M&A.  I do think that people will have to downsize but it will be a healthy market.  Remember, if we went back just to 2005, we sort of had a very big spike in volumes in 06 and 07.  So if you go back to 05, we may have to go back to staffing levels of 05.  It’s not the end of the world…Look, I think across the board you are going to see these firms have to reduce by anywhere from 30 to 35 percent of headcount.  A lot of the financial products are going to go down more than M&A, some of the actual leverage lending itself and mortgage products and I do think you are going to see a significant retrenchment on Wall Street."

On relationship investment banking:

"What we are really doing out there, that is leading to our success, is that we’re going back to relationship investment banking.  I think that there was a lot of distraction here put on leverage and how much you could lend people and at what rates and I really think the CEOs and these companies want long-term relationships.  People who are willing to say no to them when you should say no and will know that they will still be involved with that company 3, 4, 5 years from now when they might do a transaction.  And I think that Wall Street really has to get back to that and we hope we are leading the charge in that direction."

Sounds like a page out of the Accidental Investment Banker or Goldman Sachs: Culture of Success.

On how Wall Street firms will survive a private equity fee diet:

"Well I think the good ones are going to manage back to remember who their client relationships were.  I think they are going to have to go back out, remember that their client is a relationship not a counterparty, and I think they are going to have to remember that about their own people too.  I think some of these firms have gotten used to moving paper around in size and forgot that the people within their own organizations are the true assets.  We used to say that the assets went up and down in the elevators at these investment banks but now the assets are piled up in CDOs and warehouse facilities and that’s the problem.  So I think you are going to see the firms go back to relationships with their own employees, the ones who do it right, I’m not sure that everyone will get there as quick as they should, and we might actually see some deconglomeration of these financial institutions." 

Given the first quarter M&A numbers all of what Moelis describes lays out sounds correct.  In the first quarter M&A activity by volume was down 22% to $861 billion globally versus Q12007.  U.S. activity was down 28%, to $318 billion, reflecting lack of credit for acquisitions and the related hiatus of financial sponsors.  Also consider that Yahoo-Microsoft at $45bn and Phillip Morris’ divesture by Altria at $111bn make up 50% of U.S. M&A thus far.  M&A fees are also down 28% globally in Q12008 versus Q12007. 

The recent wave of layoffs have predominately been in departments that are close to the credit crisis, i.e. structured product groups and leveraged finance product groups.  While some layoffs have occurred within investment banking division with deal volumes dropping more layoffs will be coming.  Certainly product groups like leveraged finance have already been cut and will continue to be cut but even coverage groups will be trimmed.  Many banks are even beginning to reexamine their M&A groups, normally considered the safest and most prestigious groups within most investment bank.  The investment banking divisions at major banks are going to be facing significant headwinds over this year and possibly even through 2009.  While these headwinds will certainly lead to some restructuring of the divisions, The Prince agrees with Moelis, that some downsizing will take place. 

However, those predicting cuts similar to those that occurred in 2002 in the wake of slow M&A from 2001 to 2004 will probably be wrong.  Moelis is right on point when he says we are going back to 2005 staffing levels.  Much of the headcount that was focused on financial sponsor transactions will be directed towards the middle market, deals with foreign buyers, and hostile transactions.  This makes sense considering that DB, GS, and MS all have their global M&A group heads based out of Europe now. 

If you are curious about what Moelis and Company is up to check out this great article from Dealmaker (free subscription required).

Amazingly, the goal of both the government and banks is to jump-start corporate lending and funding for consumers.  If that was the aim of Federal Reserve they sure have been pursuing the wrong policies recently.  The Federal Reserve has a similar program but the British approach would allow banks to park mortgage loans with the central bank for an entire year, or possibly more. The Fed’s effort allows banks to exchange mortgages for government bonds for 28 days with additional restrictions.  The European Central Bank recently began lending against mortgages for periods as long as six months. 

Under the terms of the pact with the banks, the Bank of England will swap as much as £50 billion in government bonds for securities backed by mortgages and some credit-card debt.  It is rather surprising to the Prince that in a small country where the public is very watchful of government spending the BOE is able to take such actions.  Taking these rotten assets into the public’s ownership amounts to just handing cash out to banks.  Although I am sure the calls for similar program will soon mount in the U.S. The Prince seriously doubts that such a massive swap of rotten assets for good assets would ever get past U.S. politicians or be cheap enough to bring to fruition.  From the scare details out at this point it seems clear that the BOE’s asset swap plan will cost taxpayers millions if not billions, it just won’t be apparent to the public for a few years.  However, if the medicine works, and it might work despite the doubter, the United Kingdom’s taxpayers will be getting a good deal given their high level of consumer indebtedness. (According to the WSJ total household mortgage debt in Britain at the end of 2007 stood at about £1.19 trillion — or about 84% of the country’s gross domestic product, compared with 75% of GDP in the U.S.  British banks also got a big chunk of the money they needed to make those mortgage loans from financial markets, rather than customer deposits: As of mid-2007, they counted on markets for nearly half their funding.) 

The United Kingdom is taking drastic measures to get credit flowing to businesses and consumers again.  The Prince is not holding his breath. 

Treasury Chief Alistair Darling plans to make an announcement on the plan Monday, the Prince will check back in on this one then.

The prince doubts that Goldman does risk management better than other firms or they have a secret edge.  Yes, they were right last spring and summer when others were wrong but that may be nothing more than a great call not an active choice to reign in risk.  Yet, nothing about a large short various tranches of the ABX trade necessarily screams that they have a risk management edge over other firms. Maybe the prince is way off base but he would love to hear from anyone who can answer his questions with anything more than pointing to Goldman’s recent performance.   Other firms may have had risk management processes just as good or even better than Goldman but were on the wrong side of this one.  Also, the prince is operating under the assumption that risk managers move from firm to firm.  How would Goldman be able to maintain an edge in risk management with its people moving to its competitors continuously.  The revolving door at top wall street firms for talented and/or lucky individuals makes it difficult to keep any advantage a secret for long.

Anecdotally, if you really want a glimpse into Goldman’s risk management or the culture of risk management they eschew ask Gary Cohn, current GS President and COO, about his famous aluminum trade. That position made his name at the firm when he made millions for the bank right around the time of the IPO.  I think you will hear a story that doesn’t display Goldman’s risk management in a positive light.  A highly concentrated position that was trying to corner the world aluminum market in London was deeply in the red.  Cohn refused to listen to his superiors and risk officers who told him to close the position.  After avoiding disaster by bluffing his way out of proposed higher rental rates on aluminum storage by his landlord in London, the aluminum market began to respond to a lack of supply and his position skyrocketed.  He was rewarded, his legend grew, and he advanced up the firm. 

