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The Buyout Boys Reload
Their New Killer Deals: Leveraged Purchases Of Their Own Debt

By Allan Sloan and Katie Benner
Sunday, May 18, 2008

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.)

Doing a swap rather than a sale avoids various complex financial and legal problems. It also means that the buyout firms are on the hook for only the cash they've put up, unless they choose to put up more. So if the loans prove to be truly disastrous, they will be Citi's problem all over again.

This kind of transaction isn't as sexy (or lucrative) as lining up the first $100 billion buyout. But hey, it helps cover the overhead. Double-cropping leveraged loans isn't likely to produce the 25 percent or so (before fees) returns to which buyout-fund investors have become accustomed (or would like to become accustomed). But it beats a sharp stick in the eye. Firms can realize returns in the high teens or low 20s (before fees) from buying this paper, which is a far less risky investment than putting up the equity in an LBO.

One reason banks are so eager to do these deals is that the takeover loans made late in the cycle tend to be really messed up. That's because banks were competing so hard for buyout business that they took leave of their senses. At a gathering of business journalists last month, Carlyle's Rubenstein riffed on the way banks were competing to finance buyouts on increasingly ridiculous (for the lenders) terms. After playing the banks off against one another, Rubenstein said -- a big smile on his face as he milked laughs from the crowd -- the firm ended up with a deal that worked like this: "I don't have to pay the debt on time, I don't have to write covenants, I don't have to worry about nuclear bombs, I don't have to have any equity. I'll do that deal."

In a more serious vein, consider a study of post-2003 buyout debt by Marty Fridson's Distressed Debt Investor. Fridson, who has been around high-yield debt since back when it was known as junk, said that before the lending excesses started in 2004, buyout debt followed a familiar pattern: The longer the debt had been outstanding, the more likely it was to be distressed (which he defines as yielding 10 percentage points or more above equivalent Treasury securities). The reason: The longer a buyout has been around, the more chance it has had to run into economic problems.

But the trend has reversed -- the more recently a loan was made, the more likely it is to be distressed. As of early May, 42 percent (62 of 146) of post-2003 LBOs were distressed, more than double the rate in the rest of the high-yield universe. This includes three of the four issues from this year, 49 percent (18 of 37) from 2007, and 34 percent (14 of 41) from 2004. The good news is that now is better than in mid-March, when Fridson found a full 50 percent of these issues to be distressed.

None of this means that huge private-equity deals -- formerly management buyouts, formerly leveraged buyouts, formerly bootstraps, soon perhaps to be "transformational equity" (a term that you hear bandied about on the buyout circuit) -- are dead. They're just in hibernation.

Buyout firms, which are always in full sales mode, are telling potential investors that this is a great time to commit money to their funds, because investments made in meltdown years and the two following years tend to do exceptionally well. History backs up the idea that investing in a burst-bubble climate is a great way to make money. A Cambridge Associates study shows that investors in funds formed in the years when bubbles popped and the two subsequent years have made returns far superior to those from funds in other years. For example, funds raised in 2001, 2002 and 2003 (after the stock market bubble burst) returned 33 percent, 29 percent and 31 percent, respectively, after fees, the best three years in the 20-year survey.

However, just because post-bubble buyouts have been good in the past doesn't mean they'll be good in the future -- history, after all, isn't destiny. The fact that firms are double-cropping in the debt markets is a departure from the historical pattern. In the past, they kept their powder dry in post-meltdown years and waited for things to improve.

It's going to take a while -- possibly a long while -- to see how all this plays out. For now, you've got to work on the companies you have, do smallish deals and find really creative ways to keep the Gulfstream in fuel until the market turns.

The folks at Clayton, Dubilier & Rice, a low-profile buyout shop that's been around for 30 years, waxed philosophical about this in their year-end letter to investors. "If the wind will not serve," they said, citing an ancient proverb, "take to the oars." In short, get ready for some calluses, buyout boys.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@fortunemail.com. Katie Benner is a reporter for Fortune. Her e-mail iskbenner@fortunemail.com.

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