Private equity underwriters (PEU's) had little to do with meltdown, at least that was the message Carlyle Group co-founder David Rubenstein delivered at a WSJ breakfast talk. He sounded remarkably like a subprime mortgage borrower:
“Debt was offered to you no matter what,” he said, laying out a hypothetical example to make his case. It went something like this:
Let’s say you have a $1 billion buyout in mind, and J.P. Morgan, hypothetically, offers you $650 million in debt, at 200 basis points over Libor, with a 1% to 2% fee.
Let’s say you go to Citigroup, hypothetically, to see what they’ll offer, and they say they’ll match those terms, but also with no covenants on the debt.
So you go back to J.P. Morgan, and they offer to match all that, and also throw in some PIK toggle notes - in other words, notes that you don’t necessarily even have to pay any interest on.
Right about now, you’re thinking the debt terms couldn’t possibly get any better, but you go back to Citigroup, and turns out they’ll make sure there’s no Material Adverse Change clauses on their offer. Or as Rubenstein put it, even if “a nuke goes off in the corporate headquarters of the company you’re about to buy,” they’ll still fund the deal.
Surely J.P. Morgan can’t do any better than that? Well, maybe they can. How about not only all of that but also an equity bridge?
Sold! “Very few of us were able to resist the temptation,” Rubenstein said.
Highly leveraged, cheap debt terms, frothy bidding, it wasn't our fault! Apparently nothing is Carlyle's fault. They backed away from the implosion of Carlyle Capital Corporation, an offshore investment they set up in the Channel Islands. Long time Arab investors are livid over their losses.
Rubenstein likes China, which might be a nice fit. Chinese firms regularly manufacture dangerous goods, comparable in quality to junk Wall Street innovation. Carlyle used commercial mortgage backed securities to finance many real estate and other buyout deals. Deteriorating CMBS's stink up many bank balance sheets. Systemic risk.
What happened to loans Carlyle Group took on in frothy deals? Many imploded or teeter on the edge. Rubenstein noted:
“Banks don’t really want to take over these companies.”Which means Carlyle can buy back debt for pennies on the dollar, while exercising an Obama stimulus plan tax break. Rubenstein omitted his firm's welshing on those bank debt deals. Systemic risk.
In his talk Rubenstein noted the impact of financial reform on bank private equity and hedge fund divisions. Non-bank (PEU's) received a free pass in the Dodd bill.
While the Volcker rule might benefit firms like Carlyle, by banning banks from investing in private equity deals and thereby getting rid of a group of competitors, Rubenstein said he doesn’t really see the need for such legislation. “The problems…did not come about because banks were investing in private equity or hedge funds,” Rubenstein said. The rule is not “the salvation of the Western world.”
Yet PEU's, with $400 billion on the sidelines, apparently are America's salvation. The White House believes private equity is the solution for our ills in infrastructure, banking, education and health care. Carlyle & company received up to $4.9 billion in FDIC subsidy for taking over BankUnited, a failed Florida bank. After rewriting the rules, Uncle Sam is now providing capital. Another rule tweak may be in order.
Who rode to the rescue of private equity in the meltdown? PEU's had some risk, despite the incredibly lax debt deals. Public pension funds ponied up. CALPERS put up $2.8 billion in private equity capital calls, over $600 million to Rubenstein's Carlyle Group. What if pension said no, we want our money back. PEU run, which equals systemic risk. But Congress and the White House will ignore all this.
He doesn’t expect the issue of changing how carried interest is taxed to normal income rates from capital gains rates to be addressed by Congress this year. More likely, he said, is that it will be part of a comprehensive look at tax reform next year.
How long have Democrats promised to make this change? Long enough, such that when it occurs, the PEU boys have an offshore workaround. As for comprehensive tax reform, even Rep. Charlie Rangel is calling for lower corporate tax rates.
Update: In another talk Rubenstein reiterated his interest in Canada and suggested many PEU's would go public. He conveniently forgot about Carlyle Capital Corporation, pension capital calls and the PEU's numerous bankruptcies in this talk.