By David Stockman, Budget Director under President Reagan, then partner at private-equity firm Blackstone Group, is the author of THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA:
The very idea that LBOs can carry massive debt loads that never have to be paid down defies the historical first principles of leveraged buyouts. It was once taken as axiomatic that any buyout deal lacking a realistic five-year plan to materially ramp down its initial LBO debt was destined to fail.
The reason is simply time and risk. Few businesses can remain financial zombies on the ragged edge of insolvency for a decade or longer because cash flows invariably hit a rut in the road, whether owing to faltering demand, product or technology obsolescence, the rise of an aggressive new competitor, or simply a downturn in the macroeconomic cycle. Accordingly, LBO deals would not get done on the free market if they carried so much debt relative to current and prospective cash flow that they were virtually guaranteed to become capital-destroying debt zombies.
Blackstone’s $27 billion LBO of Hilton Hotels completed in late 2007 is exactly one of these free market defying zombies. Without the deep tax subsidy for debt and the Wall Street–coddling policies of the Fed this mega-LBO deal, which five years later still remains one global business slump away from bankruptcy, would never have seen the light of day. The Hilton Hotels deal thus illuminates the entire syndrome of bubble finance and the financial engineering deformations which afflict the American economy.
At any time prior to the 2006–2007 mega-LBO frenzy, the Blackstone offer would have been an unfinanceable bad joke; at 21X Hilton’s actual operating income of $1.3 billion for 2006, the deal price broke all the rules. It meant that from day one, the deal would be going in the hole because it didn’t even earn its annual interest tab of about $1.5 billion.
During those heady moments, of course, the LBO crowd preferred to focus on EBITDA rather than operating income, because the exclusion of charges for depreciation and amortization (D&A) made profits look bigger and the leverage ratio smaller. In this case, the purchase price also amounted to fifteen times EBITDA, but that should have been cold comfort. Hilton Hotels was then a heavy user of capital; that is, the D&A charges had to be reinvested and were not available to service its massive LBO debt.
The company’s actual business plan for 2007, for example, was to spend about $1 billion on CapEx and generate $1.8 billion in EBITDA, or just 4.5 percent more than the prior year. The recklessness of the deal price is therefore evident in these numbers, which were not secret, but constituted the company’s own financial “guidance” to public investors at the time. They implied that Blackstone’s purchase multiple would amount to a mind-boggling 32X its projected $830 million of free cash flow.
In short, the deal amounted to an ultra-high price for exceedingly slow earnings growth at the very top of a business cycle. Indeed, the Hilton deal was so pricey that its sponsors were struggling to close the bank financing until the day of Cramer’s famous rant (chapter 23). When Bernanke buckled in response to the minor stock correction then under way and went into a full panic mode with the emergency discount rate cut on August 17, the true nature of the “emergency” became apparent.
Ground zero of the crisis was on Wall Street and its bulging pipeline of financial engineering deals like Hilton. At the time, American businesses did not need cheap loans for capital equipment or new technology; they were drowning in excess production capacity already. The part of the economy that needed the stock and debt markets propped up, in fact, was the private equity houses and leveraged financial engineering players.
It was they who were stuck in uncompleted CEW [corporate equity withdrawal] maneuvers and needed to issue tens of billions of new high-yield debt without delay. At that moment in August–September 2007, in fact, there were nearly $100 billion of unfunded deals in the Wall Street pipeline, and therein lay the true secret of central bank bailouts and the continuous resort to “shock and awe” financial intervention which commenced only a few months later.
Thus, when Bernanke threw caution to the wind, the Hilton deal was miraculously revived, thereby bringing another happy CEW day to Wall Street in early October. The Hilton deal was thus an offspring of the Fed’s patented style of untough love.
The deal’s morning-after windfall to existing shareholders amounted to a payout of $21 billion. It goes without saying that recipients were soon thanking their lucky stars. Within twelve months the stock price of Hilton’s twin sister, Starwood Hotels and Resorts, plunged from $60 per share to $10 owing to the collapse of hotel occupancy and pricing, and also to the abrupt disappearance of third-party financing for room-count expansion on which these go-go hotel stocks had been valued.
The Wall Street Bridge To Bailouts
As it happened, Blackstone’s underwriters were not able to sell a planned $12 billion commercial mortgage-backed securities (CMBSs) deal or syndicate an $8 billion mezzanine debt loan, either. Instead, the deal was funded entirely with three-year “bridge loans” taken down by seven Wall Street underwriters who were a who’s who of the financial meltdown which materialized exactly twelve months later.
When the Wall Street banking houses funded an unprecedented $20.5 billion bridge loan it was one of the most reckless syndications ever undertaken. Fittingly, it closed on the very day of the all-time S&P 500 index peak, itself merely a dead-cat bounce from Bernanke’s initial round of panicked stock market coddling.
Not surprisingly, the lead underwriter of nearly one-quarter of this preposterous bridge loan was none other than Bear Stearns, which piled onto its own already wobbly balance sheet $4.7 billion in short-term credits to what was essentially a hotel management and franchising company. Prior to the buyout, in fact, Hilton had already pawned most of its hard assets to third-party real estate investors in order to scrap up cash to pump its stock price via dividends and share buybacks.
