The Great Deformation

by David Stockman

  The latter were called CLOs, for collateralized loan obligations, and were another wonder of bubble finance emanating from the same financial meth labs that produced mortgage-based CDOs. In this instance, however, Wall Street dealers sold debt to yield-hungry Main Street investors that had been issued by what amounts to financial “storefronts.” These shell companies were stuffed with LBO junk loans rather than subprime mortgages.

  The daisy chain of financial engineering was thus extended one more notch: leveraged buyouts were now financed from the proceeds of bank debt which, in turn, was funded with the proceeds of CLO debt. Nor was that the end of the leverage chain. Not infrequently, these CLO “storefronts” also employed leverage to enhance their own returns. Thus did the true equity in the system retreat ever deeper into the financial shadows.

  By the top of the cycle in 2006–2007, the CLO market of debt upon debt upon debt was expanding at a $100 billion annual rate, compared to less than $5 billion at the prior peak seven years earlier. In its headlong pursuit of asset inflation, therefore, the Fed was spring-loading the financial system with a fantastic coil of debt.

  As it happened, however, the miniscule 2007 default rate for junk loans was no more sustainable than had been the initially low default rates for subprime mortgages. By 2009 defaults were actually back above 10 percent, signaling the third junk market crash since 1990.

  Accordingly, investors and traders fled the leveraged loan markets even faster than they had stormed into them. Junk debt issuance plunged by 85 percent from peak levels. The CLO market disappeared entirely.

  This cliff-diving denouement should have come as no surprise. Near the end of the boom, many issuers were simply borrowing to pay debt service and few had sufficient excess cash flow to withstand a sharp economic downturn. The massive coil of LBO debt fostered by the Fed’s financial repression policies had thus been an accident waiting to happen.

  Yet the leveraged finance boom went on right until the eve of the 2008 Wall Street meltdown because risk asset markets had been sedated by the myth of the Great Moderation. If the Fed had indeed abolished the risk of steep and unexpected business cycle downturns, as Bernanke claimed, the corollary was that deal makers were free to push leverage ratios to new extremes. This was a matter of spreadsheet math: the banishment of recessions obviously meant that the cash flows of leveraged business wouldn’t plunge in a downturn.

  It also meant that the junk bond interest rate spread over risk-free treasuries would stay narrow, owing to reduced expectation of recession-induced defaults. So the junk market’s read on the Great Moderation was that it meant a floor under cash flow and a cap on default risk. Better still, since many junk bonds now had the “toggle” feature, they couldn’t default; they could just add the coupon to what they owed.

  If defaults were thus minimized or eliminated, the hefty yield on junk bonds would be pure gravy. Not surprisingly, the leveraged loan market became fearless, happily assuming that the Fed had infinite capacity to prop up the economy and peg the price of risk. Nearly two-thirds of all the junk bonds issued in 2007 were of the so-called covenant lite variety, and that was another canary in the coal mine.

  The purpose of covenants is to trap an LBO’s cash flows inside a company’s balance sheet for the benefit of the bondholders. So when these protections were permitted to fall away, it meant that high-yield investors were no longer looking to the borrower’s cash to keep themselves whole. Instead, they assumed that borrowers who didn’t have the cash to redeem their debts at maturity would simply refinance; that is, investors would get their money back not from original issuers but from the next punter in the Ponzi.

  Likewise, purchase prices for larger LBOs soared to more than 10X cash flow, compared to 6.5X when Mr. Market was endeavoring to heal the excesses of the previous leveraged finance bubble back in 2001–2002. Indeed, the light was flashing green for issuance of every manner of risky credit. These included second-lien loans, which effectively meant hocking an LBO company’s receivables and inventory twice.

  THE CORNUCOPIA OF PRIVATE EQUITY: EXIT AND RELOAD

  Owing to this outpouring of leveraged finance, all of the deal markets were on fire during 2005–2007, thereby instigating a fantastic feedback loop. Owing to the debt-fueled explosion of buyouts, buybacks, and M&A takeovers, the S&P 500 was levitated to an all-time high north of 1,500. In turn, the booming stock market facilitated a surge in so-called “exit” transactions by sponsors of existing private equity deals through IPOs or M&A auction sales. In turn, these “exit” transactions, along with dividend recaps, permitted sponsors to return huge amounts of cash to their institutional investors such as pension funds and insurance companies.

