Archive for the ‘Private Equity’ category

Contrarian View: Goldman

September 17, 2008

Goldman could be screwed? Surely I jest. Well, I would suggest that if Goldman thinks it can survive, it could wind up being the next firm to refuse to sell at the levels being offered. Also, who is left to acquire Goldman? Clearly a second-tier of potential acquirers with big balance sheets. Maybe private equity? HA! Imagine P.E. firms swooping in to take Goldman private. Amazing irony… Perhaps a sovereign wealth fund will swoop in.

Interesting thought: Could Goldman Sachs Capital Partners take Goldman Sachs private? Goldman Sachs has a market cap of about $45 billion right now… probably not, but with some trickery, who knows? A few more days like today, and the answer will be yes!

On Recent Stories: Something for Everyone

August 27, 2008

I haven’t had the opportunity, in a long time, to cobble together some real thoughts. However, here are a few quick takes on what is going on recently…

1. Citi continues to shuffle deck chairs. Now, I don’t know what they could be doing right now to fix their situation. The problem they are facing is that they need to control costs in an environment rife with morale problems. As one commenter on Dealbook pointed out, I don’t know who believes that Jamie Forese is asking a subordinate to become his equal–indeed that’s probably not even within his power to do. I also don’t know why there is such a massive use of management consultants–in a large bank with an everything-needs-signoff-from-the-C.E.O. culture it’s hard to imagine someone who runs a department of 200 people can go out and hire McKinsey … Those managers can’t even upgrade their own travel arrangements to first or business class! Anyway, the real issue with these measures is that the worst abusers are powerful and find their way around these policies and senior management’s time is better spent doing other things than approving new computers and offsite meetings.

IRONY ALERT: As I was writing this post, I saw this item from Research Recap:

McKinsey sees considerable scope for investment banks to cut their noncompensation costs – possibly up to $2 billion in recurring savings.

McKinsey said its experience indicates that data, printing, supplies, delivery and professional services usually yield the fastest results; restructuring real estate and IT spending may take longer but generate much larger savings.

McKinsey said its analysis suggests that “executives can embark on this additional belt tightening without harming a bank’s culture and morale.”

Of course, morale at most investment banks is already so low that a further whack at expenses is unlikely to make it any worse.

(emphasis mine.)

Honestly, you can’t make this stuff up…

2. Lehman is approaching a deal to sell a stake in it’s asset management unit,  Neuberger Berman, to a private equity firm. This is a good start for a relationship, of the kind I have already opined on, between Lehman and a business that should be looking for disintermediation. I would, if I were Mr. Fuld, look to sell a stake in the asset management unit, get an equity investment in Lehman itself, and form a permanent J.V. with whatever top-shelf private equity firm will be winning the auction. Maybe Lehman can try cross-selling … “Mr. Kravis, I see you own a part of our asset management division, can I interest you in some cheap real estate debt? With gas prices so high who couldn’t use some hard assets?” Feel free to fo read my prior post–I go into a lot more detail there about the nuances of what the structure, in an ideal world, should look like.

3. Fannie and Freddie are falling … in slow motion! I have no idea, none at all, why the failing and bailout of Fannie and Freddie are both taking so long. Guess what? If Fannie and Freddie are woefully undercapitalized now then what’s the catalyst for things to get better? There is none. This whole situation doesn’t make sense. Are they waiting for the G.S.E.’s to be insolvent? We already know they are leveraged instutions completely concentrated in markets that are dead, dying, or woefully sick. I guess I don’t understand the rationale for waiting to take action… From the WSJ:

The Treasury probably doesn’t need to make a decision imminently unless the companies lose their ability to tap debt markets at reasonable costs, said Joshua Rosner, a managing director at research firm Graham Fisher & Co.

If the Treasury is forced to inject capital into Fannie and Freddie, though, that is likely to be part of a restructuring that would likely wipe out the value of previously issued common and preferred shares and lower the value of subordinated debt.

[Obligatory paragraph about what the stock did today.] …

Fannie increased its holdings of “liquid” investments, cash and short-term securities that can easily be sold, to $103.6 billion, up 43% from June. The move gives the company more flexibility to reduce its future borrowings if market conditions worsen, company officials said.

