Going Private

KKR Real Time Returns

I'm a bit bored today, waiting on some figures from a banker and getting ready for an overseas trip so I've been watching the Sealy IPO.  (Readers will recall I wrote about the proposed IPO of Sealy and the buyout by Kohlberg Kravis & Roberts that preceeded it last month).  Wow.  Just for giggles I put together this cute spreadsheet that tracks KKR's cash v. paper return on the transaction from a tool I had used for a similar transaction (but much smaller) that we were involved in.  It pulls the current stock price and gives a nice summary of the IRR.  Cute.  Fun for the whole family.

I haven't gone deeply into the assumptions (for example, I don't know exactly what deal the shareholders cut with the underwriters, I can't tell how much of the recap fees paid to KKR and Bain were profit v. compensation for advisory expenses incurred by KKR, and the schedule for management fee payments to KKR isn't clear) but I suspect it's pretty close.  Now I can track KKR's various IRRs in real time.  (Screenshot below).

Interesting to note: Yahoo! Finance is tracking Sealy (NYSE: ZZ) just fine.  Google Finance, however, doesn't even recognize the ticker.  Tut tut.  Someone at Google is going to need job security.  I wonder if it's the same person.

Sleeping Sealy

So, the hype should have worn off a little.  How is Sealy doing for KKR this week?

Cable Complexity?

An inscrutable reader writes in to point out a fascinating Bloomberg interview I had not yet seen of Blackstone's Hamilton James.  My reader wonders in email if private equity firms really consider these sorts of investments (Blackstone's Deutsche Telekom deal) viable.  I wondered after this transaction once before in Going Private.  It is, after all, a government-owned firm and Blackstone is only making a minority investment that lacks the control private equity firms usually demand to create the sort of change that impacts their returns.  At first blush I would agree with my reader, but further examination makes it clear why this was a pretty good move by Blackstone.  I've excerpted some passages below so we can try to get into James' head.

Blackstone's James on Deutsche Telekom (Transcript)
2006-05-18 14:51 (New York)

May 18 (Bloomberg) -- Hamilton James, president of Blackstone Group LP, responded to questions on May 17 about Blackstone's investment in Deutsche Telekom AG, the evolution of private equity funds, and the growth potential of Univision Communications Inc. James spoke at a private-equity conference in New York sponsored by the Daily Deal. Senior writer David Carey moderates.

(This is not a legal transcript.  Bloomberg LP cannot guarantee its accuracy.)

I've [...]

The reason we like Deutsche Telekom now is it's a - it's a - it's a gold-plated company. It's got massive assets. It's got great market positions in its core businesses that aren't going away. And the biggest economies in the world look at U.S., the U.K. and Germany. Frankly, I get tired of looking at companies that are mediocre, small, marginal competitors at 8.5 to 11 times EBITDA. And when I see a good, chunky, meaty company with lots of assets that I can buy at 5.5 times EBITDA, that looks pretty good to me.

So, I think, bottom line there, we just - we thought it was a good management. A company with great assets, great market positions and a compelling price. We've had a thesis in the last few years in Europe, in general, that the telecoms were undervalued and that they would be re-rated sometime over the next five years as some of the changes that are coming - flowing to the industry get worked out; as things get re-priced as - and things like that. And we still believe that thesis.

So, there's a lot to like about Deutsche Telekom in terms of just sheer fundamental value and quality of company, that has nothing to do with anything but the value. We - you're right - we were able to set this up with a very clever financial structure; such that we essentially had 85 percent leveraged to capitalization. Effectively, these days, we put up about a third of the purchase price and equity. In our - in our deal, we ended up putting about 15 percent of the purchase price up to equity. And the leverage was in the - was in the mid single digits in terms of average cost. So here we have, by comparison to most LBOs,far more leverage, far lower cost.

So we have all of this very, very positive financial and structural things working for us. If - to use to your favorite term - if the EBITDA doesn't grow at all over five years and we exit Deutsche Telekom at five times cash flow at the end of five years, number of trades we've brought in at 5.5 times, we'll still double our money, based on the cash flow of the company. If EBITDA - if EBITDA grows like it has, at a few percent a year, and we hold our multiple 3.5 times we'd expect. And if we can - and that's before we've done anything to impact the value of the company ourselves.

I've commented before on the issue I have with LBO firms that depend on leverage, or perhaps I should say, pure financial structuring, to generate their returns.  Clearly, with enough leverage massive returns almost fall out of the firm, unless revenues or costs conspire to damage earnings.  For some firms that is enough.

Herein lies what I believe is the distinction between "private equity firms" and "good private equity firms."  The structure of a deal defines the downside.  The talent of the private equity firm establishes the upside.  James says it here:  "...and that's before we've done anything to impact the value of the company ourselves." That's the key.  This attitude: Financial structure is a tool to enhance returns, not to create them outright.  The work really begins after the transaction.  After the deal guys have packed up and the lawyers and accountants signed off.  That's when you have to work to generate returns.

Blackstone has something else going for them on this deal.  Though it is a minority stake, this is still a state-owned firm. It is also "too big to fail."  Their downside risk of bankrupcy is very, very low.  The German government will probably not let it go bust and we all know how the Germans love subsidies for their state-owned ventures.

So why the minority investment?  Personally, I suspect this is a stepping stone to a larger stake by Blackstone.  They can get their toe wet here, feel the business out, sit in on board meetings and effectively have a strong option at a much larger, even a control stake down the line.

My reader points out that so far the deal looks bad, on paper:

Here's a back of the envelope calculation:
Eur 2.6 billion investment @ Eur 14.00 per share = 185.714 million shares.
85% debt = Eur 2.21 billion.
15% equity = Eur 390 million.

Since the announcement was made on 24 April, the DT shares have fallen to Eur 12.62 x 185.714 million shares = Eur 2.344 million value of holding. Less the Eur 2.21 billion of debt outstanding = Eur 134 million of equity. So in less than 1 month, the value of Blackstone's equity has fallen from Eur 390 million to Eur 134 million (66% loss).

Remembering, however, the nature of the leverage here we see that if they have this debt on a 7 year term (and I don't actually know what the terms of the debt are, except for the "single digit" rate Blackstone commanded), and they work down the debt properly, which is, of course, the point, and even if the stock sits at its present nadir, Blackstone will have paid Eur 390 million in equity for a 2.344 billion stake in DT.

Let us decide that we want to make it tough for Blackstone.  Let's see how far their downside goes.  Let us just pretend that the stock tanks by another 50%.  That means Blackstone paid Eur 390 million for Eur 1.152 billion 7 years later.  IRR: 16.73%.  Not bad for a "total failure."  That's the leverage at work.  Of course, in a bankruptcy, or even serious distress, Blackstone probably loses the entire Eur 390 million.  But then, this is a state-owned firm.  It would be interesting to do a bankruptcy risk analysis for large state owned "utilities" and see what Blackstone's risk adjusted returns are on this basis.

