Even though Tony’s call for the attendees to go out a tell the people about the benefits of covenant-lite and PIK toggle debt was a joke but he did put up a valiant PR/charm offensive to try to defend these kinds of financing.  Basically, his argument amounted to an argument about the damage done to companies by debt holders through a company into a bankruptcy and getting DIP financing.  James argued that in most cases a liquidation of a struggling sponsored owned company is not the right move.  By having more flexibility to not trip covenants and toggle to interest payments tacked onto principle allows companies to continue to operate, not fire employees, and fix themselves.  He downplayed the damage that this kind of debt does to senior debt holders.  It is alright if James doesn’t have a problem with the senior debt holders taking a bath but he should not complain when the senior debt holders and senior subordinate debt holders do not want to give him aggressive terms.  James may also just be wrong when he makes the statement that defaults are low and will stay low because of loose covenants.  It may just be the case that because of covenant-lite and PIK toggle features of recent LBO related debt there will be fewer warning signs since covenants will not get tripped and once the companies do go into default they will be more badly damaged before the restructuring specialists and distressed investors get their hands on them.  Basically, PE firms may get more rope to hand themselves with if they can take senior debt holders for a ride longer because of covenant lite and PIK toggle features on the debt that finances their portfolio companies.  

Richard Shinder, a director in Goldman Sachs’ Special Situations Group, made basically these arguments which James disagreed with in Q&A.  There are plenty of banks and distressed investors that are staffing up right now for a major ramp up of defaults so obviously not everyone agrees with James.  Shinder coming over from Avenue Capital in and of itself serves as an example of Goldman Sachs staffing up for the start of a distressed explosion.  A representative of S&P at the conference said that their worst case scenario put defaults at 8.9% in 2008.  Other panelists at the conference thought that the debt markets were pricing in a 10-15% default rate in 2008.  In fact, no one was as rosy on where defaults would be than James but what did we expect him to say.  James attributes the lack of defaults in the face of a slowing economy to the covenant-lite debt terms portfolio companies received in the boom times.  James said that, "Covenant-lite debt structures are not only private equity’s interest, they’re in everyone’s interest … The only one you might argue is not better off is the senior secured. By keeping the company intact, the private equity owners are able to fix the problems, and by preserving the employees, the customers and the business society at large benefits."

Here are some interesting quotes from Shinder courtesy of The Deal:

"There are important factors affecting the marketplace. Even in deals that weren’t covenant-lite, the covenants were looser in general … What that will mean through this cycle is that those early warning signs that you had in prior cycles won’t be there anymore."

"Because you will have not had the intervention from turnaround advisers, businesses will be presented to [distressed investors] in a different state … because the opportunities to save the patient will have been missed. They’ll be more badly damaged from an operational point of view because there was no earlier intervention."

Also, let The Prince just point out that James really misrepresented his firm’s activities when he said that they were conservative users of leverage.   Blackstone was one of the most aggressive users of leverage and demanded the most concessions on covenants during the boom.  Almost any banker who worked opposite Blackstone during the boom will confirm this.  Just look at Freescale.  Who cares what the comps are trading at, 8.5 turns of leverage on a technology company is absurd.  Keep in mind that cash flows from this kind of company are way more variable than the industrial/manufacturing companies that PE firms have bought for years with successful results.  Please also believe The Prince when he says that if Blackstone and its partners could have got 10 turns of leverage from their lenders they would have taken it.  Blackstone, like other big buyout shops, does try to improve operations but lots of their returns do come from leverage.  James said something like only 10% of Blackstone’s PE fund returns in the past came from leverage.  That figure is immediately suspect and clearly misleading.  How would one even go about coming up with such a number?  How would you calculate it or determine which parts of a return are attributable to leverage, multiple expansion, or operating improvements?

Tony James was quite smug on the performance of Blackstone’s portfolio.  He defended the buyout of Freescale by saying that the acquisition was done at 8.5x EBITDA when the comps were trading at 12x.  He also said that outside of cell phone chip sale weakness related to Motorola’s weakness Freescale had gain share in all other markets.  He had a reason to be smug about Blackstone’s EOP deal.  That deal is rumored to have been an almost immediate success because of the great prices that pieces of the portfolio were sold for.  James was also smug when he talked about Blackstone saw opportunities to take advantage of many companies/individuals that bought EOP properties from Blackstone with short-term debt and no cannot roll the debt into long-term financing.  Wow Tony, so nice of you to lend them a hand.  With any luck you will get a chance to rip the faces off of the buyers of EOP properties from you once more.

