The Great Deformation (96 page)

When the deal closed, the company had $5.4 billion of debt, or eight times its EBITDA. A decade earlier, even aggressive LBO houses would not have marched an LBO straight into the jaws of Wal-Mart with even half that leverage ratio, in part because the high-yield debt market would not have financed it.

As it turned out, neither the passage of time nor the “magic” of private equity management could cure the profound disabilities that resulted from the company's crippling level of debt. At the end of fiscal 2011, Toys R Us still had $5.2 billion worth of debt; its leverage ratio was still more than five times EBITDA; and it was still just one bad holiday season from hitting the wall.

In fact, the saga of Toys R Us perfectly resembles that of most of the financial zombies which came out of the mega-LBOs of 2005–2008. The LBO deal boosted the retailer's debt from $500 million to nearly $5.5 billion, thereby permitting $5 billion of CEW to be extracted and recycled to Wall Street.

In the aftermath, however, the company now struggles with tired stores and a tired strategy and is locked in a straitjacket of LBO debt that it cannot reduce. And the debt itself has been refinanced and kicked down the road repeatedly. The company thus stands only a new recession or another frontal attack by Amazon or Wal-Mart away from eventual demise.

FREESCALE SEMICONDUCTOR:

ACCIDENT SCENE OF BROKEN RULES

The Freescale Semiconductor story is worse. This $17.6 billion deal was led by Blackstone, but on the numbers it wasn't the cautious, investment rule–based Blackstone I had known during twelve years there as a partner through 1999. In those earlier times we had avoided cyclical businesses, especially those with a heavy technology and an R&D component because sales could experience sudden displacement by new technology. LBO candidates which competed with East Asian cheap labor, government subsidies, and pegged currencies got short shrift, too.

By 2006, Blackstone apparently succumbed to the mania of the hour and abandoned most of those old-time disciplines. Semiconductors were the very embodiment of cyclicality and especially so with Freescale, due to its sales mix. Nearly 45 percent were in the purely cyclical automotive market; another one-third of sales went to its former parent, Motorola, which had already fallen drastically behind the competition in the cell phone market. So the company's sales base was unusually vulnerable, but even these sales were not all they seemed.

Freescale also required a massive $1.2 billion annual R&D investment, 20 percent of sales, to stay up with the competition and changing technology. This meant that these costs were largely fixed even if short-term revenues plummeted. On top of all that, Freescale operated in the crosshairs of fierce competition from Japan and the Korean semiconductor power-houses led by Samsung.

The great LBO houses formed tag teams and conducted a bidding war in the fall of 2006 as the bubble neared its fevered peak. Blackstone and its top-drawer partners, TBG Group and Carlyle Group, won over KKR and its equally pedigreed partners, but at a price which was ludicrous by any rational reckoning. Despite all of Freescale's unsuitability for a leveraged buyout, the $17.6 billion winning bid amounted to nineteen times the company's 2006 operating income of $950 million.

The sponsors rationalized that the multiple of EBITDA, as opposed to operating income, was “only” in the low double digits, but that was a non sequitur. No company up against the likes of Siemens, Samsung, Toshiba, or Qualcomm would have proposed to skimp on capital expense, meaning that every penny of the depreciation charge was already spoken for. So the deal was done at a lunatic multiple against performance numbers that could well have represented a cyclical peak.

In fact, they represented high watermarks that would never be seen again—not by a long shot. The $6.4 billion of sales inherited in 2006 actually dropped by 10 percent the next year, even before the recession began, and then plunged steadily until they hit bottom at $3.5 billion in 2009. This calamitous 45 percent reduction in top-line sales is exactly the kind of horror story scenario we had spent the 1990s fastidiously avoiding in Blackstone investment committee meetings.

The fear had always been that costs at big industrial operations were “sticky” in the near term and that operating income and EBITDA would therefore take a beating in the event of a cyclical collapse in sales. In this respect, Freescale turned out to be a case that revalidated the textbook.