(emphasis mine.)

In what world is $100+ billion of anything easily sold? Simply stupid. Especially with the Fed pressuring the Treasury Department to ease up on wiping out certain equity holder because of the destruction wiping out parts of the G.S.E.’s capital structure would cause. Have any of these people ever seen markets function in the face of uncertainty? Oh, right … the last year or so. Well, at least that’s going well…

4. The next big problem is here: distressed companies. People expect that this will be the next set of losses and economic distress. Corporates have been fairly resilient, as a sector, to this economic downturn. Part of this is the lag that corporates have from the time consumers start tightening the purse strings to the time that effect is seen on the bottom line. Nothing else to say, really, the numbers are all moving in the same direction.

5. Random Assortment of other things…

A. Remember the rating agencies? Well, now one is going to sell you something that will tell you how much you’re going to lose on the C.D.O. paper you bought because they said was safer than it actually was after using their flawed ratings methodology… Apparently the part of their suite that worked was the part that picked out the downgrade candidates.

B. In a slight nod to my political views, there is finally hard data that we, as a society, have a vested interest in investing in those amongst us that have the least.

Merrill Cleanses Itself, We Think

July 29, 2008

Well, there was an announcement from Merrill about some things:

  1. Selling CDO Assets
  2. Settling monoline issues
  3. Selling equity

Now, while all these are important, #2 is better covered elsewhere as I think reliance on insurers was stupid to begin with and #3 is what it is… best left for analyst reports for nuance, but very generally obvious. Let’s go to the release…

Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.

… [The] sale will reduce Merrill Lynchs aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral 2005 and earlier. The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure…

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction. The transaction is expected to close within 60 days.

(emphasis mine).

Now, this is (via the WSJ via naked capitalism) 22 cents on the dollar. Wow! But, to be honest, this is sticker shock that comes from the massive liquidity being used here. The bid someone shows you on $30 billion versus $30 million is a very different proposition. This sounds like advice I gave before (see item #1 on that post). Now, what questions should the analysts be asking? Note the bold, italicized, underlined parts above. Seems as if the purchaser will be an entity, most likely formed for this transaction, that will only need 25% of the $6.7 billion, or $1.675 billion. Now, since the other 75% is financed, what happens if losses start flowing to these CDOs? The amount of equity decreases. From the Journal …

Many CDOs held by Merrill were viewed as highly likely to default and lose some or most of their principal value. Of around 30 CDOs totaling $32 billion that Merrill underwrote in 2007, 27 have seen their top triple-A ratings downgraded to “junk,” according to data compiled by Janet Tavakoli, a structured-finance consultant in Chicago. Their performance has been “dreadful,” she says.

(emphasis mine).

So now Merrill is in a race. Up to 78% of notional value can be written down, now, with no one taking a loss. Then the next $1.675 billion falls to Lone Star’s equity, and then the rest come out of capital Merrill has put up for the benefit of Lone Star. With the above downgrade statistics such losses aren’t completely out of the question. With this in mind, I would want to know the financing terms. The devil is in the details. Such financings could require only some margin up front in addition to the 25% equity, or none at all. The financing terms could limit Merrill’s ability to claw back more capital as the assets see further writedowns. In general, these terms could mean the risk is only cushioned, not removed. I’m sure these questions will be asked, and that Merrill anticipated such questions. This makes me think that these issues lead to the depressed price–price was the one protection potentially preventing Lone Star from having to have to cough up more money (you can’t owe money if the assets are performing better than their price implies). However, if these terms aren’t very favorable (Merrill was trying to get rid of these assets, after all) one might not ever see the financing terms. It’s also possible that Merrill retains some equity upside in these assets. I guess we’ll wait and see…

More Bear! (Part One)

May 28, 2008

Well, today begins the three part story of Bear Stearns, as told by the WSJ. Deal Journal has a great summary post … A few thoughts:

