Private Equity 101...

a very interesting Money Morning article about how Private Equity firms (aka Leveraged Buyout Firms) operate. The part about "covenant-lite" and "reverse convenants" is especially eye-opening since it means controlling PE firms don't have to answer to stakeholders or act in the company's best interest (two seemingly antiquated notions nowadays).

PE's current push into assisting (aka purchasing) distressed banks is also very disturbing since they would then be playing with our bank accounts/deposits and would also be backed by the bailout machine known as the U.S. government...moral hazard anyone?



The once booming business of private equity faces an uncertain future. What’s not uncertain, however, is that many private equity deals are imploding from the weight of leveraged debt and greed. Inevitable bankruptcies will result in higher unemployment and a deeper recession.

Private equity firms are the debutante sisters of hedge funds. They raise huge pools of capital from pension funds, endowment funds, sovereign wealth funds, institutional investors and wealthy entrepreneurs. But while hedge funds buy and sell the stocks of companies they hope to profit from, private equity shops buy whole companies.

The trick of the deal is to pay for the target by using as little equity capital as possible, and raising the remainder by actually having the target company borrow the required funds. (I assume the author is referring to the use of tax shields here to maximize overall firm CF's) Except for the private equity firm’s initial equity investment, the target company is essentially buying itself (More likely burdening itself with massive, crippling debt).

And if that isn’t enough of a trick, very often when the target is privatized, their new masters have the company borrow even more money so they can then pay themselves a dividend as a bonus for the good job they did in leveraging the company to the hilt so they can streamline it.

There are two elements that made massive borrowing possible.

The first was a ready supply of capital courtesy of the U.S. Federal Reserve’s easy money policy and low interest rates. The second was the ability of banks that lend money to acquired companies to pool those loans into securities called collateralized loan obligations, or CLOs, and sell them off to investors. Banks and investors refer to this asset class as “leveraged loans.”

Banks and non-bank lenders attach covenants to the loans they make. Typically, covenants dictate to borrowers what specific balance sheet requirements must be met and include debt-to-cash flow leverage ratios, limitations on the total amount of debt a company can carry, minimum equity provisions and other dictates that serve to secure collateral that is relied upon by lenders.
But, banks were so flush with money and so eager to lend that privately acquired companies, driven by their new private equity masters, proposed that the money they borrowed should not be encumbered by the protective covenants lenders are used to demanding. Hence the birth of “covenant-lite” loans.

Covenant-lite loans included insane “reverse covenants” that benefited the borrowers not the lenders. (unbe-f**king-lievable! How backwards is that?)

Among other things, some borrowers demanded and got rights to:
-Increase debt-to-EBITDA levels to 10:1.
-Freely substitute collateral.
-Issue unsecured debt equal to the total amount of existing debt (if they hedged or effected swaps.
-Employ PIK (payment-in-kind) options, where instead of paying interest in cash they could substitute more debt.
-Employ PIK toggles**, sometimes called “extendibles.”
**PIK toggles...like an option ARM mortgage, where borrowers can choose whether to pay the interest due, some part of it, or none of it, and roll unpaid interest into principal.

Eventually, investors simply stopped buying leveraged loans. And the net result is that banks may be sitting on over $150 billion of junk leveraged loans that they can’t place. They are taking hits to their balance sheets as they have to mark down these loans....they are terrified that the recession will drive more of these leveraged companies into bankruptcy.

Thomson Reuters recently reported that 40 private equity companies have sought bankruptcy this year. According to Standard & Poor’s, of 86 S&P rated companies that defaulted this year, 53 of them were private equity related transactions. Linens ‘n Things which was taken private by Apollo Group Inc. went bankrupt. Sharper Image, Wickes Furniture and catalogue company Lillian Vernon, were all taken private by Sun Capital Partners Inc., all of them are bankrupt. Mervyn’s which was taken private by Sun Capital and Cerberus Capital Management LP. is bankrupt.

Then, of course, there’s the pure genius of PE firms coming to the rescue of troubled banks. But, TPG Capital (formerly Texas Pacific Group) doesn’t look so genius with its $7 billion investment in Washington Mutual Inc. (OTC: WAMUQ) which was wiped out in a matter of five months. ($7 billion lost in 5 months...lmao...what a bunch of idiots).

There’s a lot of pressure on banks to raise capital and there’s a lot of pressure being exerted by the private equity guys to lean on the Fed and U.S. Treasury to bend the rules to let them play in that sandbox. (I AM NOT EASILY FRIGHTENED BUT THIS SCARES THE SH*T OUT OF ME!) Pushing hard from the private equity camp are Randall Quarles, Managing Director of Carlyle Group Ltd. and a former senior Treasury official and none other than the former Treasury Secretary himself, Chairman of Cerberus Capital Management, John Snow.

What the private equity guys want is the ability to buy into banks and control them. If they get their hands on the low cost deposit-based capital at commercial banks, they’ll be unstoppable. How about having the piggy-bank, backed by taxpayers to leverage at will?

Right now there’s a limitation imposed on investors in Federal Deposit Insurance Company insured commercial banks. Once an investment exceeds 9.9% there must be an agreement with regulators to not “control or influence” management. If an investment exceeds 24.9% the investing entity must register as a Bank Holding Company, and subject itself to all necessary transparencies called for by regulators and the Fed. Private equity guys do not want any part of either of those restrictions. They don’t want their business looked through nor do they want their capital encumbered. (Not surpised...only 28 days until Hank Paulson and Bush Co. are gone! They are the only ones who would be stupid enough to let this go PE "assistance" go through).