Were you wondering which sector of the U.S. economy would be next to take a dive from the year-old credit crunch? Well look no further, because Barron's [subscription required] reports that private equity firms like Apollo Global Management, Kohlberg Kravis Roberts, and Blackstone Group (NYSE: BX) are hurting gators thanks to too much borrowed money and the weak financial performance of the companies they bought. And business is way down, Barron's reports that through mid-August, the 2008 total deal volume "stood at $67 billion, versus more than $400 billion in the corresponding 2007 period."
This does not come as a surprise to me. In February 2007, I appeared on CNBC arguing that private equity had peaked. And I began to question its long-term viability back in August 2006 when Barron'sAlan Abelson quoted my thoughts on the matter. The basic problem is that when debt is cheap, private equity booms and when it starts selling itself to the public, investors should hold onto their wallets for dear life. People who own private equity firms tap their superior knowledge of the coming downturn to convince the public to bail them out by buying their stock.
Barron's cites -- as evidence of trouble in private equity land -- examples of the declining value of the publicly traded debt in companies that private equity took private at too-high prices with too much borrowed money. It writes that bonds of "many companies taken private in the past two years have plunged to 50 cents on the dollar or less, signaling that investors fear they won't be fully repaid. Many companies that were the subjects of buyouts a year or two ago are so grossly over-leveraged that they're struggling simply to pay interest. If they were to default, debt investors would be stung, but equity investors would be even worse off; the value of their holdings would be deeply impaired or wiped out."
TheStreet.com's Jim Cramer says the only action in the sector is that the rumor mill is spinning overtime.
There are tons of ridiculous stories that can be written in the Naked City. Notice that every day we are blessed with a story about how there are three private-equity firms examining Lehman Brothers (NYSE: LEH) (Cramer's Take) and Neuberger Berman (NYSE: NEU) (Cramer's Take). I think I have read that story a dozen times now.
You can list them, too: Blackstone (NYSE: BX) (Cramer's Take), KKR (NYSE: KFN) (Cramer's Take), Apollo (NASDAQ: AINV) (Cramer's Take), maybe Cerberus. What are they going to do, deny it? "No, we are not looking at it?" Their investors would love that: "Well what the heck are they doing with our money?" would be the reaction of investors if they issued denials. I predict weeks more of phantom tire-kicking of Lehman by nonexistent private-equity firms.
How about private equity about to swarm over collateralized debt obligations? Usual cast of characters there. Right? Come on, those stories are a penny a dozen. Every day I read about them. But nobody, other than Lone Star, is doing anything, anything at all on this front. If there were buyers, you can bet that Lehman and AIG (NYSE: AIG) (Cramer's Take) wouldn't be in the woods, lost, hopeless, with tons of bad European paper.
I'm not normally one for union-bashing, but I'm puzzled by organized labor's record of private equity-bashing. The New York Post reports that the two million member Service Employees International Union wants increased government oversight of the private equity industry, with a special emphasis on the various banks that are in desperate need of cash.
"The biggest buyout firms are used to gaming the system to turn a profit -- it's no surprise they want special rules now to take over another sector of our economy," SEIU president Andy Stern told the Post.
KKR and other buyout shops counter that the SEIU is trying to unionize employees at companies acquired by private equity, and is grasping at straws to drum up support.
That may be the case, but I can't imagine one has to do with the other. Employees should join unions (or not) because they feel (or don't feel) that their pay, job security and working conditions will benefit from membership. Bashing buyout firms would seem to be an irrelevant sideshow and a counterproductive one at that. Many union pension plans are large shareholders in banks and other firms that stand to benefit from private equity involvement, and they may be shooting their members in the foot by fighting macro issues like banking regulations that have absolutely nothing to do with their members' interests.
For financial markets, August is always a slow time as Wall Streeters head for their vacations. But this year, there was more than just seasonality. Simply put, it was a very tough month for M&A operators.
It's been about a year since the credit crunch started, and it looks like things aren't getting better. If anything, it's a good bet we'll continue to see volatility and layoffs in the financial services space.
In August, the M&A volume in the U.S. came to about $28.5 billion, which is 53% off from the same period a year ago.
Ironically, while private equity funds have a huge amount of capital to put to work, there is not much bank financing. As a result, most of the private equity deals have been fairly small (below $2 billion or so).
Also, some of the recent mega deals – such as InBev's $45 billion acquisition for Anheuser-Busch Cos. (NASDAQ: BUD) – are crowding out the financing market.
In other words, investment bankers may need to wait until next year for things to warm up again.
Launched in 1992, private equity firm Madison Dearborn Partners, LLC ("MDP") has grown into a powerhouse. The firm invests in a wide array of industries such as communications, consumer, financial services, health care and so on.
However, MDP is now feeling the pressures from the credit crunch. In raising its next fund, investors have been fairly lukewarm. Instead, MDP is now planning to raise a mere $7.5 billion. The original goal was $10 billion.