1. It struck me that Bear wasn’t able to see the forst through the trees when it came to it’s strategy, specifically demonstrated with the “Chaos” trade. When one thinks about how these sorts of things can play out, especially in unprecedented times, how the decision to unwind these trades came about makes perfect sense. Someone puts on a unique trade and management asks them to justify it. Well, there’s a slide with four or five bullet points explaining why this trade should work (mostly qualitative/anecdotal). Also, there there’s a chart presented that shows a pretty bad history for the trade if it had been put on in the past. Indeed we can examine Mr. Schwartz’s history with the trade to see this:

For some of the assets, the market was frozen, Mr. Schwartz reasoned, so selling was out of the question. On others, he had mixed feelings. He didn’t want to unload tens of billions of dollars worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.

The [hedge, called "the Chaos trade"] was a deeply pessimistic bet — essentially a method for making money if the mortgage and financial markets cratered. The traders bet that the ABX, a family of indexes made up of securities backed by subprime mortgages, would fall. They made similar moves on indexes tracking securities backed by commercial mortgages. Finally, they placed a series of bets that the stocks of major financial companies with exposure to mortgages … would decrease in value as well.

Faced with the fierce divide among his top executives, Mr. Schwartz, who was generally supportive of the chaos trade, decided to abandon it. He wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed. Frustrated, Mr. Marano ordered the trades undone.

(emphasis mine).

Now, everything until the last part follows naturally. The last part (matching your hedges to your positions one-to-one) is fine, until you realize that it’s impossible to do this in a liquidity-challenged market. Also, with a massive re-pricing of risk, due to liquidity constraints, one should take a broader view. The CDO market drove demand in securitized products generally and mortgages specifically. Inventories in loans and bonds were sitting on firm’s balance sheets while credit concerns were coming to fruition. So, firms can’t sell risky products, which are losing value from a fundamental re-pricing, and, also, the lack of buying (overall liquidity) is causing a further, more broad technical re-pricing. That is the subtle point from above–why bet on “financial markets cratering” if you own mortgages and call that a hedge? Well, given the widespread ownership of these products, their credit impairment caused widespread credit concerns. With credit worthiness in doubt, liquidity became scarce. Scarce liquidity means less available money to buy these products, and leads to a technical problem with markets and drives prices lower (lower demand … easy, right?). Clearly this requires a deeper understanding of how interconnected markets are and exactly how they work together–potentially a leap of faith or a layer of complexity a firm wasn’t willing to bet on.

There was, however, evidence markets were behaving this way. Spread product was moving in lock step (directionally). LCDX (index of loans, generally made to high yield companies) was moving wider, corporate bonds had a secular widening, and mortgage product was impossible to trade, commanding a larger and larger liquidity premium… Also, LIBOR was rising and banks were finding it harder and harder to borrow. But, instead of using relatively liquid indices and stocks to bet on these “second order” effects, Mr. Schwartz started asking for specific bets that offset highly illiquid positions. Good luck. To ask for relevant hedges is logical, follows from first principles, seems safer, and wasn’t executable–easy for risk managers and executives to demand and impossible to do, leaving the problems unsolved. Keep in mind, too, that the stock market hedges could easily be unwound in the event they failed to be correlated to the loans they were hedging. Would the “specific” hedges that would, themselves, be highly illiquid? No chance. CMBX and ABX have been known to trade in markets that are 5-10 points, or percentage of notional value, and that’s for small size (5-10 million dollars). To hedge the size here … well, I can’t imagine the costs.

Just to review: They had toxic positions, hedged them, and then removed the hedges, but (from what I can tell) didn’t sell the positions (while trying to one-to-one hedge the). There’s something to be said for taking the hit you know about today instead of trying to call a bottom.

2. Regulators were having calls, as regular as daily, with Bear. From the article:

Bear Stearns’s … risk officers were meeting in the sixth-floor executive offices with staffers from the Securities and Exchange Commission. The regulators had traveled from Washington to make sure Bear Stearns had access to the day-to-day loans it needed to fund its trading operation. After scrutinizing the firm’s $400 billion balance sheet well into the afternoon, the regulators agreed to reconvene with Bear Stearns managers for daily briefings until the market crisis passed.