Sounds like the risk management team at Goldman really reigned him in. Hmmm.  Goldman got to show strong profits right around the time of the IPO which were materially increased by the out-performance of Cohn’s proprietary position that the risk managers and senior firm leaders had insisted he close because it was large, deeply in the red, and had it went public would have portrayed Goldman in a negative light right as it became a publicly traded company.  Albeit this is just an antidote and things have become more sophisticated in risk management since that time.  However, it is a good example of where the risk management process was wrong and disregarded, the eventual outcome looked great, and no one focused on why the risk managers had been wrong.  Had the trade been a huge failure then the risk management process would have drawn critics amongst the first investors in Goldman Sachs at their first earnings meetings after becoming a public company.

Goldman and all the other banks still have balance sheet problems and their earnings power has been greatly diminished, as the Prince has pointed out in recent posts.  If we want to continue to judge Goldman’s risk management by the performance of the firm then the press may be crying foul if Goldman struggles comparatively in the year ahead as a result of not delevering like its competitors in this volatile environment.  Maybe the press a year from now will be touting some other firms risk management practices based on outcome based evidence only.  The Prince thinks it is highly likely.

Also, stay tuned this week as the prince deconstructs fortunes special on how to fix wall street. Not only does the piece convey a naïve understanding of the crisis and Wall Street in general but in Fortune’s rush to dumb down the crisis for the average Joe they get a number of facts and practices just flat wrong. The Prince can’t wait to tackle the Fortune coverage and talk about Nassem "The Dream" this week.  I will also lay off Goldman for awhile a lay some grief on some other firms, but Goldman has been taking such a different course than its competitors lately that it demands the Prince’s comment.

Just take a look at the chart above from Thomson.  Private Equity firms, once a major driver of worldwide mergers and acquisitions, are largely on the sidelines.  During the opening quarter of 2008 they announced just US$81.3 billion in deals.  The volume of financial sponsor-backed transactions reached its lowest levels since the third quarter of 2005. The impact of the credit crunch was particularly evident for large-cap targets as only one transaction over $5 billion was announced since July compared to 32 deals over $5 billion announced during the first seven months of the 2007. As a result, financial sponsors accounted for just 11% of announced transactions during the first quarter of 2008 compared to 22% during the first three months of 2007.  Wall Street is certainly feeling the pain from the private equity industry’s fee paying hiatus but the larger story is what the private equity firms have been up to while the LBO game has been shutdown.

To begin, private equity firms have been bringing all sorts of new activities under their umbrellas.  Many have started hedge funds or bought hedge funds to brand with their names.  An example that has been hugely successful is TPG-Axon, which is run by Dinakar Singh, former head of principal strategies at Goldman Sachs.  The fund launched with $5bn in 2005 and now has assets over $8.9bn since returns have been great and new money has flowed in.  TPG owns a minority stake in TPG-Axon’s management company and is an investor in the funds managed by TPG-Axon.  For another example, let’s consider Blackstone’s fund of hedge funds which is now one of the largest of its kind in the industry.  Furthermore, many larger buyout firms like Blackstone have started to provide advisory serve and begun to look more like investment banks.  Many PE firms have also launched venture funds or smaller private equity funds to invest earlier in growth companies.  They have also notably started leveraged loan funds to buy the debt that is created by LBOs.  KKR Financial and Carlyle’s now defunct fund stand-out in this category.  The story of private equity funds diversifying into other business areas has been ongoing for the last 3 to 5 years.   However, the first story has been going on for the past few years.  Two major events this week should give investors in private equity funds pause.

First, we had the $7bn capital infusion into Washington Mutual in the form of direct sale of equity securities.  TPG led the group doing the financing in exchange for a minority stake in the company and a board seat.  TPG Capital anchored an investment group comprised of WaMu’s top institutional investors to provide the $7bn.  TPG will buy $2bn worth of newly issued securities in WAMU.  WaMu’s board of directors intends to appoint TPG Founding Partner David Bonderman to the board. In addition, Larry Kellner, chairman and chief executive officer of Continental Airlines and former executive vice president and chief financial officer of American Savings Bank, will become a board observer at TPG’s request.  Keep in mind that Mssr. Bonderman was on WaMu’s board a few years ago and it did not cost him a $2bn investment.  For those of you who do not know, Bonderman is a founder and principal of TPG and TPG Asia (formerly Newbridge Capital).  Before founding TPG in 1992, Bonderman was Chief Operating Officer of the Robert M. Bass Group, Inc. in Fort Worth.

Now, private equity firms holding minority public equity stakes is nothing new.  Yet normally these stakes come about as a result of LBOs.  For example, if a PE shop LBO’s a company and then they take it public then they usually retain large portion of the shares.  Overtime they sell off these shares to realize the gains or losses on their LBO.  In some cases the PE firm may hold the shares even longer if they believe the shares will appreciate more in value.  However, the TPG investment is at the beginning of the investment process and not a result of a past LBO by TPG.  This should worry investors in private equity firms considering such minority investments because then what value does a private equity firm add over a mutual fund or hedge fund.  If their true alpha generating activities and their comparative advantage is in taking companies private using leverage, improving them, and then selling them why should we expect their minority investments to work.  Furthermore, why would investors in TPG Capital, want to allow this investment style drift brought on by taking minority public equity investments when they already have managers doing public minority investing that probably charge less the TPG and do not lock up their money for the 5 to 7 years that TPG does.  Even the most successful marquee hedge funds have lock-ups less than three years.  Given the liquidity problem and the lack of a comparative advantage brought on by TPG Capital or any private equity firm making minority public equity investments investors in such firms must consider if they should stay put in these funds.

Second, several private equity companies take on some $12 billion of Citigroup’s debt portfolio.  Apollo Group, TPG, and Blackstone Group are the buyers in the Citigroup case.  This portfolio was entirely composed of leveraged loans.  This action certainly clears some of the leveraged loan logjam.  So the private equity firms stepping in to buy this debt may stimulate other buyers to enter the market and clear the pipeline so new debt can possibly begin to be issued for LBOs.  From this perspective the investment makes sense.  Furthermore, if the private equity firms did credit work during the bidding for the companies that are referenced by this debt they may actually know a lot about these companies that may make these investments very good.  During 2007 we saw private equity firms that lost sellside auctions step in to buy the debt of LBOs because they believed that the company would perform well and they had already invested time in understanding the credit of the company being bought out.  So clearly on two levels buying this debt portfolio may be a strategically sound move and possibly a good investment. 

However, this action by the PE firms may still prove to be a risky business for firms and their investor.  Private equity investors are used to getting percentage returns in the late teens and would be disappointed if investment in debt delivered returns that were considerably lower.  Now returns in PE have been falling for years as a result of competition but holding this debt to maturity would further drop returns.  This drop in returns may cause some large investors in PE to reconsider the size of their allocations to private equity.  In fact, just the investment style drift brought on by buying this LBO debt may make investors concerned because most of these investors already have managers running hedge funds or bond funds that invest in this kind of credit.  These funds probably have better talent, knowledge, and experience investing in this kind of debt that the PE shops currently have.  Private equity firms purchasing leveraged loan debt may be strategically sound and could be lucrative but it raises all sorts of questions for investors about if PE firms are qualified to do such purchases.  Furthermore, investors will begin to wonder why they are paying PE firms high fees to do these purchases when other firms they have invested in already do them with more skill.  The danger is that private equity firms use money from their buyout funds to buy what they consider to be mispriced debt when investors in those funds have bought in on the basis that they would be exposing themselves to equity.  The return profile on debt is very different to that on private equity investments and the private equity guys may think they have sufficient credit experience when they don’t.

