Loanly

Picture Scrooge McDuck – if you can remember those Disney cartoons – and see him bathing in his money vault, diving into piles and pools of dollars and other untold riches. Hold that image. Imagine a graduate of a top graduate school of business… a year out from that cap and gown thang… checking out having made $400,000 between salary and bonus in his first year of work. Millions a year were the expectation after a relatively short tenure with the company. Hold that image.

Private equity was a path to riches. These firms, most of them non-publicly-traded and not subject to much government scrutiny, controlled one of the largest investment segments in the United States. Their money came from mega-wealthy investors, big institutions – from legendary insurance giants to the most prestigious financial companies, pension plans and anywhere else pools of capital concentrated.

Their basic business practice was to find companies, private and public, that could be “cleaned up” (unnecessary workers laid off, new management added, a few mergers added if attractive, new financial structuring)… then buy these companies with as little of a down-payment as they could justify and borrow the rest (debt was far and away the largest component of the cost of buying the company – multiples of the equity). Debt was plentiful, cheap, and had a ceiling on the rate of return (interest, basically, but there often was a component of convertibility into common stock for part of that debt), and most of the profits stuck to the private equity managers and their investors.

But what was best about that debt? The private equity film didn’t borrow a penny! Instead, they used the cash flow of the company they were buying to borrow that money, pledge its assets, and sink or swim with all that debt. The private equity firm that set up the deal was only minimally at risk (their down-payment). So a small investment leveraged up into a very large buying ability.

After the company was “cleaned up,” it could then be sold to another corporation or, very often, flipped back out as a publicly traded corporation. The rates of return on these deals were astronomical, all predicated on lots of cheap debt and a rising stock market. From about 2003 well into 2007, these companies particularly raked in the profits. But when debt dried up and the markets crashed in 2008, so many of those over-borrowed (“over-leveraged”) acquired companies slid way down in value (often eating up most if not all of the private equity company’s down-payment), and without cheap debt (how about any new debt?), new deals could not be financed anyway. Not to mention that without a strong stock market, you can’t get rid of a “cleaned up” company to make that profit.

But there’s still a lot of money sitting around with nothing to do, nowhere to go. According to the June 9^th theDeal.com: “Buyout firms now command some $470 billion in committed but uninvested capital, according to consulting firm McKinsey & Co. Moreover, sponsors usually only dream about this sort of investment environment, with countless companies begging for capital, banks and other capital suppliers on the sidelines, and deal values way down. Prices have tumbled so steeply, one sponsor remarks, that even debt-free investments done today could bring sterling returns after the economy turns back up.” If anyone would lend you money…

For all those MBA candidates vying for those lucrative jobs in private equity, the opportunities have, for the most part, vaporized. We are unlikely to see, in the lifetimes of most of us, the ability to borrow so much (relative to the down-payment) so cheaply every again. Regulators are eying this market sector in order to assess exactly where new regulations will be imposed. Scrooge McDuck-wannabees will be frustrated.

And in a chorus of dropping shoes, there are victims among these firms, yet to be counted. theDeal.com again: “But for now, that alluring prospect is vying for sponsors' attention with a worrisome, brewing development that could lay waste private equity returns and foster an industry shakeout. Though previous downturns have forced slews of poor performers, including some well-known names, from the business, the body count this time could be great. The problem lies in the staggering amounts of equity and debt capital that poured into LBOs from 2004 to 2007. From 2012 to 2014, about $430 billion of senior debt tied to that deal spree is set to come due. And unless the leveraged loan market roars back to life by then to accommodate a mass of refinancings -- something experts consider doubtful -- an avalanche of defaults could wipe out much of the equity the buyout industry wagered on scores of deals.”

Just remember that bankrupt companies like Linen ‘n Things, Tribune Co. and Chrysler were all financed this way. And that’s just a drop in the bucket.

I’m Peter Dekom, and I thought that you might like to know.