The Great Deformation

by David Stockman

  Moreover, in this instance crony capitalism was actually a family affair. Fully $1 billion of the equity capital for the HCA buyout was supplied by the estimable Thomas Frist, the original founder of HCA and energetic foe of the very Big Government on which his fortune was based. In waging this campaign the Frist family left no stone unturned, placing Bill Frist in the US Senate and seeing to it that he eventually became majority leader.

  Needless to say, the Senate majority leader required no schooling as to why Federal bureaucrats needed to be prevented from reducing payments for stent surgery by 33 percent, or cutting the Medicare payment for a defibrillator implant from $30,000 to $22,000. In fact, the entire proposed DRG reset was designed to drive these kinds of expensive specialty treatments away from high-cost general hospital chains like HCA and toward a medical version of low-cost, high-volume “focused factories.”

  The estimate at the time was that this sweeping change in the Medicare reimbursement régime could have reduced its hospital payments by 30 percent and would have struck a mortal blow at high-cost general hospital chains like HCA. Stated differently, much of the inflated EBITDA which was absorbing HCA’s $2.0 billion annual interest bill would have been clawed back to the benefit of taxpayers.

  As it happened, Bill Frist retired from the Senate at the end of 2006 in a blaze of glory for numerous deeds which had allegedly taken a nick out of Big Government. Among these was a congressional kibosh on the proposed Medicare reimbursement reforms, an action that actually made Big Government fatter by tens of billions per year; a favor it bestowed upon the Frist family fortune as well.

  With the Medicare reimbursement spigot locked in the “wide-open” position by congressional mandate, HCA has generated a healthy 5 percent growth in revenues since 2005 and a 5.5 percent annual gain in EBITDA. This has permitted it to service its $2.0 billion per year interest tab and still make the huge dividend payments described above.

  Still, the fact that $28 billion in debt can be serviced in this manner is only possible owning to the interest rate repression policies of the Fed and the tax deductibility of interest payments. This case makes self-evident that together these policies have fostered an insanely leveraged capital structure that would never see the light of day in a genuine free market with neutral rules of taxation. Moreover, the régime of “too big to fail” now adds insult to injury by encouraging banks to fund reckless self-dealing dividends which would have been shocking even to the LBO industry one decade earlier.

  In short, the KKR and Bain buyout of HCA makes for a fitting tombstone on free market capitalism. In a world in which the financial maneuvers described above can happen, the discipline of the free market has long since disappeared.

  THE DEBT ZOMBIES KEPT ON COMING

  All the founders of the LBO industry—KKR, Blackstone, Apollo, TPG, and Bain Capital—have been stuck in giant deals that have turned into debt zombies. Accordingly, the outbreak of mega-LBO mania during 2006–2007 was not simply the result of one or two firms becoming overly exuberant. Instead, it reflected a financial market deformation that sowed mania and recklessness across the entire private equity space.

  The eventual result might best be described as turnkey bidding wars. Syndicates of the big Wall Street banks offered turnkey financing packages consisting of multitudinous layers of secured, unsecured, and exotic “toggle” and “second-lien” debt to competing private equity bidding groups. The latter only needed to “slot-in” a 20–30 percent equity commitment at the bottom of these turn-key debt structures in order to reach a total bid price for giant companies put up for auction by other groups of Wall Street investment bankers.

  The heated bidding wars among the top tier private equity houses thus resulted in a “topping-up” of transaction prices which were being set in the yield-crazed debt markets. In this frenzy even the most disciplined private equity houses lost their heads because by now a second fatal assumption had planted deep roots on Wall Street—namely, that the Fed’s Great Moderation guaranteed that GDP would not falter and that financing markets would remain buoyant.

  The $28 billion buyout of First Data Corporation, the nation’s largest processor of credit and debit card data for banks and merchants, dramatically illustrates the sheer insanity of these LBO bidding wars. In theory, First Data might have escaped the zombie debt trap since—for better or worse—credit cards have been a growth industry and, in fact, the company’s revenues have risen at a 7 percent rate since 2007, notwithstanding the Great Recession.