Now, uness Bear is different from ever other financial institution, when it’s regulators come knocking it’s unusual–everyone walks more straight and takes much more care when dealing with them. The reason is simple: there’s nothing to be gained when a regulator is pleased, the best thing that can come from making regulators happy is avoiding the situation where said regulators are unhappy and consequences arise. I wonder if, ever, in the history of Bear, regulators called in to check on their situation daily. This should have been a major warning sign and left employees involved extremely uncomfortable as it was going on.

3. Many sophisticated investors walked away from a deal with Bear.

  • KKR walked away, and we never learn what their concerns were (Bear was focused on not crossing clients)
  • Allianz SE’s Pacific Investment Management Co. (PIMCO) had discussions with Bear that “fell apart”
  • Fortress discussed a merger with Bear (sounds similar to what I wrote about recently) that never went anywhere

Now, J.C. Flowers walked away because both sides had issues, so I don’t count them. Similarly, I don’t count the hiring of Lazard, and that effort failing to bearing fruit. I’m not sure why each of these potential transactions fizzled, but certainly it seems like a pattern that one can read into.

4. Two institutions with a major financial stake in Bear’s viability expressed concerns. One of these, PIMCO, unless I’m missing something glaring, had been in talks to acquire a stake in Bear and declined (second bullet point above). Maybe they knew something the rest of us didn’t, from their earlier talks and whatever due diligence they had performed? It would make sense, but would probably also be illegal. More likely? PIMCO was focused on Bear and extrapolated to the current market conditions. Perhaps, also, some unease exuded from the senior PIMCO ranks…

On a side note, what’s with the illustrations? Maybe this is going to be a chapter or section of a book? It reads that way almost… Newscorp swooping in to add a fresh (and awkward) feel to the WSJ? It was distracting to say the least. Of course Dealbreaker goes (almost scarily) deeper with this observation (as is their charge), and they have some amusing thoughts.

I can’t wait for part two!

Dear John Thain: Think Outside the Box with T.P.G.

May 26, 2008

Dear John Thain,

I am intrigued to see you talking to T.P.G., although the media seems to only care about discussing capital infusions from the P.E. firm and hedge fund manager. With the recent Clear Channel conflict reverberating throughout the financial system it’s never been more clear the friction points that exist between investment banks and the other firms with which they interact. Building a collaborative relationship with a large private equity firm will give Merrill the ability to innovate their business model and profit where other banks are trying to mitigate losses. Would T.P.G. be in a better position with Merrill seeding their funds? Absolutely. Would Merrill have a better franchise if they were assured to be retained as an adviser for all/most of T.P.G.’s acquisitions (and likewise for portfolio companies)? Absolutely. Would financing large deals be easier if both sides (lender and borrower) have a stake in the transaction being completed and the total P&L of the deal (debt and equity)? Absolutely.

The best part is the model already exists and been proven out: Goldman Sachs. Goldman Sachs Capital Partners is one of the top fee payers amongst private equity funds, showing a clear benefit to Goldman’s advisory business. Goldman has been able to be aggressive in moving loans throughout the recent credit market turmoil–having a large P.E. operation, the fee income from their equity investments provides a positive balance to the negative marks for loans. In good times Goldman’s private equity arm generated profitable loans for itself and other banks (wow, how far those days seem) and added to their total income associated with a transaction. Clearly this dynamic is superior to the situation the Clear Channel financing consortium found themselves in, suing the financial sponsors because the sponsors are making money and the banks aren’t.

Merrill would also have an extremely valuable asset in the T.P.G. brand, proven fund raising ability, and long track record–a benefit that other investment banks have pursued but not had much success in achieving, Goldman being the closest to an exception (or perhaps Morgan Stanley in the form of M.S.R.E.F.). Clearly these considerations are extremely similar to the considerations that drove Merrill’s decision to invest in a top brand in money management (Blackrock). Oh, and let’s not forget the alternative asset management platform Merrill will gain access to with T.P.G.-Axon.