By the 2009 cycle bottom operating income had vanished and posted at negative $150 million. The company's EBITDA also collapsed to $300 million, meaning that its debt of $7.5 billion stood at twenty-five times EBITDA. Even that deathly leverage ratio was achieved only after the sponsors injected about $2 billion of additional equity to retire debt in a desperate effort to keep the company alive.

While Freescale has slowly limped back from its near-death experience of 2009, it remains a financial zombie. Sales at $4.5 billion are still 30 percent below the level at the time of the buyout, while operating income and EBITDA are still down 20 percent and 33 percent, respectively. Debt remains at $6.6 billion, meaning that aside from the partner's equity injection the debt burden remains about where it started.

Accordingly, Freescale has been reduced to a rounding error in the global semiconductor industry and will never survive the next cyclical downturn. It remains a monument to the irrational exuberance of the second Greenspan bubble, and a complete perversion of whatever justification
LBOs originally had. The only purpose of this one had been to extract about $10 billion of CEW and recycle it back into the Wall Street casino.

None of the other three deals in this group have made much progress in lessening their debt burden, either. Univision's $9.3 billion of debt, for example, has not been diminished at all and still represented fourteen times its operating income in fiscal 2011. The largest Spanish-language TV network thus hangs on by a financial thread, having recorded net losses every year since the 2006 LBO and cumulating to more than $6 billion.

Overall, these five mega-LBOs started with $45 billion of debt, and save for modest equity injections by sponsors have not paid down a single dime. The four which remain private and financially precarious desperately pursued an IPO in 2010–2012, hoping that the Fed could keep its third bubble going long enough to unload stock onto the next round of punters. It didn't happen, and so they remain financial zombies, lugging a massive load of debt they cannot escape and which will eventually cripple the business enterprises which labor underneath.

THE SEVEN BIGGEST LBO MONSTERS OF ALL

As the binge gathered momentum, the deals grew skyward like some kind of financial beanstalk. The nation's largest radio broadcasting operation, Clear Channel Communications, was taken private in a $23 billion deal. Alltel Corporation, a large cellular utility, and Hilton Hotels each underwent $27 billion LBOs. First Data Corporation, the nation's leading financial services processing vendor, came in at $28 billion, followed by Harrah's, a huge casino operation, at $29 billion, and the nation's largest hospital chain, HCA Inc., at $32 billion.

Finally, TXU Corporation, a giant Texas utility, became the largest LBO of all time at $47 billion. All of these mega-LBOs occurred in a twenty-month interval between late 2006 and early 2008, and on a combined basis amounted to $210 billion of transaction value. Still, they absorbed only a modest $40 billion increment of the massive private equity hoard then foraging for deals.

Accordingly, these seven deals were the true leverage monsters of the second Greenspan bubble. The preponderant share of their funding came from $175 billion of bank loans and junk bonds, resulting in an 80 percent debt-to-capitalization ratio. Yet with the possible exception of HCA, which had already gone private once before, none of them would have been considered plausible LBO candidates by past standards, and most especially not with debt ratios at the outer edge.

Nearly all of these final giant deals were the outcome of heated bidding wars between ad hoc coalitions, or “clubs,” of the private equity houses.
The result was outlandish deal prices that virtually guaranteed failure but were made possible by the state of near delirium in the high-yield debt markets. The latter enabled the private equity “clubs” to keep bidding higher until they tapped out the last dime of available debt funding.

When the smoke cleared on these seven mega-LBOs, their combined capitalization of $210 billion amounted to sixteen times operating income and eleven times EBITDA. Under the facts at hand, such valuation multiples had no discernible relationship to sanity. They were computed against earnings near the top of the business cycle, and which mostly arose from mature businesses with trend growth rates tethered to GDP, meaning that these multiples were double what would have made sense in ordinary times on the free market.

Most of these giant companies also had substantial recurring capital investment needs. Drastic overvaluation at the setup, therefore, was not amenable to the classic LBO remedy; namely, to strip virtually 100 percent of operating cash flows so that the initial crush of debt could be steadily alleviated.

