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Is Private Equity Having Its Minsky Moment?

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SubscribeSign inShare this postIs Private Equity Having Its Minsky Moment?mattstoller.substack.comCopy linkTwitterFacebookEmailApr 16, 2020Share this postIs Private Equity Having Its Minsky Moment?mattstoller.substack.comCopy linkTwitterFacebookEmailHi,Today I’m going to write about how private equity is reacting to the pandemic and the bailouts. PE is heavily indebted, and therefore is at high risk in a shock. I’m going to explore PE’s vulnerability, and how the industry is engaged in a political strategy to repurpose the Federal Reserve to its ends. I’ll also explore whether their strategy can work. The West Wing ThingAnd now…It’s Michael Milken’s EconomyGoodfellasGoodfellas,Goodfellas. control of the bank. The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&amp;L IndustryIn addition to weakening laws against corporate mergers, Reagan also eroded white collar criminal enforcement, and deregulated the savings and loan industry. These changes allowed Milken, then an investment bank employee at a small firm called Drexel Burnham Lambert, to begin organizing a new means of financing for takeovers. In 1983, Milken began staking a different class of corporate raiders, men like T. Boone Pickens, Carl Icahn, Nelson Peltz, and Henry Kravitz, with giant pools of money he raised by selling ‘high-yield bonds,’ more commonly known as junk bonds. These new takeover artists used these pools of money to buy corporations that generated cash, had little debt, and owned assets. The theory, promoted by law and economics scholars Milton Friedman, Henry Manne and Michael Jensen, was that the market for corporate control moved assets from bad managers to good ones. And while a raider might buy a company and improve corporate operations, more often he would sell assets, fire employees, give the cash to himself through various mechanisms, and borrow money against the corporation he had just purchased. Sometimes raiders would have the corporations they just acquired shift working capital or corporate pension money into junk bonds to finance more takeovers, in a daisy chain. As far as we could determine, [Milken]’s underwritings never failed and appeared to be marketed successfully, no matter how suspect the company or how risky the buyout deal that was being financed. Other investment houses had some failed junk bond offerings, but Drexel's record was near perfect. We directed our faculty to research the matter.. . . The faculty came up with no plausible explanation; like so many others they fell back on the thesis of the junk bond king's unique genius.The reason was likely not genius, but market manipulation. Many Drexel bonds eventually went sour, because the basic idea behind any bust-out is to screw the creditor. Akerloff and Romer realized that the people who owned junk bonds would not notice problems, because they largely entrusted their money to pension and mutual fund managers and insurance company executives. These agents, who controlled pools of other people’s money, had different incentives than the actual people whose money they were entrusted with. There were a number of mechanisms Milken used to keep the confidence of bond holders. The agents for the investors could be in on Milken’s game. He could favor trade, offering to let certain fund managers into private deals for themselves personally if they used the money they controlled to buy bonds Milken wanted to offload. Junk bond investors would often have corporations work with bondholders to restructure or roll over bonds, rather than missing coupon payments, so as to make it appear that junk bond default rates were lower than they really were. And then finally, if necessary Milken could simply put losses into government-backed vehicles, savings and loan banks, who used accounting rules to avoid losses, and then eventually were taken over by the taxpayer. Charles Keating, a major S&amp;L villain who ran the infamous Lincoln Savings and Loan, was a Milken ally and a buyer of junk bonds. As Akerloff and Romer put it, “The junk bond market of the 1980s was not a thick, anonymous auction market characterized by full revelation of information. To a very great extent, the market owed its existence to a single individual, Michael Milken, who acted, literally, as the auctioneer.” Was this legal? Some parts were. And the other parts? “For half a million dollars you could buy any legal opinion you wanted from any law firm in New York,” said one banker anonymously. Moreover, because of savings and loan laws passed in 1980 and 1982, S&amp;Ls, formerly sleepy banks that only lent to people buying homes, could now buy junk bonds using depositor’s money, what a banker called “the key to the U.S. Treasury.” As Ben Stein put it, “the federal government basically repealed Glass-Steagall if an investment bank just called its commercial banking captive a ‘savings and loan.’”This game could not go on forever, but it could go on for a very long time, as long as Milken had a way to hide a small percentage of his losses. From the mid-1970s to 1989, the junk bond seemed to flourish. And as takeover artists bid up corporate asset prices with borrowed money, the price of stocks would keep going up, which seemed to justify bond values. After all, if a corporation could always be sold at a high prices to service a large debt load. But then, when Milken went to jail, the whole scheme unraveled. According to Stein, Milken’s bank issued around $220 billion in junk bonds, with a loss to investors and taxpayers of something on the order of $40 billion and $100 billion. But these losses understate the impact; by making it cheaper to borrow for takeovers, the junk bond kings influenced $1.3 trillions of dollars of assets that changed hands in the decade.These kinds of transactions were highly consequential in the American economy. In the 1980s, the American corporation, which had traditionally kept a thick layer of cash and done a substantial amount of R&amp;D, became far more debt-laden and responsible to short-term financial incentives to deliver cash to shareholders, lest a corporate raider see a target. “The hostile tender offer,” said management consulting legend Peter Drucker, “has become a dominant force—many would say the dominant force—in the behavior and actions of American management, and almost certainly a major factor in the erosion of American technological leadership.”The Bailouts BeginChris Arnade, a trader at the time, described the shift that the Democratic embrace of Wall Street enabled.The use of bailouts should have also been a reason to heavily regulate Wall Street, to prevent behavior that would require a bailout. But the administration didn’t do that; instead they went the opposite direction and continued to deregulate it, culminating in the repeal of Glass Steagall in 1999.It changed the trading floor, which started to fill with Democrats. Wall Street now had both political parties working for them, and really nobody holding them accountable. Politically, private equity continued to gain power, using the same political patrons. During the Great Recession, as he had with Clinton, Rubin served as an advisor to Barack Obama, who bailed out Wall Street again, through both a direct bailout fund administered by Treasury, and through lending by the Federal Reserve. So that’s three economy-shaking bailouts, one in the 1990s, one in 2008, and one in 2020. The policy response to financial policy isn’t just the same, it’s literally the same people doing the same things. (I’m leaving out a few other bailouts, but the point stands).