  But First Data has actually made no progress at all in reducing the $22 billion LBO debt it took on in September 2007 for a single overpowering reason: the speculative climate fostered by the Fed was so frenzied that even the gray eminence of the industry, KKR, was induced to acquire a good company at a preposterous price. The $28 billion price tag thus represented an astounding 51X the pro forma operating income of the company during 2007 and nearly 16X EBITDA.

  It goes without saying that the company’s modestly growing sales and cash flow have been no match for $2 billion of annual interest expense. Accordingly, during the eighteen quarters since the buyout, First Data has recorded nearly $7 billion in net losses. After netting capital spending and minority partner payments against income from operations, the company generated less than $450 million of free cash flow during the entire period. Needless to say, at that rate ($25 million per quarter) it would take First Data 220 years to pay off its debt!

  In truth, a crash landing has been prevented so far only because billions of LBO debt has been subjected to “extend and pretend.” During the first quarter of 2012, for example, the company refinanced $3 billion of bank debt at higher interest rates, thereby deferring these maturities from 2014 until 2017. At free market interest rates, by contrast, First Data could never refinance its $23 billion of loans as they come due. Keeping the debt zombies alive, therefore, is just one more deformation that flows from the Fed’s financial repression policies.

  CLEAR CHANNEL COMMUNICATIONS:

  DEBT ZOMBIE ON A “STICK”

  In May 2008 Bain Capital and Thomas Lee saw fit to pay fourteen times operating income for a company that was the communications industry equivalent of the proverbial buggy-whip maker. Clear Channel Communications, in fact, had been a speculator par excellence in the humble business of owning what were called radio “sticks,” or FCC licenses, to operate AM and FM radio stations.

  By the time of its $23 billion LBO, it owned 850 radio stations, and it could not be gainsaid that radio stations were profitable. During 2007 Clear Channel had generated about $1.6 billion of operating income, a figure which amounted to a healthy 24.1 percent of its $6.8 billion in net revenues.

  Thus, the deal sponsors did not hesitate to pile on the debt, pushing the company’s borrowings from $5 billion to $20 billion in order to fund an $18 billion payday for the current stockholders. This massive debt load was readily raised, however, because radio “sticks” were a favored offspring of the Greenspan bubble era.

  Due to abundant and increasingly cheaper debt financing, LBO operators large and small had driven the value of radio sticks steadily higher, from less than $8 per pop (population served) to nearly $20 per pop at the peak in 2007–2008. At that point deals were being valued not on their operating income, but on their resale value; that is, based on stick flipping.

  Accordingly, Clear Channel’s $23 billion LBO reflected the trading value of its massive collection of sticks and billboards, not the company’s operating income which had increased at only a prosaic 4.5 percent rate during the four years ending in 2007, and even much of that was due to acquisitions. The magic value gains of radio sticks, however, rested on a double helping of bubble finance; that is, consumer advertising growth and cheap debt.

  Radio advertising revenue grew moderately during the bubble era because the heaviest advertisers—auto dealers, home builders, restaurants, and bars—were the beneficiaries of the housing boom and consumer spending obtained from their home AT
M machines. In effect, valuations rose because consumers were spending borrowed money which fueled radio station advertising and cash flow. And then, cheap financing for leveraged radio deals caused stick valuation multiples to be bid up even further.

  Needless to say, the music stopped in September 2008. Radio advertising has not recovered from the sharp decline triggered by the violent collapse of the auto and housing industries. And now radio operators are also confronted with gale-force headwinds owing to the migration of advertising dollars from broadcast to the Internet, and to competition from alternate technologies such as Internet radio (e.g., Pandora).

  Not surprisingly, Clear Channel’s financial results have headed irrevocably southward. During fiscal 2011 its revenues were still 10 percent below 2007 levels, but, more importantly, the fat profit margins which once reflected the state-bestowed gift of scarce radio spectrum are now beginning to rapidly erode in the face of genuine free enterprise competition.

  Thus, by 2011 Clear Channel’s historic 24 percent operating margin had diminished to just 16 percent. Consequently, the double whammy of lower revenues and rapidly weakening margins has taken a huge bite out of operating income. In fact, its 2011 figure of just $1 billion was down nearly 40 percent from the pre-LBO total of $1.65 billion reported in 2007.

