Private Equity & Dividing By Zero

I’ve been pulled from a period of post-nuptial dissolution and lassitude by an astonishing article in yesterday’s Wall Street Journal on private equity buyouts. It describes a simple game. Private equity firms persude creditors fund highly leveraged buyouts. The bought-out firm then takes on more debt to quickly pay large sums to the private equity firm, its new owner and manager, in the form of management fees and dividends.

Consider Intelsat. According the the WSJ article, private equity investors put up $515 million, while creditors footed the remaining $5.5 billion to purchase the communications satellite business. Within two years, the private equity investors had extracted more than $576 million in fees and dividends, while still retaining full ownership of the firm. Now that’s a good position to be in. After two years, while the underlying firm was struggling, renegging on promised employee benefits, and showing a negative net worth, it’s owners had already earned 5.75% annual returns on their stake and recovered their capital in full, while still retaining control of the company and claim to any future profits it might earn! Alluding to a previous post, this is a deal right on the dotted line. For zero net investment, the private equity firm gets to gamble taking all the profit and growth a 3 billion dollar firm can generate, or walking away from the table with a bit of bad publicity and the unwinding of some legal entities.

It’s easy, as is apparently the German custom, the think of private equity firms as “locusts”. But this is capitalism, and people are supposed to figure out ways to exploit unusual opportunities. It’s not the sharks who are feeding, but the rare, bloody meat floating in the water that’s the problem here.

There’s an old math cliché that you can prove any proposition so long as division by zero is permitted. I think a finance version of this cliché would be that anything is possible if there’s a mispricing in any market that can’t undone by its exploitation. Credit markets for the past half-decade have matched this description. Central banks have held money cheap, despite unprecedented and every growing use of borrowed funds by everyone from strapped consumers to eager-to-please businesses to multibillion dollar investment funds. In unmanipulated markets, the orgy of borrowing that has characterized the last few years would have led naturally to tighter rates. Thanks to the US Fed, the People’s Bank of China, the freewheeling dollar lending of petrostates, and of course the Bank of Japan, that hasn’t happened. Money has been nearly free. Banks have had to compete mercilessly for the privilege of lending for any interest at all. Risk has been so sliced and diced and sold and apparently “managed” by the derivatives boom that many creditors have been made comfortable with positions that in the past would have looked like laughably bad deals for them. Global interest rates have been fixed by the behavior of central banks collectively and state-affiliated investment funds at absurdly low levels.

The current private equity boom is largely a means of exploiting that mispricing. The underlying businesses that are bought and sold are means to ends. It is not what they do, what new efficiencies or synergies or what not that can be introduced that matters. It is how well their assets can be used to justify continual leveraging, how cheaply they can be bought, how good a story can be told to keep the terms of borrowing from becoming too onerous even while cash is sucked from the firms by equityholders, that matters most. The underlying business then becomes a lottery ticket. If a firm can, in the course of doing a deal, build a really great company, put together several firms and take advantage of synergies, improve underlying efficiencies, then the value of all those improvements is pure profit for the private equity fund. Leveraged buyers have every incentive to try to build and improve the companies they float through. But in a world of artificially cheap credit, taking underperforming companies and turning them into great ones becomes secondary, gravy. An arbitrage opportunity is better than any risky investement. The first order of business for a rational private equity fund would be to find target investments through which to exploit mispricings in credit and risk can be efficiently exploited.

Of course this will all come apart, rather soon I hope. If collective state behavior does change (a very big if) and the era of absurdly cheap money ends, many of these heavily leveraged deals will go south, and we’ll have a predicatable wave of Enron-like scandals, as firms go bust, private equity funds write off their investments, and creditors sue them for fees and dividends they extracted from retrospectiovely insolvent companies. If central banks around the world are determined to keep money cheap, if China keeps ramping its exports and lending away all the proceeds for next to nothing, if the petrostates keep buying up dollar debt with all their oil proceeds, if the Bank of Japan and US Fed get spooked by the prospect of recession and hold rates low, we can put off much of this unpleasantness, but with much worse eventual consequences.

After all, it is not liquidity or interest rates or equity deals that matter in the enterprise of human wealth. It is the business of producing real goods and services. A world in which nominal wealth becomes detached from real production, and bound instead to cleverness in manipulating the machinery of high finance, is a world in which financiers will have an ever larger share of a progressively smaller pie.