Breakingviews

Carlyle’s big payday does private equity no favors

By Jeffrey Goldfarb

 The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Carlyle Group isn’t doing its industry any favors. As part of the private equity firm’s initial public offering process, this week it revealed the lucre reaped by its three founders last year. David Rubenstein, William Conway and Daniel D’Aniello took home a combined $400 million in cash payouts. That’s on top of their nearly $4 million salaries and the profits on $200 million of distributions on personal investments in the firm’s funds. Carlyle’s timing is impeccable.

Given the firm is based in the nation’s capital it might have better attuned its disclosure to the political climate. Mitt Romney, the frontrunner for the Republican nomination, is smack in the middle of a pounding over his time spent running Carlyle rival Bain Capital. Fellow candidates, including Newt Gingrich and Jon Huntsman, who are no strangers to the benefits of private equity largess, have unleashed a full-blown roasting of Romney’s record. With the issue going mainstream as part of broad coverage of the race for the White House, it can’t help but damage private equity’s plight in the public eye.

Carlyle’s whopper payday won’t do much to help the image of the 1 percent. At least the firm can reasonably claim to have benefited the 99 percent, too. The pension funds representing teachers and other public workers that have entrusted their wealth to the firm’s funds will have taken a commensurate cut of Carlyle’s bumper year. And Rubenstein and his co-founders , who manage some $148 billion, remain strongly aligned with those alongside it: they plowed most of their earnings back into the funds.

But just as the fervor against private equity scales new heights, the Carlyle windfall provides a stark reminder of a major disparity. The firm’s senior members will pay only a 15 percent tax rate on the $400 million-plus of carried interest they snagged, instead of the 35 percent rate paid on wages. That means the three men cost Uncle Sam at least $80 million.

After multiple failed attempts to rewrite this particular wrinkle in the tax code, the tide may finally change in Congress now that even Republicans are taking the industry to task. Indeed, that could actually explain Carlyle’s high distribution rate last year. While the eye-popping riches won’t do the buyout business any favors, the timing may in fact have been just right for Carlyle’s founders.

Ferretti’s yachts find fitting berth in China

By Quentin Webb The author is a Reuters Breakingviews columnist. The opinions expressed are his own

Few companies embody the highs and lows of turbo-charged modern finance better than Ferretti. Once the luxury yachtmaker made a mint for private equity. Now a state-backed Chinese industrial conglomerate is buying it for at most a fifth of its peak value.

Ferretti’s financial journey launched in 1998. Previously family-owned, the firm became a small, wildly successful investment for a forerunner of Permira, the European buyout house. Turnover quadrupled in three years, and the backers made more than 50 times their money back in a 2000 flotation. That valued Ferretti at about 400 million euros including debt.

Two years later, luxury stocks were languishing. Another Permira fund bought Ferretti back, in an 833-million-euro deal. Ferretti gobbled up rivals, and sales soared yet higher, aided by the rise of the super-rich. Permira sold a majority to rival Candover in 2006. This “secondary buyout” valued Ferretti at 1.7 billion euros. Talk followed of a 3 billion euro flotation.

Then things went adrift. As the financial crisis set in, customers no longer felt filthy rich. High costs, plunging orders, and 1.1 billion euros of debt proved toxic for Ferretti. Candover lost control in 2009, hastening its own downfall.

Enter Shandong Heavy Industry Group-Weichai Group, which is taking control in a second restructuring. The lengthily named Chinese firm and Ferretti aren’t obvious bedfellows, but there is some logic. Shandong Heavy already makes marine engines. China is minting millionaires daily, and the only way is up for its tiddling yacht market.

The Chinese are paying 178 million euros for 75 percent of Ferretti’s equity and providing 116 million euros of new term debt, which implies an overall enterprise value of about 350 million euros. Major lenders RBS and Strategic Value Partners, a hedge fund, get the remaining equity for 25 million euros. Previous debt, totalling about 690 million euros, will be repaid at about 32 cents on the dollar, a person familiar with the matter says.

Predictions 2012: Upside down and inside out

By Robert Cole

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Planet finance has a propensity to turn itself upside down and inside out. It’s up to its old tricks again. A new collection of commentaries from Breakingviews sets the financial agenda for the next 12 months.