One more thing.  Citigroup is planning to sell its package for an average price slightly below 90 cents on the dollar, according to people briefed on the deal.   Average market prices for leveraged loans are now around 90 cents on the dollar, versus a low of 86 cents in early February, according to data from Standard & Poor’s Leveraged Commentary & Data.  The private equity firms are saying that they are going to finance this purchase with debt and equity.  Raising more debt to buy this debt raises all sorts of questions but it is significant.  Unfortunately, The Prince does not have the time to fully discuss the implications of this.  One quick comment though.  The action will raise the returns the PE firms can earn buying this debt but it also raises the risk of investing in these assets since the price of the loans could continue to fall.  Leverage combined with a volatile and declining leverage loan market would be really toxic for these PE firms holding this debt that used to be owned by Citigroup. 

In summary, all this recent investment style drift for private equity firms is nothing new.  However, the drift has certainly increased and spread into new kinds of investments.  The nature of these new kinds of investments should make investors in private equity firms concerned and suggests they should revaluate their investments in private equity firms.  Furthermore, The Prince believes that as a result of all this investment style drift private equity returns will continue to drop which may make cause investors to pull some of their money out of private equity.  It is just difficult to see how private equity firms have the expertise to move into these new investment styles and why they should continue to lock up money longer and take larger fees if they are going to be making these new investments that other managers already specialize in.

Corrections and Clarifications: This post was originally published on April 10, 2008.  Since that time a few factual inaccuracies have come to the Prince’s attention and he wishes to correct them and clarify some other points.  All of changes relate to the paragraph on private equity firms starting hedge funds.  The Prince mistakenly listed TPG-Axon’s AUM as $11bn when it was listed by Reuters as $8.9bn on January 8, 2008.  Dinakar Singh previous position was more specifically head of principal strategies at Goldman Sachs.  Furthermore, the Prince mistakenly said that "the hedge fund [TPG-Axon] uses TPG’s infrastructure, office space, etc.".  It has been brought to the Prince’s attention that this is not true.  TPG is a large minority investor in TPG-Axon funds and does own a minority position in the management company.  The aforementioned corrections and clarifications have been made to the article above.  Even though TPG is only a minority investor and is a distinct legal entity from TPG-Axon, the use of TPG’s brand and the their large initial investment in TPG-Axon’s funds at launch, are seen as a vote of confidence in the TPG-Axon.  These two actions by TPG made it easier for TPG-Axon to raise capital initially.

Now these demands, which are directed at investment banks for less leverage and more liquidity (more capital cushion), are very similar to the demands that regulators made on commercial banks following the stock market crash/great depression.  However, very little attention has been focused on how this is going to affect the organization of the investment banking industry or how it will affect profitability in the industry.  Bill Gross, famed bond investor and CIO of PIMCO, wrote on his company’s website in his April investment outlook that regulators will force investment banks to set aside more capital, "resulting in reduced profitability."  A report by analysts at Morgan Stanley and consulting firm Oliver Wyman predicts "longer term ROEs to fall as banks seek to de-lever and regulators ask banks to hold more cushion.”  Others have privately speculated that profitability will go down as measured by ROE but how this change in profitability induced by further regulation will effect the competitive positions of the various firms has not been directly addressed.

Allow the Prince to take a look at this.  In this article this morning from Bloomberg David Viniar, Goldman Sachs’ chief financial officer, was asked if he thought the crisis would have “permanent implications” for Wall Street’s appetite for leverage. His answer: “No, I don’t.”  He made this statement less than 48 hours after a government-backed deal rescued Bear Stearns.  The Prince disagrees, and in fact, the regulation that will come about to limit leverage and the liquidity of assets will impact Goldman more than its peers.  Despite Mssr. Viniar’s strong comments The Prince must believe that privately Goldman management is seriously worried about how their firms comparative advantage in proprietary trading may be taken away by regulators wanted to reign in risk at investment banks.  Like The Prince wrote in his earlier post, if Goldman’s edge over JP Morgan is removed by more regulation then the JP Morgan business model will reign supreme on Wall Street and firms that used to have big trading books like GS will be permanently handicapped.

Llyod Blankfein, CEO Goldman Sachs Group, Smug Contrarian or Arrogant Fool?

Before we pursue this commentary further the Prince needs to make clear to his readers how liquidity and leverage are inextricably linked when an investment bank tries to finance its balance sheet.  Keep in mind that most firms, except Goldman Sachs which increased its leverage, are reducing historically high leverage levels right now because of market volatility and uncertainty.  Now the Prince thinks Goldman Sachs increasing its leverage reeks of arrogance and will probably end poorly for them given the lack of confidence and volatility in the market place.  They do have more freedom to increase their leverage compared to their competitors, since Goldman can still borrow at 10 year duration at 2.41% over 10 year treasuries versus 3.02% over treasuries for Lehman.  Yet, just because they have the freedom to do it does not mean it is a good choice.  In fact the Prince thinks they will regret it but he has to grant that recently their contrarian stances have paid off.   On this move, however, their luck may run out.

Yet, back to the strong link between liquidity and leverage when financing an investment bank’s balance sheet.  Clearly regulators and to some extent ratings agencies will put pressure on banks to lower their leverage.  There are multiple ways for an investment bank to finance and most use a combination of long-term debt, short-term commercial paper, and repurchase agreements to finance their liabilities and lever up on the equity they have.  The better the bank is as a credit risk the more opportunity they will have to get longer term capital by issuing long-term bonds (like 10 years) or issuing short-term commercial paper.  The third kind of financing, repurchase agreements or repos (also remember the opposite reverse repos), is where Bear Stearns got crushed. 

In the case where no one will buy new issuance of commercial paper or more new issuance of long-term debt or the yield demanded just makes such paper too expensive for a bank to make the interest payments a bank must rely more and more on repos to finance their liabilities and leverage.  Goldman tends to borrow more short-term CP and long-term debt and not rely as heavily on overnight or short-term repos.  "Goldman is still AA rated and has a good image in the marketplace as shrewd risk takers, so the spreads they’re paying for 10-year money are a lot less than everybody else’s,” said CreditSights’ Hendler.  Goldman only finances 14.8% of its balance sheet with repos while Lehman finances about 27.2% of its balance sheet with repos.  For comparison, Bear Stearns used repos for 26.2% of its borrowing at the end of 2007.  The problem with the repo market is that you must rely on other broker dealers or other counterparties to trade with you.  When Bear could not tap the commercial paper or long-term debt markets, could not get an equity infusion, and its counterparties stopped doing repos with them they were inches from becoming insolvent.  Combine that with all the prime brokers saying at once they would not disintermediate trades done with Bear Stearns for derivative contracts like CDS. 