Bear in mind, I haven't really gone through these numbers and I don't know much about the financial structure of the deal (term of the debt, how it is being paid off, etc).

Edit: A reader, NG, suspects that Blackstone's stake doesn't bear any particular cash flows other than normal dividends, which are probably around 5-6%, less, most likely, than Blackstone's cost of debt.

If this is so, and on reflection I believe it is, then Blackstone's acquisition vehicle is going to have to service the debt out of its own pocket.

NG also points out, correctly, that in this instance Blackstone's IRR won't be anything like described above.  My analysis above only holds if the stake Blackstone stake can support its own debt (and pay down principal).  If it can't then Blackstone is going to have to fund that debt service from elsewhere, and, accordingly, pillage IRR from another investment.  The advantage of leverage is when you can get the acquired stake to service itself without using your own cash.  That's lost here if NG is correct.

I believe this makes even a stronger case for this investment being a stepping stone for an eventual majority stake in the business.  If that's the case, Blackstone's IRR will only deteriorate by the amount of interest and principal they throw in before they enjoy the free cash flows (i.e. before they take a majority stake).  Since their leverage here is so high, (15%/85%) they can afford to sit around for some years before taking a majority stake and still have a reasonable deal (perhaps the ratio will look more like their usual 33%/66%).  Not a bad option, really.  If anyone is really interested I'll recalculate the IRRs with some scenarios on the time they sit on their "option."

They're KKRrrreat! (Part I)

At 319 pages the April 18, 2006 version of the KKR "Preliminary Offering Memorandum" isn't the largest such document I have ever seen, but it rivals anything I have seen for pure linguistic density (and I've read the work product of Arnold & Porter).  Note that the April 18, 2006 copy I am reviewing still anticipated only $1.5 billion in investment, that was later revised to $5 billion and may well have undergone significant structural revision in the process.

Because I had to research the structure anyhow, I worked up a summary of the transaction and I'm including some diagrams for Going Private readers here.  As you will see, the structure is complex and the offering document's diagrams often omit key entities.  A overview of the structure can be viewed by clicking the thumbnail to the left.  I'll attempt to review the entire transaction and highlight the bits that I think are interesting in this, and as many as three more entries over the next many days.

The basic building blocks are KKR itself, the Delaware based U.S. general partner that we all know and love.  KKR Guernsey GP Limited, the general (managing) partner of the new entity, KKR PEI Associates, LP the general partner of the investment vehicle that is named KKR PEI Investments, LP.  I am calling KKR Delaware "KKR Proper," KKR PEI Investments, LP "KKR PEI," for now.  There's also KKR PEI SICR S.à.r.l., (or société à responsabilité limitée) Luxembourg Limited Liability Company.  We'll get to the others later.

The managing general partner that makes the investment decisions and effectively directs the investment policy of KKR PEI (here that is KKR Guernsey GP Limited, "KKR GGPL"), is co-chaired by Henry R. Kravis and George R. Roberts (no surprise there) and an unnamed CFO.  In general, KKR GGPL is toothless.  All the real decisions are made at KKR Proper.  To wit:

KKR will be responsible for selecting, evaluating, structuring, diligencing, negotiating, executing, monitoring and exiting our investments and for managing our uninvested capital in accordance with our cash management policy. These investment activities will be carried out by KKR’s investment professionals and KKR’s investment committee pursuant to our services agreement or under investment management agreements between KKR and its private equity funds. KKR will have broad discretion when making investment-related decisions under our services agreement and its investment management agreements and our Managing General Partner’s board of directors will approve specific investment decisions in only limited circumstances. Pursuant to our services agreement, our private equity and opportunistic investments will be approved by KKR’s investment committee.

Early on I, and other commentators, wondered how KKR Proper would be incentivized to invest in a separate entity that shared distributions with public investors.  As a partner in KKR you certainly would have no incentive to permit a public investment vehicle like KKR PEI to co-invest and dilute your return and your carry.  KKR devised a rather simple scheme to realign these incentives.  That structure is described in the diagram below.

By requiring a degree of reinvestment, KKR PEI manages to lock up some of the distributions to KKR Proper.  In this case an investment agreement requires KKR Proper to re-invest 25% of all pre-tax distributions it recieves from KKR PEI.  This effectively links the return fates of the two meta entites.  Says the offering document on the topic:

Additionally, under an investment agreement that we will enter into with KKR, KKR will agree to cause its affiliates to acquire additional common units from us on a quarterly basis with an amount equal to 25% of the aggregate pre-tax cash distributions, if any, that are made to KKR’s affiliates pursuant to the carried interests and incentive distribution rights that are applicable to our investments. Common units that are issued to KKR’s affiliates in connection with the global offering and related transactions or pursuant to our investment agreement will be subject to a general prohibition on transfer for a period of three years from the date of issuance. We believe these arrangements will create an incentive for KKR to pursue investments that help us achieve our goal of creating long-term value for our unitholders.

KKR PEI intends to make initial investments in limited partner rights to two KKR funds, the KKR European Fund II and KKR's 2006 Fund.  Following those initial investments, KKR PEI will follow an investment policy permitting it to co-invest no less than 75% of its net adjusted assets in KKR investments as a co-investor and no more than 25% of its net adjusted assets in "opportunistic investments."  The diagram below gives a quick summary.

And what about these "opportunistic investments?"

We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities. We expect that our opportunistic investments will include long-oriented positions in publicly traded equity securities and debt securities and securities with equity-like features that we believe underestimate the asset quality or credit strength of the issuer. We expect that our opportunistic investments also will include investments made alongside the KKR Strategic Capital Fund, which is currently being formed by the manager of KKR Financial Corp. for the purposes of making investments in fixed income securities with a focus on stressed and distressed debt and investment opportunities created by market dislocation events.

There is also a planned investment of $50.6 million for a 2.5% stake in Capmark, the former GMAC commercial mortgage subsidiary.  I wonder why an LBO fund would want a commercial mortgage subsidiary.  Hmmm.

Of course, cash management is often less of an issue for LBO funds that have committed but undrawn funds from their limited partners.  This is a larger issue with KKR PEI given the fact the the public is dumping all its cash, not commitments, into the fund.  That mandates a careful cash management policy disclosure.  I think KKR PEI's falls short:

Upon completion of the global offering and related transactions, we anticipate that our temporary investments will consist of government securities, cash, cash equivalents, money market instruments, asset-backed securities and other investment grade securities. We expect that, initially, between 30% and 50% of our surplus cash will be invested in government securities, cash, cash equivalents and money market instruments, between 30% and 50% will be invested in highly rated asset-backed securities (primarily relating to credit card receivables and mortgages) and up to 25% will be invested in other investment grade securities.

They're KKRrrreat! (Part II)

Friday afternoon, what better time to delve back into KKR's Amsterdam offering memorandum and revel in its complexity, interwoven incentive structure and propensity to fleece the investing public in favor of its general and limited partners.