Click here for the e-book

In 2012, the euro poses question number one. Those looking on the dark side think the single currency will divide into a collection of national or multi-national coinages. If the euro does break up, the toll on jobs, economic activity, freedom of movement, and social cohesion would be huge. And that’s why it probably won’t fail.

Bright-siders at Breakingviews prefer to put a number on the odds of survival rather than extinction of the euro. Let’s say there’s a nine out of 10 chance that European monetary union will weather the storms of 2012 and beyond. Then the big question becomes, “How much will it cost, and how long will it take, to nurse the euro back to full health”.

Stateside, meanwhile, it is election year, and Barack Obama has a fight on his hands to stay in the White House. Financial markets will be on alert for swings in the presidential race and in the make-up of the new U.S. Congress. It is not just about the winners, but also about how successfully the world’s largest economy will deal with its budget gap and political gridlock.

Double-dipping Twinkies tarnish bankruptcy process

By Agnes T. Crane

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Wednesday marked a day of mourning for American junk food aficionados – and not for the first time. Hostess Brands, maker of the cream-filled bright yellow Twinkie snack, filed for Chapter 11 bankruptcy just three years after emerging from the court’s protection. That’s not just a kick in the gullet for Ripplewood Holdings, the private equity owner that sank $40 million into the baker last year. The company’s failure leaves a greasy stain on the American bankruptcy process itself.

Filing for Chapter 11 protection is supposed to give debt-laden companies a fresh start. General Motors, Chrysler, major U.S. airlines like United and others have used the courts precisely for this reason. It is easier to renegotiate labor contracts and ax unsustainable debt loads inside the courtroom. Hostess clearly didn’t go far enough in pruning its obligations the first time around. Its largest unsecured creditor isn’t a bondholder or bank; it is a pension fund. The company, in fact, blamed legacy pension and health benefit costs for its current predicament.

To be fair, Hostess isn’t the only repeat filer. Edward Altman, finance professor at New York University, tallies 215 so-called “Chapter 22” filings between 1984 and 2009. The main problem, it seems, is that companies are not emerging from bankruptcy in solid enough shape. One 2006 study found that firms had higher debt ratios compared with the industry standard even after substantially cutting their debt burdens in bankruptcy.

That’s hardly encouraging for firms like General Motors that have returned to the land of the living in recent years. Operating at a disadvantage when times are tough, especially if, like at Hostess, pension costs remain significant, is hardly ideal. Yet if a producer of baked staples like Wonder Bread and Ding Dongs can’t make it, investors should remain skeptical about just how effectively Chapter 11 can scrub away problems.

Private equity skewered by Romney-bound arrows

By Jeffrey Goldfarb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Private equity is caught in the crossfire. Rivals for the Republican nomination for the U.S. presidency are leading a full-blown assault on front-runner Mitt Romney’s track record at Bain Capital. The attacks won’t stop Romney, but the collateral damage could hurt the buyout industry.

Only two months ago, KKR kingpin Henry Kravis warned his fellow buyout barons to beware the barrage. If Romney becomes the nominee, “they’re going to describe us all as asset strippers,” he said. But “they” were supposed to be the Democrats. Not even Kravis anticipated friendly fire.

Romney, to an extent, invited the onslaught. To burnish his economic credentials, he put forward an unsupportable claim about job creation during his time at Bain. But that doesn’t justify the absurd spectacle that has unfolded. Newt Gingrich, who once advised private equity firm Forstmann Little, claimed that Bain “looted” companies. Jon Huntsman, whose family’s publicly listed chemical business agreed to an ultimately unsuccessful $6.5 billion leveraged buyout in 2007, jumped on the bandwagon. So did Texas governor Rick Perry, even though his state’s teachers – whose retirement fund board he appoints – have invested in Bain funds.

Moreover, the GOP en masse has helped thwart repeated efforts to make buyout firms pay a fairer tax rate on a big chunk of their profits. And while Republicans in Congress took less money related to private equity than Democrats between January 2007 and June 2011, they still pocketed some $6.5 million, according to research firm MapLight.

The rhetoric is unlikely to derail Romney’s chances of taking on President Barack Obama in November’s election. The populist anti-private equity message from GOPers could, however, have staying power. For one, it gives fresh fodder to the Occupy crowd. It also will make it harder for Republicans to defend the industry when debates such as the one over taxing carried interest are rejoined in Congress.