  Not surprisingly, these large distributions to investors helped reignite the cycle all over again. Whereas only $30 billion of new private equity commitments were made by institutional investors in 2003, this number went on a tear, rising to $160 billion in 2005, followed by $200 billion in 2006 and nearly $300 billion in 2007. The latter single-year total was so astonishingly large that it exceeded all of the private equity ever raised from the time of the first famous private equity deal, the Gibson Greetings home run in 1983 through the end of 1999.

  It is well-nigh impossible to exaggerate the speculative firepower implicit in this tenfold escalation of annual new commitments. The $1 trillion of new private equity money during 2004–2008 was off the charts by orders of magnitude, but it was just the high-powered apex of the leveraged-deal pyramid. At the going rate, LBO balance sheets required a 20–30 percent equity contribution, meaning that the $1 trillion of new private equity could fund $3–$5 trillion of leveraged buyouts and recapitalizations. No more powerful stimulant to the speculative mania already rampant in the deal markets could have been imagined.

  It would have been virtually impossible to put this much money to work in the $200–$400 million sized “middle market” deals prevalent during the first two decades of LBO history. Consequently, the era of the mega-LBO was born, but the resulting $10–$50 billion scale deals had faint resemblance to the entrepreneurial management model which had been the original rationale for leveraged buyouts.

  THE $300 BILLION CARRIED INTEREST JACKPOT AND THE RISE OF MONSTER LBOS

  These mega-LBOs were simply opportunistic exercises in leveraged speculation. They arose because private equity sponsors were not about to allow their immense new inventory of committed capital to sit idle. The economics of private equity investing were too compelling.

  Over a five-year holding period, for example, this $1 trillion of new capital implied private equity fund profits of $1.5 trillion, assuming an industry minimum 20 percent annual rate of return. In turn, the 20 percent “carried interest” share of profits allocable to general partners who ran private equity firms would have been worth $300 billion. It goes without saying that a jackpot of that magnitude, even if only theoretical, presented what were truly stupefying incentives for deal making.

  The fact of the matter was that 80 percent of these massive new private equity commitments were attributable to a few dozen major LBO firms. The implicit $300 billion carried interest jackpot, therefore, would have been realized by a few dozen senior partners and a few hundred principals overall. Never before in history had a central bank deformation of financial markets delivered such massive opportunities for speculative gain to so few.

  Rather than a dot-com bubble, the deformation this time was a runaway string of supersized leveraged buyouts. Even a cursory review of the facts establishes that these massive transactions had no rational purpose except to strip-mine cash from the business sector and recycle it to the hedge funds and private equity firms which had come to occupy the center of the nation’s financialized economy.

  STRIPPING THE YELLOW PAGES: HOW CEW HAPPENED

  The order-of-magnitude increase in deal size that materialized in the leveraged buyout market was kicked off in 2003 by the $7.5 billion Dex Media transaction. Since the company had only $1.6 billion of
revenue and its yellow pages were a dying business in the Internet age, the deal price of nearly 5X revenues was truly astonishing.

  It was also a forewarning of the speculative mania to come. Within just a few months of the deal, its private equity sponsors led by the Carlyle Group took out a $1 billion dividend by piling more debt on the $6 billion from the initial transaction. Yet, in a world the Fed favored with 1 percent interest rates and a renewed policy of stock market levitation, this growing mound of debt made no waves at all.

  In fact, during mid-2004 Dex Media was taken public at a value of about $3 billion for the equity on top of the LBO debt which remained at its original level. So on an apples-to-apples basis, the IPO was valued at approximately twice the $1.5 billion equity investment that its private equity owners had made only fifteen months earlier.