We left off with "opportunistic investments" and cash management, which readers will recall is a larger issue because of all the cash sitting around because this was a public offering.  On opportunistic investments the memorandum says:

We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities. We expect that our opportunistic investments will include long-oriented positions in publicly traded equity securities and debt securities and securities with equity-like features that we believe underestimate the asset quality or credit strength of the issuer. We expect that our opportunistic investments also will include investments made alongside the KKR Strategic Capital Fund, which is currently being formed by the manager of KKR Financial Corp. for the purposes of making investments in fixed income securities with a focus on stressed and distressed debt and investment opportunities created by market dislocation events.

I expect it will have occurred to most readers that this particular segment of KKR is looking a lot like a hedge fund.  If not, this passage should be a strong hint: "We intend to gradually invest up to 25% of our adjusted assets in opportunistic investments, principally those that KKR identifies but is not able to pursue in the course of its traditional private equity activities."

It is no secret that buyout funds have been jealously looking at hedge funds and their aggressive moves into the private equity space.  This move, a little side fund, permits private equity funds to return the favor.  A careful reading of the areas they cite as investment potential for this portion of the assets sounds a lot like hedge fund strategy.  The only part missing is the short positions.  I'm not sure if this means they don't intend to take short positions, or it was just too obvious to make explicit.  The description is elaborated on later in the document:

These investments are expected to consist of investment opportunities that KKR historically has not pursued due to the fact that they tend to be inconsistent with the investment mandates of its private equity funds as a result of such factors as the relatively small size of the investment, the fact that the investment involves a public company or a debt investment or the unwillingness of the potential target to sell control of its business or pursue a possible private equity transaction.

This looks a lot like Blackstone's recent German dealings.  I wonder if "...the unwillingness of the potential target to sell control of its business or pursue a possible private equity transaction," means hostile takeovers or shareholder activism opportunities.  Your guess is as good as mine, probably.

Of course, one of the greatest features of a public offering involving a private equity fund is the ability of non-limited partners to get a peek at returns and internal financials.  The memorandum does not disappoint:

...the annual compounded gross and net rates of return for the seven private equity  funds that KKR sponsored prior to January 1, 1997 have ranged from a low of 12.11% and 8.83%, respectively, to a high of 48.14% and 39.18%, respectively, and the multiples of invested capital achieved by those funds have ranged from a low of 2.1x to a high of 17.1x.

A chart with pretty solid details is present in the offering memorandum, interested readers will enjoy examining it.  It can be downloaded via DealBreaker.

Of course, when you're scooping in all these unrealized gains, you need some way to pay your taxes.  Luckily, KKR PEI has thought of that problem.  Not surprising since all funds with illiquid assets and lock-in periods have wrestled with this issue.  The solution is to provide significant distributions on a quarterly basis.  In this case:

...we intend to make cash distributions (which we intend to pay to all of our unitholders on a quarterly basis) in an amount in U.S. dollars that is generally expected to be sufficient to permit our U.S. unitholders to fund their estimated U.S. tax obligations (including any federal, state and local income taxes) with respect to their distributive shares of net income or gain, after taking into account any withholding tax imposed on our  partnership.

KKR PEI does take pains to note, however, that they aren't required to make this distribution, and may decide not to.  This highlights, once again, that owning limited interests in private equity vehicles can be damn expensive.

And speaking of damn expensive, how much does KKR Proper get from this new vehicle for management fees?

Under our services agreement, we and the other service recipients have jointly and severally agreed to pay KKR a quarterly management fee in an aggregate amount equal to one-fourth of (i) our equity up to and including $3 billion multiplied by 1.25% plus (ii) our equity in excess of $3 billion multiplied by 1%.

Sounds like a Lehman formula in a way.  How much will they claim if they have a $5 billion fund?  Let us just see.  Assuming their net asset value (which should initially closely approximate the "equity" calculation that drives the fee structure) is $5 billion they should command 25% of (1.25% of $3 billion and 1.00% on $2 billion). Or around $14.375 million per quarter.

Apparently, someone thought that sounded greedy, so KKR Proper graciously agreed to waive, just for the first year after the offering, the payment of any management fee on the assets raised by the offering that are still sitting in temporary investments.  KRR PEI also gets to deduct from any management fees to KKR Proper any management fees they pay to KKR Proper or any third party as a result of investments (such as in KKR funds).  KKR gets the typical 20% carry, but not before the offering and placement fees for the offering are caught up by PEI.  Back when the offering wasn't yet $5 billion those fees were estimated at $85 million.  (I love how these offering documents always call such fees "manager commissions").  It is interesting to point out at this point that KKR PEI probably won't itself get management and monitoring fees, since it is really a fund of KKR funds with a little hedge fund hooked onto the side.

We then run into their first summary of risk factors, which are mostly to be expected.  Some, however, stand out.

• We expect returns on cash invested pursuant to our cash management policy to be lower than returns on our private equity and opportunistic investments and, as a result, we expect that the longer it takes to deploy our capital, the lower our overall returns will be.

In other words, we are sitting on a pile of cash making around 5%.  Until we can spend it on LBOs and other stuff, your returns are sitting ducks.  They elaborate later in the document:

The limited partners of KKR’s private equity funds generally are only required to make capital commitments to a fund, which are funded only when a capital call is made by the fund’s general partner, while our unitholders will be required to contribute their capital to our partnership when acquiring our securities. Because our unitholders must fully fund their investment in our partnership at the time they purchase our securities, and because our cash management strategy is likely to result in lower returns than our private equity and opportunistic investments, our unitholders may realize rates of returns on their investments that are lower than the rates of returns realized by limited partners of KKR’s private equity funds.

And, they have no preference over limited partners (particularly over existing limited partners who want to make follow-on investments) in existing KKR Proper funds.

• Although we intend to selectively acquire limited partner interests in one or more of KKR’s existing private equity funds over time, we cannot predict the extent to which limited partners of those funds will be willing to sell their limited partner interests to us on acceptable terms or at all.

I'm somewhat surprised that KKR Proper didn't agree to give a preference to KKR PEI, but then on reflection I am not.  KKR Proper, and its employees/partners, are the value driver.  Pissing off their existing or future limited partner pool by, for example, giving the public a preference, is probably the wrong idea.  Plus, the public is ravenous enough to really buy in regardless of how limited their interests are and how much they get screwed.  More on this later.

• Your rights as a unit holder will differ substantially from the rights of limited partners of KKR’s private equity funds and the potential return on your investment may not be commensurate with the returns achieved by limited partners of KKR’s private equity funds.

This deserves much attention, we will get to it presently.

• Our organizational, ownership and investment structure may create significant conflicts of interest that may be resolved in a manner which is not always in the best interests of our partnership or the best interests of our unitholders.

Welcome to private equity.

Of course, these documents never miss an opportunity to pump up the "key men."  (Interestingly, I've never seen a "Key Woman" insurance policy).

The departure of any of the members of KKR’s general partner, including Henry R. Kravis or George R. Roberts, or a significant number of its other investment professionals for any reason, or the failure to appoint qualified or effective successors in the event of such departures, could have a material adverse effect on our ability to achieve our investment objectives. The departure of some or all of those individuals could also violate certain ‘‘key man’’ retention obligations specified in the documentation governing KKR’s private equity funds.