LBO debt gluttons have now gorged on equity too

By Jeffrey Goldfarb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Leveraged buyout kings renowned for their debt gluttony have now gorged on equity, too. They’re sitting on nearly $400 billion of cash committed by investors, according to Preqin, or more than $1 trillion of purchasing power. A big slug of it belongs to mega-buyout funds that are already at or approaching their use-by date.

For a fourth consecutive year in 2011, private equity firms have been starved of larger acquisitions. Apax’s $6.3 billion purchase of Kinetic Concepts was among the few big deals this year. In 2007 alone, the volume of global leveraged buyouts larger than $500 million each was $450 billion, according to Thomson Reuters. For the last four years combined, it was around $300 billion.

Meanwhile, limited partners – the pension funds and other investors in private equity – keep bellying up to the buyout bar in hopes of securing better returns than are available elsewhere. And LBO firms have mostly been happy to accept the funds and the lucrative management fees they bring.

The typical buyout fund has five years to invest the capital committed to it. That means voracious fundraising in the boom years of 2006 to 2008 is still having an effect. Some $125 billion from the era remains to be deployed, Preqin estimates. Blackstone’s sixth fund, for example, first closed in 2008 with about $7 billion. It now has some $16 billion, but didn’t invest any of it until this year.

The firms have options. They can ask investors to extend the life of funds. They can also return capital, as Oaktree did earlier this year when it gave back some $3 billion of a $10 billion distressed fund. But it takes unusual financiers to surrender so much fee income. Instead, there’s a real risk that discipline is lost as private equity dealmakers try to deploy their so-called dry powder before it goes poof.

Loan hangover will cast pall over European buyouts

By Quentin Webb The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Once again, banks in Europe have been left standing when the music stopped. In an echo of 2008, lenders backing private equity deals have found themselves with a big backlog of unsold loans. That bodes ill for future buyouts.

Private equity deals are usually financed by a handful of banks, which tide the borrower over until it can arrange permanent financing in the form of “senior” loans and riskier instruments such as high-yield bonds. But numerous banks, including Goldman Sachs and Morgan Stanley, were wrong-footed by the rapid escalation of the euro crisis. Lenders suddenly found there were few takers for the loans they wanted to syndicate, while the market for new junk bonds effectively closed.

Eleven European buyouts remain “hung” in this way, with total debt of nearly 5.2 billion euros, Thomson Reuters LPC data shows. That’s a fraction of the 80-billion-euro mountain that banks were left with four years ago. And it’s halved since August, as banks have pulled out the stops to shift deals.

But managing the backlog hasn’t been easy. Banks have increased interest rates to make the loans more attractive to buyers, and sold them on for as little as 91 percent of face value. Debt packages have been rejigged to reduce cash interest payments, or to replace junk bonds with costlier mezzanine finance.

In financial terms, the absolute hit looks modest for banks. So-called “flex” clauses allow them to pass on perhaps 1.5 percentage points of extra interest costs to the borrower. And underwriting fees, equivalent to maybe 3-4 percent of the financing package, effectively provide a cushion that can be absorbed before banks have to recognise a loss.

Still, banks are forced to set aside large chunks of scarce capital against the loans on their balance sheets. And writing off fees still hurts, particularly when the investment banking industry is suffering.

Capitalism takes three big hits in one day

By Edward Hadas The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It may just be an unhappy coincidence. Still, there was a common theme to three pieces of bad news from different parts of the financial world on Tuesday. Monuments of financial folly are falling apart and the debris is hazardous.

Start with Greece. The decision to hold a referendum on the latest bailout plan makes a disorderly sovereign default more likely. How did the country get into this mess? Domestic and euro zone politicians bear much of the blame, but if lenders had not been so willingly blind, the country would not have been able to borrow mountains of debt, and Greek citizens would not have become accustomed to an unaffordable lifestyle. For two decades, though, the accepted financial wisdom was that the euro zone made that a safe bet. Just like U.S. mortgages before them.

As for investment banking, Credit Suisse is taking the axe to risk weighted assets in the fixed income business, while losses at Nomura may mean it has to reconsider the future of its European business. Most investment banks expanded because their managers shared the boom-time belief that financial intermediaries could earn high returns with low risk by trading at the expense of clients. Clients still seem pretty complacent, but now that regulators are imposing more reasonable capital requirements, the approach seems to be unravelling.