  So its $2 billion annual interest bill is now double its operating income, meaning that the game of “extend and pretend” is getting increasingly dicey. The company is now leveraged at twenty times its operating income, yet faces a huge debt maturity cliff in the immediate future: $4 billion is due in 2014 and another $12 billion of debt must be repaid in 2016. Yet by then advertising revenues will be in deep secular decline due to competitive venues, and the value of its “sticks” will be vaporizing. The digital technology revolution is, in fact, turning the company’s portfolio of FCC licenses into the world’s largest collection of buggy whips.

  BERNANKE’S (UNTOUGH) LOVE CHILD:

  THE $27 BILLION AFFAIR AT THE HILTON

  The very idea that LBOs can carry massive debt loads that never have to be paid down defies the historical first principles of leveraged buyouts. It was once taken as axiomatic that any buyout deal lacking a realistic five-year plan to materially ramp down its initial LBO debt was destined to fail.

  The reason is simply time and risk. Few businesses can remain financial zombies on the ragged edge of insolvency for a decade or longer because cash flows invariably hit a rut in the road, whether owing to faltering demand, product or technology obsolescence, the rise of an aggressive new competitor, or simply a downturn in the macroeconomic cycle. Accordingly, LBO deals would not get done on the free market if they carried so much debt relative to current and prospective cash flow that they were virtually guaranteed to become capital-destroying debt zombies.

  Blackstone’s $27 billion LBO of Hilton Hotels completed in late 2007 is exactly one of these free market defying zombies. Without the deep tax subsidy for debt and the Wall Street–coddling policies of the Fed this mega-LBO deal, which five years later still remains one global business slump away from bankruptcy, would never have seen the light of day. The Hilton Hotels deal thus illuminates the entire syndrome of bubble finance and the financial engineering deformations which afflict the American economy.

  At any time prior to the 2006–2007 mega-LBO frenzy, the Blackstone offer would have been an unfinanceable bad joke; at 21X Hilton’s actual operating income of $1.3 billion for 2006, the deal price broke all the rules. It meant that from day one, the deal would be going in the hole because it didn’t even earn its annual interest tab of about $1.5 billion.

  During those heady moments, of course, the LBO crowd preferred to focus on EBITDA rather than operating income, because the exclusion of charges for depreciation and amortization (D&A) made profits look bigger and the leverage ratio smaller. In this case, the purchase price also amounted to fifteen times EBITDA, but that should have been cold comfort. Hilton Hotels was then a heavy user of capital; that is, the D&A charges had to be reinvested and were not available to service its massive LBO debt.

  The company’s actual business plan for 2007, for example, was to spend about $1 billion on CapEx and generate $1.8 billion in EBITDA, or just 4.5 percent more than the prior year. The recklessness of the deal price is therefore evident in these numbers, which were not secret, but constituted the company’s own financial “guidance” to public investors at the time. They implied that Blackstone’s purchase multiple would amount to a mind-boggling 32X its projected $830 million of free cash flow.

  In short, the deal amounted to an ultra-high price for exceedingly slow earnings growth at the very top of a business cycle. Indeed, the Hilton deal was so pricey that its sponsors were struggling to close the bank financing until the day of Cramer’s famous rant (chapter 23). When Bernanke buckled in response to the minor stock correction then under way and went into a full panic mode with the emergency discount rate cut on August 17, the true nature of the “emergency” became apparent.

  Ground zero of the crisis was on Wall Street and its bulging pipeline of financial engineering deals like Hilton. At the time, American businesses did not need cheap loans for capital equipment or new technology; they were drowning in excess production capacity already. The part of the economy that needed the stock and debt markets propped up, in fact, was the private equity houses and leveraged financial engineering players.

  It was they who were stuck in uncompleted CEW maneuvers and needed to issue tens of billions of new high-yield debt without delay. At that moment in August–September 2007, in fact, there were nearly $100 billion of unfunded deals in the Wall Street pipeline, and therein lay the true secret of central bank bailouts and the continuous resort to “shock and awe” financial intervention which commenced only a few months later.