The Prince must be allowed one ending digression on the smugness of Tony James and Blackstone.  I think the Epicurean Dealmaker sums up the ethos of Blackstone conveyed by their annual report quite well in his latest post, Bubble Land.  Here is an excerpt that The Prince found particularly funny but true:

Second, what kind of self-image do these images of Blackstone’s personnel convey? That they are so fucking powerful they use the streets of Manhattan for a conference room? That New York City itself is merely a vaguely fake-looking background to the important issues BX deals with every day? That BX functions in a surreal bubble devoid of all other human presence? That the Executive Committee likes to reenact scenes from Reservoir Dogs?

Third, what’s with the black cover? A sort of reverse Beatles White Album? An evocation of the all-powerful monolith from 2001: A Space Odyssey? A sympathetic black armband for pathetic unitholders who have lost somewhere between 35 and 50% of their investment value in BX shares since the IPO? Or just a "We’re so powerful and important we don’t need to put anything on our annual report cover" fuck-you?

And last but not least—although I admit the connection to semiotics or symbolism is tenuous at best—what the hell is with Steve Schwarzman’s suit? I mean, the guy is a fucking billionaire, and he looks like he’s wearing something The Men’s Wearhouse custom-made for MC Hammer. I haven’t seen pants that baggy below 116th Street since 1988.

Get a fucking tailor, man.

(Oh, and next time, hire someone who actually knows what they’re doing to design your annual report.)

Click here for the bios of the speakers and a schedule of the events.  The Prince has been really looking forward to this conference for the past few weeks and the featured speakers and the panels should offer some really great color on the state of the private capital investing world and the acquisition debt markets that finance PE investing. 

The Prince is especially interested in hearing the interview with Ken Moelis (click here for The Prince’s coverage of a previous interview with Moelis).  The panel with Alan Jones from Morgan Stanley and John Eydenberg from Duetsche Bank should also be really interesting.  The panel moderated by The Deal’s senior writer, Vipal Monga, will examine how financing will change as a result of the recent credit crisis.  The Prince often wonders how private equity firms will continue to bring in assets if their returns continue to decline and financing gets less aggressive.  Someone will benefit from changes that come about as a result of the recent crisis and The Prince is looking forward to hearing the professionals on this panel make some predictions.  The Prince will be writing about how the various industry leaders perceive the private equity environment during and after the conference. 

Daniel Primack at PE Hub discovered on Friday that J.P Morgan is leading the lenders.  He also got the opinion from the sponsors that the process to get committed financing was made easier by ConvaTec’s high cash flow and lack of cyclicality.  A few months ago you could make those arguments until you were blue in the face and not get committed financing.  The banks must believe that the leveraged loan markets improvement is here to stay if they are handing out this much debt at terms that a sponsor could accept.  It is also interesting to note that ConvaTec was probably shopped around by its advisors as an LBO candidate and Avista and Nordic probably won a competitive bidding process.  Look out strategics, the PE sharks may soon be back in the water.

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).

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.

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.

"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 fired.  While some cuts are probably necessary at the banks that have large groups devoted to servicing private equity firms key relationship managers should be kept in place.  Private equity will reemerge from its hibernation and the bankers who have strengthened their relationships with the PE firms during this lull will be rewarded.  

David Bonderman - Co-Founder of TPG

The New York Times ran an interesting story (Mergers in a Time of Bears) yesterday morning by Andrew Ross Sorkin.  The article comments on a recent study, which examined how successful mergers were based on when in the merger cycle they were announced.  While the findings of the study are not exactly earth-shattering, they do confirm what many investors have long believed: many mergers that were completed when acquirees were cheap at the beginning of a merger boom have been successful.  Some of the best IRRs on investments by private equity firms have been achieved when the PE firm purchased the company in a recession or at the beginning of buyout boom.  Buying something cheap when no one else is buying it makes perfect sense; you could earn a larger return than if you bought it at the peak of valuations in a merger boom. 