More detail emerges on the control KKR exerts over KKR PEI:

...because our Managing General Partner’s board of directors may take action (other than with respect to the enforcement of rights under our services agreement or investment agreement with KKR) only with the approval of two-thirds of its directors, and because we expect that more than one-third of our Managing General Partner’s directors will be affiliated with KKR, our Managing General Partner generally will not be able to act on our behalf without the approval of one or more directors who are affiliated with KKR.

Read: Kravis and Roberts (and perhaps their cronies).

While our Managing General Partner will be permitted to take action with respect to the enforcement of rights under our services agreement or investment agreement with KKR with the approval of only a majority of its directors, such approval would require the approval of all of its independent directors to the extent none of the directors affiliated with KKR agree with such action. Such approval may be difficult to obtain.

Good luck.

Sticking it to the public, vis-à-vis "normal" limited partners is a bit of an art here.  Something that is really sneaky, after a fashion, is that the returns to KKR are segregated.  This means that KKR Proper will command a carry from the one buyout that returns 6.00x cash on cash after a year, but that return will NOT be netted against $70 million in losses that KKR PEI put into "Ken Lay not-guilty" futures on the online betting exchange in Bermuda via their "Opportunistic investment" strategy.  Moreover, because public investors rely on their ability to resell common units or RDU's, and those will likely be based on net asset value, public investors probably will be subject to those losses directly.  True, KKR Proper will lose to the extent their own 2,880,000 units decline in value, but that's a paper loss offset by a cash gain.  Public investors do not enjoy the same luxury.  As a result:

Due to this limited netting, KKR’s affiliates may be entitled to receive a portion of the returns generated by our investments (in addition to the management fee that will be payable to KKR under our services agreement) even though our investments as a whole do not increase in value or, in fact, decrease in value.

Then there is this little quirk related to management fees to KKR Proper:

The management fees that limited partners of KKR’s private equity funds must pay KKR, in its capacity as the investment manager of the funds, generally are based on a percentage of capital committed to the fund during the fund’s investment period and thereafter based on a reducing percentage of the cost basis of the funds’ investments, which causes the fees to decline over time. The management fee that is payable to KKR under our services agreement, on the other hand, is based on our ‘‘equity’’ and does not, by its terms, decline over time.

This means that overall unitholders pay much larger fees than limited partners.

Typically, private equity funds have provisions to "claw-back" fees paid to general partners of the fund in the event the fund closes with a net-loss.  Not so here.  To wit:

Distributions that are made to the general partners of a KKR private equity fund pursuant to a carried interest in the returns generated by the fund’s investment generally are subject to reimbursement in the event that the fund is in a net loss position upon the termination of the fund. Distributions that are payable to KKR’s affiliates in connection with our co-investments and opportunistic investments will not be subject to similar reimbursement, although such distributions will take into account prior realized and unrealized losses.

In other words, KKR PEI could be a total bust except for three big LBOs that KKR Proper was only able to complete because of the additional funds available from this public entity.  Those LBOs would pay 20% carries to KKR Proper, but the rest of KKR PEI's investments could tank and drop the fund to below the initial offering price.  Despite this, KKR Proper keeps the LBO gains, and keeps the management fees it has packed in over the last many years.

Speaking for myself, I was quite looking forward to getting a peek at the various investments KKR Proper was making via disclosures that would have to be made now that a public vehicle was attached.  So much for that idea:

We expect that limited partners of KKR’s private equity funds will receive comparatively more information concerning a fund’s portfolio company investments than will be provided to our unitholders.

These will be subject to confidentiality requirements as well.  Ugh.  More in the days ahead.

KKR Luxembourgeoise

Why in the world would anyone want to do anything in Luxembourg?  It is a country socially divided between French and Flemish, it is filled with bankers, almost none of which are from the country itself, its small and gossipy, the local language, one of three official langauges, is a mish-mash of French, German and Flemish.  It was an important feature in the Battle of the Bulge, and is therefore the site of General George S. Patton's grave and its cliff faces and gorges are lined with the ruins of old fortresses, most of which have their origins in The Great War, but some that date back to 1000 AD.

KKR, however, like many foreign financial entities, found a more attractive use for the jurisdiction.

We expect that any investments in issuers that are based outside the United States or in private equity funds whose investments are focused outside the United States will be made through KKR PEI SICAR, a wholly-owned subsidiary of the Investment Partnership. KKR PEI SICAR qualifies as a risk capital investment company (soci´et´e d’investissement en capital `a risque), or a ‘‘SICAR,’’ under the laws of Luxembourg. A SICAR is a newly established vehicle for investment in risk-bearing capital for which the tax rules are still developing. Under Luxembourg law, distributions from SICARs are free of withholding tax and gains recognized by SICARs are not subject to capital gains tax....

Not a bad gig.  Smart development for a small EU country focused on financial services and where there are over licensed 900 banks.  But, warns KKR:

...the applicability of European Union directives and bilateral tax treaties to SICARs by certain other countries has not been definitively determined. If KKR PEI SICAR is not entitled to the benefits of European Union directives or relevant tax treaties, including Council Directive 90/435/EEC, KKR PEI SICAR could be subject to a withholding tax on distributions from portfolio companies of KKR’s private equity funds as well as a capital gains tax on dispositions of investments, any of which could have a material adverse effect on the price of our common units. Furthermore, the SICAR tax regime may be challenged by the European Commission if it is considered to have infringed upon the European Union’s state aid rules. In February 2006, a request for information was made to the Luxembourg government by the European Commission on the compatibility of the Luxembourg law SICAR vehicles with the European Union Treaty provisions on state aid. As of the date of this offering memorandum, it is not clear whether, as a consequence of this request, Luxembourg laws on SICARs and certain tax provisions thereunder as currently in force will ultimately be affected and whether the tax regime applicable to KKR PEI SICAR could ultimately be denied, with or without retroactive effect.

Wouldn't that be a rude awakening?  It is around this time that readers of the prospectus wonder "how complex is this entity... exactly?"  Luckily, a diagram about 10 pages later answers that question.

The KKR memorandum also brings to the surface something that isn't often talked about in the buyout world.  Overcommitments.  For the unwashed, investors in private equity don't typically write a check for the entire amount of their proposed investment the day they invest in the fund.  Instead, they make a "commitment" for the entire amount and tender some or none of that at closing.  The "commitment" is drawn down on by the private equity fund when it needs capital via a "capital call" to the limited partners.  Since the private equity fund cannot really invest the entire amount of its fund on day one, this makes some sense as it allows the investor to manage its own money according to its own treasury policies while the cash sits on the sidelines.  Some institutional investors, however, practice "overcommitment," whereby they commit more funds than they actually have to invest betting that enough time will pass for them to raise more, sell assets, etc., before a capital call that exhausts their free cash is made.  Overcommitment can, however, cause problems.  Specifically:

As is common with private equity investments, we expect that the Investment Partnership and its subsidiaries will generally follow an over-commitment approach when making investments in KKR’s private equity funds. When an over-commitment approach is followed, the aggregate amount of capital committed by us to private equity funds at any given time may exceed the aggregate amount of capital available for immediate investment. Depending on the circumstances, the Investment Partnership and its subsidiaries may need to dispose of investments at unfavorable prices or at times when the holding of the investments would be more advantageous in order to fund capital calls that are made by private equity funds to which they have made commitments. In addition, under such circumstances, legal, practical, contractual or other restrictions may limit the flexibility that the Investment Partnership and its subsidiaries have in selecting investments for disposal.