Now how much money you can borrow against your cash bond collateral in the repo market is directly proportional to the quality of the bond collateral you hold.  So in Bear Stearns case the CDO and MBS collateral they were trying to borrow against would not fetch as much money on loan as if they held government treasurys.  So banks that have AAA rated non-mortgage debt of long and short term maturities can actually get more leverage cheaper in the repo market using such debt as collateral in the repurchase agreement.  So in this case the better your assets they more you can lever up and the more liquid your collateral/financing. 

Now in Bear Stearn’s base they were holding illiquid mortgage securities that were falling in value or had no bid in the marketplace.  They were trying to borrow against this collateral but some banks would not take that mortgage debt as collateral to lend money in the repo market.  When no one would do repo with Bear with any kind of collateral the game was really up.  So in this case the banks that are left standing now will have as much liquidity and freedom of action to lever their balance sheets as the strength of the bonds they hold can provide serving as collateral in the repo market for cash on loan.  Yet, like the Prince said before, freedom of action with respect to leverage is not a reason in and of itself to actually put on more leverage given market conditions.

To summarize the Prince’s predications.  ROE will fall across Wall Street as regulators force banks to deliver.  Goldman Sachs will suffer more losses than peers in this volatile environment because of their contrarian move to increase leverage.  In the long term Goldman Sachs will be stripped of its proprietary trading advantage which is the central component of its business model by regulators wanting to lower risk in the investment banking world.  JP Morgan and other big balance sheet banks with small trading books will replace Goldman Sachs as the top investment banks.  Disagree with the Prince’s analysis or predication?  He grants an audience to any subjects that wish to question his commentary.  What him to tone down the negative comments on Goldman Sachs?  Tough.

Disclosure: The Prince currently owns SKF but has no other positions in broker dealers or other positions linked to broker dealers.

In more recent buyouts that are under pressure the banks have started to make MAC arguments in committed financing negotiations with sponsors.  This time the banks are using the MAC’s against the sponsors and not in the interest of the sponsors.  While, the Prince is not aware of a MAC being officially invoked in any recent busted buyouts, he certainly believes that banks are using MACs in contract negotiations as a threat and a bargaining chip.

Given the power that these clauses have to break up buyouts, absolve sponsors of paying breakup fees, and get banks off the hook from committed financings among other things, we should not be surprised that these clauses are and will be getting more attention.

A material adverse effects clause is a provision in M&A agreements that allows a party to walk away from a deal if a counterparty has suffered a so-called "MAE" as defined in the document.   "The last nine or 10 months feel like one big MAE," said Faiza Saeed, a partner at the venerable M&A law firm, Cravath, Swaine & Moore LLP in New York (quote courtesy of The Deal).  "Pointing to one case where the interpretation of an MAE clause was central to a dispute, she noted that the one in the Finish Line Inc.-Genesco Inc. agreement was fairly standard in carving out a number of potential occurrences from the definition of MAE.  "Definitions tend to be repeated from deal to deal without a lot of thought," said Saeed, who also noted that the complexity of MAE clauses often baffles clients as well as judges. "We’ve gone back and looked at these definitions and asked if anyone understands them."

Clearly the language of what a MAC and an MAE needs to be carefully considered.  For example, consider the MAC in the merger agreement for SLM Corp’s acquisitions by J.C. Flowers.   That agreement stated that Flowers could walk from the deal if SLM suffered a decline worse than that of other companies in its industry, but the agreement was ambiguous on a critical issue.  Should the court compare SLM to the whole of financial services?  Should it just compare it to student lenders?  Clearly SLM is an example where the drafting of the MAC and MAE could of been done better and The Prince does not believe that this is an isolated incident.

Given the power that MACs hold it is clear to the Prince that many attorneys will have to rethink how they draft such clauses and how they define an MAE in the future.  Furthermore, sponsors, banks, and sellers would all be wise to approach the drafting and inclusion MACs with a bit more caution and attention than in the past.

There was much hand wringing and scowling in congress when sovereign wealth funds descended upon struggling U.S. financial firms with cash to mend tattered balance sheets.  Many congressman made arguments reminiscent of arguments made against Japanese investments in U.S. real estate in the 1980s.  Some of these arguments even referenced the U.S. trade deficit with China and decried the purchase of U.S. assets, specifically U.S. government securities, by the Chinese.  While these arguments by congressman display a profound ignorance of basic economics and the incentives which face the Chinese and other foreign investors in the U.S. assets including U.S. government debt, they all have an underlying xenophobic tone and/or expression of suspicious thought.  The Prince could go on for days thanking foreign investors for bailing out U.S. financial firms, subsidizing the insane borrowing of the U.S. consumer and government, and artificially keeping the dollar stronger than it should be.  Would not that be an amazing sight to see a congressman offering such thanks and praise to the other countries on which the U.S. relies.  Yet, we will never see this happen because the truth which The Prince perceives is not popular and this post will probably also not be widely popular.  In fact this post may make many people uncomfortable just like the leading photo The Prince choose for this piece.  The disdain and complaining about foreign investments in the U.S. is not limited to the federal government and certainly reaches down into state governments, as my following example will illustrate.

There is one recent story, brought to The Prince’s attention by The Deal’s Dealscape blog, which really makes the Prince question the wisdom and intentions of lawmakers in this country when it comes to dealing with the financial industry.  Basically, there is a bill in the California legislature right now that could effectively pull the two largest U.S. pension funds, the California Public Employees’ Retirement System and the California State Teachers’ Retirement System, out of their private equity investments.  The bill is called Responsible Private Equity Investment Act of 2008 bill (AB 1967) and it restricts the two big state pension funds from investing in private equity funds that have sold stakes to sovereign wealth funds.  The bill establishes a group of tests that most private equity funds will fail.  For example, the fund’s country must be a signatory of five of the United Nation’s six human rights treaties.  CalSTRS has already said that is the bill passes it will have to cease investing in private equity, which is its best performing asset class.  CalPERS has been quiet on the bill.  Not surprisingly the bill is co-sponsored by Service Employees Union International (SEUI), a union that is a huge critic of PE (witness the attack on Rubenstein at the Wharton conference).

This bill has huge implications if passed.  We are talking about the top tier firms being excluded because they have sold stakes to foreign investors.  Firms like Apollo, Blackstone, and Carlyle would be sidelined.  So will the bill pass?  AB 1967 has only one sponsor in the legislature, Democrat Alberto Torrico.  He is a former assistant majority whip, meaning he knows the ropes in the legislature.  The Prince is not interested in handicapping the chances that the bill passes because the just the fact it has been proposed raises serious ethical issues.  Not to mention that fact that like the drive for Socially Responsible Investing, this bill would probably lower returns at both pension funds and thus harm all the pensioners within those funds.  What are we really afraid of when it comes to foreign investors?  Why do legislators not talk about the secret dirty reasons that make them uncomfortable about foreign investments.  These reasons are all too poorly hidden by such legislators’ rhetoric and actions.

