Contrarian View: Goldman

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!

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

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….

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

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.