Diamonds in the Rough Set in Platinum

No doubt readers of Going Private will be aware of the value of slurping up suppliers into a business, particularly those that provide high margin products or raw materials (where a steady supply is critical or the commodity is unusually scarce).  This sort of vertical integration has been a critical part of business strategy since who knows when, but was probably best typified by Standard Oil in the industrial era.  As an interesting aside, the proper use of vertical integration can have substantial anti-trust issues, as was seen with Standard Oil, but, in my view more interestingly, also with DeBeers, of diamond fame.

DeBeers, then controlled by the Cecil John Rhodes (of the notable "Rhodes Scholarship") and Charles Dunhill "C. D." Rudd (almost entirely unnoted for anything but his association with Rhodes and DeBeers), managed to establish its stranglehold on diamond mines by controlling an altogether common and bland asset: water pumps and contracts to pump water from the main mines.  Water management being critical to mining, their grip on the water pump business made them a fortune before they even began to take large mining interests.

It is easy to see why a firm like Textron would be interested in owning fastener companies.  Particularly those that make expensive, FAA certified fasteners for aircraft, like Cessnas and Bell Helicopter (both firms owned by Textron).  Wondering why they would sell Textron Fastening Systems, which makes the lion's share of their high-precision, critical fasteners, to Platinum Equity, one of the larger operation private equity firms out there is, therefore, an interesting study.

Textron had Textron Fastening Systems on the block back before December of 2005.  They even went so far as to call it a "discontinued operation" back then.  Said the firm in its recent 10-Q:

On May 4, 2006, as a result of the offers received from potential purchasers of substantially all of the business of the segment, and the additional obligations that Textron now estimates will need to be settled as part of the sale, Textron determined that the net assets of discontinued operations related to the Textron Fastening Systems business may exceed the fair value less costs to sell. Consequently, Textron determined that it will incur a non-cash impairment charge in the second quarter of 2006 in the range of $75 million to $150 million.

One wonders aloud what might have been the headache with a well vertically integrated business that supplied critical, quality dependent and expensive parts to a manufacturer.  We are given quite a hint in the 10-Q again.

PART II.
OTHER INFORMATION
Our business could be adversely affected by strikes or work stoppages and other labor issues. Approximately 18,500 of our employees are unionized, which represented approximately 40% of our employees at December 31, 2005, including employees of the discontinued business of Textron Fastening Systems. As a result, we may experience work stoppages, which could negatively impact our ability to manufacture our products on a timely basis, resulting in strain on our relationships with our customers and a loss of revenues. In addition, the presence of unions may limit our flexibility in responding to competitive pressures in the marketplace, which could have an adverse effect on our financial results of operations.

Yeah.  Ouch.  In fact, so burdensome were the capital and managerial requirements needed to make a running with a unionized manufacturing entity based in Troy, Michigan that Textron decided to just divest the unit, and take a rather substantial hit to goodwill and related write-downs ($335 million in 2005).  They also charged $289 million for restructuring, though some of that is related to their other flagging businesses, InteSys and OmniQuip.

Back in 2002 Textron Fastening Systems had sold its 60% stake Grand Blanc Processing, LLC, a wire processing firm right back to Shinsho American Corporation, its joint venture partner.  Grand Blanc had been taking raw wire and supplying Textron with wire prepared (annealed, etc.) for use in Textron's fastener manufacture.  Again, another vertical integration play unwound by Textron.  And this particular divestiture was the last bit of the rather large wire processing interests Textron had acquired earlier in a big binge that went all the way back to 1996, before Textron bought Valois, a French manufacturer of fasteners.  It was also one of three wire processing business located in Michigan that Textron dumped.  This was partly because major clients were in automotive, and therefore in Michigan, but partly because Textron Fastening is in Troy.  One wonders if Textron was wisely exiting from the automotive industry back in 2002.  Not fast enough says their annual report:

During 2005, the Textron Fastening Systems business experienced declining sales volumes and profits. Volumes were down due to soft demand in the automotive market and operating difficulties. Profits were down due to the lower volumes, a lag in the ability to recover higher steel costs and inefficiencies associated with the consolidation of manufacturing operations in North America. Due to the continuation of these conditions, further softening of demand in the North American automotive market and an expected decline in the European automotive market, Textron’s Management Committee initiated a special review at the end of August to consider strategic alternatives for the segment, including the potential sale of all or portions of its operations.

Note how this explanation, low volume and revenue, differs some from their quarterly rationale.  Notice also that the reported revenues of the unit were $1.7 billion, $1.9 billion and $1.9 billion for 2003, 2004, 2005.  Not exactly a firm in crisis on the revenue side.

Still, Textron has been divesting "non-core" businesses for several years now, and being particularly anxious to rid themselves of Michigan businesses, particularly labor intensive ones, but also carbon manufacturers, fuel management system and flow control manufacturers since 2002.

This isn't a new hunting grounds for private equity firms, large corporations that failed to properly integrate an otherwise sound vertical integration strategy.  It is also unsurprising to see union shops being dumped left and right as well as Michigan businesses (are you listening to this Governor?) given the increasingly outsourced manufacturing capacity out there.  And what about quality?  I suspect Platinum Equity won't think twice about moving manufacture of the less complex products offshore and replacing all that expensive union labor with robust (but less expensive) quality control programs.

It is far cheaper to inspect the hell out of shipments from, e.g., China, in your local facility and just reject delivery of non-compliant product.  Who cares if the failure rate triples?  You just saved so much by killing off the most expensive labor on the planet (outside of Germany) that the pittance of a price you paid (something like 0.35x revenue), is going to make your IRR look quite yummy.

Plastic People, Paper Money

In October of 1997, Texas Pacific Group acquired an 88% stake in J. Crew composed of $66 million in common equity, $97.4 million in preferred stock (with accruing and payment in kind dividends).  The remainder of the nearly $527 million in purchase price was financed through private placement of debt and a mish-mash of the typical sorts of instruments readers of Going Private have come to expect from such transactions.  The debt to equity ratio at the time was around 3.2:1.

The best I can decipher the unusually opaque S-1/a filing for J. Crew, they had a series of traunches as well as a refinancing or two over the years.  Now, of course, they are IPOing.

As my time this week is dedicated to real deals, my analysis here is limited and I haven't bothered to delve deeply, nor do much with the complex option plan outlined (poorly) in the S-1/a.