Whenever our representatives ( don’t think many of The Prince’s readers have a problem with foreign investments) decry foreign investments in the U.S. they hide behind arguments like SRI, the human rights record of the company, national security concerns, etc.  Maybe they should take a good hard look at what intuitively makes us uncomfortable about foreign investments in the U.S.  They may realize that our real motives for protectionist actions and angry rhetoric is nothing more than racism.  They may find out that they don’t like what they see or believe.  Maybe the lawmakers who pass laws like the one being considered in California are nothing more than a dressed up 21st Century group of nativist when it comes to dealing with foreign investors.  The Prince leaves it to his loyal subjects to decide.

However, just the fact that they have chosen to tape the public equity markets for $3bn speaks to the weakness of their position. If anything this move may exacerbate fears that the bank has an extremely troubled balance sheet.  This fear may persists even with a $3bn fundraising.  It seems like the smarter move would have been to lineup a large investor or two to take convertible preferreds or put private equity into the company like many of Lehman’s competitors have done.  Those who have pursued this path have not been punished by investors and are investors are not speculating about their viability.  The fact that Lehman is going into the public equity markets is another sign that makes them look weak since it raises speculation that sovereign wealth firms took a look at the books and said no thanks. 

Lehman will offer 3 million convertible preferred shares.  Demand for the shares was already three times greater than the amount offered as of 6:30 p.m. in New York, according to a person familiar with the offering.

"We still maintain that we don’t need capital, but we’ve realized that perception is the dominant issue in today’s markets,” Chief Financial Officer Erin Callan said in an interview. "This is an endorsement of our balance sheet by investors.”  The Prince doesn’t disagree but her saying they don’t need capital seems implausible and almost laughable.  The CDS on Lehman has fallen so it would appear that the credit markets believe the move makes Lehman a better credit risk.  Credit-default swaps tied to Lehman’s senior unsecured bonds narrowed 15 basis points after the announcement to 285 basis points.

The fact the deal is so oversubscribed shouldn’t be surprising since it is offering such great terms.  It has a coupon payment of 7 percent to 7.5 percent.  The conversion premium is said to be 30 to 35 percent above the current stock price.  Yet, like the Prince said earlier, the move will certainly improve their balance sheet but restoring confidence in their firm will not be helped by the weakness this offering displays. 

Disclosure: The Prince has a short position in Lehman Brothers and a net long a basket of broker dealers.

Sen. Barack Obama described the Bush administration’s sweeping changes to financial market regulation as “inadequate” on Saturday.

While noting that he had not yet seen the full proposal, which Treasury Secretary Henry Paulson will unveil on Monday, the Illinois senator said that, based upon news reports, he believed the proposed regulatory reforms didn’t go far enough, though he lauded the proposed consolidation of regulatory agencies.

Obama laid out his own proposals to boost regulation of the financial industry during a speech in lower Manhattan earlier this week. Speaking to reporters in Johnstown, Pa., on Saturday, he criticized the lack of any increased capital reserve requirements for investment banks, which can now use the discount window from the Federal Reserve.

“If I’m a commercial bank right now, I’m still not clear why it is that investment banks… are able to do things I can’t do, aren’t subject to the same capital requirements and liquidity requirements that I am and yet they’ve got the same fallback with the Fed as we do,” he said.

The Prince’s Commentary: Does Mssr. Obama wish to regulate the financial industry like the electricity industry because that has been a "huge success"?  Or would he like to just have the president be commander and chief/CEO of all U.S. based investment bank.  The truth is The Fed and the Treasury are already way outside their regulatory authority and this is going to the courts.  The Prince will guarantee it.  Take a look at the executive summary.  Even if congress grants this regulatory authority to the Fed you could still challenge this as an unlawful delegation by the President and Congress of regulatory authority.  See this Supreme Court case that was decided in emergency times of the Great Depression not unlike our own when it comes to the Mortgage Crisis/State of Economy. Home Building & Loan Association vs. Blaisdell.

This morning in the New York Times, Andrew Ross Sorkin draws attention to the the fact that the Fed was calling the shots behind the Bear Stearns "bailout."  This point was obvious last week.  Just because the price moved from $2 to $10 and there is speculation about whether or not the Fed set the offer prices does not make this any more or less of a "bailout."  It was pretty obvious the Fed was pulling the strings from the beginning.  Just take a look at the original $30bn backstop (now $29bn with JP Morgan on the hook for first losses of $1bn on risk derived from illiquid BS assets).  By meddling in the Bear Stearns mess again the Fed has entered a quagmire of competing interests.  The parties it must politically handle are Bear Stearns’ shareholders, J.P. Morgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman trying to figure this out.  To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world.  However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BS could only seek Chapter 7 with the trustee being SPIC).  Were the actions the Fed took in the "national economic interest" of the U.S.?  It does not matter much to The Prince—what is done is done, and its implications are enormous.  

After reading Mssr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle.  It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JP Morgan’s bid.  These actions clearly favor the argument that the Fed preferred the first bid, as Mssr. Sorkin points out.  The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business."  But why is this problematic? 

Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc.  Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for Investment Bank regulation going forward.  The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important.  Please allow The Prince to illustrate some of the most problematic implications.

First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates.  This is a landmark event in American monetary and economic policy.  The Fed as a lending last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate.  The Prince does not know when the current credit crisis will end or when the Bear Stearns will be put down, but one thing is beyond clear.  At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now.  While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.

Let’s analyze the situation more closely.  The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed.  Remember BS is regulated by the SEC.  The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates.  The Fed has taken these steps because of its concerns over counterparty risk.  That is the worry that Bear Stearns liquidating would impose enormous burdens on its counterparties and throw the financial system into a frenzy.  This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).

We will soon learn that the Fed has learned its lesson when it comes to counterparty risk.  Such risk will have to be managed much better by banking regulators around the globe.   This will bring an end to the free-wheeling days of fixed income derivatives.  The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks.  More robust (regulated) settlement and clearing processes are coming and the Fed/Treasury will be driving these changes not the ISDA, the SEC, or the broker dealers themselves.  Fixed income derivatives are likely to go the way of other securities markets.  This means they will be non-levered hedging and speculation tools.  Leveraging through derivatives will probably end with an order from the regulators against such actions.

Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction.  The financing of $29bn is almost equity type financing.  It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns only protected by $1bn cushion of first loss collateral from JP Morgan.  What would happen if a broker deal is going down and there is no other broker dealer to buy the company like JPM?  This BS deal better work or we are may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.

Third, the days are gone when an independent investment bank could have a large trading book.  The Fed will ensure that if it is required to bailout such institutions, not having regulatory of capital jurisdiction over such entities would be wholly unacceptable.  The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended because any investment bank is subject to counterparty risk in the financial marketplace.  Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities.  Under this new regulatory system Goldman Sachs, with its large trading book, is no longer the model investment banking and JP Morgan now assumes that title.  JP Morgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime.  As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.

