The private equity bubble (pg. 2)
Ready access to a seemingly bottomless source of funds encouraged buyout shops to make ever bigger and bolder bids. "I kept asking people from the firms, 'Why are you paying these prices?'" says Michael Tennenbaum, 71, of Tennenbaum Capital Partners, a $7 billion investment firm specializing in distressed debt. "They said, 'Because we can finance them.'"
That's not how markets are supposed to work. As the deals became more daunting, investors should have demanded far higher rates to finance them. But incredibly, in the past 18 months, money effectively got cheaper. From late 2005 until the July meltdown, the spread between high-yield debt and ten-year Treasury bills - in effect, the price the market puts on risk - contracted from 3.8 percentage points to 2.6 points.
The cheap money just pumped the bellows, and the pace of dealmaking accelerated. In 2006, U.S. LBO firms notched $422 billion in announced deals, dwarfing the record $156 billion in 2005, according to Dealogic, a capital-markets research firm. That incredible pace actually accelerated again through June. The buyouts also mushroomed in size. The two biggest buyouts of all time were announced this year: Canadian phone giant BCE, at $48.5 billion, and Texas energy giant TXU, at $43.8 billion. (All the figures in this paragraph include the existing debt of the company being bought.) A few weeks ago Wall Street was buzzing about the likelihood of the $100 billion private equity deal. The party had gotten out of control.
Risk on top of risk
Then the music stopped. The trouble began with rising defaults in the subprime mortgage market. While that market is unrelated to the buyout financing, the problems there served as a wake-up call. Suddenly debt investors began - for the first time in years - facing up to the risks they were taking. In mid-July the spreads on high-yield debt exploded, hammering the prices of junk bonds and loans. "This is one of the sharpest corrections I've ever seen," says Tennenbaum, who saw the bust coming and is paying 85 cents on the dollar or less for loans that sold at full value three weeks ago.
Today the entire money-raising machinery that powered the boom has seized up as lenders awaken to the danger in these deals and insist on being paid for it. Investors are torturing Wall Street underwriters by demanding far bigger yields on junk bonds and loans than they were willing to accept as recently as June. The market for C debt - the great enabler - has evaporated entirely.
That doesn't mean that the highly touted deals that have already been announced won't be completed. It's likely that all of them, including First Data and TXU, will obtain financing. That's because the banks that underwrote their debt are contractually obligated to fund the deals at fixed interest rates. But the banks will take a bath on those transactions.
For the private equity shops, higher rates reduce the potential value of the companies they hold, since a new buyer will pay more in interest to carry the debt. "If spreads on high-yield debt stay this wide, it's extremely negative for the profitability of private equity firms," says legendary investor Carl Icahn.
The biggest losers, though, are likely to be the swashbuckling hedge funds that gorged on high-yield debt and did it in the most reckless way possible. To amp up their returns, they borrowed heavily to buy the bonds of already highly leveraged companies. That's piling risk on top of risk in a rickety structure that a slight bump can topple. Wall Street firms promoted the practice. Not only did they sell high-yield bonds to the hedge funds, they also lent them money through their prime brokerage arms to buy the bonds on margin. It wasn't uncommon for the funds to borrow 80% of the price of the loans. With that kind of leverage, for example, they could earn 18% or more owning bonds with a nominal interest rate of 10% or so.
The same leverage that magnified their returns will multiply their losses, with potentially dire effects. Here's what the worst-case scenario might look like: As the hedge funds get margin calls from Wall Street, they're forced to dump their holdings of loans and bonds to raise cash. The glut of distressed debt for sale crashes prices and pushes yields to towering levels. Then everyone holding high-yield debt, from Asian banks to small investors with money in junk-bond mutual funds, will take a horrendous pounding.
What we're seeing here is simply sanity returning to the market. And as always in the aftermath of a bubble, sanity returns the hard way.