So, Mr. Thain, what is my proposal? Well, I’m hardly an expert on structuring these sorts of transactions, but some specific points worth exploring come to mind:

  • Merrill should take an equity stake in T.P.G. to align it’s interests with the performance of T.P.G.’s funds.
  • Merrill and T.P.G. could form a J.V. where Merrill’s leveraged loan business would, partially or in its entirety, reside. This unit would be responsible for financing buyouts and servicing T.P.G.’s needs. Leveraged finance professionals, leveraged loan trading, and distribution of loans would occur in this unit.
  • Merrill and either T.P.G.-Axon or T.P.G. itself (or both) could create an actively managed debt fund to opportunistically purchase corporate loans, real estate loans, etc. Merrill would provide some amount of leverage with T.P.G. using it’s deep relationships to acquire the rest. Some Merrill loans in inventory would seed this venture.
  • Merrill would become an adviser to the various T.P.G. funds. I’m not sure if it’s permissible to “lock up” future advisory business, but certainly there would need to be an understanding for a strong preference for Merrill to be included on all advisory work.
  • Merrill’s current private equity business, where allowed and not in violation of any agreement (O.M. terms, perhaps), would sell it’s private equity business to T.P.G.
  • Merrill and T.P.G. could institute a program for high net worth brokerage/private wealth clients to invest in T.P.G. funds.

Those are just some of the points that could lead to a productive and profitable relationship. This would turn other firms’ weaknesses and conflicts into an opportunity for Merrill. There are, obviously, tons of places where such an arrangement could break down (valuation of businesses, legal constraints, logistical issues, compliance and conflicts, etc.) but innovating the business model of Wall St. is going to set the stage for the next boom, in much the same way firms have failed this time around by, for example, relying on the same distribution-centric business models for new, unproven products. Just a thought.



Debt? Equity? Let’s Not be Nitpicky … Invested Capital!

April 14, 2008

Here’s an interesting trend: lots of investment banks and buyout firms buying debt from their own and others’ acquisitions (and, obviously, the most recent headline, something that sounds familiar). With recent developments it seems like some roadblocks have been removed to actually getting banks to sell these loans. However, one has to wonder what kinds of issues this will raise down the road… If, for example, Chrysler, TXU, or First data run into problems, how will things be different with the financial sponsor (P.E. firms) in the debt? (Although, for P.E. firms and investment banks that invest through funds that raise third party money, it’s obviously a requirement to have information barriers in place to prevent conflicts and all kinds of other illegal and improper behavior.)

Well, how about some current events to help answer the question? As one could read here Apollo’s portfolio company, Linens ‘n Things, is expected to file for protection under Chapter 11 of the United States Bankruptcy Code.  From the New York Post (as much as it pains me use this publication as a source…):

Apollo Management, which took the retailer private in 2005 for $1.3 billion, is weighing the idea of a potential “prepackaged” bankruptcy, sources said.

In such a plan, Apollo and creditors would settle on a restructuring plan before a Chapter 11 filing is made.

The speculation comes as the cash-strapped chain faces a clampdown on its $700 million revolving line of credit from GE Capital, sources said. While GE hasn’t cut off the flow altogether, sources said payments to vendors that supply sheets, towels, curtains and kitchenware have become more selective.

That, in turn, has prompted several of the largest suppliers to stop shipping merchandise during the past few weeks, sources said.

About half of the largest 25 vendors have halted deliveries because of late or insufficient payments, according to one source familiar with the matter.

(emphasis mine)

Now, this an interesting situation. Imagine “and creditors” reads “and Apollo’s debt fund” (or some other P.E. fund’s debt fund) or “and the institutions that depend on Apollo for fee revenue” (investment banks) … I wonder how things would be different. Anyone who works in finance, at some point, has seen a customer or other client of the firm go high up the food chain to make a “relationship call.” Certainly there are examples of very public outcomes that are both positive and negative for many “relationships.” But, honestly, isn’t a “top of the house” decision, when supportable, going to be in the favor of the house, versus the part of the house that has the upper hand in negotiating? The part about, “when supportable” is key, obviously. Why would Leon Black’s creditors accept his plan? As a matter of fact, if the company is going to default, then why would he even come out with a plan? Most likely because his plan doesn’t wipe out the equity holders. And why accept said plan? Because it’s probably unclear what the company is worth if it defaults (to the creditors). And, to be honest, can’t one almost always find a reason to go with a decision supported by numbers and projections instead of a protracted legal battle?