Accordingly, it owned only 54 of its 2,500 hotels at the time of the deal. This meant that it had no real estate to pledge and that the bridge loan was secured only by flimsy claims on income flows from its long-term franchise agreements. Only in the late hours of a speculative mania would such intangible assets be confused with legitimate loan collateral.
When Bear Stearns hit the wall a few months later, one of the largest “toxic” assets on its balance sheet was the dodgy bridge loan backed by Hilton’s bottled air. Accordingly, JPMorgan insisted the taxpayers underwrite any loss on the $4.7 billion Hilton bridge loan before it swallowed up Bear’s good assets.
Not far behind on the swaying Hilton bridge were Bank of America, Goldman, and Deutsche Bank with nearly $4 billion each. Like the corpse of Bear Stearns, all three of these “too big to fail” institutions would soon be gorging on funds from TARP and the Fed’s bailout lines. Finally, the $5 billion balance of the deal went to the hindmost of the Wall Street pack: Merrill Lynch, Morgan Stanley, and Lehman.
All three went down for the count within twelve months, owing to balance sheets that cratered under the weight of deeply impaired and illiquid assets like the Hilton bridge loan. Perhaps indicative of the financial madness then under way, Lehman was still carrying the Hilton bridge at 93 percent of par by June 2008, when it was already evident that the commercial real estate financing market was dead and the US economy was heading south.
The Hilton Hotels bridge loan is thus a testament to the destruction of financial discipline and rationality fostered by the Greenspan-Bernanke era of Wall Street coddling. As it happened, the Main Street economy plunged into the Great Recession and the “takeout” financing markets which the bridge lenders were banking on—junk bonds and commercial real estate securitization—were stone cold by early 2009. Also by then Hilton’s EBITDA had dropped by 30 percent, so there was not a remote chance of refinancing the deal on commercial terms.
Needless to say, in an honest capital market the Hilton tower of debt would have been foreclosed upon. Once again, however, the free market’s therapeutic discipline was negated by the Fed’s panicked slashing of short-term rates to almost zero. While this foolish policy crushed middle-class savers, it did achieve its intended effect: it provided a huge interest subsidy (that is, virtually free overnight money) to carry-trade speculators so they would put a bid back into the market for risk assets.
Accordingly, beginning in the second half of 2009 this Wall Street– friendly form of monetary “stimulus” flowed into the busted markets for securitized commercial mortgages and hotel real estate investment trusts (REITs). In short order, leveraged speculators drove the price of these beaten-down asset classes upward by 50 to 90 percent. Soaring prices for what had been deeply distressed loan paper only months earlier, in turn, enabled banks to revert to a full-bodied “extend and pretend” mode, pushing out maturities, waiving covenant violations, and deferring scheduled repayments.
This miraculous “recovery” in the hotel debt market was both a stupendous gift from the Eccles Building to speculators and a complete distortion of market signals. Yet it did the trick. In April 2010 the banks agreed to extend the Hilton loan maturities until the end of 2015, reduced outstanding debt by $1.8 billion in return for an $800 million cash payment from Blackstone, and swapped another $2 billion of junior debt for preferred stock.
Still, the company remains saddled with $16 billion of debt, which represented about sixteen times Hilton’s free cash flow after CapEx during 2011. Accordingly, this so-called restructuring deal is evidence that the financial markets are being medicated by the Fed to support debt zombies, not that the company’s fundamental prospects have measurably brightened. In fact, Hilton’s 2011 EBITDA of about $1.9 billion represented a tepid growth rate of only 1.6 percent annually from the pre-LBO outcome in 2006. Self-evidently, a company with such anemic long-term trends can’t grow out of its debts.
So the Hilton Hotels mega-LBO remains a ward of the state’s central banking branch. The company’s $16 billion debt maturity cliff in 2015 would result in Hilton’s demise were the Fed to normalize interest rates and thereby send the carry-trade speculators who own its debt scrambling for cover.
But that won’t happen. The nation’s central bank has already promised to keep middle-class savers pinned to the floorboards through 2015 in order to sustain an artificial bid for risk assets. Indeed, the Princeton math professor that Karl Rove brought to the Eccles Building has implemented the precise monetary strategy which that self-avowed Keynesian, Paul Krugman, urged on Greenspan back in 2002 in the wake of the dot-com bust.
Rather than allowing the free market to dispatch speculators to the ruin they deserved, Krugman urged a massive stimulus campaign to put them back in business. “To fight this recession the Fed needs more than a snapback,” the learned professor intoned, “Alan Greenspan needs to create a housing bubble to replace the NASDAQ bubble.”
Greenspan followed that fatuous advice and millions of Main Street families are in ruins for it. Now Bernanke adds insult to injury through maniacal adherence to money-printing policies which inflate the middle class’s cost of living and demolish its rewards for thrift in order to keep leveraged speculators in business and the debt zombies solvent. By David Stockman.
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