Private Inequity

By Neil Weinberg and Nathan Vardi, Forbes
March 13, 2006

Driven by greed and fearlessness, private equity firms are the new power on Wall Street. Investors beware: A reckoning is nigh.

Hamilton James is raising one of the largest private equity funds the world has ever seen, a $13 billion whopper for Blackstone Group, renowned kingpin of the buyout business. Suddenly this thriving trade is redefining the terms of power, profit and greed on Wall Street. He waxes rhapsodic on the benefits to the economy.

“Good private equity funds improve companies operationally and lower the cost of capital for those that are financed inefficiently,” says James, president of Blackstone and chief of its private equity arm. Known as Tony, he is a Harvard M.B.A. who ran investment banking at Credit Suisse First Boston before joining Blackstone in 2002. As he wraps up fundraising for Blackstone V, investors are well aware of its predecessors’ home runs, with Blackstone IV rising 70% a year.

“If you look at our record, or any good buyout fund’s record, you see consistent outperformance in good times and bad.”

Investors poured $106 billion into leveraged buyout funds last year, double the total of 2004, says Private Equity Analyst. Weary of the wobbly stock market and alarmed by the real estate run-up, they were lured by eye-popping returns of 50% a year (or better) at a few elite funds. Globally, 2,700 funds are raising half a trillion dollars in cash to invest; this will bankroll them for $2.5 trillion in deals, given their penchant for putting $4 (or more) of debt leverage atop every dollar they put up.

Just half a dozen giant firms control half of all private-equity assets. Three titans--Blackstone, Carlyle Group and Texas Pacific Group--lord over companies with 700,000 employees and $122 billion in sales. Buyout shops own such iconic brands as Hertz, Burger King, Metro-Goldwyn-Mayer, amc Entertainment, Linens ’N Things and more. Adept at reaping riches whether their investors win or lose, ten buyout chiefs grace the Forbes 400 list of wealthiest Americans. Among them is the billionaire cofounder of Blackstone: Stephen Schwarzman.

Egging on the buyout boys: all of Wall Street, which collects marvelous fees from all the buying and selling. While it was making its own executives quite comfortable, Blackstone rewarded investment banks with $358 million in fee revenue last year. Investment banks get fees for brokering or advising on tender offers; get fees for underwriting bonds or arranging the bank debt to pay most of the acquisition costs; get more fees for selling off some of the assets to pay back the debt; and get still more fees for taking target firms public all over again.

Last year saw $35 billion of public equity money raised globally as bought-out firms went public again. Underwriting fees on those stock sales, plus all of the other fees generated by the private equity business, added up to an $11.8 billion payday for investment banks in 2005, according to Dealogic. jpmorgan Chase collected $933 million of this loot; Goldman Sachs scooped up $870 million.

There would be no reason to begrudge the financiers their take if they were building enterprises and creating jobs. But they do not make their fortunes by discovering new drugs, writing software or creating retail chains. They are making all this money by trading existing assets.

Some buyout firms dabble in deeds that got Wall Street and Big Business in trouble in the post-Enron era--conflicts of interest, inadequate disclosure, questionable accounting, influence-peddling and more. Increasingly the big guys jump into bed with each other. Last year buyout firms sold more than $100 billion in assets back and forth to one another, 28% of all buyout fund deals are up fourfold in two years, says Dealogic.

Moreover, some buyout shops ply rape-and-pillage tactics at their new properties. They exact multimillion-dollar fees advising businesses they just bought. They burden a target company with years of new debt, raised solely to pay out instant cash to the buyout partners. It is akin to letting the Sopranos come in and gut your business to cover your gambling debts.

More politely known as a dividend recapitalization, this quick-buck ploy, entirely legal, paid out $18 billion in instant gratification to new owners last year, Standard & Poor’s says. Now and again corporate carnage follows, as thousands of employees lose their jobs, long-term prospects are diminished and the business files for bankruptcy, stranding minority investors and debtholders.

Buyout funds defend brutal tactics by citing their results: They claim to beat the overall market by five percentage points. But in fact they trailed the rise in the S&P 500 from 1980 to 2001, say professors Steven Kaplan of the University of Chicago and Antoinette Schoar of the Massachusetts Institute of Technology.

