07-04-07
One Rate to rule them all,
One Rate to find them;
One Rate to bring them all,
And in the Cash Flow bind them.
– with apologies to Tolkien
THE LORDS OF WALL STREET stride forth to claim their crowns.
The procession began in February of this year, when Fortress Investment Group (FIG:NYSE) went public. Fortress runs four hedge funds and fourteen private equity funds, Forbes reports; five partners became billionaires as a result of the IPO.
The success of Fortress' offering was historic. It showed that, in addition to buying and selling other companies, secretive asset management firms could make a mint by going public themselves.
On June 22nd, the Blackstone Group followed Fortress' lead, launching symbol BX on the New York Stock Exchange. Blackstone, the largest private equity firm on the Street, has approximately $88 billion under management. Thanks to extensive use of debt and leverage, its investment holdings are a considerable multiple of that.
On the heels of the Blackstone deal comes an IPO filing from Kohlberg Kravis Roberts, the legendary buyout firm of "Barbarians at the Gate" fame. KKR has $53.4 billion in its coffers. There also comes an announcement from Och-Ziff Capital, a 13-year-old hedge fund hybrid with just under $27 billion.
This rush to go public is driven by a sense of envy and urgency; envy at the huge paydays founders have enjoyed, urgency for fear that the window of opportunity may close soon. Other firms with possible IPO dreams include outfits like Apollo Management, the Carlyle Group, Citadel Investment Group, and Cerberus Capital.
Ego plays its usual outsized role—par for the course on Wall Street. Who is the Grand Poobah, the loftiest Lord of them all? The battle for that unofficial title is between Steven Schwarzman, head of Blackstone, and Henry Kravis, the face of Kohlberg Kravis Roberts.
Mr. Schwarzman looks to have the upper hand for now. Blackstone comes out on top in head-to-head size and profitability comparisons with KKR; it is thought to have "most favored firm" status in China, after selling a chunk of itself to Beijing; and best of all, Blackstone has been compared to a pool table with a shortened leg, with profits habitually rolling toward the founder's pocket. (Schwarzman's 30% stake was valued at roughly $8 billion at the time of IPO.)
Not everyone is pleased with the high profile nature of Schwarzman's success. He has ruffled feathers with his talk of "inflicting pain" and seeking to "kill off" opponents. His Fortune magazine cover ("the new king of Wall Street") smacked of hubris. His own mother stated flatly that "money is the measuring stick" for her son's success. And neither congress nor the SEC can be too pleased with the overheard boast that Blackstone will be "a private company in the clothing of a public company." More discreet players fear that by stepping into the limelight so boldly, Schwarzman is bring a populist backlash down on everyone.
Political fears aside, the Lords of Wall Street have a bigger concern. Their power is not truly theirs to keep; the bulk of it comes from low interest rates. In an editorial titled "Blackstone's World of Cash," Andy Kessler explains:
The biggest beneficiary [of low interest rates] has been private equity funds. They buy companies by putting up some cash and then borrow the rest. Their borrowing costs, which show up in the spread between their rates and 10-year Treasuries, have been at historic lows. Anything less than four percentage points is a gift. It bottomed recently at 2.4 percentage points. That's a ridiculously low hurdle to jump over to justify a buyout. Plus, Wall Street has created a huge business in credit swaps and derivatives to help more money flow into private equity deals. So everything has been in play. Environmentally challenged electricity generator Texas Utilities? Sure. Dying auto maker Chrysler? Why not?
The dirty little secret is that private equity investors really aren't all that good. They take mediocre investments with lackluster growth but steady cash flow and add leverage to amplify the returns.
It's neither love nor money that makes the business world go round, but credit. Easy credit lets you multiply the dollars you already have in your pocket; this neat trick allows for all sorts of other neat tricks.
For example, consider Blackstone's $39 billion purchase of Equity Office Properties (EOP). More than 90% of the money in the deal was borrowed, Barron's reports; Blackstone only put up $3.5 billion. After turning around and selling a big chunk of what it just bought, Blackstone was able to record an immediate $500 million net profit on the EOP deal. Easy upside, just like that. But what's the catch?