Actually, when compared to the 1990s, this is still a pretty big fund and will generate juicy fees. What's more, MDP is likely to get some nice valuations on deals, which should benefit investors over the long haul.
Although, things are far from done. MDP has raised about $4 billion so far, and if the markets continue to be rocky, even the $7.5 billion target could be elusive.
GSTrue, which is operated by Goldman Sachs (NYSE: GS), is a new-fangled marketplace to trade privately-held interests. One of its high-profile listings is Apollo Management LP., a top-tier private equity firm.
Unfortunately, the shares have lost more than 40% over the past year. Of course, this has been the treatment for many other private equity players because of the severe credit crunch.
According to the latest quarterly report, Apollo suffered a loss of $96 million, compared to a net profit of $144 million in the same period a year ago. The internal rate of return (IRR) fell from 42% to 21% over the quarter.
Moreover, Apollo is involved in litigation on its botched deal for Huntsman Corp (NYSE: HUN). And there was a 20% write down on the investment in Harrah's.
Despite all this, Apollo still appears to be on track for an IPO – to be listed on the New York Stock Exchange. Don't expect it to be easy.
TheStreet.com's Jim Cramer says KKR will join the list of buyout firms that fleece the small investor by going public.
Just what we need, a private-equity firm to go public. That worked just great with Fortress Investment (NYSE: FIG) (Cramer's Take), and it was terrific with Blackstone (NYSE: BX) (Cramer's Take). At least this one is some sort of reverse merger that might not inflict too much pain on the public.
Of course, folks in this business are displaying their usual lack of shame. It would be an excellent time for them to have a good reason beyond employee retention; I mean if you are making all of that money, what's the issue with retention? It would also be terrific if they were doing well, but there hasn't been a deal in so long that it would be a bit of an oddity if they were doing anything other than making a lot of fees.
But Kohlberg Kravis Roberts is a storied lot, so I figure the public will lap it up and all will be well until the losses start.
Or maybe this will be the one that's in the blue moon and the public will not be pants'd by the really smart bankers.
In one of the least convincing editorials in recent memory -- no small accomplishment -- Service Employees International Union international president Andy Stern argues that "short-term capital infusions from private-equity funds will only make the banking crisis worse, by encouraging risky behavior and abusive banking practices."
He's so wrong. Risky behavior is encouraged by compensation systems that reward returns regardless of risk, supine directors lacking true independence, and an ownership structure so diffuse that there is no one to enforce accountability.
A private equity fund with a large equity stake and no ulterior motives -- they make money from increased shareholder value, not fees and bonuses -- who paid cash for their shares is the best thing for shareholders. The one valid point that Stern makes is this: "It's hard to imagine private-equity funds resisting the urge to double down on the tactics banks have used to drive profits in recent years -- unfair lending practices, higher fees, and exorbitant interest rates on credit cards and other consumer products."
That's probably true -- private equity funds may push public companies to improve their profitability, but that's their job. Consumer protection is the domain of regulators, and publicly-traded banks have a responsibility to increase their profits as much as possible within the confines of the law.
We shouldn't blame private equity for lax regulation.
The Wall Street Journal also reported that the oil industry and some U.S. lawmakers are looking to end long-standing bans on domestic drilling put in place to protect areas that are environmentally-sensitive, fueled by concerns about global energy.
In an interview with the Financial Times, Citigroup Incorporated's (NYSE: C) former chairman and CEO Sandy Weill acknowledged that choosing Chuck Prince as his successor in 2003 turned out not to be the "right thing" for the company and was flawed. Instead of handing the job to Prince, Weill said the board should have fostered competition among the bank's top managers for the job.
OTHER PAPERS:
According to the Washington Post, MedImmune, a unit of drug giant AstraZeneca Plc (NYSE: AZN),settled with Genentech Inc (NYSE: DNA) a lawsuit over a patented component of its best-selling drug Synagis, which is aimed at preventing respiratory infections in infants. No details of the settlement were provided.
It looked like the deal to take BCE (NYSE: BCE), the parent of Bell Canada, private would be hung up by the unwillingness of banks to take on huge amounts of debt during a credit crisis. Instead, the $35.4 billion deal will probably be killed by the Canadian courts.
Some BCE shareholders sued the company, saying the deal was unfair to them. The debt holders who brought the suit may be fools, but they won. According toReuters, "the Quebec Court of Appeal said that BCE, Canada's largest telecommunications group, failed to prove that a buyout could have been structured to provide a satisfactory price for the company's shares while avoiding an adverse effect on the debenture holders."
If the entire deal for the BCE buyout fails, all parties who hold a piece of the company may be hurt. But, the debt holders have certainly put the stockholders in a very ugly place. The court ruling may give banks some excuses to walk away from the transaction. Providence Equity Partners, Madison Dearborn, and other institutions who put the deal together may have to watch all of those fees disappear in smoke.
And, a buyout that normally would have ended up in court because banks wanted to break their words may be killed because one class of stakeholders bested another.
