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Money Printing And The Bane Of Financial Engineering – How The Biggest LBO In History Blew-Up

Courtesy of David Stockman via Contra Corner

Financial engineering is one of the worst ills perpetuated by the Fed’s regime of cheap debt and money market subsidies for speculation. And these deformations are turbo-charged by the tax code which creates a powerful bias toward loading capital structures with tax deductible debt, and to delivering returns as lightly taxed capital gains rather than ordinary income.  In fact, stock buybacks and LBOs are the bastard offspring of the IRS and Federal Reserve.

Indeed, it would be safe to say that in an honest free market with a neutral tax regime, LBOs in particular would be as rare as a white buffalo. That’s because they inherently cause waste, inefficiency and malinvestment—–the opposite of market driven results.  These deadweight losses to society are, in turn, the product of a symbiotic arrangement of convenience between an avaristic breed of money manger——private equity funds—–and institutional investors, such as pension funds and insurance companies, which have a desperate need for yield in a financial system where returns on conventional fixed income securities are systematically repressed by the central bank.

Private equity managers are tax-enabled speculators. Their winnings come in the form of a 20% carried interest on the thin slice of equity at the bottom of an LBO capital structure. This 20% share of the return earned by the limited partners (LPs), who actually put up the money and bear the extreme risk of being pinned under a mountain of debt, might arguably be considered generous. But there is no way that it should be considered a capital gain. It is nothing more than the service fee earned for managing other people’s money.

Needless to say, the taxation once over lightly of carried interest winnings as capital gains creates a humungous incentive to swing for the fences, thereby exacerbating the inherent risk asymmetry of the LBO business model. In short, carried interest driven private equity managers loose nothing on bad bets——100% of the losses go to the LPs.  But 16% of what are often massive upsides in winning deals go to the titans of private equity on a tax free basis (i.e. 80% of 20%).

The fact is, there are a few thousand private equity partners who have captured hundreds of billions in winnings from this arrangement during the past 2-3 decades. And they have done so notwithstanding the fact that they have created hundreds of billions of financial losses—-some of them spectacular as in the TXU case described below—-in the process of harvesting their loot.

How can this be?  Call it asymmetrical averaging.  That is, due to their high leverage LBO’s inherently created spectacular wins but only humdrum losses at the equity investor level. In the case of a $1 billion deal funded with $200 million of equity and $800 million of debt, for example, a doubling of the value of the LBO company over say five years results in a distribution of $800 million to the debt investors and $1.2 billion to the equity investors. The private equity managers, in turn, take 20% or $200 million of the billion gain.

Needless to say, everyone is happy. The LPs made 4X their money ($800 million of profit) even after paying the carried interest, and the private equity managers walked off with $160 million of after-tax gains for investing, well, nothing!

At the same time, consider what happens when a deal comes a cropper. Say after 5 years, the value of the LBO company has been cut by 50% to $500 million. In that event, the LP’s lose their entire $200 million investment, the junior debt investors or junk bonds lose $300 million and the private equity managers loose nothing except some face.

But the key thing is they do not lose their business in the big leagues of private equity finance just because one deal blows up or even several deals. Indeed, institutional investors expect LBOs to blow up because they are playing a game of averaging up to a higher yield.  So in the case of four $1 billion deals in which they invested $200 million in each, they could actually have two wipeouts, one 10% return deal and one home run of the type described above.

In that event, they would recover $1.25 billion on $800 million or a 56% gain over five years. That computes to 10% per annum after fees——-far more than available on risk free government bonds or even corporates.

This all sounds like financial magic, but it’s really a financial deformation. Without the Fed-driven quest for yield and the tax deductibility of debt, there would be no multi-trillion junk bond market. And without junk bonds to absorb the losses from LBOs which blow-up, the returns to LPs would be dramatically lower and more reflective of the actual risk being incurred.

It goes without saying, of course, that the anomaly of massive carried interest windfalls to the private equity titans exists only due to tax and capital market deformations. Yes, there is a myth that says LBOs exploit the inefficiency of the public equity market and that, under the pressure of heavy debt obligations and equity-incentivized management teams, they are able to wring costs and efficiencies out of company operations. But that is self-serving propaganda.

Private equity exists because institutional investors are receiving falsely inflated returns from their LP investments in the so-called alternative asset space. The only excess returns which occur there are the result of tax subsidies and central banks financial repression of interest rates.

Accordingly, the averaging-up of home runs and busted deals in the private equity business does not reflect real economic gains on a net basis; and the losses that occur in the busted deals have no economic purpose—- unlike say losses in a venture capital deal when a promising idea simply fails to pan out.