The move is comparable to a real estate investor buying ten Florida condos at 10% down, selling off three or four of them, and booking a handsome return on investment (the money used to make the down on all ten properties). The question is, what about the unsold properties still on the books? What about the leverage that hasn't gone away—the substantial sums owed to the bank? Hidden risks don't show up in the short term profit & loss statement. By the time they do show up there, it's generally too late.
Cheap financing is the key. With a little elbow grease and some smart financial engineering (all perfectly legal), just about any company with decent cash flow can be turned into a gold mine. This is why private equity players don't mind mark-ups... like the 40% premium just offered for the Hilton Hotel chain. It doesn't really matter how much you pay when the financing is easy, valuation is an afterthought, and cash flow is there for the taking.
At some point down the road, though, easy credit terms disappear; boom-time loans have to be paid back; overinflated assets have to be sold at deflated prices, or marked down at a loss.
Florida condo flippers already know all this. Private equity investors might learn it too.
"The biggest risk we face," says Lloyd Blankfein, CEO of uber-bank Goldman Sachs, "would be a very big crisis in the credit markets." Blankfein imagines this crisis could be caused by a "sentiment shift," which in turn could make things "unravel very quickly."
And what might cause that sentiment shift? A continued rise in interest rates, leading to credit contraction and the risk of deal failure. (If, say, Cerberus Capital's upcoming $60 billion plus debt offering falls through, it could make for a very big thud indeed.)
The interest rate environment has been exceptionally accommodative for years now, dating back to Greenspan's watch. The WSJ reports:
One of the most important engines of the current bull market, if not the most important, has been the exceptionally low level of world interest rates. Low rates have fueled investment and consumption, and made it highly attractive for private investors to use borrowed money to arrange corporate buyouts.
With rare exceptions, the yield of the 10-year Treasury note has stayed below 5% since mid-2002. That is a level it had rarely been below since the 1960s. A year ago, it briefly pushed to 5.25%, only to fall back amid hopes of Fed rate cuts. Now it has moved above 5% again.
It was that rare sub-five-percent environment in which mortgage lenders went berserk, private equity firms conquered the land, and certain subprime hedge funds saw 40 months of uptick without a single period of decline. (Until the end, when the volatility came all at once. Funny how that works...)
If you'll forgive the stretch, consider that the original Ring of Power was forged in the fires of Mount Doom. The magical low rate environment, now waning, was forged in the fires of a stockmarket Mount Doom of sorts back in 2002, when Greenspan felt compelled to save the country from recession (and Enron, and Worldcom, etcetera). Asian exporters and oil producers then perpetuated Greenspan's low-rate magic by shoveling in US treasury bonds, sacrificing profit for volume... and here we are today, Wall Street leveraging everything in sight.
The trouble comes, as monetary trouble so often does, in the form of inflation… both price inflation and asset inflation. The government tries to hide it with blatant massaging of statistics, yet inflation shows up anyway in food prices, fuel prices, and other basic staples. (As countless observers have noted by now, the core rate only matters if you live in an unheated cave, travel by foot, and don't buy food.) Asset inflation puts things out of whack too. At first everyone is happy about paper assets getting an inflationary boost. But then things get out of hand—as they always do when based on whimsy—and distortions kick in, and you wind up with big ugly messes that cost more to clean up than they were worth in the first place. (Like, say, the High Grade Structured Credit Strategies Enhanced Leverage Fund.)
So what's next? That pretty little ring, so tempting and appealing in its bull market power, has to return from whence it came. Long rates must climb, after being pushed down too long; foreign buyers of US treasuries must eventually stop their gorging, lest they eat until they burst.
And how will the Lords fare… the Blackstones and KKRs and Fortresses et al? It is probably too early to tell. If they can hold on to their tangible assets through a credit contraction, there will still be cash flow to sustain them; their lenders and investors would then take the worst of it. If the firms are forced into fire sales, however, there will be precious few places to hide. (Except maybe gold.)
What's more, an unsettling anniversary looms. It was ten years ago this month that Thailand knuckled under, kicking off the "Asian contagion" of the late nineties. The entire region had gone on a financing binge to fuel economic expansion; the tigers borrowed heavily in dollars, and were badly overexposed when sentiment turned.
Asia is in a very different position now; the central bankers have learned their lesson (perhaps a bit too well) and stuffed the mattresses with cash. Ten years on, however,the Lords of Wall Street could be similarly exposed by their ambitions... with interest rates their downfall.