It’s instructive, also, to look at the entire process. P.E. firms were purchasing companies and financing those purchases with cheap debt that banks committed to providing. Some of these transactions, however, took over a year to close, like Harrah’s, for example. Now, with the credit crisis having gotten into full swing, the P.E. firms are relying on these below market debt commitments to generate their returns. Having seen this process from the inside, this isn’t really the intention. Have we seen any lowered purchase prices? Not really. Have we seen M.A.E. clauses engaged? Certainly a few, but mainly focused on business conditions and operating results (at least as reported and stated publicly), not related to financing. So what does this mean when a company is bought using debt, funded at 100 cents on the dollar, that is trading at 80 cents on the dollar? Twenty percent of th debt value is a wealth transfer from the financing institutions’ shareholders. Now, in ties of market turmoil, this kind of thing happens, but it’s certainly odd that some P.E. funds can wind up owning the entire capital structure (in different pockets or capital pools, most likely) of a company at a cost basis less than the purchase price. If a firm owns 100% of a company and paid greater than ten percent less than the buyout price that just sounds amiss soehow…

Now, also, think about this: If banks couldn’t even negotiate materially more favorable economics on these deals, and even refused to litigate or pursue valid avenues of breaking financing commitments, then how are they going to react when they own the debt o these same deals and these P.E. firms call them asking for amended terms? I wonder….

Banking Risk

February 28, 2008

It’s funny to me that all of these problems are coming to light and, while there are clearly themes as to how these various products all became so prevelent, as well as why, there are some things that still need explaining. What do leveraged loans have to do with all this? Indeed Goldman could be asking itself why it got involved in that market–one in which it had become a major player, unlike some other businesses it was lucky enough to have been unsuccessful in entering. How did C.D.O.’s, a product generally managed off of trading floors where many market-sensitive businesses didn’t lose money, seem to be a categorical loser for banks? The answer seems pretty plain to me: These were products driven by “bankers.”

A “banker” is a person, as I think of them, whose job is to pitch a transaction to an entity/person/institution/group and get the fees involved in said transaction. They don’t manage risk, that is generally outsourced–but they do worry about it insofar as one can dimension the risk. Bankers make assumptions. Bankers LOVE assumptions. “Assume that trend continues.” “Assume defaults come in at 80% of the model for this collateral.” “Assume that debt gets taken out.” “Assume rates rally.” “Assume a static L.I.B.O.R.” “Assume this rate scenario and no losses.” It’s simply amazing. Why would one stress losses and not interest rates? Wouldn’t it be a better assumption that if 10% losses are occurring when 2.5% are projected that it’s because interest rates are higher than expected and people can’t get new loans? Well, the bonds don’t perform under those scenarios and showing that would make them harder to sell. Merely an example, I digress.

Bankers run the process on C.D.O.’s and  on leveraged loan deals. Their job is to put together scads and scads of powerpoint presentations detailing all kinds of details. Bankers show nice graphs like supply (amount of bonds issued) versus spreads (yield premium required for a bond’s incremental) to show some trend. Bankers trot out the all-knowing league tables for their product. (As we now know, the most accurate thing predicted by the C.D.O. league tables turned out to be writedowns–but bankers were judged on their standing in these league tables!) So, what if a banker was so successful at pitching these transactions that they were able to sign up dozens, creating a pipeline, and lock up the fees? They were a superstar! Imagine the fees on billions of dollars of C.D.O.’s? If their bank provided the financing for the C.D.O. issuer to acquire the assets? Higher fees! If the bank agreed in advance to buy the bonds and take them onto is own balance sheet if the market wouldn’t buy them? Higher fees! If these arrangement were made, 10-15 C.D.O.’s could earn $100 million in fees. Was there more risk? Of course, how do you think bankers would justify higher fees for these incremental commitments?! But, when your job is to spend months courting C.D.O. issuers, and you spend countless hours on conference calls telling them what a good deal issuing a C.D.O. is, and when you repeat, over and over, how strong the market is, citing many datapoints, then you’ll probably convince yourself too. Indeed, when told a deal you got a client to agree to commit to is too risky, by a risk manager or other independant person, then you will probably fight back… hard! (And, feel free to substitute C.D.O. with leveraged loan transaction in every instance.)

