Will the bubble in private equity blow up? The only real question is when...
AS ANY JOURNALIST not working for FOX will tell you, there are two sides to every story. Take private equity, for instance.
When Bono, the lead singer with U2, became a partner in a private equity firm last year, stock-market bears took it as a sign that private equity was getting bubbly. Many bears, no doubt, had two thoughts:
- "This private equity bubble is getting just like Barbara Streisand day trading stocks at the peak of the internet bubble."
- "Why does Bono look cool wearing sunglasses and I look like a senior citizen after an eye exam?"
Meanwhile, the bulls were thinking, "Bono is into private equity, dude. This market rocks..."
So far, the bulls have been right. The private equity bubble has yet to implode, and along with its cousin, the share buy-back bubble, it has helped take stocks higher. But boy is their help needed!
Everything housing-related continues to crumble in the US; earnings growth of the S&P 500 is largely accounted for by financial dealings, favorable currency translations, and reduced share counts associated with the buybacks. Bears think such things are slim support for new all-time highs, particularly when earnings growth has been unusually strong for so long.
Surely, we bears think, a reversion to the more pedestrian historical earnings growth trend line is coming. And soon.
Bulls do not worry about the buy-out boom (or anything else besides short-term capital gains taxes). They simply enjoy it. Some even embrace it, rationalize it and extrapolate it. One columnist writing for a magazine catering to investment professionals argued that rampant merger and LBO activity signals that stocks are still cheap!
Here's how the storyline goes: Lots of companies are being bought out. Lots of shares are being repurchased. Therefore, by definition, stocks are cheap. Therefore, stocks should keep going up, up, up.
This kind of thinking naturally implies the following:
- Managements who buy back stock rather than pay dividends or spend the cash on capital equipment are using that cash for its highest and best purpose, just as their corporate finance models are telling them. (They are not just buying back stock to boost the price of their stock options, or because they are too worried about future demand to boost capital spending.)
- There are so many leveraged private equity buyouts because there are so many good deals, even at ever increasing prices. (This is wildly different from the bears' sense that it is not stocks that are cheap, but money. Money is not only cheap, but carefully manicured corporate types are lining at the door of every major US corporation trying to lend them lots of it for big, big deals.)
- The LBO mania has nothing to do with private equity firms having to find something to do with the truck loads of money investors are throwing at them. (Bears figure that so many wildly cyclical companies are going private because PE firms are desperate to get the money out from under the sofa cushions and into something.)
As is their nature, bulls are more interested in merger possibilities than in what is making mergers possible. And that catalyst is the bond market's unwillingness to discriminate between what is risky debt and what is not so risky. Meanwhile, bears are getting the eye twitch reading that "Junk is the new black" as Financial Week put it recently.
In other words – or at least in French sounding words – high yield debt is no longer esoteric, it's de rigueur. According to Financial Week, 43% of high-yield bonds issued year-to-date have been rated B- or lower vs. 36% over the same period a year ago. In fact, there is not only little kudos that accompanies an investment-grade rating today; there are actually disincentives to remaining moderately leveraged – including being taken over by a company that has taken on debt by the boatload.
Will this bubble end? Of course it will. Otherwise we would not be referring to the "last LBO boom"; we would be calling it the "eternal LBO boom".
When will it end? Whether or not the Private Equity boom implodes before NASA invents a tasty, synthetic bacon is anyone's guess. But there are signs that the LBO mania is getting toppy.
First of all, interest rates are rising, if anybody cares. In theory, this should make deals less doable, even those being done for the wrong reasons. Bloomberg in a June 11th story reported that at least one Wall Street strategist acknowledged that "Getting deals done in the short term is going to be hard."
The bullish counter argument is that higher economic growth will make it easier to service more expensive debt (even when corporate profit growth is chock full of the suspect contributors mentioned above).
Still, a bear can find plenty of signs that this buyout madness has a downside. Just last week the Wall Street Journal's Gregory Zuckerman and Serena Ng reported on done deals that are running into problems. They cited Linens 'n Things, Freescale Semiconductor and Realogy as newly private companies that are performing below expectations.
While such problems are being dismissed as aberrations, Zuckermand and Ng remind us that debt service ratios of recently bought out companies are the slimmest in 10 years. Today's 1.7x figure is half the 3.4x cushion of 2004.
And last week, the S&P rating agency called for better disclosure on the packages of loans that include the most permissive sort of lending. S&P's worry is that "covenant-lite" loans are being tossed into Collateralized Loan Obligations with too little mention of how lite the entire CLO is.
Cov-lites were created as a way for banks to win more LBO financing business. Here's how a banker might explain cov-lite lending to a private equity manager: "Okay, first we'll loan you lots of money. Then we promise not to hold you to any of our pesky traditional banking standards. That means, we won't know how that company you bought with our money is doing, and whether it will pay us back. And you know what? We don't care! We're selling off the loan so it can be packaged and sold to your mother's pension plan. Yippee!"
This don't-ask-don't-tell way of doing business sounds a lot like the liar loans that mortgage companies rolled out to win the business of shaky consumers. Apparently S&P sees the similarity as it wants CLO managers to tell investors just how much cov-lite stuff is being crammed into each product. And according to the Financial Times, S&P's ratings will begin to reflect the increased risk of cov-lite lending.
While institutional investors may not care about risk, some may care about bond ratings.
A bear might tell you that once investors (and those who oversee them) shine a little light on the CLOs they already own, they'll be more finicky about future purchases, thereby constraining private equity deals.
And what would a bull say?
"Just put on your sunglasses and buy."