To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution, that is a player in the capital markets, is a good buy now that we are living in an era free of moral hazard.  If a company is big enough, there is no credit risk with the Fed waiting there with a bailout.  So go forth and sell protection on LEH, GS, and MS CDS at these levels.  Also go out and buy Agency credit risk.  It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community.  If BS is too big to fail and the Fed has to provide $30bn in effective equity in a bailout then what large financial institution is a credit or a counterparty risk?  That is all my loyal subjects.

If the Federal Reserve is only cutting rates to ease the pain in credit markets and not to spur growth in the real economy then they might as well just hold rates steady.  Clearly they are not going to pause but there is an argument for pausing or not cutting as aggressively.  Federal funds futures on the CBOT indicate that investors see a 100% chance of at least another half-point cut at the March 18 meeting, and an 88% chance of a three-quarter point cut.  If the Fed cuts as much as the market expects, that would put its key federal funds rate at 2.25%, down from 5.25% when the Federal Reserve first began lowering rates six months ago.  Everyone can concede that a Federal Reserve rate cut is certain on Tuesday.  Yet, we really still need more clarity on why the Federal Reserve is cutting rates.  What are they aiming to do? 

The problem is not that money is too expensive it is that counterparties do not trust each other right now.  We are facing a crisis of confidence not expensive credit.  It does not matter how cheap it is to borrow if no one is willing to lend.  No one knows who will be the next Bear Stearns or the next failed hedge fund.  Counterparty risk is what is causing the current credit crisis problems.  No amount of rate cutting can restore confidence to banks worried about counterparty risk.  The Prince is not alone on this and several economists, including one member of the FOMC, have argued that more rate cuts are the wrong solution to spur economic growth. The Prince does believe that a recession might be the best answer for the economy in the long term.  We need an economic slowdown to cool inflation and stop another cheap money speculative bubble from being created.  Our current policy of rate cutting is killing the dollar and shooting the prices of commodities like oil through the roof.  The Prince just does not think the Fed cuts can do much to fix what is really harming the U.S. economy i.e. the credit crunch.

The Prince leaves you with some information on the one member of the FOMC, Dallas Fed President Richard Fisher, who seems to be showing some restraint.  He was the only one to vote against the rate cut in January.  He continues to talk about inflation and he will probably dissent against the cuts on Tuesday.  In recent speeches, Fisher said talk that the Fed has adopted an "easy money" policy makes his "skin crawl" and that the Fed shouldn’t be so afraid of a recession.  Fisher contended that he has one of the most bearish views of the economy of any member of the FOMC. But he doesn’t believe that even a slowing economy is justification to risk more inflation with further rate cuts.  "Our obligation is to prevent inflation in order to sustain long-term employment growth. I believe that the best way to cut through the treacherous economic waves that are upon us and keep our ship steaming forward is to stick to our purpose," Fisher said on March 4.

The Prince, like many financial bloggers, has followed the plight of the increasingly burdened  U.S. consumer for some time. (See this post, this post, this post, and this post for examples).  Yesterday we got more important news that signifies that the U.S. consumer is overextended with little access to more credit and will be forced to cut spending.  The press (WSJ, HousingWire) and financial bloggers (Barry Ritholtz at The Big Picture, Calculated Risk) have commented on the default rates for Home Equity Line of Credit (HELOC) loans.  From a lenders perspective these loans are toxic because they are subordinate to the claims of the lender on the house.  So if a homeowner can only afford to make their regular mortgage payment they will not make their HELOC payment. This will negatively impact the homeowners credit score but none of their assets, especially their home, cannot be taken by the HELOC lender.  HELOCs used to taken out to finance home improvements or pay for high health bills.  In recent years with housing prices rising across the country they were taken out to subsidize discretionary spending.  Buy the hummer, take the vacation, get the plastic surgery, etc. and don’t worry because housing prices will keep rising and you’ll get to refinance your Option ARM once it is about to reset.  We no longer live in that fantasy world and many consumers are overleveraged and barely making their payments.  Or they are trying to decide which loans to default on since they are unable to make payments on all the loans.

This is just the latest sign that the consumer in the U.S. is under serious pressure.  The tightening or credit and the credit crisis have certainly contributed to the recession which the WSJ poll of economists confirmed today.  Yet, what will really decide the length and severity of this economic downturn will be the actions of U.S. consumers.  Consumer confidence has been down.  Consumer lending and mortgage lending are also way down which is making it increasingly difficult for the overlevered U.S. consumer to continue to consume beyond his or her income.  HELOCs were just one of many instruments that consumers tapped to drive the U.S. personal savings rate even lower.  Investing in a home used to be a form of forced savings, with HELOCs that has ceased to be the case.  Give the American consumer a dollar and he or she is going to spend two.

Now with incomes not rising and home values falling it is becoming more and more difficult to keep consuming with little new consumer credit available.  Plus, to all those homeowners under pressure to make their ARM mortgage payments after reset and their home equity loan payments, don’t even think about selling your home and paying off your home equity loan since reports out yesterday showed demand for homes is at a 5 month low.  The Prince is going to do it.  He is going to bet against the U.S. consumer.  Many may think this is folly but The Prince believes the consumer will not be able to spend the U.S. out of this recession this time.  Dropping consumer spending in the U.S. is going to take a toll on international markets obviously.  Countries like China that are export economies and have not developed a large enough consumption base will be hit hardest by the American consumer with empty pockets and no access to new debt.  Given the pressure the U.S. consumer is under, the technocrats in Beijing must be a bit apprehensive right now.

More Excerpts from the WSJ article:

Other types of consumer loans also are souring, including credit cards and auto loans. But delinquent home-equity loans are rising faster, representing 12.5% of all delinquent loans in the fourth quarter at Bank of America Corp., the largest U.S. bank in stock-market value. That was up from 9.4% in last year’s first quarter, according to research firm SNL Financial.

…

Meanwhile, financial institutions are refusing to provide home-equity loans to homeowners whose residences are already weighed down by big mortgages in states like California and Florida where home values are falling fast.

"This product was meant to help people do construction on their house, [and] do debt consolidation — not to take out every last dollar of equity in their home to finance a different kind of lifestyle," Mr. Scharf said. J.P. Morgan is "rolling our changes back to represent that kind of product."

Here is an interesting article from HousingWire about Fitch downgrades related to HELOCs.

Want to know who lent the money for all these HELOCs?  Take a look at these charts from Mortgage News Online.

For the uninitiated:

Credit Support: Percentage of a bond’s total collateral that can be lost before it stops making payments.

Collateral at Risk: Percentage of a bond’s total collateral that is 90 days delinquent, foreclosed, or repossessed.

"I firmly believe that you’ll never see a CDO of asset-backed securities again but I also firmly believe we’ll eventually see another repackaging of mortgage-backed securities. It just won’t be called a CDO."