“A Better Form of Capitalism”really The Corovirus CrisisAnd this gets to the much more serious problem that PE is having with this coronavirus crisis, which is potential trouble with the engine that makes the whole thing run, or borrowers. As KKR put it to investors recently, “We and our funds may experience similar difficulties, and certain funds have been subject to margin calls when the value of securities that collateralize their margin loan decreased substantially.” Now, what happens with Ponzi financing is that at some point, nicknamed a “Minsky Moment,” the bubble pops, and there’s mass distress as asset values fall and credit is withdrawn. Selling assets isn’t enough to pay back loans, because asset prices have collapsed and there’s not enough cash flow to service the debt. Mass bankruptcies or bailouts, which are really both a restructuring of capital structures, are the result.I think you can see where I’m going with this. PE portfolio companies are heavily indebted, and they aren’t generating enough cash to service debts. The steady increase in asset values since 2009 has enabled funds to make tremendous gains because of the use of borrowed money. But now they are exposed to tremendous losses should there be any sort of disruption. And oh has this ever been a disruption. The coronavirus has exposed the entire sector. Organizing a BailoutThere are now three possible paths to deal with this Minsky Moment. First, policymakers can force PE firms to recognize losses and put their portfolio companies through a series of corporate bankruptcies, which would essentially declare a huge portion of private equity funds as losers. Going down this path would be honest and would set up the economy to grow again, but it would hit these guys in two ways, since many PE firms both own portfolio companies that would go bankrupt, and operate debt funds who would lose. This path would wipe out trillions of dollars off pension funds, and turn a lot of PE billionaires into mere millionaires. It is a reasonable path for most of us, because while mass bankruptcies can lead to even more job losses, the government can offset such job losses with spending programs to set up a more resilient society. But it’s very unreasonable for the PE execs at the top of the pecking order.Second, policymakers can find a way to reflate the bubble, and keep the debt roll-over continuing. Such a reflation strategies requires temporary government aid to prevent debt defaults. But while you can restructure debts and change capital structures, you can’t force customers back to using yoga studios or getting their dogs groomed in a pandemic. This pressure is why so many PE execs are eagerly pestering Trump to get the economy reopened, they are extremely wealthy men who are also very heavily indebted, and their debt burdens are weighing on them. Can a Bailout Work?The average yield on high-yield bonds had fallen from a high of 11.4 per cent on March 23 to 8.2 per cent on Monday. Yields go down when bond prices go up. Loan prices had risen from an average of 76 cents on the dollar to more than 86 cents over the same period, according to an index run by the Loan Syndications and Trading Association.&nbsp; The coronavirus is going to make these dynamics even worse. The massive job losses are going to mean that people simply can’t afford rent, and young people won’t be able to borrow to buy homes. The pandemic could change business in more fundamental ways, with more people telecommuting and less travel, leading to a reduced need for commercial real estate and convention space. And the destruction of a large number of small businesses, and the monopolization of commerce in the hands of Amazon and Walmart and a few others, if that is allowed to happen, will mean further erosion of rental income streams.Basically, there is massive deflation, and that’s not going to change just because lockdowns begin easing. Tens of millions of people no longer have income, and even those who do are afraid to go back to their old lifestyles. The Fed can’t ultimately can’t print a functional economy. And at the end of the day, no matter how many games you play with debt loads and capital structures, firms have to have customers, and people can only be customers if they have income.All of which brings me back to the paper Akerloff and Romer wrote in 1993 about the business model of a certain kind of financial firm, one that looks a lot like how a large part of the private equity industry operates. These two economists pointed out that these kinds of schemes, though they can last for a long time, can’t go on forever. The only question is how much damage they do. Or to put it differently, in Goodfellas, though the bust-out was profitable, in the end, the restaurant burned down. cheers,Matt StollerAlso, a few weeks ago, I said I heard but did not believe a rumor printed on Glassdoor that Vista Equity Partners was forcing employees to come in to work during the pandemic. Multiple people at Vista companies told me this was not true, so I updated my post. Thanks for the feedback.Like this postShare this postIs Private Equity Having Its Minsky Moment?mattstoller.substack.comCopy linkTwitterFacebookEmail42 CommentsFor your security, we need to re-authenticate you.Click the link we sent to , or .Expand full commentExpand full commentNo posts© 2022 Matt Stoller ∙ ∙ &nbsp;is the home for great writingThis site requires JavaScript to run correctly. Please or unblock scripts

SubscribeSign inShare this postIs Private Equity Having Its Minsky Moment?mattstoller.substack.comCopy linkTwitterFacebookEmailApr 16, 2020Share this postIs Private Equity Having Its Minsky Moment?mattstoller.substack.comCopy linkTwitterFacebookEmailHi,Today I’m going to write about how private equity is reacting to the pandemic and the bailouts. PE is heavily indebted, and therefore is at high risk in a shock. I’m going to explore PE’s vulnerability, and how the industry is engaged in a political strategy to repurpose the Federal Reserve to its ends. I’ll also explore whether their...

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