Wednesday, November 19, 2008
LBOs and Banks
"In late September the Delaware Chancery Court signaled the end of an era. That's when it ruled that Apollo Investment Management couldn't wriggle out of its $10.6 billion cash offer for Huntsman Chemical--despite pleas by the private equity firm that the resulting company would be insolvent. ... Now, if they buy a business, they may have to stick around and run it in order to make money. 'There will be no exits in the current situation,' says Dominique Senequier, head of AXA Private Equity in Pairs. 'Sponsors will have to live with their portfolios for quite a while.' ... In the absence of bank loans, private equity firms are forced either to extend credit themselves or to buy companies with pure equity. ... Remove leverage from the equation, however, and an annual return of 20% is harder to get. ... 'It changes from financial engineering to operational expertise,' says Luba Nikulina, a senior investment consultant at Watson Wyatt Worldwide who advises insititutional investors on private equity investments. Using leverage, she adds, 'is not a sustainable business model'," my emphasis, Daniel Fisher and Anita Raghavan at Forbes, 17 November 2008.
Much of private equity (PE) firms' returns arise from banks underpricing loans used to buy target companies. No individual would lend to the PE firms on the terms banks do, hence LBO loans are a continuing source of banking problems. Bank loans to effect these purchases would be impossible if banks were not "maturity transformers" to use Mencius Moldbug's term. Bank LBO loans appropriate bank depositors funds to benefit PE firm sponsors. If things get bad enough for PE firms, Apollo's Leon Black may have to get a job. I discussed bank loan pricing here: