David Stockman, Budget Director under President Reagan, then a partner at private-equity firm Blackstone Group, and now author of the bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA, takes his cleaver in this installment from Chapter 25 to one of the craziest buyouts ever.
The November 2006 HCA buyout was notable for its then-record breaking $33 billion size and its exceedingly thrifty approach to the equity account. KKR and its partners put up only $3.9 billion of fresh equity, or about 12 percent, of the capitalization of this monster deal. Funding the $28 billion debt balance required a veritable Noah’s ark of every kind of debt known to Wall Street, including revolvers, term loans, junk bonds, foreign loans, and even a far-out instrument called “second-lien toggle notes.”
At first glance, HCA’s 160-unit hospital system might appear to be exactly the wrong candidate for massive permanent leverage. After all, the HCA system obtained 45 percent of its revenues from Medicare and Medicaid, government programs which have long been on the fiscal ragged edge and which are increasingly subject to indeterminate and unpredictable regulatory and reimbursement risk.
Yet the stunningly aggressive manner in which KKR and Bain have literally plundered cash from HCA since the mega-buyout implies just the opposite. After loading HCA with $28 billion of debt to fund the original buyout, KKR and Bain have since extracted dividends and stock buybacks amounting to another $7 billion. These massive payouts to the sponsors have absorbed every dime of available cash and borrowing capacity at HCA. In fact, during the four years ending in fiscal 2011 the company generated just $5 billion of income from operations net of capital spending and investing activities, meaning that the dividends and buybacks amounted to an incredible 140 percent of HCA’s free cash flow.
By every traditional rule of leveraged buyouts, all of that free cash flow should have been allocated to paying down debt, so that the company could have edged out of harm’s way. In fact, HCA’s debt mountain had not been reduced by a net dime after four years, and it was a preposterously overleveraged deal in the first place.
Perhaps the most telling evidence of the latter point came from the company’s own CEO, Jack Bovender. When asked what had been the biggest shock which came out of the LBO, he replied, “Honestly, the fact that you could borrow $28 billion.”
KKR had been able to borrow $28 billion because the second junk loan bubble was red hot at the time of the original deal, but after collapsing into the depths in 2009 it had made a roaring comeback just in time to fund the HCA dividends in 2010. Indeed, Bernanke’s maniacal money printing after the Lehman event had catalyzed a virtual stampede back into the very same risk-asset classes which had been reduced to smoldering ruins during the financial crisis.
In fact, junk bonds had undergone their third miraculous rebirth since the age of bubble finance began in 1987. Once again, it was speculator driven money flows into the junk bond asset class that levitated prices, not the credit facts on the ground. Most leveraged issuers were still limping operationally and had neither paid down significant debts nor had any prospects of doing so.
Nevertheless, the Fed so juiced the carry trade with free “funding currency” that astute speculators now anticipated a rising junk bond market. This trend, in turn, would permit troubled LBO borrowers to refinance or otherwise “extend and pretend,” and thereby sharply reduce the realized rate of defaults and make existing junk bonds far more attractive. Accordingly, by November 2010 junk bond prices were up a stunning 85 percent from their post-Lehman lows.
Hedge fund speculators were now essentially operating in the third degree of Keynes’ beauty contest (see chapter 23). Punters were buying ugly credits hand over fist because they anticipated that other punters would find these credits considerably more attractive, once their struggling borrowers had kicked their current balloon of maturing obligations down the Fed-sponsored road of perpetual refinance.
Not surprisingly, 2010 and 2011 became record years for junk bond issuance, notwithstanding an economy that was still furtively laboring to “recover” and, according to the leading Keynesian shaman, Larry Summers, had not yet obtained “escape velocity.” Nonetheless, $500 billion of junk bonds were issued in those two years—65 percent more than during the previous peak of 2006–2007 when the mega-LBOs had been spawned.
In the context of the 2010–2011 junk bond boom, the leveraged dividend recap made a reappearance like clockwork. Thus, in November 2010 KKR and Bain announced they would pay themselves a $2 billion dividend and that it would be financed with a new issue of junk bonds to be piled on top of HCA’s $28 billion of debt.
Moreover, this was actually their third dividend payday of the year. The first two payouts had been even more egregious: the private equity sponsors borrowed $1.75 billion in February 2010 from HCA’s bank revolver to pay themselves a dividend and then, unbelievably, banged the revolver again in May for another $500 million dividend.
Lender permission to strip dividends out of a revolver would have been scarcely imaginable only a few years back. By 2010, however, the Fed’s embrace of “too big to fail” had induced the great LBO banks of Wall Street to permit borrowers to raid their own vital liquidity lines (i.e., credit revolvers) like a piggy bank. In previous times the Wall Street banks had at least insisted that unsecured or subordinated lenders be tapped for the honor of fronting the dividend money. Now, in its desperate post-Lehman efforts to encourage “risk on,” even that had gone by the wayside. The Fed had thus unleashed the financial Furies.
At the end of the day, the multiple HCA dividend recaps underscored that the world of junk debt and LBOs had taken on a whole new modus operandi. The great Wall Street banks no longer even worried about repayment risk because the Fed was now vividly confirming that redemption of debt wasn’t necessary.
Instead, under the Bernanke dispensation corporate debt was meant to be perpetually refinanced. Not coincidentally, these “evergreen” pools of debt, like HCA’s $28 billion, would also favor Wall Street with a constant stream of underwritings and refinancing fees.
Furthermore, the job of the Fed under this perpetual refinancing régime was to stand ready with a liquidity hose, prepared to fund any amount of faltering debt that Wall Street banks might be choking on during periods of “financial crisis.” Such bad debts historically had caused banks to suffer painful losses and accountable executives to get fired. Now such failing credits had been redefined as evidence of a new financial disease called “contagion” and “systemic risk” which needed to be combated at all hazards, even if it rewarded the perilous breach of sound underwriting standards so blatantly evident in the HCA dividend episode.
At it happened, by the spring of 2011 things got even better for KKR and Bain. The Bernanke bubble now had the risk asset market so cranked up that HCA was able to launch an IPO, with most of the proceeds again going into the sponsor’s bank accounts rather than into the company’s coffers to pay down debt. Based on the previous dividends, the IPO stock sales, and the value of their remaining stock at the $30 per share IPO price, KKR and Bain stood to harvest a windfall profit of $3 billion each on their original $1.2 billion equity contributions to the deal. By David Stockman, author of…. THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.