The “Credit Barometer” Shows Heavy Storms Ahead

The private equity industry is under serious pressure right now.

With the Super Crash on the way, financial stocks are taking a beating – particularly private equity stocks like Apollo (APO), Ares (ARES), KKR (KKR), Blackstone (BX), Carlyle (CG), and Fortress (FIG). The thing all of these companies have in common is heavy exposure to the high debt levels that built up since the financial crisis. The market is telling us that it is very worried that the Debt Supercycle is over and that a lot of this debt isn’t going to be paid back.

But the private equity meltdown also pinpoints something very important.

It tells you the exact stage this credit cycle has reached – if you know where to look.

Private equity firms serve as a startlingly accurate credit barometer. The less productive their behavior, the more likely the cycle is reaching its late stages.

When credit is mispriced, the credit cycle is far advanced, and debt investors should be running in the other direction from bond and loan offerings involving private equity‐owned borrowers….because private equity firms are doing two destructive things.

And that’s what we saw up until the end of 2014 when the music in the credit markets stopped.

Here’s what to watch for…

The “Dividend Deal” Means Big Losses for Lenders

The first “private equity indicator” I watch for is an increase in the frequency of “dividend deals.”

Also known as a “dividend recapitalization,” this infamous transaction involves a private equity‐owned firm borrowing money to pay a dividend distribution to its owners. We’ve seen this behavior all over the news lately – KKR-backed GenesisCare seeking $285m in loans, American Tire Distributors acquiring $805m in junk bonds to pay dividends to TPG Capital, JCrew borrowing $500 million to cash out its shareholders, and Vogue International LLC borrowing over $200 million to pay a shareholders’ dividend to The Carlyle Group.

The debt raised in these transactions is not used to enhance the business of the borrower in any way, for example, by building additional facilities, funding research and development, creating new products, or hiring new workers. The money insteadis paid out to the private equity sponsor in order to reduce the capital it originally invested in the business.  It saddles companies with more debt while reducing or eliminating any skin that the private equity firm has in the game – leaving bondholders holding the bag.

This practice is contrary to the raison d’être of private equity, which is supposed to be based on overcoming the conflicts of interest that arise when the owners and management of the company have only a small ownership stake in the enterprise. While the private equity firm generally maintains a significant ownership position after a dividend transaction, the amount of money it has at risk in the business is significantly reduced if not eliminated.

Dividend transactions are particularly noxious to the health of lenders, who are left lending money to a company whose owners are in possession of a free “call option” on any appreciation in the value of the business but are also in a position to walk away without losing money if the business begins to falter under the weight of its new debt. The only potential limitation on these dividend deals is the law governing fraudulent transfers (i.e. bankruptcy laws that prohibit transactions that defraud creditors), but these are relatively easily avoided.

Many companies that paid dividends to their private equity sponsors over the years subsequently went bankrupt, leaving their lenders with large losses and their private equity sponsors feeling no pain.

Without fail, these unproductive transactions start increasing in frequency and size when the credit cycle is reaching its breaking point.

You’ll also see another telltale sign of excess at the end of credit cycles: more “asset shuffling” deals between private equity firms.

Don’t Buy Used – Always Buy New

This second practice that indicates that the credit cycle is entering its terminal stages is the phenomenon of private equity‐owned companies being sold by one buyout firm to another, which I call “passing the hot potato.”

This has been happening at a dizzying pace lately – if you’ve been tracking our failing private equity firms, you’ve seen Ares Management buying CHG Healthcare Services from J.W. Childs Associates and snapping up Farrow & Ball from European Capital Limited; KKR selling off TASC Inc. to Engility Holdings; Blackstone and TPG teaming up to buy Kensington Group from Investec; and Blackstone selling GCA Services to Goldman Sachs Group Inc’s private equity arm and Thomas H.Lee Partners LP.

Some firms, like Simmons Company (the mattress manufacturer) or General Nutrition Companies, have been sold numerous times between buyout firms. Simmons Company, in fact, is a company that fell into bankruptcy after paying a large dividend to one of its private equity owners during the course of being bought and sold seven different times by buyout firms over a period of two decades.

These are, of course, not “real” transactions in any sense of the word – they are cooked up for the benefit of the participating private equity firms.

One of the purposes of a leveraged buyout is supposed to be to wring efficiencies out of a business that was previously publicly held. Accordingly, there is little rationale for a private equity firm purchasing a company that was already retooled by another private equity firm (or several) since there should theoretically be few efficiencies left to capture.

The real reason such deals are done, of course, is to generate fees for private equity firms. The selling firm is able to generate a “realization event” that triggers a “transaction” fee and allows it to return capital to investors, while the buying firm is able to pay itself a transaction fee on the purchase. The wonder is that lenders continue to finance such transactions, which are done at higher and higher multiples of cash flow and contribute little to economic growth.

The question investors and lenders should be asking when they see such deals is why no strategic buyer is interested in buying these companies at a higher price than another private equity firm.

And the answer to that question is the reason why investors should avoid lending to these companies and asking private equity firms why they can’t find something better to buy than somebody else’s used merchandise.

Private equity firms have mastered the art of enriching themselves at the expense of virtually everybody else with whom they come into contact in the economy. The primary economic act that a leveraged buyout or leveraged recapitalization (which is really just a partial leveraged buyout) accomplishes is to substitute debt for equity on a company’s balance sheet. It rarely creates new products. It rarely builds new plants. It rarely funds new research and development. And it rarely leads to the creation of new jobs or new industries. Every aspect of corporate existence is sublimated to the need to service the company’s debt.

And when you see this happening with a greater and greater frequency – as we do now – it is a signal that we are reaching saturation point and the credit cycle is coming to an end.

The Super Crash is coming. Stay safe.

Sincerely,

Michael-Lewitt_sig

Michael Lewitt

15 Responses to “The “Credit Barometer” Shows Heavy Storms Ahead”

  1. Hi Michael,
    thanks for sharing your post and analysis. I appreciate it.
    I bought ETC physical gold several weeks ago while waiting for the next down-leg.
    Based on the recent market reaction to Bank of Japan negative rate decision, it seems that central banks credibility are at all-time lows..

  2. Malcolm Jensen

    Why does a lender participate in a “dividend deal?” With the reduction of elimination of the skin in the game of the private equity organization and the pending substantial reduction in strength of the company serving as collateral, how can a responsible lender put up the money?

  3. I certainly agree upon Mr Lewitt arguments but I don’t feel comfortable with the “end of the credit cycle” argument. They can extend it for ever and ever if they want. And I have the impression that it’s exactly what they are doing.

  4. The ultimate sham is the dividend transaction, whereby the company borrows money to pay out a dividend to their “owner”, instead of paying out of earnings and profits. This “owner” gets a fee on the front end for creating the deal, collects payments while they own the asset, and then gets a final payment just before the Chapter 11 filing.

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