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

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 gain 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 atavistic 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. The 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 18% 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 even after paying the carried interest, and the private equity managers walked off with $160 million after-tax 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% 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 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 under the pressure of heavy debt obligations and incentivized management teams are able to wrung operational 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 deal have no economic purpose unlike say losses in a venture capital deal where a promising idea simply did not 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 the 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.