We open the papers this morning and find the same two-headed dragon we have been watching for so many, many months.
One head proudly announces that not only is everything doing well – it is doing better than ever in history. The Dow hit a new record yesterday. The funds are flush with cash. Takeovers…Mergers and Acquisitions…new IPOs…are all headline news. Rupert Murdoch is bidding for Dow Jones; Microsoft (NASDAQ: MSFT) is working on a major purchase. Money…money…money! Deals…deals…deals…!
“It is glorious to get rich”, as Deng Tsaio Ping put it. And many people, all over the world, think they are bound for glory.
Meanwhile, the other head hangs down in despair. “Actual underlying conditions of the world economy continue to deteriorate,” it mumbles.
Larry Fink, CEO of BlackRock (NYSE: BLK), a trillion-dollar fund management company, spoke out last week and said that all these mergers and acquisitions were going to cause ‘tomorrow’s problems.’ Why? Because they are all funded with debt. And lending standards for big, commercial deals have gone the same way as the lending standards for people buying trailers.
“Standards have deteriorated to a level that we never even dreamed we would see,” said Fink.
Almost on the very same day, the Bank of England said almost the same thing. Loose credit standards have, “increased the vulnerability of the [global financial] system.”
The Boston Globe helpfully provides more detail:
“Private equity firms are raising gigantic new funds, which in turn are buying companies on an unprecedented scale. The targets are bigger than ever, and the deals are gushing at fire-hose volume. But that isn’t just a function of all the billions raised from limited partner investors. Borrowed money is the real fuel driving an overheated market.
“I think of this as a debt bubble, not a private equity bubble,” says Kevin Landry, chief executive of the Boston private equity firm, TA Associates.
“Debt markets that finance private equity transactions have changed in three important ways. They are charging lower interest rates, reducing the premium normally charged for greater risk. They are lending more money for the purchase of an operating company, exceeding normal caps based on the cash generated by the acquired business. Finally, debt markets are reducing or virtually eliminating covenants and other rules that now make it almost impossible for private equity investors to default on loans used to buy companies.
“Got that? Low rates, more leverage, practically no conditions. How do you think that story is going to end?
“‘The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately,’ says Scott Sperling, co-president of Thomas H. Lee Partners, the big Boston private equity firm. ‘It’s hard to put these companies into default. I can’t think of the last time we had a real covenant in one of our deals.'”
In the financial deal business, it is still like the middle of the property boom, when householders practically couldn’t default, because lenders wouldn’t let them. As soon as they got into trouble, the lenders would give them more money.
Landry explained that in a deal his company made recently, he didn’t even have to make the scheduled payments. If he ran into trouble he could pay a ‘toggle payment,’ or ‘payment in kind,’ essentially borrowing more to make the regularly scheduled loan payment.
“‘How do you default?’ asks Landry. ‘You used to say, “Can I pay down enough of this debt so if a recession hits I can get through it?” Now it doesn’t matter even if a recession hits next week.’
“Investors stretching for yield are making all kinds of markets do strange things. Look at the subprime mortgage market to see how that practice can end badly. Private equity’s debt bubble could become another story with a very ugly ending.”
The bubble in subprime lending ended when the value of its collateral – housing – stopped rising in price. (But the property bust is nowhere near over – and subprime is the ticking time bomb under Wall Street.
The bubble in private equity financing will pop too when its collateral – ultimately, the stock market – ceases to go up.
Then, over-stretched lenders will go broke. A few high-profile hustlers, prosecuted for financial hanky-panky, will go to jail. And, like soldiers tripping over the bodies of their dead comrades, the survivors will have to find some other route to glory.
Markets and Money