Worse, their results could be headed for a slump as a huge influx of new money and bidders inflates the prices of properties at a time when interest rates could rise and increase the cost of new debt. Buyout firms are bidding “extraordinary” prices at frenzied corporate auctions, says Michael Gibbons of Brown Gibbons Lang & Co., a Cleveland investment bank doing 25 such deals.

“They’re going to have to assume very substantial growth rates to justify it.”

“There’s a group of new private equity guys chasing deals for the sake of putting money to work,” says Darrell Butler of Billow Butler & Co., an investment bank in Chicago. “They’re affectionately known as ‘dumb money.’ They’re going to have a hard time when the economy turns, profits go south and covenants get blown and banks come calling. And it will happen.”

Millions of low-rollers--employees and taxpayers--could feel the impact. Pension plans provide 40% of the roughly $600 billion now committed to buyout funds. Many pension plans, both corporate and governmental, are so underfunded they look to private equity to help them close the gap, or at least to tell their actuaries that they can close the gap. The stock market has gone nowhere for the past six years. How does a pension sponsor justify the assumed 8% or 9% annual return on its fund? By putting a fairly large chunk of that fund in “alternative” investments. It is taken as axiomatic that exotic investments will yield higher profits than plain old stocks and bonds.

Public and private pension funds overall have less than 4% of assets in private equity. But in a cruel coincidence, underfunded pension plans and companies in bad shape rely more heavily on buyout funds than healthy firms do; the sick ones need to jack up pension plans hurt by their own faltering finances.

“Not only is the relationship significant, it’s perverse,” says Stephen Nesbitt, chief executive of Cliffwater llc, a pension consulting firm. “Some companies don’t want to take a hit to earnings or increase pension contributions,” so they load up on buyout funds.

Philadelphia’s city employee pension board, at only 59% of the funding it needs, aims to double its bet on private equity to 11.2% of assets in four years. Eastman Kodak’s pension fund has 20% of assets in private equity; Delta has 13%; ailing automaker General Motors is at 10%.

But if Darrell Butler is right--if too much dumb money is getting in at the top--the insiders who run funds will still thrive. Private-equity funds typically take a 2% cut of assets annually plus a 20% chunk of everyone else’s profits. If Blackstone is doing this--and it won’t say--it’s getting $260 million a year up front, on its new fund and one-fifth of any upside. Warburg Pincus, Goldman Sachs Capital Partners and Carlyle rounded up $8 billion to $10 billion each last year, ensuring hundreds of millions in fees even if they never produce a nickel of profit for anyone else.

This vigorish, common when a $1 billion fund was the norm, hasn’t come down even as buyout funds have grown ten times as large.

“It’s like Moses brought down a third tablet from the Mount--and it said ‘2 and 20,’” says Christopher Ailman, chief investment officer of the California State Teachers’ Retirement System, the nation’s third-largest pension fund. “We’ve been trying to get the fees lower, but it’s tough.”

lbo funds popped up in the 1980s, feeding on the junk-bond takeover craze. Blackstone was formed in 1985 when Peter G. Peterson, a former Lehman Brothers chairman who had served as President Nixon’s secretary of commerce, teamed with Lehman alum Schwarzman. They put up $400,000 and raised $810 million for Blackstone I two years later.

The 1980s buyout binge peaked at 365 deals worth $99 billion in 1988. The era was immortalized in Barbarians at the Gate: The Fall of RJR Nabisco, which profiled Kohlberg Kravis Roberts’ contentious takeover of rjr. At $31 billion in 1989 ($49 billion in today’s dollars), it remains the largest buyout on record. Six of the next largest deals occurred only in the past year: Hertz ($15 billion, led by Clayton, Dubilier & Rice); Danish telco tdc ($12 billion, Apax Partners); and SunGard Data Systems ($11.4 billion, Silver Lake Partners).

This time the boom is fueled by the pop of a market bubble. More companies are going private, frustrated by the antifraud Sarbanes-Oxley Act. Thomson Financial counts 32 firms with a combined market value of $54 billion that went private in 2005, up tenfold in three years. Banks, meanwhile, have loosened up lending to extend five times as much senior debt as the equity put up by buyout funds.