  Thus, when Bernanke threw caution to the wind, the Hilton deal was miraculously revived, thereby bringing another happy CEW day to Wall Street in early October. The Hilton deal was thus an offspring of the Fed’s patented style of untough love.

  The deal’s morning-after windfall to existing shareholders amounted to a payout of $21 billion. It goes without saying that recipients were soon thanking their lucky stars. Within twelve months the stock price of Hilton’s twin sister, Starwood Hotels and Resorts, plunged from $60 per share to $10 owing to the collapse of hotel occupancy and pricing, and also to the abrupt disappearance of third-party financing for room-count expansion on which these go-go hotel stocks had been valued.

  THE WALL STREET BRIDGE TO BAILOUTS

  As it happened, Blackstone’s underwriters were not able to sell a planned $12 billion commercial mortgage-backed securities (CMBSs) deal or syndicate an $8 billion mezzanine debt loan, either. Instead, the deal was funded entirely with three-year “bridge loans” taken down by seven Wall Street underwriters who were a who’s who of the financial meltdown which materialized exactly twelve months later.

  When the Wall Street banking houses funded an unprecedented $20.5 billion bridge loan it was one of the most reckless syndications ever undertaken. Fittingly, it closed on the very day of the all-time S&P 500 index peak, itself merely a dead-cat bounce from Bernanke’s initial round of panicked stock market coddling.

  Not surprisingly, the lead underwriter of nearly one-quarter of this preposterous bridge loan was none other than Bear Stearns, which piled onto its own already wobbly balance sheet $4.7 billion in short-term credits to what was essentially a hotel management and franchising company. Prior to the buyout, in fact, Hilton had already pawned most of its hard assets to third-party real estate investors in order to scrap up cash to pump its stock price via dividends and share buybacks.

  Accordingly, it owned only 54 of its 2,500 hotels at the time of the deal. This meant that it had no real estate to pledge and that the bridge loan was secured only by flimsy claims on income flows from its long-term franchise agreements. Only in the late hours of a speculative mania would such intangible assets be confused with legitimate loan c
ollateral.

  When Bear Stearns hit the wall a few months later, one of the largest “toxic” assets on its balance sheet was the dodgy bridge loan backed by Hilton’s bottled air. Accordingly, JPMorgan insisted the taxpayers underwrite any loss on the $4.7 billion Hilton bridge loan before it swallowed up Bear’s good assets.

  Not far behind on the swaying Hilton bridge were Bank of America, Goldman, and Deutsche Bank with nearly $4 billion each. Like the corpse of Bear Stearns, all three of these “too big to fail” institutions would soon be gorging on funds from TARP and the Fed’s bailout lines. Finally, the $5 billion balance of the deal went to the hindmost of the Wall Street pack: Merrill Lynch, Morgan Stanley, and Lehman.

  All three went down for the count within twelve months, owing to balance sheets that cratered under the weight of deeply impaired and illiquid assets like the Hilton bridge loan. Perhaps indicative of the financial madness then under way, Lehman was still carrying the Hilton bridge at 93 percent of par by June 2008, when it was already evident that the commercial real estate financing market was dead and the US economy was heading south.

  The Hilton Hotels bridge loan is thus a testament to the destruction of financial discipline and rationality fostered by the Greenspan-Bernanke era of Wall Street coddling. As it happened, the Main Street economy plunged into the Great Recession and the “takeout” financing markets which the bridge lenders were banking on—junk bonds and commercial real estate securitization—were stone cold by early 2009. Also by then Hilton’s EBITDA had dropped by 30 percent, so there was not a remote chance of refinancing the deal on commercial terms.

  Needless to say, in an honest capital market the Hilton tower of debt would have been foreclosed upon. Once again, however, the free market’s therapeutic discipline was negated by the Fed’s panicked slashing of short-term rates to almost zero. While this foolish policy crushed middle-class savers, it did achieve its intended effect: it provided a huge interest subsidy (that is, virtually free overnight money) to carry-trade speculators so they would put a bid back into the market for risk assets.