The study, published in this month’s Academy of Management Journal, found that deals struck in the first 15 percent of a consolidation wave tend to do well—at least measured by the acquirers’ share performance against that of the broad market.  The value destroying deals come later, when other companies join in the buying spree.  The undeniable existence of first mover advantage seems obvious.  The study examined 3,194 public companies that purchased other companies during acquisition waves between 1984 and 2004.  “Our findings suggest that the market rewards executives who perceive opportunities early, scan the environment for targets and move before others in their industry,” said Mr. McNamara, one of the professors behind the study.  “Conversely, the market severely punishes followers, those firms that merely imitate the moves of early participants in the wave, who jump on the acquisition bandwagon largely because of pressures created by competitors. Such companies typically lose significant stock value.”  To define a merger, wave the professors looked at 12 industries over the 20-year period. To qualify as a wave, merger activity had to show a pattern in which the peak year had “a greater than 100 percent increase from the first year followed by a decline in acquisition activity of greater than 50 percent from the peak year.”  Waves were as long as six years for some industries.

If it is the case that buying early in a merger wave is beneficial then why don’t we see more of it?  Why are CEOs hesitant to be contrarians and sit back when other CEOs in their industry are not acquisitive?  During volatile markets it seems like many CEOs are hesitant to act because of uncertainty in the market.  However, by completing a merger when there is uncertainty, CEOs would certainly increase the possibility that their mergers would be successful.  It may be counterintuitive to believe that deals consummated in volatile markets will perform better but this study certainly supports that postulation.  However, many CEOs may take this all with a grain of salt since even the quintessentially successful CEO, Jack Welch, didn’t follow the counterintuitive nature of this study’s findings.   The study found, however, that serial acquirers like General Electric don’t seem to do well through consolidation waves. Companies that “undertake acquisitions on a regular basis as part of their core business routines” are less likely “to either seize early-mover benefits or suffer from the costs associated with bandwagon pressures.”   

The Prince completely agrees that most mergers fail to increase shareholder value.  It also makes sense to him that mergers completed when assets are cheaper do have a higher probability of being successful.  By this logic, one could suggest that consolidation now in the mining industry will probably result in mergers that destroy shareholder value.  Timing is everything in trading, so why shouldn’t this apply in larger mergers?  Anyway, here are some interesting excerpts from the article. 

Most mergers fail.  If that’s not a bona fide fact, plenty of smart people think it is. McKinsey & Company says it’s true. Harvard, too. Booz Allen Hamilton, KPMG, A. T. Kearney — the list goes on. If a deal enriches an acquirer’s shareholders, the statistics say, it is probably an accident.

But a new study puts a twist on the conventional wisdom. It’s not that all deals fail. It’s just that timing appears to be everything. Deals made at the very beginning of a merger cycle regularly succeed. It’s the rest that fall flat.

….

Notwithstanding Microsoft’s $44.6 billion takeover bid for Yahoo or Electronic Arts’ $2 billion offer for Take-Two Interactive, 2008 is going to be an abysmal year for deal-making. Volume in mergers and acquisitions has plummeted 37 percent this year in the United States, according to Dealogic. (Factor out Microsoft-Yahoo and the drop is a whopping 56 percent.) That’s partly a result of the private equity folks’ being taken out of the equation because of the credit crisis. But it is also because C.E.O.’s and boards become paralyzed when the markets turn turbulent. Instead of making investments, they hunker down and focus on putting their houses in order. Remember those pundits who said corporations would fill the void left by private equity? They were wrong — only they shouldn’t have been.

…

Take the telecommunications industry. AT&T’s acquisition of Cingular (now AT&T Wireless), which was announced in February 2004, has turned out to be an unqualified winner. But the merger of Sprint and Nextel, unveiled 11 months later, was and is a disaster.

The numbers tell the story. Early movers — companies that made acquisitions in the beginning of a consolidation wave within their industry — found their stock up, on average 4 percent relative to where the shares would ordinarily trade, according to the study. Shares of latecomers, who bought at the end of a wave, fell by an average of 3 percent during that time. Of course, at the end of every wave there are bigger and more deals. After all, stocks are usually up, and so is boardroom confidence (read: exuberance). “There’s a social pressure,” Mr. McNamara said. “They like to be in the herd.”