Back when it looked like the offering would be $16 per share, TPG assumed they would snag around $321.8 million from the underwriters with an over allotment option (and I expect the underwriters exercised).  $279.8, however, they counted on regardless.  On top of that, TPG was paying around $73.5 million to snag another block of shares and J. Crew was to borrow another $80 million.  Of this they intended to spend it, well, on themselves.  Specifically:

$319.8 million to redeem the Series A Preferred Stock.
$112.0 million to redeem the Series B Preferred Stock.
$ 22.5 million in transaction fees.

Any overages in the offering would, they claim, be used to reduce the borrowings, which I describe below.

Just prior (May 15, 2006) to the offering J. Crew used $12.7 million in cash and $285 borrowed at LIBOR plus 1.75% - 2.25% or a base rate formula plus 0.75% + 1.25%.  I don't know how their "base rate" is defined, but LIBOR today is around 5.50%, so we can assume that, since the offering was a big hit, they managed to keep their total borrowings near $285 million and, therefore, are looking at the low end of their interest band, or around 7.25 - 7.75%.  Not bad, really.

The offering, had it just simmered, would have left on the order of $352.4 million in long term debt sitting in J. Crew.  It probably didn't sink that far given the opening price ($20.00, instead of the $16.00 used to calculate the above).

This is an interesting dynamic.  If there's enough investor interest, the total long-term debt on an IPO like this (i.e. one used primarily to cash out a private equity holder and service the massive debt used to pay dividends to the private equity holder) is reduced and the offering gets more interesting, bringing in more investors and reducing the debt more and therefore... you get the idea.  I wonder if underwriters are savvy enough to point this out when pitching the deal.  "We are so oversubscribed the debt level isn't going to be that high post IPO."  Hmmm.

So how did TPG do?

Looking at their common stock, TPG had slowly worked down or diluted their 88% position and owned about 56% (17,490,899 shares) of the common stock of the company before the offering.  Afterwards, they end up with about 40%.  They let go of something like 5 million shares.  At $20 each that's a cool $100 million.  Add to that the cashing out of their preferred shares (around $431.8 million) minus their new purchase of common ($73.5 million) and they have realized gains of about $458.3 million.  Add to that something under a 40% stake in J. Crew (or about 12 million shares) and you get unrealized gains of around $299.3 million (at the current price of $24.94).

Going back to October, 1997 and ignoring some of the recaps, options and other fees (that I may revisit later) we see the following:

Assuming we allocate the cost of the original common share purchase pro-rata to the split of common that is realized (i.e. offered in the IPO) and the unrealized common gains (still held by TPG after the IPO) we see that on their preferred shares they saw realized gains of around 16.30% IRR.  Not bad given the length of the investment.  On the realized gains on the common shares they managed a 21.64% IRR. Unrealized gains on common show a 23.63% IRR.  Total gains, realized and unrealized are around 19.42% IRR.

Bear in mind that the pro-rata allocation isn't really the way I should be doing the realized v. unrealized common analysis.  I also know there are some recaps in J. Crew's history and I suspect TPG took some capital out of those years ago.  I also am not factoring in management fees and any management agreement breakup fee.  (There might not be one since this is such a long holding for TPG).

More Paper From Less Plastic

Clearly, private equity sleuths David Carey and Lisa Gewirtz over at The Deal did far more digging (subscription required, sort of) into Texas Pacific Group's recent payoff IPO than I.  Crawling around in dusty filings from J. Crew they paint a more accurate picture of Texas Pacific Group's initial investment than the poorly researched, 1997 Daily News piece I relied on.  The duo finds the following:

The figures I used actually represented a group of investors, probably including some of the limited partners of TPG who co-invested using, among other things, a bland sounding vehicle called "TPG Advisors II."  (Note to self: remember to name holding companies for mostly obscure victims in Greek tragedies so as to befuddle uneducated and entertain clever financial reporters in the event the deal goes south.  Jocasta is my current favorite.  A good name for a chain of highly overpriced coffee stores, no?  Well, that is, except for that whole "marry your own son, find out and kill yourself so he can gouge out his own eyes with your broaches" thing).

According to the Dynamic Debt Duo, TPG itself only invested in the Series A preferred and common.  They held about 77% of the preferred.  This is in addition to around $50 million they invested in the common along with "direct affiliates."

I suspect their figure for an original investment of between $115 to $125 million for TPG's initial stake is closer than mine.  The recalculation of IRRs is left as an exercise for the Going Private Reader.

Getting It From The King

The Wall Street Journal reports on Burger King's sad performance (subscription required) in its first quarter as a public company following its LIPO (Leveraged Initial Public Offering to new Going Private Readers).  Usually pointed on such subjects, the Journal is, this time, somewhat vague and forgiving of The King's regal lapse.  Maybe the Journal figures that the double digit stock price sacking would do the critical journalistic work for them.  It better, as the usual prodding over the massive dividends paid immediately prior to the offering is shamefully absent from the article.

Shares of Burger King Holdings Inc. fell 11% in midday trading as the fast-food chain reported a loss and tepid sales growth for its first quarter as a public company.

The results underscore concerns that Burger King's private-equity owners took huge payments while leaving investors with a company that has not yet turned the corner. Burger King spent $30 million on a management termination fee during the fourth quarter that ended June 30 that went to owners Texas Pacific Group, the private-equity arm of Goldman Sachs Group Inc. and Bain Capital.

I'm not sure why the $30 million break-up fee was cited and yet the massive $367 million special dividend and $33 million "make whole" payment (management bonus) prior to the IPO  was not.  Perhaps the Journal just didn't want to kick investors in LIPOs while they were 11% down.  And maybe that's important kindness for them.  If we are headed into an economic slowdown, (ahem) well, never fear.  Burger King's King will save you with his scintillating strategic acumen:

Burger King Chief Executive John W. Chidsey said Burger King will benefit from a slowdown in spending at sit-down restaurants that's prompting some consumers to trade down to fast-food chains. Burger King said its new value menu is performing above expectations.

Uh huh.  And how will we press forward into the new age, according to Chidsey as cited by the Journal?

Burger King intends to promote its breakfast menu, emphasize its Kids' Meals and encourage franchisees to remain open longer at night...

This sounds familiar.  Now where have I seen this before...?  Oh yes, of course.  Way back.  It was in their S-1/A.

Currently, 50% of Burger King restaurants are open later than 11:00 p.m., with 7% open 24 hours. Approximately 70-80% of the restaurants of our major competitors are open later than 11:00 p.m., with approximately 42% of McDonald’s restaurants open 24 hours. We have recently implemented a program to encourage franchisees to be open for extended hours, particularly at the drive-thru.

Innovation. That's what makes management teams great.  Adapting to new environments quickly and decisively.  Really, this makes me think there is more to the former CEO's departure than meets the eye.