Thus buoyed, buyout titans have done well grabbing underpriced, down-but-not-out businesses and whipping them into shape: Texas Pacific with memc Electronic Materials; Silver Lake Partners with Seagate Technology; Blackstone with trw Automotive. Their success has stoked ever more investor demand--never mind that buyout-fund returns go down as money inflows go up.

“People think of private equity as Barbarians at the Gate, but we’re investors with tool boxes that can help companies change capital structures and management strategies,” says James Coulter, a founding partner of Texas Pacific.

Investors with toolboxes? Germany’s Social Democrats described the Blackstone bankers who bought chemical maker Celanese off the Frankfurt stock exchange in 2004 as “locusts.” The hedge fund Paulson & Co. claimed Blackstone’s $650 million price was a lowball bid made possible only by a “fairness opinion” from its pals at Goldman Sachs, which collected $21 million in fees from Blackstone last year.

Blackstone, unrepentant, took Celanese public on the New York Stock Exchange nine months after acquiring it, netting one of its funds a $3 billion profit (and that doesn’t include shares it held on to).

Far less attention is focused on the flops and buyout funds’ sometimes central role in same, albeit subsequent lawsuits have begun to surface. In one get-rich-quick scheme, a dividend recap let Bain Capital turn an $18 million stake in faltering kb Toys into $85 million in cash--but left kb itself in much weaker shape.

Bain put up $18 million and took on $237 million in debt to buy the company in December 2000. In April 2002 kb raised $66 million more in bank debt and used cash on hand to pay out $121 million in special dividends--$85 million for Bain and $36 million for senior executives who signed off on the recap. But kb went on to lose $109 million in less than two years, creditors say, filing for Chapter 11 protection in January 2004.

Since then it has shut half of its 1,200 stores and laid off more than half of its 16,000 employees. Big Lots, the discount retailer that had sold kb Toys to Bain, was owed $45 million but lost most of it in the bankruptcy filing. It has sued Bain for fraud in Delaware state court. Bain, anticipating further opposition from creditors, preemptively sued Big Lots to get a Delaware state court to explicitly endorse the recap; that case is pending. kb Toys was bought out of bankruptcy for $20 million by another buyout firm, Prentice Capital. Unsecured creditors, who were owed $218 million, got only 8 cents on the dollar. In January they also sued Bain, in state court in Massachusetts, charging it ginned up bogus fairness opinions in imposing the recap. Bain blames kb Toys’ troubles on competition from Wal-Mart.

The Equal artificial sweetener business has been through similarly sour times.

Billionaire Michael Dell’s msd Capital and Pegasus Capital bought Monsanto’s Equal business, Merisant Worldwide, for $600 million in 2000 by putting up $160 million in cash and borrowing the rest on Merisant’s assets. Three years later the new owners had Merisant borrow $206 million in new debt and pay the proceeds to themselves; months later they did it again, this time for $75 million. The two moves gave them a 76% profit on their initial investment, while letting them continue to hold 100% ownership.

Merisant, with a negative net worth of $130 million and having spent $44 million on interest in nine months, was forced to shelve an initial public offering last year. Its Equal line is losing ground to Johnson & Johnson’s Splenda, which now has over half the market. Merisant is expected to post a loss for 2005, its third consecutive year in the red. In February Moody’s cut its credit rating to Caa3, its third-lowest ranking. Pegasus and msd won’t comment.

These days nearly half the big buyout funds take their 20% slice from the dividend recaps before their investors break even, says Karl Hartmann, chief operating officer of Franklin Park, which advises institutional investors. Previously the funds waited until outside investors (the limited partners) were in the black before collecting their own cut.

Private-equity fund managers further cash in by charging their own portfolio firms for everything from negotiating loans to helping run the business.

Heartland Industrial Partners, cofounded by David Stockman, President Reagan’s budget director, bought control of auto parts maker Collins & Aikman in 2001 for $260 million. Then it charged C&A $45 million for services and gave a cut to its limited partners; often buyout firms pocket half the take rather than only 20% of realized profits.

That may be all the partners ever get. Last spring C&A said it had violated accounting rules in booking sales, filing for Chapter 11 soon after. It is shutting five U.S. plants and firing 975 people.

In other instances, buyout shops goose returns with “secondary deals”--selling their holdings to one another.