…

There are a couple of caveats to the study. The professors measured the acquirers’ stock appreciation or deprecation by using a fancy calculation of what they call “abnormal returns,” which examined share prices five days before the announcement of the acquisition and prices 15 days later. The math is complicated, but they say the “abnormal return” is predictive of stock performance in the future. Of course, critics could argue the study doesn’t measure a long enough period after a deal is made.

Nonetheless, the point is clear: C.E.O.’s should stop being such scaredy-cats. While everyone else is battening down the hatches, go make a deal. The wave is just starting.

If you need specific examples of the problems that are plaguing other LBOs in the pipeline The Deal and The Deal’s Dealscape Blog have done some great work on this subject, which I link to below in the summary of problems with pending deals.

First up, is Bain Capital’s $2.2 billion buyout of 3Com Corp.which has raised the ire of a U.S. national security panel.  The panel is concerned about the Chinese company that is Bain’s co-investor.  The U.S. Committee on Foreign Investment recently made it clear that proposals to preempt concerns about Huawei Technologies as a minority investor were unconvincing.  CFIUS doesn’t want Huawei to gain access to 3Com’s sensitive encryption technology.  This concern prompted Bain and 3Com to withdraw their application for approval by CFIUS on Wednesday.  This move certainly is ominous for the prospects of this buyout actually getting done.  It could be the case that Bain will use the regulators as the scapegoat to walk away from this deal.  What is unclear is if Bain still wants 3Com even though technology spending is bound to slow given the recession.

A far bigger and more market moving deal is also on the ropes.  Clear Channel Communications $26 billion buyout has been plagued by problems at every step of the way.  This deal was supposed to close months ago, but everything from deal price, to shareholder approval has been a problem.  Now marketing the debt for the LBO by Thomas H. Lee Partners LP and Bain Capital LLC is looking predictably dicey. Since Blackstone’s failed purchase of Alliance Data other problems have been encountered on the Harrah’s Entertainment and Intelsat deals.  Clear Channel’s troubled sale of its television unit to Providence Equity Partners, now the subject of a Delaware lawsuit hasn’t helped ease the banker’s concerns.  Add that to the fact that ad spending is declining as the economy falters and companies operating in radio look like a poor place to be deploying money at such a high multiple.  Remember the Clear Channel buyout was and still is the poster child for an LBO with a purchase price that was a sky high multiple of EBITDA in a cyclical industry.  If you need proof that radio is tough, the Radio Advertising Bureau just announced that industry revenue fell 5% in January, and national ad sales dropped 13%.

This deal has been in the pipeline forever.  This deal was announced in November 2006.  The bid was boosted from $37.50 to $39 after shareholders complained.  Finally, the bid was raised to $39.20, and the investors were allowed to retain minority equity.  The deal is now supposed to close in March but the Prince is very doubtful on this one.  The Federal Communications Commission also held the deal up for more than 380 days and was finally cleared in late January.  The Justice Department just gave approval in February.

Yet, we still haven’t got to the marketing problem for the debt to finance this deal.   Needless to say there are not debt investors lining up to take down the debt of an over-levered company facing industry headwinds.  The banks are going to push back on their commitments and it will be interesting to see how hard a line Bain and Thomas H. Lee take with the banks.  The debt will be marketed until March 26 but financing this much paper doesn’t seem possible given the state of the markets and the weakness of the operating company in this LBO.  Citigroup, Deutsche Bank, Credit Suisse, Morgan Stanley, RBS and Wachovia have committed $22.13 billion in financing, including senior secured credit facilities, in an aggregate principal amount of $18.53 billion, a receivables-backed credit facility with a maximum availability of $1 billion and a senior bridge loan facility of $2.6 billion.  The banks want covenants tightened in the deal (because there isn’t a bid for debt that is of the covenant-lite variety peddled successfully to debt investors during the height of the LBO boom) and the PE shops are rumored to still want the deal to get done.  The Prince is highly doubtful that this thing will get financed.  However, this deal has already cleared so many larger road blocks that he thinks it will still go through with the banks taking a bath if they try to syndicate the debt or writing bridges to get the deal closed.

