I was going to write a piece about how private equity has signficantly changed the landscape of private businesses in the United States with their voaracious appetite for leverged buyouts. The majority of American workers are employed by these companies and a change in these companies fortunes could have a catostrophic effect on employment. I don’t think the Fed realizes just how deep in debt many of the companies that make up the backbone of the American economy are. To some degree, the Fed is as oblivious to this risk the same way they were oblivious to just how big the Housing Crisis was in 2007.
I got started writing and then realized I had written this back last December ( I ghost wrote it actually for a small firm….long, boring story). So here it is.
“When you can’t borrow another buck from the bank or buy another case of booze, you bust the joint out. You light a match.”– Henry Hill – Goodfellas
I have always wondered what the difference is between the mob “Bust Out” made famous in the movie “Goodfellas” and a Private Equity Leveraged Buy-out. In a mob bust out, your friendly organized crime gang becomes your business partner. If your business generates good cashflow and has decent access to credit, your new partners skim the cashflow and run up your credit with the purpose of putting lots of cash in their pockets until there is nothing left to pocket. Then, like Henry Hill said, you light a match.
In a leveraged buyout, a private equity firm gets financing from usually a syndicate of banks, to purchase a target company while directing cashflow toward paying themselves and their investors in the form of fees and special dividends. In fact, with regard to special dividends, the private equity firm can actually borrow in the syndicated loan market (in the name of the acquired company) for the sole purpose of paying themselves a special dividend. I’ve never understood how something like that could happen legally but it happens all the time and regulators seem to be cool with it so who knows. Leveraged loans have been the rage for years now as we have been in some form of zero-rate, quantitative easing monetary policy since 2008. Trillions of investor dollars desperate for yield have been funneled into private equity investments.
Private equity firms, armed with investor capital, teamed up with banks, who are hungry to create large loans that brought them huge fees and structuring opportunities (Collateralized Loan Obligations), to take tens of thousands of companies over to “improve them.” Returns for private equity investors have generally been great, but you have to wonder, are all these companies so undervalued that leveraged buyouts should be so magnificently profitable? When the mob busts out a restaurant, it makes a fantastic return too, but nobody kids themselves about unlocking the untapped value of the restaurant! A good chunk of the outsized returns comes from leverage and redirecting cashflow into the private equity investor’s pockets.
For this model for work, as it has for over a decade it needs two things, very low financing rates and very stable input prices. Many of the companies that make up the levered loan private equity acquisition financing (as well as financing for special dividends) are rated at the lowest levels of junk, B to CCC. Many of these companies have very tenuous cash flow profiles. Many of these companies make up a group labeled “Zombie Companies.” Zombie Companies are left negative cash flow after debt service. These companies, already in dangerous cash burn mode need to at least keep their profit margins intact. Therefore, if the Zombies cannot pass along the rise in input costs to the consumers of their products, they are in trouble. The zombies need demand for their product to be almost completely inelastic (demand for the goods or services a company produces does not change with price). Most legal product’s demand are not inelastic. Therefore, if rising cost of goods sold cannot be met with equally rising product pricing there is a problem.
{Discussing the Fed’s inflation fight here…remember I wrote this in December 2021..so this bit has gotten a whole lot worse as the Fed has raised rates 250 basis points in 2022}
Unfortunately, rising prices are not the only problem. As we saw this week, the Federal Reserve has gotten serious about taming inflation. A review of the FOMC member dot plot showed that the consensus estimate by Fed Governor and Fed Bank Presidents is three 25 basis point hikes in 2023. Raising the upper band of the Fed’s policy are from 25 basis points to 1% shouldn’t be that big of a deal as the rate would go from “extraordinarily low” to “very low.” However, when you are leveraged to the hilt and you are already burning through cash, raising higher funding rates becomes a huge problem. Currently, large, syndicated loan borrowers funding rates are indexed to Libor. What exactly happens when Libor goes away as it is supposed to do is for another day! Libor, in its current version, moves more or less lock steps with moves to the Fed’s effective Fed Funds rate so if the Fed raises 75 basis points, then junk company borrowing rates will move more or less by the same amount.
Over the last decade, as private investors have taken over thousands of companies, many of whom employ thousands of people, by adding leverage to balance sheets and redirecting cashflow. The balance sheets of the companies that collectively employ millions of Americans have been weakened to the point that it will not take much to tip them over. Inflation, elastic demand, and higher rates could be that tipping point to where it is time to “Light a Match.”
Freaking Ben Bernanke said in a NYT op Ed that the Fed has no role in dealing with this current inflation bc it’s not demand from too much dollars causing this but a supply problem ie supply chains and price gouging done under cover of darkness. Yeah the decision in 2018 for the Fed to stop raising rates every time inflation approaches 2% caused some inflation but it mostly benefitted workers and allowed them to benefit from productivity gains.
I wonder if Powell will raise rates until something breaks, and then begin QE then. I suspect that we'd see inflation get a little hot, but the market would react and go up, and then the FED could say they "fixed" everything.
I'm not sure I've got it right, but the market is crazy no matter which way you look at it.
The 'bust out' comparison is perfect.