Capitalism’s third big hit in one day brought private equity into the equation. The sector’s principal competitive advantage has always been the tax deductibility of debt. That is effectively a subsidy from taxpayers to risk-taking investors. These investors are still taking — and underestimating — risks. One of them, illiquidity, just hit the owners of ISS, a Danish services provider. The company has done well in the six years of private equity ownership, but an IPO was pulled earlier in 2011, and a takeover offer was withdrawn this week.

The crisis of finance is now well into its fourth year, with no end in sight, and the risks to real economy are increasing by the day. Financial exuberance, like other sorts of addictive behaviour, is fun while it lasts. But it eventually brings far more pain than joy.

Apax misses with HIT disposal

By Quentin Webb The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Mattel’s $680 million purchase of HIT Entertainment, the company behind kids’ characters Bob the Builder and Thomas the Tank Engine, brings a sorry tale of private equity ownership to a close. But uniting Bob with Barbie does not necessarily mean they’ll live happily ever after.

With HIT, Apax Partners seems to have fallen short as a builder of businesses and a financial engineer. HIT is worth less, and enjoys lower revenues, than at its 2005 buyout. Sales were 148 million pounds in financial 2004, its last year as a public company, or about $236 million at current exchange rates. Now they stand at about $180 million. The current deal values HIT at about 60 million pounds less than in 2005 — although HIT’s stake in a TV channel is still to be sold, which could help narrow that gap.

In 2005, with the buyout boom in full swing, Apax over paid. It went in at 14.6 times historic EBITDA, versus an exit at 9.5 times. It also put too much debt on the business, forcing it into negotiations with lenders last year. Strategically it misfired too, dabbling with in-house toy-making, and probably overestimating the potential for Bob, whose star was already waning. Newer shows, like Rubbadubbers, sunk sadly into obscurity. DVD sales, a key revenue source, are also under pressure.

From Mattel’s point of view, the price tag looks more palatable. Japanese rival Tomy paid 11 times historic EBITDA for U.S. toymaker RC2 earlier this year, for example. There is also strategic logic for the new combination. Mattel already makes the non-wooden toys for Thomas & Friends, by far HIT’s strongest set of characters. Moreover, its clout with big retailers like Wal-Mart should ensure toys based on HIT characters get better shelf space.

But it’s not without risks. Mattel is a company that has forged its reputation making toys. HIT’s skill lies in creating characters, making shows and licensing products. Judging kids’ tastes is as much an art as a science. Synergies between the two, meanwhile, look thin. It is too early to write the fairytale ending.

U.S. government has chance to borrow very long

By Agnes T. Crane The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Orson Welles once hawked Californian wine using the tagline: “Paul Masson will sell no wine before its time.” The same could be said about the U.S. Treasury and 50 or 100-year bonds. Maybe it’s finally the right moment to actually sell some.

The Federal Reserve’s latest maneuver, colloquially known as Operation Twist, is squarely focused on reducing longer-term interest rates. By mid-2012, it plans to buy about $116 billion-worth of Treasuries maturing in 20 to 30 years’ time. That represents roughly a quarter of the outstanding stock, excluding what the central bank already has on its balance sheet, according to Deutsche Bank. Following the Fed’s announcement of its plan, 30-year yields have already dropped below 3 percent.

One reason is the Fed will be muscling in on scarce supply. Pension and retirement funds, along with insurance companies, need long-dated paper to match their distant liabilities. These investors own more than half the 20 to 30-year U.S. government bonds not already in the Fed’s hands, Deutsche reckons. They want more safe long-term investments — but the central bank’s move will leave fewer available.

The Treasury could just issue more 30-year debt. Foreign holders prefer shorter maturities, so that could attract more domestic investment. And it would lengthen the average maturity on U.S. debt, which is scarcely more than five years currently. Though that figure has been increasing somewhat, America’s debt profile is still front-ended compared with other large, developed economies, so there’s room to extend it.

But if the Treasury ramps up sales of 30-year bonds just as the Fed is buying them, it risks criticism as a policy conflict. One way to avoid that could be to go even longer. Treasury kicked off a debate on the merits of a 50 or 100-year bond in February. At that time, 30-year bonds were yielding more than 4.5 percent. Today’s much lower rates surely make adding debt that runs another couple of decades that much more attractive.

Welles was famously inebriated while filming some of his wine commercials. The Treasury shouldn’t get drunk on ultra-long bond issuance. But there may genuinely never be a better time to sell them in judicious quantities.