Now let’s move on the big elephant in the room.  That is the enormous loan package needed for the LBO of BCE.  The $23bn loan needed by Ontario Teachers’ Pension Plan, Providence Equity Partners and Madison Dearborn Partners for the buyout of Canadian telecom BCE Inc.   The looming financing, which was expected to hit the market in the first quarter, is drawing more scrutiny.  However, a lawsuit by Canadian bondholders, who claim they have been oppressed by the adverse effect the new debt will have on existing bonds, has scrambled the timeline somewhat.  A ruling by a Quebec court is expected in coming days, but the appeal process could drag the case out for some weeks. Bondholders and BCE agreed to an expedited appeal process, with a final ruling expected within 30 to 90 days after the appeal is filed. If bondholders lose, financing arrangements will be finalized soon after.  Yet, who knows if this debt will get sold to investors.  The deal is in a more stable industry and isn’t as absurdly levered as Clear Channel so this one’s debt may have a chance of getting sold to investors.  However, the buyers have said publicly that they won’t complete the LBO if the bondholders win the suit.

Finally, we end with the deal that seemed doomed from the start: Goodman Global.  San Francisco private equity firm Hellman & Friedman, a firm which The Prince really likes and respects, finally completed a $25.60-a-share, $2.65 billion leveraged buyout of Goodman Global.  It bought the air-conditioning equipment business from Apollo Management which had acquired it in 2004.  Barclays, GE Commercial Finance, Crédit Agricole’s Calyon New York subsidiary, GSO Capital Partners and Farallon Capital Management arranged $1.6 billion of debt financing for the LBO. An $800 million term loan garnered more than $900 million in interest after the banks sweetened the terms: launched at LIBOR plus 375, with a 98.5 original issue discount, the five-year loan eventually was placed at LIBOR plus 425 and at a discount of 96. In addition, a LIBOR floor of 3.25% was set for the life of the loan.  The relatively small size of this financing and the stableness of Goodman’s business probably contributed to the banks’ success in selling these loans.  It is ironic that the deal that seemed on the ropes when the buyout boom was still strong and constantly plagued by problems is the standout success in a sea of trouble for other PE LBO deals.

1 The Carlyle Group $32.5 billion
2 Kohlberg Kravis Roberts $31.1 billion
3 Goldman Sachs Principal Investment Area $31 billion
4 The Blackstone Group $28.36 billion
5 TPG $23.5 billion
6 Permira $21.47 billion
7 Apax Partners $18.85 billion
8 Bain Capital $17.3 billion
9 Providence Equity Partners $16.36 billion
10 CVC Capital Partners $15.65 billion
11 Cinven $15.07 billion
12 Apollo Management $13.9 billion
13 3i Group $13.37 billion $
14 Warburg Pincus $13.3 billion
15 Terra Firma Capital Partners $12.9 billion
16 Hellman & Friedman $12 billion
17 CCMP Capital $11.7 billion
18 General Atlantic $11.4 billion
19 Silver Lake Partners $11 billion
20 Teachers’ Private Capital $10.78 billion

To make his case against an M&A slowdown he points to some deal statistics from the newly minted year.  He basically shows that the combined value of completed global M&A in January is down 32 percent to $182 billion versus January 2007.  However, he responds that announced M8A is so far strong in 2008.  He bases this on the fact that the number of announced deals is up 8% to 2,381 globally, according to DealLogic.  He doesn’t really mention the volume of deals but The Prince would suspect announced M&A volumes are down substantially.

So now that The Prince has laid some of the groundwork for this argument he wants to offer a little commentary of his own.  The truth is there is no way this year is going to get up to the M&A volume of last year.  Many claim that companies are so cheap now that strategic buyers and even some PE firms are going to be active buyers this year. 

I think this argument is illusory.  For one, sellers expectations take some time to adjust (just look at Yahoo’s board rejecting Microsoft’s bid as too low).  Many sellers are going to be looking at where their stock prices were this summer and expecting to get that again in a sale.  Sure, distressed companies are going to get snapped up and the number of distressed companies is sure to rise as many are unable to refinance their debt.  PE firms do still have money to put to work and they are looking for targets.  However, they are not going to pursue large scale buyouts until they can get leverage on the transactions at good terms.  This seems like it will take a while to get fixed considering we probably have a un-issued debt backlog of $180-250bn on bank’s balance sheets globally.  The average deal size in January fell by 17% which is completely attributable to PE being effectively on the sidelines and the unavailability of capital.  Yes, PE has lots of cash and they are looking but they are not going to waste that case chasing deals that they can’t appropriately lever.  Also, why would you buy companies when the economy is slowing, earnings are coming down, and seller expectations are still at Spring 2007 levels?  Blackstone, KKR, and company are not that stupid.  They will buy at the bottom but this isn’t it and even if it was the returns are terrible with no leverage.