Well of course he or she is going to say that.  This person may not have a job in a few months if he or she believes differently.  The Prince is now going to touch another assertion made in the article:

In fact, one can argue strongly that the CDOs at the heart of the crisis are not even necessary to the functioning of the mortgage markets. "The reality is that [mortgage-backed] CDOs never had to exist," offers one debt investor.  

This comment seems suspect since it is hard to believe that all those subprime, state incomed, NINA, etc. borrowers would have been able to get into houses if the mortgages were not going to get repackaged into MBS which would then by bought by CDOs.

The Prince, in all his posts related to mortgage securities and the credit crisis, has consistently focused on incentives and the behaviors they illicit.  Before we turn back to the future prospects for CDOs, let’s take a detour to worship at the altar of The Prince’s favorite blogger, Equity Private of Going Private.  This was the first financial blog that the Prince began to read religiously. Equity Private’s focus on deconstructing situations based on incentives consistently yields interesting insights.  For recent proof of her focus on incentives check out this excerpt from her recent post lambasting Sun Capital’s overreaching:  

The reality is that firms like Sun have been victims of their own overreaching and the nature of the incentive structures and fund raising cycles in private equity.  Given my views on the nature of human nature…

Man is basically lazy.  Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior).  Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.

…even the novice Going Private reader will understand my focus on incentive structures (both designed and resulting from unintended consequence) and the behaviors that they, well, incentivize.  As such, it should be easy to see why the only prompting I need to start shaking my head is the "management fee" section in Sun Capital Partner’s Private Placement Memorandum.

The existence of CDOs provided incentives to parties at all levels of the mortgage industry to make decisions that now have led to our capital markets being undermined. 

Consider our first part in the chain of the mortgage industry’s industrial organization, the broker/wholesale originator.  The existence of Wall Street banks hungry to buy mortgages from these originators to repackage into MBS or into CDOs created incentives that gave originators every reason to say yes to prospective borrowers.  The existence of someone else to pass the risk onto of loans made with poor lending standards gave originators no reason to say no.  At the end of the day, if the quality of the loans was awful, the originator would not be on the hook, and would most likely have no skin in the game.  CDOs created incentives for mortgage originators to be accomplices to blatant fraud on loan applications, occupancy fraud, the creation of Option ARMs, and the creation of stated income loans among many other faults.  It is unsurprising that it was hard to hear the voice of common sense when the chant of "Close’em Close’em Close’em" was filling many of the chop shops that originated these subprime loans.  However, The Prince strays with that last comment since human beings don’t follow common sense, they respond to incentives.

Consider the second part of our chain, the investment banks and the rating agencies.  The only way they were going to make money here was originating CDOs full of loans they had bought from originators.  They would then collect the management fees for these CDOs.  The rating agencies rated the top tranches AAA so many of the investment banks thought that a good size chunk of that tranche should not be originated but held on their balance sheets.  The rating agencies had no incentives to probe CDO issuance deeper because they were not going to be financially harmed by their ratings being wrong.  The only thing the ratings agencies stood to lose by not doing their homework was some credibility if their ratings proved to be faulty.  It is difficult to weigh the value of this credibility in an industry so uncompetitive that it only has three market participants (but that is a different post on a different day).  Wall Street banks had every incentive to believe the ratings that their CDOs were getting stamped with because investors bought up the debt based on these ratings.  What did the banks care; they were going to get rid of these toxic mortgages by selling the various tranches to investors that were hungry for yield, while keeping only the most senior tranches for themselves.  The Prince is sure many a structured products salesman used the sales pitch, which is very similar to the junk bond sales pitch invented by Michael Milken, that by combining many poor credit quality mortgages into a CDO the investor could earn a good return based on how much risk they were willing to take.  This is the case because surely not all the mortgages will default.  Well, now we see the AAA section of the ABX trading at 65-70% of par.  That sales pitch seems laughable in hindsight.

Finally we come to our final link in the chain.  The institutional "sophisticated" investors that bought CDOs.  Investors had every incentive to satisfy their clients by earning superior returns in a low return environment.  CDOs offered such an opportunity to earn high returns and select the level of risk that the investor was comfortable with.  Investors took comfort in their belief (or the salesman’s pitch) that diffusion and portfolio diversification had ameliorated risk.  There were other misperceptions out there.  For example, Keith Styrcula, chairman of industry group Structured Products Association, says, "The triple-A rating lent the impression that the underlying assets [the mortgages themselves] were also triple-A."   Furthermore, we had SIV’s buying these assets by borrowing short-term and lending long-term through the purchase of CDOs.   Although the managers of these SIVs had very little incentive not to pursue this over leveraged strategy, since their holdings were not on the balance sheets of their banks and they were operating with relatively little oversight.  If anything is going to change in this market it is that investors will take away some of the agency of CDO managers.  Investors will tighten controls on managers investing their money.  In most CDOs, managers had five-year windows to trade securities in their portfolios. This allowed the managers to sell defaulted bonds for new ones that were better-performing.  This was all done to supposedly maximize gains for investors.  In practice, this meant investors could not be sure of what was exactly backing the CDOs as their managers shifted investments.  Investors didn’t do their homework on the credit quality of the mortgages that composed the CDO’s tranches they were buying because they chose to do the lazy/easy thing and just believed the rating agencies.  Investors pursued the behavior of buying CDOs for their high returns because that is what the incentives they were facing suggested.   When it turned out that the risk borne by the tranches they bought was much higher than they estimated they found little comfort in the banks and ratings agencies simply saying, "We made mistakes."

So basically every party in the mortgage industry followed the behavior that their incentives dictated.  By behaving this way they all led us to the mess we currently face.  If the incentives that drove the behaviors of the actors in the mortgage industry remain unchanged then The Prince will guarantee that CDOs or CDO-like instruments by another name will never rise like a phoenix from the ashes.

Now CLOs are another story.  Over the summer many CLOs were forced to sell corporate bank debt and high yield debt (mostly related to companies that were taken private) they owned to meet margin calls on the mortgage assets they held.  CLOs were the largest demanders of buyout related debt issuance.  In fact, CLOs represented almost two-thirds of primary demand for loans in the syndication market over the past three years.  They have been absent from the market since the turmoil began this summer.  CLOs will come back because the leveraged loan and high yield corporate debt markets have properly aligned incentives but are merely going through a repricing of risk right now.  Investors in these forms of debt are pushing back against the buyout shops and taking aim at the covenant lite/PIK toggle terms of these debt instruments that made them very unappetizing for investors.  There is also certainly a level of contagion going on in the leveraged loan market as well.  Many firms that own buyout related debt may be selling this debt not because they think it has become less valuable but because they must meet margin calls on the their mortgage related portfolios. 

