Wednesday, November 25, 2009

Will the Next Credit Tsunami Drown Us All?

Many of us are still feeling, and some even reeling, from the effects of the financial credit crisis last year. Well, prepare yourself, because another tsunami of defaults might just be on the horizon, threatening any chance of full economic recovery. Once again, as excess on Wall Street continues, despite the disastrous results of their previous actions, another sector - the private equity industry - is about to deliver another giant credit disaster.

What are private equity firms?

Essentially they are companies that buy other companies with the help of huge loans. In a nutshell, these companies put 20% down, raised mostly from public pensions, in much the same way you and I would arrange a mortgage, with one major difference. While we put 20% down and borrow 80% for a mortgage, PE firms make the companies they acquire borrow the 80% to finance the deal and the companies they acquire are responsible for that debt. They then try to resell the companies or take them public before the loans come due. Often times, private equity companies make huge profits while destroying the companies they buy and sell.

The giant tax loophole that makes this all possible is called, interest tax deductibility, which states that any company can deduct the interest they pay on loans from their taxes.

Joshua Kosman predicts this crisis in his new book, The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis . Kosman said, the Boston Consulting Group predicts that half of the 3,188 companies purchased by PE firms will default on their loans by the end of 2011. The problem is that the companies owe more than $1 trillion in debt and if a significant amount of those loans become worthless, that will cause a freeze in lending. Not to mention, PE firms are the largest employers in the country when combined. They employ one out of every ten Americans.

Remember the Collatorized Debt Obligation (CDO) - mortgage debt sliced and diced, packaged and repackaged, sold and resold in the form of exotic instruments - involved in our current crisis? Well, the Collatorized Loan Obligation (CLO) will replace the CDO in the next crisis. the "exotic instrument that PE firms use to make it much easier for them to fund leveraged buyouts (LBO).

The same hedge funds that were creating CDOs which caused the mortgage market to boom also created collatorized loan obligation funds which made it much easier for PE firms to borrow money to finance LBOs. Hedge funds and banks would buy a pool of LBO loans, slice them up, and sell them to Sub-Saharan African countries. Ratings agencies gave these CLOs triple A ratings just as they did the CDOs, when they knew they were junk. When the LBOs collapse, these CLOs will be nearly worthless.

In addition, private equity fund managers, like hedge fund managers are taxed at a much lower rate than most Americans pay, even though they are providing services that are normally taxed at the ordinary income tax rate up to 39%. They take in 20% of the profits from investments, and under current law, this is often treated as long-term capital gains, therefore much of their pay is being taxed at the capital gains tax rate of 15%.

Should private equity firms register with the SEC?

In September 2008, the Federal Reserve relaxed bank ownership rules for private equity firms, allowing an investor to buy up to a 15 percent voting stake instead of the previous 9.9 percent limit. It also allowed investors to buy up to 33 percent total equity interest, including voting and nonvoting shares, instead of the 25 percent prior limit.

In other words, private equity firms are engaging in activities that closely resemble what investment banks do: operate hedge funds, taking ownership interest in banks and acting as counter-parties in derivative transactions.
“Leveraged private investment funds with assets under management over a certain threshold should be required to register with the SEC to provide greater capacity to protect investors and market integrity.” – Tim Geithner
Related news:

Report Says Big Buyouts Are Likelier to Default
- "The 10 largest companies bought by private equity companies are performing worse than similar stand-alone companies or smaller private equity deals, according to a new report from Moody’s, the rating agency."

Private equity's get-rich-quick days 'are over' -- "Banks are not interested in cleaning up their balance sheets because they would have to recognise additional losses, forcing them to take more government bail-out cash. This could stop increased lending, which would otherwise help recovery."

Which private equity firms return the most bang for the buck? -- The three biggest names in private equity firms are the Carlyle Group, Blackstone Capital Partners, and Kohlberg Kravis Roberts, however, one recent study using the HEC-Gottschalg method looked at which private equity firms return the most bang for the buck, and found few brand names. The top 10 shown in the image at left.

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