  This saga of quick riches only got better, rapidly. As the Greenspan bubble gathered momentum in 2005, the Washington insiders who ran the Carlyle Group might have sent the maestro a case of champagne. In October of that year, they sold Dex Media to another yellow pages publisher, the venerable R.H. Donnelley & Sons, for $4.3 billion plus the assumption of all the LBO and dividend debt.

  So the whole investment life cycle consumed only about forty months, but the rounds of debt upon debt were stunning. There was a huge $6 billion debt issuance at the time of the LBO; another large debt issuance to fund the quickie dividend; and then an M&A takeout by a heavily leveraged company that for all practical purposes was a publicly traded LBO. The post-merger company, in fact, had about $11 billion of debt.

  A cascade of debt thus built up inside the company and its successor. In the meantime, the private equity sponsors were favored with a CEW extraction of startling magnitude. During their brief interval in the yellow pages business they pocketed more than $5 billion from the dividend and the sale of their Donnelley shares shortly after the merger.

  That amounted to 3.3X their original investment for adding no detectable value. On an organic basis, the sales and EBITDA of these scattered yellow pages operations continued to decline, meaning there is little evidence that the Carlyle Group and its other private equity sponsors did much (or could have) to put Dex Media’s three-hundred-odd local phone directories on a life extension program.

  What is indisputable, however, is that Washington reduced the tax on capital gains and dividends to a historic low of 15 percent at the beginning of their holding period. Carlyle and its other investors were thereby enabled to harvest their multibillion-dollar windfall essentially tax free.

  This private equity windfall bore another distinctive hallmark of the speculative tide then cresting; namely, that the deal amounted to a fraudulent conveyance in economic terms, if not as a legal matter. Indeed, the underlying business reality was that the deal from which Carlyle extracted the preponderant share of its cash winnings, the ultra-leveraged merger with R.H. Donnelley, had been destined for a crash landing from the start.

  On a post-merger basis, Dex Media and Donnelley combined had $2.8 billion of revenue and $1.1 billion of operating income compared to a debt load in excess of $11 billion. Even the proverbial “cash cow” type business on which LBOs had originally been predicated would have been hard pressed to sustain an 11 to 1 leverage ratio across an entire business cycle.

  In fact, by January 2006 when the merger was completed, the yellow pages already had the aspect of a milk cow heading for the great pasture beyond. Their revenues and cash flow were being inexorably Googled away.

  Worse still, there wasn’t much magical merger “synergy” to exploit because Dex Media was twice the size of Donnelley, and its LBO sponsors had already picked its cost structure to the bone. Accordingly, pro forma operating margins were already at 40 percent and there was little evidence elsewhere in the industry that they could be pushed much higher.

  At length, nearly every single yellow pages publisher has stumbled into bankruptcy after years of bravely insisting it could make the transition from cellulose to silicon. R.H. Donnelley suffered the same fate, but it was symptomatic of the 2005–2008 financial mania that lenders had ever believed otherwise.

  This thoroughgoing suspension of disbelief contrasted sharply with the LBO business only a decade earlier, when annual LBO volume for the entire industry had been less than R.H. Donnelley’s debt. In these more sober times, my colleagues at Blackstone had considered any traditional business being stalked by the Internet as strictly off limits. These businesses were not only seen as the equivalent of a dead man walking, but they had also been avoided for another reason: Alan Greenspan had not yet thrown in the towel on irrational exuberance and mainstream investors did not yet assume that the Fed had abolished the business cycle.

  In short, a sunset industry was no place to become trapped with a boatload of debt. Yet that is exactly where the yellow pages business stood after the turn of the century. That it was a dying industry was no state secret, but investors now assumed that the risk of any business cycle downside was in the nature of a rounding error. Owing to the Great Moderation, therefore, five- and ten-year loans would get repaid before the yellow pages ran out of cash.

  Accordingly, R.H. Donnelley’s $11 billion of debt traded at par, and its stock price climbed by 25 percent within a year or so of the merger. Since it had pioneered the directory business more than a hundred years earlier, speculators in both its debt and equity apparently assumed that Donnelley possessed a secret sauce. But it had none—only the dubious franchise right to sell ads in a shrinking phone book.