The Prince also believes that since most PE shops got such great terms with wide covenants and PIK toggle characteristics that we will see less corporate defaults by sponsor owned junk rated companies during this cyclical downturn than in past downturns.  To distinguish CDOs from CLOs we need look no further than the fact that CLOs have continued to return money to investors, as the rate of corporate defaults has remained below the 4% historical average.  So CLOs have not had to write down the value of their portfolios since they operate as cash flow vehicles.  Another good example is the fact that CLOs only buy loans as primary purchasers of whole loans offered by banks that lend to companies or sponsor owned companies.  CLOs do not buy repackaged securities like CDOs did when they bought MBS.  The leveraged loan and high yield debt markets are discounting these securities in anticipation of much higher defaults than The Prince sees on the horizon.  There are probably some good deals available in these two markets for long-term investors if the investors know the credit of the underlying company very well and believe that they will get their payments without a default.  Much of this paper is trading so far off par that The Prince finds it difficult to think of adverse scenarios in the future which could justify these prices.  CLOs will return, especially those that mainly focused on buying buyout related debt.  The incentives which drive the players in the CLO space are appropriate but those that drove CDOs could only lead to ruin.  Let’s just hope the destruction wrought by CDOs doesn’t continue to have knock on effects throughout other parts of the credit markets.

The Usual Suspects: Down but Not Out

Mass also saw equity checks continuing to rise in the current turmoil in the market.  However, she emphasized that this is a trend that has been underway for quite some time.  She provided the example of KKR’s takevoer of Safeway Stores in the late 1980s which was a $5bn buyout with only $130mn in equity from KKR.  Today 30-35% equity is assumed for most buyouts even at the peak of the buyout book last spring.  Mass said the percentage could rise to as high as 50%.  This will obviously dampen returns for private equity firms since the impact of lower leverage will be lower returns.  Remember that there are are essentially three ways to make money in an LBO.  First, the PE shop can improve operating performance by improving margins through rising revenues and/or cutting costs.  This would serve to improve the EBITDA of a company that has been been taken private by a PE firm.  The second strategy is to depend on multiple expansion.  That is buy companies in industries that are out of favor at low multiples and resell them with the industry cycle hits its peak for a higher multiple.  The final way to make money in an LBO is through leverage.  The best firms employ all three strategies effectively but some firms specialize in one in particular.

Now all this is fine and dandy when it comes to creating value at a company that has been been taken private but it doesn’t mean anything if the PE shop cannot exit its investment and realize its gains.  In the past this was done through an IPO, a sale to another private entity, sale to a strategic partner, or a dividend recapitalization where the PE shop paid itself a special dividend with the proceeds of newly issued debt.  The leveraged bank loan and high yield markets are shut to new issuance so the dividend recapitalization option is off the table (not to mention new LBOs but that is another story).  Furthermore, the IPO market for an over leveraged sponsor owned company looks very weak right now.  Finally, selling the company to another private entity doesn’t seem likely since the other private equity shops are all facing an inability to get financing for new acquisitions.  So basically, the only option that is left for PE firms to exit their investments is a sale to a strategic partner.  Many investment grade strategic partners have record amounts of cash on their balance sheets.  However, many are going to be hesitant to invest given the gloomy forward outlook for the economy and technology.  So selling a sponsor owned company to a strategic will also probably prove to be a tall order.

This is not to say that these four options for realization will not eventually become available again it just means that PE firms can not rely on them right now.  Mass doesn’t see a huge problem with this since she points to the fact that many large PE firms, which are sitting on record amounts of cash, are holding their investments longer or are diversifying into other asset classes like real estate, hedge funds, mezzanine and distressed debt. Others are doing smaller deals. Mass said she is getting calls from clients looking to do deals in the $800 million range, which just a year ago the same firms couldn’t even afford to spend time on.  Having bought up $1.9 trillion of companies from 2005 to 2007, private owners are now confronting how to monetize their investments.  The doors look shut right now.  The M&A markets are shut, as potential buyers wait for asset prices to decline.

For an example of this process of value creation followed by realization The Prince turns to an example highlighted by Dennis Berman at the WSJ. 

Dex Media Inc. was one of the greatest private-equity trades of the decade. And that is precisely why it is important to take note of its deep failings in public-company life.  For four years, buyout shops Carlyle Group LLC and Welsh, Carson, Anderson & Stowe played the yellow-pages firm, Dex, with a maestro’s aplomb. They paid themselves special dividends. They took the company public in 2004, cashing in part of their stake. The capper came in the 2006 merger with fellow publisher R.H. Donnelley Corp., creating the nation’s third-largest phone-book outfit by total volumes published. By the time it was all over, the $1.6 billion Dex investment had yielded a $2.6 billion profit.  As sold to the public, the yellow-pages story was always about faith. Faith that the pen-and-ink business would hold up despite lower margins from Internet offerings.  Faith that directories were like oil wells, monotonously pumping cash.  Over the past 12 months, Donnelley shares have shed 77%. Shares in the Verizon Communications directories spinoff, Idearc Inc., are off 80%. The Internet is more irrepressible than first thought, which is why phone books are making for nifty computer-monitor stands.  "Timing is everything," is how Carlyle Group managing director James Attwood put it at a recent conference, explaining how the firm had exited from its position by November 2006. "What we did see over time is [the directory business] can be disintermediated partly, if not fully, by the Internet."

The next cycle of private equity portfolio company IPOs will struggle.  Mainly because the prices originally paid for targets were so high.  Purchase multiples reached their highest prices in 10 years during the first half of 2007.  There is little doubt that if Clear Channel Communications Inc. or Freescale Semiconductor Inc. or Equity Office Properties Trust were bought today they would receive much lower valuations.  Using the power of leverage, private-equity buyers still can turn a profit even if their assets don’t grow in value. But that assumes some of these valuations aren’t deeply underwater already.  Statements from PE executives now suggest that some investments will have to be held for as long as seven years to make back a middling return.

This suggests that valuations are swimming with the fishes already on some of the mega-buyouts.  The other problem for prospective IPOs is the nature of the companies that went through LBOs.  The vast majority of them were not traditional buyout targets that required substantial refurbishing.  The PE shops pursued healthier businesses, which were expected to grow along with the world’s economy.  If that growth does not materialize there may be little that the owners can do to get an edge.  These dynamic will certainly work to the advantage of buyers who bring significant operating improvements to their holdings or purchased companies with high amounts of leverage (so long as the cash flows from the company continue to grow or become constant).  Firms that rely more on multiple expansion will probably take the most pain now that multiple expansion exits look unlikely.

So how should Wall Street firms respond to the "purgatory" that PE shops are in right now?  These clients were extremely valuable to Wall Street Banks for the last five years.  For example in 2007 Carlyle dolled out $300mn in fees to Wall Street and this number was dwarfed by Blackstone.  Sponsor clients that the public had never heard of paid the street far more in fees than GE, Verizon, Apple, etc.  While the smaller deals (those less than $1bn in aggregate value) will be pursued by the larger private equity firms and these deals will generate some level of fees to support staff in sponsors, the blockbuster fees earned from PE firms will take awhile to return.  Some of the top banks in leveraged loans and financial sponsors like Credit Suisse, UBS, JP Morgan, etc. have been pairing down these groups since this fall when it became clear that the music had stopped for LBOs.  Dealbreaker drew attention to the plight of some sponsors analysts who were told to speed up their jumps to PE firms but were not fi