Posted tagged ‘KKR’

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!

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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….