Douglas A. McIntyre is an editor at 247wallst.com and author of the Ten Stocks Under $10 newsletter.
Until the middle of 2007, the credit markets were essentially in a bubble. Underwriting standards were loose and there were fewer and fewer covenants.
As a result, many companies binged on debt financing such as for going-private transactions, stock buybacks and so on.
But, according to the Wall Street Journal [a paid publication], investors may now be taking some hits from their past sins.
Because debt had few restrictions, it made it easier for companies to hold onto their cash. Hey, might as well extend things and hope for things to improve, right?
That may be true, but what if things don't improve? Well, in that case, debt holders may see the value of their securities fall.
Take a look at Claire's Stores, which went private last year. The company's debt structure had paid-in-kind securities, which means that debt payments can be made by issuing more debt securities. So, when the company had to make a debt payment, it issued more debt -- not cash.
It's hardly something that encourages confidence. However, it appears that there's little that investors can do right now – that is, until things get much worse.
The meager IPO market has been tough for the private equity crowd. After all, this is a key way for them to make big returns for their investors.
But Thursday, a private-equity-backed firm -- Verso Paper (NYSE: VRS) – hit the public markets. The company priced 14 million shares at $12 each. Unfortunately, by the end of the trading day, the stock was at $10. The company originally wanted to issue 18.8 million shares at a price range of $16-$18.
Verso's private equity sponsor is Apollo Global Management LLC, which bought the company back in 2006.
The company is a major supplier of coated papers for catalog and magazine publishers. Some of the customers include Condé Nast Publications, National Geographic Society, Avon Products and Sears Holdings
However, with high energy prices and pesky inflation, Verso's industry has come under much pressure. As a result, there have been a variety of mill closings from the competition, which should ultimately help the survivors. What's more, Verso has built a low-cost structure.
But as seen with Verso's stock performance Thursday, it's not a story Wall Street is interested in right now.
Warburg Pincus, which is a top private equity firm, got its start over 40 years ago, bringing a professional approach to the business. Since then, the firm has invested $29 billion in more than 585 companies across 30 countries.
Well, now the firm has even more firepower for deals as it has raised a hefty $15 billion for its next fund. Some of its marquee investors include Washington State Investment Board and GE Asset Management.
But with the credit crunch, what can Warburg Pincus do with the money? Well, keep in mind that the firm has a growth orientation, which has less reliance on debt sources. What's more, Warburg Pincus has a global platform, which is particularly attractive to institutional investors.
Interestingly enough, Warburg Pincus has ventured into some distressed investing. The most notable transaction was a $1 billion investment in MBIA (NYSE: MBI), which suffered from bad timing (the deal was struck late last year).
But this doesn't seem to be much of a concern for Warburg Pincus. After all, the firm has undergone a variety of market cycles and realizes that real returns take time.
This week, I was on a panel at the USC School of Business. One question I got was: what is private equity?
I had to think about it. First of all, the traditional definition is fairly straightforward. That is, private equity funds buy companies using large amounts of debt.
But what happens when the debt market goes into meltdown?
Well, interestingly enough, private equity firms learn how to adapt. Perhaps, the best example is TPG.
In fact, the firm had a busy week. First, TPG has assembled a group of investors to buy a piece of Washington Mutual, Inc. (NYSE: WM) for $7 billion. Next, the firm got a piece of SIA International, which is a leading drug distributor in Russia. And, finally, TPG has joined a group that plans to purchase $12 billion in leveraged loans from Citigroup Inc. (NYSE: C).
Traders came in this morning wanting to carry on from last week's stability on word that Washington Mutual, Inc. (NYSE: WM) was perhaps going to get a private equity bailout. At least a lifeline was the hope. But throughout the day shares slid from a 100 point gain to close mostly flat on the day as the market decided it had better get ready to go into earnings season yet again for Q1 2008 earnings reports from major companies. Below are the unofficial closes for US index levels:
Were you wondering which sector of the U.S. economy would be next to take a dive from the year-old credit crunch? Well look no further, because Barron's [subscription required] reports that private equity firms like Apollo Global Management, Kohlberg Kravis Roberts, and Blackstone Group (NYSE: BX) are hurting gators thanks to too much borrowed money and the weak financial performance of the companies they bought. And business is way down, Barron's reports that through mid-August, the 2008 total deal volume "stood at $67 billion, versus more than $400 billion in the corresponding 2007 period."
I'm not normally one for union-bashing, but I'm puzzled by organized labor's record of private equity-bashing. The New York Post 
For financial markets, August is always a slow time as Wall Streeters head for their vacations. But this year, there was more than just seasonality. Simply put, it was a very tough month for M&A operators.
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Until the middle of 2007, the credit markets were essentially in a bubble. Underwriting standards were loose and there were fewer and fewer covenants. 
The meager IPO market has been tough for the private equity crowd. After all, this is a key way for them to make big returns for their investors.
This week, I was on a panel at the USC School of Business. One question I got was: what is private equity?
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