The proof that these deals were a derangement of classic proportion is in the pudding. More than a half decade later, hardly a dime of their original $175 billion debt capitalization has been paid down. In fact, on an apples-to-apples basis, the current debt of the seven companies is $165 billion, and most of this minor difference is accounted for by sponsor swaps of fresh equity for the distressed junk bonds of their own companies.

This failure to pay down debt is fatal because it is fundamentally inconsistent with the true economic function of an LBO, which is massive debt issuance in order to prepay selling shareholders for future excess cash flows. Accordingly, when this initial LBO debt doesn't get paid down, it means there was no excess cash flow in the first place.

That is precisely what occurred with these seven mega-LBOs. A huge amount of putative future excess cash flow was monetized by these deals. Accordingly, more than $160 billion was paid out to existing shareholders in the most concentrated episode of CEW extraction during the entire second Greenspan bubble, but, alas, the implied huge magnitudes of excess cash flow were not really there.

These seven companies have been able to generate only enough cash flow to pay the interest and meet the minimum reinvestment needs of their businesses. Accordingly, they have become permanent beasts of financial burden, lugging a massive debt that cannot be repaid and that has left them on the ragged each of insolvency and continuous resort to “extend and pretend” refinancings. They will go down for the count in the next recession.

CHAPTER 25

 

T
HE WILDEST SPECULATORS IN LEO MELAMED'S PORK-BELLY RINGS
at the Chicago Merc could never have dreamed up a commodity trade as fantastical as that underlying the $47 billion LBO of TXU Corporation. It was basically a bet on a truly aberrational price gap between cheap coal and expensive natural gas—a “fuels arb”—that couldn't possibly last. So the largest LBO in history was the ultimate folly of bubble finance.

THE TEXAS GAS BUBBLE MASSACRE

Electric power utilities are normally stable generators of cash flow, plodding along a tepid path of growth. But TXU's financial results in the year before its February 2007 buyout deal had been mercurial, making its initially benign leverage ratios an illusion. Thus, TXU had posted about $11 billion of revenue and $4.5 billion of operating income prior to the buyout, but by fiscal 2011 the company's sales were down by 35 percent, to $7 billion, and operating income was just $960 million. Its bottom line had plummeted by nearly 80 percent from the pre-LBO level.

Accordingly, the company's leverage ratio has become a horror show. Its fiscal 2011 debt stood at $36 billion and thereby amounted to nearly thirty-eight times its reported operating income. In LBO land that ratio is beyond the pale—it's a veritable financial freak.

How the largest LBO in history ended up this far off the deep end is a crucial question because it goes right to the heart of the great deformation of finance. The TXU deal is the financial “Vietnam” of the Greenspan bubble era, not some dismissible aberration from the main events. It was sponsored by the “best and brightest” in the private equity world including KKR, the founding fathers of LBOs, and David Bonderman's TPG, which was also a successful LBO pioneer of legendary rank.

Since the equity portion of the financing at $8 billion was only 17 percent
of the total capitalization, TXU's existing $12 billion of conventional utility debt had to be tripled, to $38 billion, in order to close the deal. Accordingly, Wall Street had a money orgy coming and going. Fees on the new deal exceeded $1 billion, and at the LBO closing there was an epic $32 billion payday for selling shareholders, including the hedge funds which had front-run the deal.

At the time, the reckless wager embodied in the TXU buyout was rationalized as nothing special. The purchase price at 8.5 times EBITDA was purportedly in line with the 7.9X average for publicly traded utilities. Yet when the onion was peeled back by a year or two it became clear that the buyout was being set up at a lunatic multiple: an astonishing 18X the company's EBITDA in 2004.

This jarring difference reflected the fact that TXU's income was temporarily and drastically inflated by a utility deregulation bubble floating on top of a natural gas bubble. Under the Texas deregulation scheme, wholesale electric power prices were set by the marginal cost of supply, which was natural gas fired power plants. But TXU generated most of its power from lignite coal and uranium, so when natural gas prices soared its own fuel costs remained at rock bottom. The company's revenue margin over the cost of fuel, therefore, also soared, rising from 38 percent in 2004 to nearly 60 percent in 2006. The gain was pure profit.