What busted LBOs do, instead, is generate huge transactions costs in the so-called work-out space where legions of lawyers, bankers, accountants, consultants and speculators make a killing on the carcass of busted deals. But these are dead weight losses to society that would not occur in an honest free market because the cratered deals would not have been done in the first place.

This is all by way of saying that the greatest busted LBO of all-time, and the wasted economic resources which it generated during its prolonged bankruptcy, workout and recapitalization process is nearing its baleful conclusion right now. Namely, the TXU fiasco, which was the largest LBO in history at $47 billion.

Based on current indications, it appears that investors in the $40 billion of debt which went into the deal will recover about 40 cents on the dollar. So investment losses will be in the range of $24 billion plus several billions more of transactions costs consumed in the bankruptcy. All of this represents capital wasted and malinvested owing to falsification of debt prices by the central bank and the deep bias of the tax code toward debt and speculative capital gains.

Even when LBOs avoid the fate of TXU——-harm is still done. That’s because the capital structure of most businesses needs to have the flexibility that is inherent in equity securities. Namely, the ability to vary the current return to investors based on short-term business conditions, competitive opportunities/threats and cash flow timing issues.

By contrast, heavily leveraged LBO’s transform managers and executives into slaves to the bi-annual coupon payment to junk bonds and monthly loan service to the senior lenders. Through a process both overt and subtle, cash flows are systematically under-applied to business development, staffing and capital improvements in favor of meeting interest obligations and paying down principal.

Stated differently, cash disposition in the context of LBOs is not a market driven process that adds to economic efficiency and productivity; it is an artificial byproduct of tax and central bank distortions of the free market.

In sum, the LBO variant of financial engineering generates large market inefficiencies when it works; huge transaction costs and waste when they blow-up; and endless windfalls to the practitioners on both sides of the life cycle.  That is, the private equity mavens who harvest the carried interest windfalls from averaging up the homeruns and busted deals in a private equity portfolio, and the vulture investors who work the bankruptcy process and feast off the carcass.

The excerpt below from The Great Deformation underscores how the TXU deal blew-up and why it would never have happened in an honest free market.

From The Great Deformation

The wildest speculators in Leo Melamed’s pork-belly rings at the Chicago Merc could never have dreamed up a commodity trade as fantastical as that underlying the $47 billion LBO of TXU Corporation. It was basically a bet on a truly aberrational price gap between cheap coal and expensive natural gas—a “fuels arb”—that couldn’t possibly last. So the largest LBO in history was the ultimate folly of bubble finance.


Electric power utilities are normally stable generators of cash flow, plodding along a tepid path of growth. But TXU’s financial results in the year before its February 2007 buyout deal had been mercurial, making its initially benign leverage ratios an illusion. Thus, TXU had posted about $11 billion of revenue and $4.5 billion of operating income prior to the buyout, but by fiscal 2011 the company’s sales were down by 35 percent, to $7 billion, and operating income was just $960 million. Its bottom line had plummeted by nearly 80 percent from the pre-LBO level.

Accordingly, the company’s leverage ratio has become a horror show. Its fiscal 2011 debt stood at $36 billion and thereby amounted to nearly thirty eight times its reported operating income. In LBO land that ratio is beyond the pale—it’s a veritable financial freak.

How the largest LBO in history ended up this far off the deep end is a crucial question because it goes right to the heart of the great deformation of finance. The TXU deal is the financial “Vietnam” of the Greenspan bubble era, not some dismissible aberration from the main events. It was sponsored by the “best and brightest” in the private equity world including KKR, the founding fathers of LBOs, and David Bonderman’s TPG, which was also a successful LBO pioneer of legendary rank.

Since the equity portion of the financing at $8 billion was only 17 percent of the total capitalization, TXU’s existing $12 billion of conventional utility debt had to be tripled, to $38 billion, in order to close the deal. Ac- cordingly, Wall Street had a money orgy coming and going. Fees on the new deal exceeded $1 billion, and at the LBO closing there was an epic $32 bil- lion payday for selling shareholders, including the hedge funds which had front-run the deal.

At the time, the reckless wager embodied in the TXU buyout was rationalized as nothing special. The purchase price at 8.5 times EBITDA was purportedly in line with the 7.9X average for publicly traded utilities. Yet when the onion was peeled back by a year or two it became clear that the buyout was being set up at a lunatic multiple: an astonishing 18X the company’s EBITDA in 2004.

This jarring difference reflected the fact that TXU’s income was temporarily and drastically inflated by a utility deregulation bubble floating on top of a natural gas bubble. Under the Texas deregulation scheme, wholesale electric power prices were set by the marginal cost of supply, which was natural gas fired power plants. But TXU generated most of its power from lignite coal and uranium, so when natural gas prices soared its own fuel costs remained at rock bottom. The company’s revenue margin over the cost of fuel, therefore, also soared, rising from 38 percent in 2004 to nearly 60 percent in 2006. The gain was pure profit.

