Leveraged Buyouts

Investment Manager's Letter July 2007

On Saturday, June 16, the Wall Street Journal ran a story about the effect of the buyout bubble on corporate income tax receipts. Toward the end of the article the author gave a couple examples of the leverage involved in these buyouts.

"As part of TPG Capital and GS Capital Partners' $27.5 billion buyout of wireless company Alltel Corp., Alltel is borrowing a little more than $20 billion in additional debt. If Alltel borrows the money at an interest rate of 9%, it will have about $1.8 billion in incremental tax-deductible interest, estimates Lehman's Mr. Willens."

"That would wipe out the $1.298 billion in pretax income Alltel had last year, Mr. Willens says, and create a net operating loss that can be carried forward to future years to offset pretax income in those years."

So with a little leverage we have transformed a profitable company into a tax shelter. A $1.3 billion profit plus a little leveraged Hocus Pocus = a $500 million loss. Such is the magic of the private equity buyout. Of course it is unimportant that some or all of the $20 billion may find it way into the pockets of managers and limited partners of the two hedge funds involved. Nor is it material that all it will take to topple some of these overleveraged balance sheets is a brisk wind.

The author’s next example deals with our old friend First Data.

"Similarly, to finance its $26 billion acquisition of First Data Corp., a processor of electronic payments, Kohlberg Kravis Roberts & Co. has said it is borrowing as much as $24 billion in incremental debt to finance the acquisition."

"If First Data borrows money at 9%, it would have $2.16 billion in additional tax-deductible interest, wiping out its 2006 pretax income of a little over $1 billion and creating a loss for future years, Mr. Willens says."

So First Data Goes from a $1 billion profit to a $1.2 billion loss. The author quotes Robert Willens of Lehman Brothers Inc. who estimates that at current levels the buyout activity will cut $20 billion from government revenues this year. Curiously the author seems more concerned with the loss of government revenue’s than she is by the huge debt loads that are being taken on by the companies that are going private. The flip side of this $20 billion reduction of tax revenue has to be something like a $57 billion dollar reduction in corporate profits caused by higher interest expenses.

Currently most of the debt seems to be coming from cov-lite loans. These are "Junk" Bonds that really are junk. Wall Street is passing out cocaine candy bars to anyone that will sign a promise to pay. This orgy of indenture comes at a time when corporate profits are at historic highs as a percent of GDP. The return to normal profit levels will bring lots of collateral damage to the over leveraged, and you don’t even want to think about what will happen if we experience (god forbid) a serious recession.

Monday June 18th in another "Journal" article Steven Rattner had this to say:

"The subprime mortgage world has been reduced to rubble with no lasting impact on another, larger, credit market dancing on an equally fragile precipice: high-yield corporate debt. In this fast-growing arena of loans to business – these days, mostly, private equity deals – lending proceeds as if the subprime debacle were some minor skirmish in a little known, far away land.

How curious that so many in the financial community should remain blissfully oblivious to live grenades scattered around the high-yield playing field. Amid all the asset bubbles that we've seen in recent years – emerging markets in 1997, Internet and telecoms stocks in 2000, perhaps emerging markets or commercial real estate again today – the current inflated pricing of high-yield loans will eventually earn quite an imposing tombstone in the graveyard of other great past manias."

Easy money makes people stupid, and there is no one so stupid as the intelligent person blinded by their own self interest ("compensation based bias" as Charlie would say). The current buyout bubble is making a lot Private Equity managers and corporate executives a lot of money, but is also creating a debt bomb that sooner later will blow up.

I, as investment manager, think it is important to consider the possibility that the pop of the liquidity bubble may create a set of conditions that will allow Berkshire Hathaway the kind of relative performance that we have not seen since the 1980’s and early 1990’s. It may not happen, but it is something to think about. In the Summer of 2010 there may be a lot of people who wish they had held a lot more Berkshire Hathaway in the summer of 2007.

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