  What it also had was a book of sales which depended upon the continued willingness and ability of car dealers, bowling alleys, and about 600,000 other mostly small businesses to buy advertising. On those facts alone, R.H. Donnelley’s days were numbered.

  The roaring bull market paid no note. It priced the company’s pro forma earnings of $2.25 per share at $78, meaning that a far-flung set of three hundred local phone books which experienced no organic revenue growth for five years were being valued at 35X net income. This was the “audacity of hope” before the term was invented and before the Fed’s bubble economy finally buckled.

  In the event, the severe slump in yellow pages advertising by Main Street businesses during the recession caused the company’s cash flow to plummet. The resulting balance sheet kill was quick and clean: when Donnelly filed a prepackaged bankruptcy plan in June 2009, its market cap of $5 billion had vaporized and it was forced to write off $6 billion of its debt.

  In the course of four years of leveraged deal making, therefore, Dex Media–Donnelley had mounted $11 billion of enterprise value which proved to be entirely phantom-like when the equity vanished and the bonds were cut in half. In the interim, private equity operators and those stock market punters who got out before Donnelley’s share price plunged extracted more than $6 billion in windfall gains. Here was the mark of CEW. These dying yellow pages never would have been leveraged at all on the free market.

  THEN CAME THE DELUGE: THIRTY GIANT LBOS

  The Dex Media–R.H. Donnelley saga was not an outlier, but a prototype for the string of giant LBOs and the fantastically leveraged deal making at the heart of the second Greenspan bubble. In fact, it was these huge debt-financed deals which drove the stock market and other risk assets skyward during the final phases of the mania.

  The mountains of the debt piled upon target companies during the mega-LBO mania could never be sustained in the fragile, credit-addicted economy that the Fed spawned. So the entire mega-LBO boom was the equivalent of a state-assisted fraudulent conveyance. Hundreds of billions of CEW was extracted from the balance sheets of the target businesses and transferred to speculators on the top rungs of the economic ladder. But it was financed with so much debt that most of these deals were candidates for eventual insolvency under any realistic long-term economic scenario.

  For that reason, virtually none of these mega-LBO deals, as detailed more fully in chapter 25, would have passed muster on the free market. They were the spoils fr
om the central bank’s drastic repression of honest market-clearing prices for debt and risk.

  The sheer magnitude and speed of this supersized buyout wave is difficult to exaggerate. But we can see its importance through a string of thirty giant LBOs occurring from early 2005 through the spring of 2008. Each was seemingly larger than the previous one but most shared a common fate: they ended up teetering on bankruptcy, undergoing voluntary restructuring, or limping along as financial zombies which labor to this very day under an unshakeable load of debt.

  The largest was nearly $50 billion and the average size was $17 billion. This average size for two and one-half dozen LBOs was remarkable because with the exception of the 1989 RJR-Nabisco deal there had never been a single leverage buyout that large. Furthermore, the aggregate value of these deals was a staggering $500 billion, meaning that nearly half of the $1.1 trillion of LBOs completed during this period was accounted for by just these thirty giant deals.

  Two data points vivify the enormous financial shuffle embodied in these mega-LBOs. First, approximately $115 billion in new money was invested by the private equity sponsors, representing about a 25 percent equity ratio in the deals. At the same time, existing shareholders were paid out the staggering sum of $375 billion in cash at the deal closings. That was CEW on steroids. Most of the cash circulated back through the Wall Street–hedge fund complex looking for the next upside speculation.

  Secondly, to finance this enormous CEW extraction the balance sheets of these thirty mega-LBOs were freighted down with $375 billion in debt, an amount nearly four times the debt they carried prior to the buyouts. As shown below, however, most of these companies were decidedly not good LBO candidates, and almost all the deals drastically overvalued future cash flows.

  As a consequence, after five to seven years virtually none of this debt has been paid down in the manner of the classic LBO model. Nearly half of the thirty companies have entered bankruptcy or voluntary restructuring. Most of the remainder are financial zombies which have managed to use the Fed’s third financial bubble during 2009–2012 to delay their debt maturities through “extend and pretend” refinancings.