In any event, it looks like the private equity folks timed this transaction right down to the quarter.  At the risk of saying "I told you so," do consider my musings on the transaction back in May. I had glowing things to say about management, after all, it is hard to sneeze at eight quarters of sales growth when contrasted to the seven previous quarters of dismal failure.  But even then, I wondered why the then CEO bailed, seemingly unexpectedly.  Still, back then I was already picturing the deal set to Peter Gallagher and Annette Benning's sex scene in American Beauty:

Private Equity Sponsors: "You like getting nailed by The King?"
Public Equity Markets: "Yes!  I love it!  Oh, yes!  Fuck me, your majesty!"

Now I wonder, didn't anyone bother to tell Burger King investors that you can't eat for at least eight hours before LIPO suction surgery?

(Photo: Burger King Crime Scene, September 2004, [daily dose of imagery])

High Tension Cable

Blackstone's acquisition of a 4.5% stake in Deutsche Telekom got a lot of Going Private Headlines over the last several months, not least because of the highly atypical nature of the deal (a minority investment in a public firm by a generally control-obsessed buyout firm).  I read with interest, therefore, a self-proclamed "dilligent fan"'s email missive pointing out that the equity stake Blackstone had taken in the deal, and indeed the investment at large, has been pounded.  Bloomberg reports yesterday that:

Blackstone Group LP's stake in Deutsche Telekom AG has dropped by about 540 million euros ($689 million) in value after shares of Germany's former phone monopoly lost almost a quarter of their value in four months.

The New York-based buyout firm bought 191.7 million Deutsche Telekom shares for 14 euros apiece from KfW Group, the state bank said in April. At the time that stake was worth 2.68 billion euros. Shares of Europe's largest phone company have since dropped to 11.17 euros, cutting the value of Blackstone's 4.5 percent stake to 2.14 billion euros.

The stock sagged another 4% today, I'm told.

Blackstone's self-imposed two year lock-up prevents them from exiting, though I'm not certain why they would at this point in any event.  If they truly believe in their investment premise, and my speculation about their motives is anything near correct, now would be the time to start acquiring a larger stake.

Alternatively, perhaps rumors of their interest in a larger stake were buoying the shares, i.e. the next stage of the acquisition might have been already priced in, and the failure of such a plan to materialize with anything like speed is now weighing them down.

Certainly, given the size of the firm it would be a difficult deal to pull off without a club-like setup. Will other firms be confident enough in Blackstone's investment theory to join the party in the face of sagging shares?  More than ever, perhaps, at this new price if the balance sheet for DT looks as good to them as it sounded to Blackstone.  Still, one of the purposes of buyout funds is to structure for the long term.  If DT's assets are fundamentally sound and this is a temporary dip then it is an opportunity.

It will be interesting to see how one of the largest buyout firms responds to this very public short-term setback.  And this, in turn, highlights one of the problems with PIPE deals by private equity firms- they aren't private.  Are large buyout firms prepared to deal with foreign investor relations issues?  Charges that they are locusts?  Plagues?  A forward looking career consultant might suggest there will be a growing need for public and investor relations experts with finance backgrounds in large private equity firms as these low hanging fruit becomes harder to find, these sorts of deals become more common and this issue grows to a more significant one.

Neiman Marcus or Needless Markup?

The Wall Street Journal points to payment in kind options on debt agreements or payment in kind (PIK) "Toggle" debt as a sign that the power in the hands of debt issuers is substantial.  The Journal wonders, are these tools helpful breathers for firms that stumble for a quarter or two, or dangerous multipliers of risk?

Both.

Payment in kind is the payment of interest on a debt instrument with more debt instruments (i.e. in kind), rather than in cash payments.  In effect, the interest accrues and is paid at a later date (usually the maturity of the instrument).  In my experience, non-switching PIK instruments usually sit below several other layers of more senior debt, and bear a higher rate of interest.  This should be intuitive to Going Private readers who will recognize that, lacking interest payments, PIK instruments are riskier for a lender to hold.  There is no canary in the mine for this layer of debt.  No missed payment to warn the holder of an impending default and therefore less of an ability to monitor the debt.

PIK Toggle instruments turn off interest payments and switch to PIK interest at a particular time, perhaps at the option of the issuer.  This was the structure of the example the Journal uses, in which Neiman Marcus was granted $700 million in PIK Toggles, the interest payments of which could be switched off at Neiman's option to reduce the debt burden on the company in a time of difficulty.  The interest would accrue at a higher rate (9.75% v. 9.00%) when the instruments mature in 2015.  Neiman would hardly be off the hook even if they flipped the toggle.  They started off with $3.2 billion in debt so turning the PIK on would increase their cushion, but not eliminate payments by any means.

One assumes that the increase in interest rate on the debt in question would provide a strong disincentive to flipping the PIK on unless the situation were dire, and we might also assume that, since the PIK would only be activated if the company were nearing default on interest payments due to collapsing revenue or unanticipated costs, the lender would expect to have the debt paid via a refinancing on maturity (or perhaps a LIPO).  (Certainly the cash would not be sitting in the company's coffers at that point).

Indeed, we can see that PIK toggle permits struggling firms to "live to fight another day" when they are staring default in the face, but this begs the question: should they be able to?  After a fashion, a PIK Toggle bypasses the events that typically signal default and, by proxy, indicate that the firm has become a distressed.  Though we may sympathize with management, giving them more rope to hang themselves and charging nearly an additional percentage point for the pleasure might not always be the best option, as opposed to taking the keys and imposing more drastic fiscal discipline via the debt recovery department of the lender.

The other thing that concerns me about the practice is exactly what Texas Pacific likes about it.  To wit: ""This innovation was one factor enabling us to pay a more aggressive price."  This should, of course, be read: "This innovation was one factor enabling us to assume much more debt that would otherwise have been prudent."  Really, what the PIK layer did for Texas Pacific and Neiman was increase the amount of debt that could be assumed to beyond what would have been prudent if the interest payments could not be turned off.

Far less safety margin seems required when PIK instruments are used and it is quickly tempting to push the limit to win auctions.  It is, perhaps, telling that, "Nearly every TPG deal since Neiman Marcus includes debt with the PIK toggle feature."  It's easy to forget that the effect of a PIK Toggle is to dramatically increase the debt burden on the company at a time when it is already showing signs of difficult with the existing levels.

The good folks at GoldenTree Asset Management are mentioned poo-pooing PIK Toggles.  Sub Rosa has done some work with GT folks and they do love their PIKs, at least in my experience, but they just don't toggle them much.

Used prudently, PIK Toggles seem like a decent tool to hurdle a speed bump or two in the road.  I suspect, however, they cause some rather severe damage to the rims of the faster driving deals out there.

The King is Recovered

In past, I have been pretty tough on Burger King's LIPO in the past and its management plan for expansion and growth.  Burger King was a pretty easy target after Texas Pacific Group, Bain and Goldman Sachs all took a fat special dividend paid for in debt immediately prior to the IPO.  Interesting, therefore, that the Wall Street Journal, which, in one breath, wonders after (subscription required) the poor state of the restaurant industry...