The point is the mentality. Bankers weren’t paid to manage risk day-to-day, watch the market, and hedge. Bankers became salespeople with some analytical and technical expertise. They weren’t thinking about hedging–they might not even have assets to hedge, they hadn’t created bonds yet. Market fluctuations didn’t affect the revenues from fee income. Although, a commitment to buy unsold bonds if the market has lost liquidity and values are plummeting is a risk, it’s not one bankers would have assumed, and definitely not hedged. Indeed these bankers, at some firms, even had separate reporting lines than the traders and risk management professionals. Their division was generating lots of revenue, so their senior layers of management gained a lot of power. A perfect storm? Seems like it was.

In fairness, the perfect storm that occurred was due to a fundamental problem–the disappearance of liquidity. In the heyday it wouldn’t have seemed rational to consider scenarios that correspond to what the market has actually experienced. But the methods of accounting for and cataloging the risk of, for example, derivative contracts exposed to tail events or highly illiquid investments clearly wasn’t used (When a P.E. firm makes a highly illiquid equity investment, I would bet bankruptcy risk is discussed!). Indeed most of the C.D.O. bankers were ex-lawyers, ex-structurers, or converted salespeople who didn’t have the background in these views on risk either. As for leveraged loans, the leveraged finance professionals were also mainly investment bankers and refugees from other relationship-driven fee-based businesses. I even know of people that jumped between the two (C.D.O.’s and leveraged loans)!

Another point, that seems obvious, is the scheme of compensation. Roger Ehrenberg had a recent post that discusses some of these issues. My personal belief is that the mentality was much more of an issue than the structure of the compensation scheme–but the perils of compensation, as it currently stands in the financial world, are well discussed and documented.

Maybe I just have the benefit of 20/20 hindsight, but maybe the traders and other people who poke fun at bankers (see Monkey Business  and, of course, DealBreaker) for not seeing the forest through the trees were on to something.

Who Still Credits the Suisse with being Neutral? Anybody? Anybody at all?

February 12, 2008

A story that has been a focus for the debt markets, specifically as it relates to (corporate) credit debt markets, is the fire sales by C.S. of its stake in Harrah’s without coordinating with other banks. Indeed there is evidence that this wasn’t the first time C.S. got creative. The interesting thing about this turn of events is that these syndicates are put together to share risk and broaden distribution channels (some banks talk to accounts that others do not). Well, with the C.S. shenanigans creating a fire sale, leaving Harrah’s new bonds 7-10 points (cents on the dollar) lower and the loans being offered 5-6 points lower (estimates, market participants are rather cagey, but low 90s dollar price for the loans and 88 cents on the dollar for the bonds was widely noted in the marketplace) it seems like they made a good sale. Complicating the situation, of course, is the fact that they seemed to have caused the panic that led to the downdraft. Add to this technical overhang the lack of help from C.S. in distributing the remaining debt, and the fact that a sizable buyer was taken out of the market. It’s plain to see that C.S. worked against the syndicate and hurt the distribution power of the group.

Further, here’s an interesting datapoint: C.S. was reported to have around $30 billion in LBO debt on its books, around 10% of the estimate of $300 billion total LBO debt out there. Let’s assume all of this is too high by half (although why would journalists stress an extreme figure in a headline, hmm?). That leaves C.S. with around $15 billion. If, including Harrah’s, they sold $5 billion (rounding up all numbers in the previous Deal Journal post) but caused a 5 point decline in the market (assume it’s all loans they hold, no bonds, which suffered a more severe price movement), they lost $500 million. The figure includes $250 million that was saved on the loans they had already sold (overestimating their savings, since they only really “saved” that loss on Harrah’s, other sales occurred earlier). Ouch. But the remaining unsold LBO debt shed $7.5 billion in value (5 points on $150 billion) due to the sale, and ensuing panic. It seems that letting C.S. into the syndicate did anything but mitigate risk.

