Sunday, March 6, 2016

Lewitt Identifies Two Worrisome PEU Moves

Michael Lewitt's Sure Money reported:

The private equity industry is under serious pressure right now.

With the Super Crash on the way, financial stocks are taking a beating – particularly private equity stocks like Apollo (APO), Ares (ARES), KKR (KKR), Blackstone (BX), Carlyle (CG), and Fortress (FIG). The thing all of these companies have in common is heavy exposure to the high debt levels that built up since the financial crisis. The market is telling us that it is very worried that the Debt Supercycle is over and that a lot of this debt isn’t going to be paid back.
Carlyle is off its lows from several weeks ago.  Lewitt is concerned about two private equity practices given the huge debt levels corporations. i.e PEU affiliates, have taken on.  Private equity firms also package, sell  and service corporate debt through collatoralized loan obligations (CLO). 

Concerning practice #1 is well know to PEU Report readers., dividend recaps or what I call dividend bleeding.

The first “private equity indicator” I watch for is an increase in the frequency of “dividend deals.”

Also known as a “dividend recapitalization,” this infamous transaction involves a private equity‐owned firm borrowing money to pay a dividend distribution to its owners. We’ve seen this behavior all over the news lately – KKR-backed GenesisCare seeking $285m in loans, American Tire Distributors acquiring $805m in junk bonds to pay dividends to TPG Capital, JCrew borrowing $500 million to cash out its shareholders, and Vogue International LLC borrowing over $200 million to pay a shareholders’ dividend to The Carlyle Group.

The debt raised in these transactions is not used to enhance the business of the borrower in any way, for example, by building additional facilities, funding research and development, creating new products, or hiring new workers. The money instead is paid out to the private equity sponsor in order to reduce the capital it originally invested in the business.  It saddles companies with more debt while reducing or eliminating any skin that the private equity firm has in the game – leaving bondholders holding the bag.
Practice #2 is monetizing a PEU affiliate via sale to another PEU.  Rarely is the price paid revealed in a PEU to PEU deal.

This second practice that indicates that the credit cycle is entering its terminal stages is the phenomenon of private equity‐owned companies being sold by one buyout firm to another, which I call “passing the hot potato.”

This has been happening at a dizzying pace lately – if you’ve been tracking our failing private equity firms, you’ve seen Ares Management buying CHG Healthcare Services from J.W. Childs Associates and snapping up Farrow & Ball from European Capital Limited; KKR selling off TASC Inc. to Engility Holdings; Blackstone and TPG teaming up to buy Kensington Group from Investec; and Blackstone selling GCA Services to Goldman Sachs Group Inc’s private equity arm and Thomas H.Lee Partners LP.
Selling an affiliate to a peer avoids public disclosure.  It enables the repricing of asset values and debt to be reissued.  It also enables both PEUs to charge deal fees.

The real reason such deals are done, of course, is to generate fees for private equity firms. The selling firm is able to generate a “realization event” that triggers a “transaction” fee and allows it to return capital to investors, while the buying firm is able to pay itself a transaction fee on the purchase. The wonder is that lenders continue to finance such transactions, which are done at higher and higher multiples of cash flow and contribute little to economic growth.
Carlyle frequently charges a huge fee to make up for losing years of expected PEU management fees.

Private equity firms have mastered the art of enriching themselves at the expense of virtually everybody else with whom they come into contact in the economy.  
Lewitt believes the credit cycle is nearing a bad end.  That would spell trouble for PEUs.