Simmons Co., a bedmaker, is the industry’s fruitcake, changing hands five time in 20 years. Now owned by Thomas H. Lee Partners, it was forced to pull a public offering in 2004, yet the buyout firm gets a 1% cut of Simmons’ operating earnings each year. For helping Simmons issue $200 million in new debt, the firm charged Simmons $20 million plus expenses. Simmons received no cash from the offering; it all went to refinance old debt.

In another secondary deal, abry Partners last August paid $500 million to Providence Equity Partners to acquire F&W Publications, a book and magazine publisher that Providence had taken private for $130 million in 2002. In November 2005 abry filed a lawsuit in Delaware state court claiming Providence had “engaged in various fraudulent practices such as channel stuffing and other schemes to overstate (F&W’s) revenue.” Providence denies wrongdoing.

In another recent case, employees of Canadian Imperial Bank of Commerce accuse the bank of using a buyout fund to rip them off. Former brokers James Forsythe and Alan Tesche say they and 490 colleagues invested $561 million, half of it borrowed, in a cibc fund in 2000. Since then it is down a shocking $420 million. In a lawsuit filed in Delaware, they allege the bank used the fund as a “dumping ground” to pawn off “worthless investments” and suck out $35 million in fees. Its holdings include Spectrasite, which went Chapter 11, and CityNet, a telecom on which the fund took a 50% writeoff. cibc says the lawsuit is baseless.

When things go bad, limited partners can look to a specialty firm that will buy out what’s left of their stakes--but even in this game fraud can happen.

“We’ve seen general partners convert funds to their own accounts, use them for personal reasons, and overdraw management fees,” says Frank Morgan, who runs the U.S. arm of London-based Coller Capital, which has $2.6 billion in assets and runs the world’s largest fund for buying out limited partners of other funds. He says such disputes happen more often than they should and usually are handled quietly.

But Coller itself went to court. Coller sued private equity firm Houston Partners in 2003 after becoming its top investor. Coller sued the firm in state court in Texas, claiming Houston managing partner Harvard Hill Jr. had made unauthorized distributions and loans to himself and his son and had set up secret fee arrangements with related parties. The two sides reached an undisclosed settlement in August. Hill denies wrongdoing.

Other buyout firms come under fire for shrewd (or illegal) fundraising tactics.

In Illinois a scandal erupted over allegations private equity firms paid hundreds of thousands of dollars in bribes to coax investments out of officials of the state’s teachers pension fund. A HealthPoint director recently pleaded guilty to federal charges of attempted extortion in the scheme; a pension plan lawyer also pleaded guilty, and a board member, Stuart Levine, has pled not guilty and awaits trial, charged with soliciting bribes.

Levine also plays a role in a second controversy, this one involving Carlyle, the Washington-based buyout behemoth with $35 billion in assets. U.S. Attorney Patrick Fitzgerald in Chicago has issued a subpoena to the teachers’ fund in the matter. After being spurned by the pension plan, Carlyle hired a local pol, Robert Kjellander; he lobbied Levine on the pension board, and Carlyle landed $500 million from the pension plan.

Only later did pension officials learn that Kjellander had approached Levine and that Carlyle Group had agreed to pay Kjellander a $4.5 million finder’s fee, says the pension plan’s executive director, Jon Bauman. The board now bars such finder’s fees. Kjellander and officials at Carlyle insist they acted properly.

More such conflict-of-interest cases could arise as buyout funds harvest more retirement dollars from strapped pension plans. Corporate retirement funds collectively face a $450 billion pension funding shortfall and are throwing Hail Mary passes to private equity funds to close the chasm; likewise for public pension plans.

“I can’t think of an industry structure that’s more screwed up,” says one manager of a midsize buyout firm.

“The biggest suppliers of capital”--the pension funds--“are the most thinly staffed and underpaid,” he says. State plans with a few employees oversee billion-dollar investments and report to “political entities--their boards--relying on consultants whose business is mostly about marketing and politics,” he says.

They aren’t any match for the buyout guys--who already are anticipating a coming correction and are preparing to profit from it. Some of the biggest names in buyouts--Blackstone, Carlyle, Apollo Advisors--now are raising “distressed investment funds” (read: vulture funds). Feeding on big discounts, they will buy the equity and debt of companies their brethren helped get into trouble.

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