The Buyout Boys Reload
On a spring day at the Ritz-Carlton hotel in Key Biscayne, Fla., Michael Klein, Citigroup's chairman for institutional clients, took the stage at the bank's ninth annual private equity conference. In front of pension fund investors, hedge fund managers and private equity dealmakers, Klein flashed a series of newspaper headlines on the giant screens.
One slide read, "The collapse of a major investment house," evoking groans -- Bear Stearns had collapsed two weeks earlier. "End of the 'leveraged' era," read another. "Middle East investor buys major stake in a U.S. bank." The audience nodded along, thinking about how the Abu Dhabi Investment Authority had poured capital into Citi. But before the conference could turn into a wake, Klein revealed that the stories were not from this past year but from 1990 and '91. The bank in question was Drexel Burnham Lambert, which was a casualty of the junk-bond collapse. Citi's Middle Eastern investor was Saudi Prince Alwaleed bin Talal bin Abdul Aziz al-Saud.
Plus ça change, plus la même chose, as they say in the fancy French restaurants the buyout boys frequent. The industry, as the more grizzled audience members recalled, had survived that implosion and grown into a $2 trillion colossus. Paraphrasing Charles Dickens, Klein went on to explain how 2007 was a tale of two halves. The first was ebullient: nine of the 10 biggest leveraged buyouts ever ("leveraged" means using borrowed money) and Blackstone Group becoming a publicly traded company. The second was one in which LBOs fell from almost 40 percent of the dollar value of all deals through July to a single-digit market share.
While the days of the brainless megabuyout are over (at least for now), private equity has not gone away. It's merely retreated. Veteran dealsters say they welcome the current separation of the men from the boys, of the serious players from those who merely surfed on waves of cheap debt but have now wiped out. These periodic shakeouts are "what keeps the industry healthy," said Blackstone President Tony James, who has been in buyouts for almost three decades. "It squeezes out a large number of marginal players." TPG (formerly Texas Pacific Group) co-founder Jim Coulter describes the change this way: "There aren't 100 bankers showing up with companies they want you to buy, but the ones they're offering are much more interesting."
What's different in private equity now from its last meltdown, in the late 1980s? Answer: It has become part of the landscape in a way that it wasn't 20 years ago. If you buy a teddy bear at Toys R Us, stay at a Hilton or drive a Chrysler, private equity is part of your life. If your pension fund has money invested in buyouts, these guys' performance will have a say on whether your golden years are spent eating caviar or cat food. Many public-employee pension funds have a piece of buyout action (or soon will), and if they don't make their projected returns, governments will turn to taxpayers to make up the shortfall.
So what do smart people like the buyout boys do when they're confronted with violent change in the markets? They're engaging in what we call "double cropping," a classic example of the way the largest private-equity firms can adapt. Okay, you can't buy companies anymore, but you can make a second profit from the buyouts you've already done. How? By offering capital to the institutions with the greatest need -- the banks that financed your original deals.
The banks, nowhere near as clever as their clients, figured they would sell most or all of their takeover loans to institutions throughout the world, ending up with some nice fee income while having little or none of their capital at risk. But when the credit crunch began last summer, the music stopped and the banks lost their would-be dance partners.
Enter the buyout firms, which have tons of new money flowing into their funds. What to do with it? Rummage for value in banks' used-loan inventory. "The flavor of the day is buying your own debt at below face value," said David Rubenstein, co-founder of the Carlyle Group. "I'm buying bank debt in my deal with leverage from the bank that made me that deal."
You have to love it. First, banks provided lavish financing for the takeovers, making it possible for LBO firms to show double-digit returns to investors even if the properties themselves produced gains in single digits. (Example: Borrow $5 billion at 6 percent to buy a $6 billion company that's growing at 9 percent, and you make 24 percent on your $1 billion investment.) Now the banks are lending their borrowers money to cart off the loans at a discount, giving them another bite at the buyout apple.
Consider, if you will, the biggest double-cropping transaction to surface thus far: a deal in which Citi sort of unloaded $12 billion of buyout loans onto Apollo, TPG and Blackstone. The firms stand to make double-digit returns because they get to borrow so much money from Citi -- and they've even managed to limit their risk.
We're saying "sort of unloaded" because Citi didn't sell the paper to the buyout groups, contrary to what's been reported. Rather, Citi and the firms did "total-return swaps." The firms forked over $3 billion of cash and agreed to pay Citi interest (at a low 1 percent over the London Interbank Offered Rate) on $7.8 billion. In return Citi will pay the firms the interest and principal repayments generated by the $12 billion portfolio.
We don't have details on every loan, but we do know that Apollo and TPG, which took Harrah's Entertainment private for $28 billion, got some of Citi's Harrah's debt. We also know that TPG, which partnered with Kohlberg Kravis Roberts in the $45 billion purchase of the Texas utility TXU, got some of Citi's TXU paper. (None of the firms involved would discuss specifics.)