Because this situation has wreaked such havoc, perhaps other shops will actually take a stand and block C.S. from future syndicated deals. Their actions seem to show they can be relied upon neither to mitigate risk nor aid in distributing any.

My Thoughts on the Cycle (From LBO’s to sub-prime)

February 6, 2008

Wall Street is a funny place. Your friends are almost worse for you than enemies. At the top of the market every deal worked. You would enter into a commitment that might have been aggressive for the market, but the truth of the matter was that in an environment where spreads are tightening (essentially rising prices) the market was subsidizing your poor choices. For those that don’t know how the process works, I’ll go through a sample time-line and try to keep it as generic as possible.

  1. A deal is brought to an investment bank, by a sponsor of some kind or a corporation.
  2. The investment bank bids on some aspect of the deal. For an acquisition or L.B.O. it’s usually a role in the debt.
  3. Banks go out to the market and solicit “color” (information). This is used to figure out what economic terms they should quote for a role in the deal. For example, they might offer to arrange a set of loans at an interest rate of 400 basis points above some benchmark (LIBOR, treasuries, swap rates, etc.) based on the information they received.
  4. A process is run to determine who has offered the most attractive terms.
  5. The firms are offered roles. Some might lead portions of the deal and some might just earn fees. The nuances of the various roles and how they work varies based on the product in question (loans, bonds, equity, etc.).
  6. The terms that banks will be agreeing to if they take a role are given to them–these terms are derived from the terms proposed by the banks themselves (see #3). From what I have seen a role is rarely turned down. Not only that, but any given term offered on the deal might be incrementally worse than the worst proposal drawn up by the banks (an aggressive sponsor, for example, will take conditions or covenants and make them more lax, and then present that set of terms–any bank that doesn’t have access to all proposals will be none the wiser until much later).
  7. Banks accept roles and begin the process to close the deal, due diligence the various points that were represented to them, and documenting everything that has been agreed to already. Banks will also, later in the process, begin their process of distributing whatever risk they have taken on (once again, bonds, loans, etc.) where applicable.

Now take into account the fact that P.E. firms have been paying billions in fees, that the leaders of these P.E. firms have very senior relationships, and investment banks have league table pressures. The fact that investment banks trip over each other to bid for a place in deals, sometimes through the market (and, if you read the prescient piece by Steven Rattner you would know banks even rushed to reprice loans as the market moved in their favor, giving P.E. firms back some of the upside despite the fact that the P.E. firms took no risk). Now you see P.E. firms sticking it back to the banks again. While banks were rushing to give back money and while the secular direction of the market was bailing banks out of bad decisions everyone was making money but P.E. firms were making more than their fair share. Now that the market has stalled and banks are stuck holding lots of inventory and sitting on the losing side of underwater commitments there is nearly no movement o the part of P.E. firms.

Now you see investment banks putting some protection for themselves where they should have had them before (the same way P.E. firms have protected themsevles), but there are still these pressures. You still have banks swallowing their pills for P.E. firms–all while these P.E. firms are doing deals that only work because of the banks. This isn’t a relationship or a partnership. And the question is, how will this affect business going forward? I would imagine there would be more outs built into the legal agreements between banks and sponsors (P.E. firms are often called financial sponsors) now. One would also hope that there would be a very senior understanding that economic flexibility works two ways.

Now, one thing I see all over is how, much like a fractal the same tricks are employed by Wall Street over and over again.  The situation described above is essentially EXACTLY the same way the sub-prime situation occurred. Banks bid on loans that they could profit from during a tightening spread environment because the market would bail them out. I remember when sub-prime loan packages were being bought from originators at 103% of their face value (100 million on loans would sell for 103 million dollars).  And now, just like with L.B.O. debt, the day of reckoning has come. Except here, banks can’t really rely on relationship or even a central entity to bargain with to try to get themselves out of their predicament–their own short-term profit motivation has created the same long-term pain.


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