Without the monster private equity transactions of last year we are not going to see M&A volumes go very high this year.  For those that are predicting significantly lower bonuses for bankers in 2008, The Prince believes bonuses will be down.  However, they will be down in the 10-20% range versus 2007 not in the 50%+ range many commentators are claiming.  Remember that 2007 bonuses were effected by the terrible forward outlook plus a week 3rd and 4th quarters (usually banks base half of bonuses on past performance and half on forward outlook, with a wildcard for paying more to keep people from defecting).  2008 bonuses will probably be dolled out when the forward outlook is fairly good.  Yet, I have to emphasize my first point one more time.  Without big private equity transactions this year M&A will not be the godsend to the economy that writers like Weidner claim it will be.  Many in the financial press simply do not understand how much investment banking business was tied to the transactions related to sponsors and they also don’t appreciate how many companies were bid up by PE firms and put in play by activist hedge funds & PE shops.  These forces will not be in the marketplace this year so long as the financing markets remain uncooperative.

So here is what went down.  Before Rubenstein could complete his first sentence protesters filled the room and stormed the balcony.  They began to chant loudly as 30-50 people steamed into the room passing out fliers and onto the balcony.  They unveiled a banner which you can see in the photos below.  The protestors were from the Service Employees International Union (SEIU).  After a short time a dialogue began between the protesters, the audience, and Rubenstein, lasting for between ten and fifteen minutes.  The finance professionals mostly left or waited for security but some students did respond to the protestors with one audience member calling the main protestor a "fat cow".  Some in the audience verbally abused the protesters.  SEIU, which has nearly 2 million members, has raised questions about whether the recent boom in private equity deals is good for the average worker.  Last summer, they organized a small demonstration in the Hamptons where protesters pretended to be billionaires and expressed mock opposition to raising taxes on private equity fund managers.  Definitely, have to give them points for creativity.

Their main gripe was related to Carlyle’s buyout of Manor Care.  Manor Care is a Toledo-based chain of 500 residences, which Carlyle bought last month for $6.3 billion.  Accounts of the disruption are all over the place.  Some people claim that punches were thrown and others said that it was just scuffling.  Almost all account say the situation was out of control and could of turned violent because of lack of security.  Despite the craziness of the situation Rubenstein remained on stage and agreed to address questions from a woman with a mega-phone, who said she was a Manor Care employee.   In response Rubenstein said "Obviously we’re interested in making the company better, that’s why we bought it," but sarcastically admitted that "It’s difficult to change a company in two weeks."  At one point Rubenstein said to the mega-phone woman that "I think a remedial English course would be helpful before going any further," but the context of that comment is unknown at this point.  After about 10 to 15 minutes of protest chants as conference-goers exited through the doors, Rubenstein left the stage and the police arrived to remove the protestors.

Now let The Prince disclose a few biases against organized labor.  Basically, The Prince believes labor unions are relics of the past possessing only token power.  Not only have they become irrelevant but they mistakenly think that they still have the ear of decision makers.  Now The Prince is from a middle class background as he has disclosed earlier.  His parents are middle class.  His grandfather was a mill worker for Alcoa aluminum and his other grandfather founded a grew an electronics components company.  The Prince still believes that labor unions are irrelevant and rarely serve the best interests of their members.  Furthermore, in industries where unions still exist they have consistently and naively fought hard to keep the rules the way they want them regardless of the economic realities.  The truth is that labor is now globally mobile, especially in manufacturing.  The mill worker in South Carolina has to compete with the mill worker in India and China.  The Prince believes that this reality is acceptable and irreversible.  While the global competitiveness among laborers from different doesn’t apply as much to SEIU since most of its employees work in the service sector, it doesn’t mean that SEUI has any realistic place in our society.  They are an organizat