Activist shareholders and private-equity firms are reshaping the restaurant industry as it retrenches after years of overbuilding and struggles to lure cash-strapped diners, with Applebee's the latest chain to respond to a big shareholder.

...elsewhere (subscription required) in the same edition outlines Burger King's new-found good fortune owed to exactly the thing that others in the industry are being skewered for.

Burger King Holdings Inc., benefiting from aggressive restaurant expansion and the rollout of a breakfast value menu, reversed a year-earlier loss and posted better-than-expected fiscal third-quarter earnings Friday.

The world's second-largest hamburger chain said it expects to beat its revenue goal for the fiscal year, which ends in June. Revenue is forecast to increase 6%-7% and adjusted net income more than 20%.

[...]

Burger King said its strong free cash flow allowed it to pay down debt to historically low levels in recent months.

Pretty impressive, actually, considering what seemed, at least to me, to be a rather rudderless forward-looking strategy and the general state of the industry.

Personally, I noticed that Burger King's LIPO left a bad taste in my mouth.  I wouldn't have bought the stock in the IPO, or since.  However, some pundits used the LIPO as an excuse to decry the private equity world and name 2007 the "year of private equity crisis."  Never mind that the investors who bought into the Burger King IPO did so with open eyes, well aware of the company's debt load.  (And the patient ones seem, for now, to have done moderately well).  Even unpopular LIPOs seem to have a place in the private equity schema.

Wouldn't it be ironic if some activists, noting the historically low debt load on Burger King now, decided to pile in and demand a dividend recap?

Mad Dear Disease

I wasn't a believer in the efficacy of "sheer willpower" in a deal-making context, but I may well be prone to alter my skepticism after watching the close of the Intelsat transaction last week- a deal which seemed teetering on the brink of failure on an almost daily basis.  Of course, deals with this kind of debt load (it floats at around 9.3x EBITDA) generally only get done when the underwriting banks feel they can easily lay off the debt to the public (or a set of Qualified Institutional Buyers ("QIB"'s) willing to endure the highs and lows of holding buyout debt bought though a Rule 144a sale.  As an aside, the rise of Rule 144a exchanges has been quite a boon for liquidity with respect to these sorts of debt instruments and, I suspect, has softened the blow to debt markets quite a bit).

In this case, however, the banks didn't even bother going to the street.  Bank of America, Credit Suisse and Morgan Stanley underwrite nearly $5 billion in new debt in the transaction, less than half of the $11 billion of debt that now burdens the weary shoulders of Intelsat.  Interestingly, the old debt holders were, somehow, lured into hanging on to their existing debt to reduce the amount the underwriters would have to float (and burden some debt market or another with) to close the deal.

The Wall Street Journal points out that Clear Channel Communications and BCE are queued up to saturate the debt market with their paper before long, so it's probably more than minor coup that Intelsat's underwriters aren't headed to the street with more than $10 billion in debt to place.  The less than pleasant, but highly entertaining Harrah's debt issue has already pushed the saturation limits, which makes one wonder how long those underwriters will have to hold the debt on their own books.  Maybe quite a while.

Some rather uncivilized behaviors by certain banks (ahem, Credit Suisse) that have gone to market with their share of Harrah's debt before the schedule agreed upon by their fellow underwriters (very bad form, that) will cause the always astute Going Private reader to draw many conclusions about the "desperation quotient" these kind of balance sheet lodestones can create.  This event also generates my favorite debt-related quote of the year so far from a Credit Suisse banker on the subject of front-running their underwriting colleagues:

"There is no contractual obligation.  We cannot concede control over our own capital."

This is interesting as, at least by the numbers, Harrah's is one of the better looking of the large LBOs right now.  $6 billion of equity has kept its debt:equity ratio comparatively low.

This is boring news compared to the sort of antics to be seen over at Clear Channel.  It doesn't take deep psychological analysis to read the internal memo from John Hogan back in January as originating from something resembling panic.  To wit:

From: Hogan, John
Sent: Friday, January 25, 2008 09:31
To: Radio General Managers - All; Radio Business Managers
Cc: Radio EVP's; Radio SVP's ; Radio SVPP; Radio RVP
Subject: First Quarter Contingency Plan

Good Morning,

As you are undoubtedly aware, we are generating less revenue for Q1 than we budgeted and less than what actually ran last year. At the same time, our budgeted expenses for Q1 are up 4%. While there are a number of factors contributing to our revenue shortfall the fact is we are behind on our revenue plan, up over last year on expenses, and as a result we will be well below our budgeted Q1 bcf. As responsible managers, we need to address the shortfall not only by continuing to find ways to increase our revenue but also by implementing cuts on the expense side until revenue production improves.

[...]

The following Q1 expense reductions are to be implemented immediately in your market and correctly reflected to San Antonio by having your Market Controller access the Flash website under Reporting Events and complete the form titled "Q1 Contingency Plan"

[...]

-any/all discretionary monies (i.e. travel, meals and entertainment, etc) for your market. If you can save it, do so.

[...]

I completely understand the challenges associated with implementing the above cuts. It will make your job more difficult and have some long term affect (sic) on your overall performance. It goes without saying that leading through these reductions will be challenging. If there were another better alternative, we would not be requiring these reductions be implemented. Unfortunately, there is not another alternative.

Impact on share price once the memo got out (instantly, of course) should be predictable.  (Spoiler below).

Still, add to the distress the fact that the bottleneck in loan markets is quite severe, and the picture looks dim indeed for banks holding CCC and BCE debt with the hopes of unloading it.  Standard and Poor's points out that something like $150 billion in unsyndicated debt sits on the books of various banks, the vast majority of it LBO related.  $0.90 on the dollar is a gift for many of these instruments at this point.

It resembles the sort of thing we started to see back in January.  Or as the Journal put it more specifically:

With the prices of existing loans tumbling, investors have little incentive to buy new loans unless they are sold at steep discounts, something banks are reluctant to do.

The result: More assets building up on bank balance sheets, growing tensions among rival bankers who had grown accustomed during the buyout boom to cooperating with each other and a deepening crisis in the market for buyout debt.

The crisis started last summer, when investors turned up their noses at billions of dollars in buyout debt, just after many buyout firms and their bankers made commitments to history-making megadeals. Many investors say January was the worst performance for this market since those summer months.

And this is why it is difficult not to let out a low whistle when reading about the Intelsat deal.  And that's before you do any sort of IRR calculation on the figures, which, after a January, 2005 investment of $128 million by Madison Dearborn (with Apax, Apollo, and Permira as co-investors) pulled down $1.2 billion or so for Mad Dear with the purchase of Intelsat by BC Partners, Silver Lake and others for $5 billion.  Add to this about $163 million in various other fees (management fees, probably) and you have a tidy sum.  Assuming those management fees were paid yearly or thereabouts and in equal measure (and this is probably wrong as a large chunk of the fees were likely for "early termination" of the management contract itself, as it's hard to imagine they predicted a liquidity event so soon) and you get figures that look about like this:

Yum.