Sorting Through the Buyout Freezeout

By ANDREW ROSS SORKIN, New York Times, Sunday, August 12, 2007:

WELL, so much for the “slow leak” theory.
Now that the buyout boom has officially gone bust and the credit markets are in meltdown, it’s time to assess what went wrong — and what went really wrong. And, of course, to shower a bit of praise on those who got it right.
It is going to be a long August. Here are some talking points to get you through brunch in East Hampton, or if you just happen to run into Jimmy Cayne, the chairman of Bear Stearns, working off some subprime-related stress at the Hollywood Golf Club in New Jersey.
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Again, Kohlberg Kravis Roberts has shown a remarkable knack for accelerating into the crash. The buyout giant has more “hung deals” — transactions that have been announced but not yet closed — than any other private equity firm out there, thanks in large part to its frenzied deal-making in the last few months. First Data and TXU are the biggies, and they are likely to cost the banks that lent Kohlberg Kravis the money dearly. (Banks agreed to lend Kohlberg Kravis $24 billion to acquire First Data and $37 billion for TXU). Kohlberg Kravis’s investors will likely be hit, too, as it increasingly looks as if the firm overpaid in these deals.
Just three months ago, at a conference in Halifax, Nova Scotia, Henry R. Kravis said we were in a “golden era” of buyouts. It is the kind of thing that people were saying in 1987 at the Predators’ Ball — Michael Milken’s annual junk-bond sales conference — just before Kohlberg Kravis bought RJR Nabisco, an investment that turned into a decade-long headache.
This time around, Kohlberg Kravis has again leaped headlong into a closing window, taking advantage of its ability to generate enormous fees on supersize deals, even if the returns are not going to be stellar.
Warren E. Buffett said last year at the annual meeting of Berkshire Hathaway that private equity’s long-term success, to the extent it has any, would not come from outsize returns. “They’ll make it on fees, fees, fees,” he said.
Speaking of closing windows, given the current state of the market, don’t hold your breath for Kohlberg Kravis’s planned initial public offering.
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Handshake deals are causing some mighty sweaty palms. An idea has been floating around Wall Street, suggesting that private equity firms may try to walk away from deals and that some banks, on the hook for huge, underpriced loans, may try to push them to do it. (The banks would offer to pay the breakup fee, which would be cheaper than financing the deal.) The idea was initially pooh-poohed by private equity professionals because of the damage it would cause to their reputation.
“The next time David Bonderman or Henry Kravis wants to buy a company, the board could say, ‘Aren’t you the same guys who backed out of that other deal?’ ” a private equity executive said.
But look what’s happening now: A group of firms that bought Home Depot’s wholesale supply business for $10.3 billion is trying to renegotiate the price lower, and J. C. Flowers, a private equity firm that agreed to buy Sallie Mae, is threatening to back out of the deal. And those are just two deals where the negotiations are public. There are probably dozens more conversations going on privately. But what about that issue of reputational damage? Come on. Wall Street has a short memory.
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How is this for irony? While the credit squeeze has crushed the life out of the buyout boom, guess who has quietly begun talking about buying up deal debt on the cheap? Yes, the buyout firms themselves. While the likes of Kohlberg Kravis are forcing big banks to uphold their commitment to lend money on deals like First Data at rates that will surely cause them losses, Kohlberg Kravis and others are exploring the prospect of buying some of that debt from the banks at discounted rates. The Apollo Group has already played the role of debt vulture, picking up some of the debt on the recent buyout of Thomson Learning that the Royal Bank of Scotland had been unable to offload at the initial rates, people involved in the deal said.
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Who’s the biggest bully on Wall Street? For the last year or two, Cerberus Capital Management hasn’t made too many friends by often pushing banks to the brink on loan terms. Two weeks ago, however, Cerberus eased up, permitting JPMorgan Chase and the other banks backing its purchase of Chrysler to renegotiate the deal. The next time Cerberus needs a favor from Wall Street, it is likely to get it. Kohlberg Kravis, which hasn’t let up on its lenders so far, may want to take note.
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The board of Alltel, which sold the company for about $27.5 billion in May to TPG Capital and Goldman Sachs, should take a bow. The board and its adviser, Merrill Lynch, were criticized for accepting a pre-emptive bid before hearing offers from other suitors, which were due in June as part of a full-fledged auction. Phew! Had they waited, there is a good possibility there would have been no deal at all.
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While we’re handing out kudos, the independent directors of Cablevision look as if they deserve some. The company’s founding family, the Dolans, tried to buy out the company for a song twice, and the directors stopped them until the family ponied up a major premium. Even then, some investors felt shortchanged. Now, with markets in turmoil and Cablevision lowering its 2007 revenue projections, the deal may have been a boon for shareholders.
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Speaking of timing, good or otherwise: Shouldn’t the private-equity-controlled Warner Music Group have entertained an offer this year to sell itself to EMI for $31 a share? Warner’s share price briefly dropped below $10 last week. Just asking.
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Finally, the big question on Wall Street is this: Which heads will roll when the dust settles? There are a few candidates to consider. John J. Mack, the chief executive of Morgan Stanley, jumped into the buyout game with both feet at the worst possible moment. While some people have been calling for months for the ouster of Chuck Prince, the chairman of Citigroup, they could get their way if he is not able to offload some of the jumbo loans on his books.
And then there is a dark horse: the Goldman Sachs “it” boy, Lloyd C. Blankfein. He bet more on private equity than any of the other banks. The Citigroup analyst Prashant Bhatia says the firm has $20 billion of loan exposure, more than any other firm on the street. On top of that, Goldman’s private equity and hedge fund business has been in a world of hurt. Even its flagship Global Alpha fund is down significantly.
To be sure, each of these guys has experience riding out storms. A lot will depend on whether this is a summer squall or something more serious.