If deregulation meant a permanent increase in TXU’s profit margins, of course, the heady February 2007 LBO valuation of its current cash flow might have made sense. The underlying reality, however, was that the price of wholesale electric power in Texas at the moment had been inflated by a humongous natural gas price bubble which flared-up in the wake of Hurricane Katrina’s August 2005 disruption of offshore gas production.

Natural gas prices had soared to the unheard of range of $10 and $15 per thousand cubic feet (Mcf ), compared to a band of $2–$5 per Mcf that had prevailed for years. So TXU’s fulsome cash flow was running on the afterburners, as it were, of one of the greatest commodity bubbles of recent times.

At the same time that TXU was booking revenues of 13.7 cents per Kwh based on natural gas prices, the fuels cost at its base-load nuke plants was 0.4 cents per kWh and just 1.2 cents in its lignite coal plants. Thus, at the coincident peaks of the Greenspan credit bubble and the natural gas price bubble in February 2007, TXU was selling electric power at 12X and 36X the cost of its lignite- and uranium-based power, respectively.

These markups were off-the-charts crazy. Even after absorption of modest fixed operating costs (labor and maintenance) at its power plants and corporate overhead, the profits were staggering. It was only a matter of time, therefore, until the natural gas bubble ruptured and TXU’s power margins came crashing back to earth.


As it happened, the Fed’s rock-bottom interest rates were contagious and fueled a boom in debt-financed gas drilling that soon caused supplies to soar and natural gas prices to plummet. In this manner, the power plant “fuels arb” was flattened and with it the company’s financial results. The Fed thus unintentionally bushwhacked the largest LBO in history. So doing, it demonstrated just how badly the nation’s central bank had mangled the free market.

When Bernanke slashed interest rates to nearly zero, it triggered a Wall Street scramble for “yield” products to peddle to desperate investors—at the very time that the natural gas patch was swarming with drillers willing to issue just such high yielding securities. The natural gas price bubble had encouraged a drilling boom based on horizontal wells and chemical flooding of gas reservoirs. This “fracking” process can liberate prodigious amounts of natural gas that otherwise would remain trapped in low-porosity shale reservoirs, but it also slurps capital in vast amounts: fracked wells generate bountiful gas output during their first few months of production but then peter out rapidly. Thus, the whole secret of the so-called fracking revolution was to drill, drill, and keep drilling.

The tens of billions of fresh cash required for the shale-fracking play was not a problem for the fast-money dealers of Wall Street, who had just the answer: namely, high-yielding natural gas investments called VPPs (vol ume production payments). These were another form of opaque off-balance sheet debt. In this case investors provided up-front funding for gas wells in return for a fat yield and a collateral claim on the gas.

Accordingly, a flood of Wall Street money found its way to red-hot shale gas drillers like XTO, which was soon swallowed whole by ExxonMobil, and to the kingpin of the shale-fracking play, Chesapeake Energy. Its balance sheet grew explosively between 2003 and 2011, with proven reserves rising from 2 trillion cubic feet to 20 trillion and total assets climbing from $4 billion to $40 billion.

It was virtually limitless Wall Street drilling money that accounted for this pell-mell expansion. During this same eight-year period, Chesapeake’s outstanding level of “high yield” borrowings—bonds, preferreds, and VPPs— rose by 10X.

This debt-driven explosion of reserves, production, and injected storage eventually left giant drillers like Chesapeake gasping for solvency; massive new gas supplies caused prices to steadily weaken and then crash. By the spring of 2012, natural gas was trading at a price so devastatingly low ($2.50 per Mcf ) that even the monster of the gas patch, ExxonMobil, cried uncle. “We are losing our shirts” complained its CEO, Rex Tillerson.

With little prospect that natural gas will revive anytime soon, TXU’s revenues and operating income will remain in the sub-basement. The $36 billion of LBO debt raised at the top of the Greenspan bubble is therefore almost certain to default (note: it did!) owing, ironically, to the aftershocks of the even larger debt bubble which fueled the fracking binge.

The larger point is that artificially cheap debt causes profound distortions, dislocations, and malinvestments as it wends its way through the real economy. In this case underpriced debt

fostered a giant, uneconomic LBO and also massive overinvestment in natural gas fracking. When the collision of the two finally brings about the thundering collapse of the largest LBO in history, there should be no doubt that it was fostered by the foolish money printers in the Eccles Building and the LBO funds who took the bait.

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