Of course we all know what it is. “Equity” is at-risk capital; “debt” is a loan, repayable according to its terms, and sometimes “collateralized,” or “secured.” In bankruptcy, for example, equity is the last to get paid, and secured debt, in theory at least, is unaffected. The point I would like to make, however, is that this distinction becomes blurry, or even not useful, as a company’s capital structure (i.e., the “liabilities” side of its balance sheet) approaches either 100% debt, or 100% equity. Because then, one is functionally equivalent to the other, and any difference between them becomes meaningless.
Although not made in quite this way, this point was illustrated in a recent article, Sender, H., “Debt Buyers vs. The Indebted,” Wall St. Journal (Oct. 17, 2006). The thesis of the article is that “A potential battle is brewing between two groups of Wall Street’s most powerful players – private equity firms and hedge funds.” According to the article, this battle primarily involves finding deals to chase. This paucity of deals is exacerbated by the fact that “The party may be nearing an end for investors betting on cash … For the first time since early 2004, banks are cutting rates on many CDs and other cash instruments,” Kim, J., “Cash Starts to Lose Its Luster,” Wall St. Journal (Oct. 26, 2006). In other words, investment managers of all stripes (i.e., both debt and equity) are under pressure to find investments other than cash that “perform,” which in market parlance means, yield a high rate of return.
As if by magic, Blackstone Group announced on the same day that it would increase the size of the world’s largest private-equity fund to $20 billion, Singer, J. & Sender, H., “Growing Funds Fuel Buyout Boom,” Wall St. Journal (Oct. 26, 2006). “Private-equity firms have been on a tear lately, buying up publicly traded businesses with the intention of making them more profitable – frequently by aggressively cutting costs – and then selling them for big gains, either to other companies or to public shareholders via new stock listings.”
But what happens when no further costs can be cut? What happens when the market becomes saturated, and the “big gains” no longer materialize? Although not explicitly discussed in Mr. Sender’s article, there remains a scenario that “the battle” could turn nasty – especially if the economy experiences a down-turn, and firms begin to (a) default (in the case of debt), or, (b) become dramatically unprofitable, experience asset erosion (necessitating a write-down of equity), or go out of business (in the case of equity). This would pit the interests of the holders of debt (secured) versus the interests of the hedge funds (unsecured equity).
This scenario becomes even more plausible when one contemplates the types of investments that hedge funds now are considering. For example, Clear Channel Communications, the large owner of radio stations and outdoor billboards, is in the process of “evaluating various strategic alternatives to enhance shareholder value,” meaning, it’s on the auction block, “McBride, S. & Berman, D., “Clear Channel To Study Options; Suitors Form Line,” Wall St. Journal (Oct. 26, 2006). The headline “Suitors Form Line” is particularly amusing, as it indicates the level of interest in almost any transaction these days, even for radio, which is the classic paradigm of an “old-media” business that hasn’t changed much since the 1960s. In fact, the entire old-media business is insanely risky right now, meaning not only radio stations, but also newspapers, television stations, television networks, and anything else not connected to the Internet. Nonetheless, “Private-equity firms are plunging deeper into the large-scale media business,” McBride, S. & Berman, D., “Clear Channel to Study Options; Suitors Form Line,” op. cit.
Another illustration is the turmoil at Tribune Co., owners of (among other properties) the Chicago Tribune and the Los Angeles Times. Regarding the issue of whether Tribune Co. shareholders might receive any premium over the stock’s current price, in the event the company is sold, “A partner at one of those firms said he did not expect any offers for Tribune to reach $40 a share. A person at another of the firms said Tribune would be a challenging acquisition. He stressed that interest was only marginal because the firm’s partners were having a hard time seeing how they would wring more savings or higher revenue out of Tribune,” emphasis added, Rainey, J., “Bidders said to be lukewarm on Tribune – Suitors, which sources say include two private equity firms, may want to split up the company,” Los Angeles Times (Oct. 28, 2006).
There also remains the risk that the “hedge fund” simply is holding a long position in equity investments, which has nothing to do with hedging, per se. Or, even when hedged (in the conventional sense of the term), its trading strategies are flawed, resulting in the possibility of catastrophic losses. Such was the case (recently) at Amaranth Advisors, a $9.2 billion hedge fund that lost $6.5 billion in less than a month, Anderson, J., “Hedge Fund With Big Loss Says It Will Close,” New York Times (Sep’t 30, 2006).
All of this only goes to reinforce the maxim that around the time an investment, or an investment strategy, starts to get a lot of publicity, or at least enough publicity that ordinary people like me start to hear about it, then it’s gotta be time to bail.
UPDATE: Another concern with hedge fund investments in media properties is that they may run afoul of FCC rules prohibiting concentration of ownership in geographical territories, see Berman, D. & McBride, S., “Private Equity May Face Snags In Media Hunt; Clear Channel Race Spotlights Limits Posed by Ownership Rules; ‘LBOing of Western Civilization’,” Wall St. Journal (Oct. 27, 2006).
UPDATE: “The United Kingdom financial regulator yesterday warned of risks to financial markets posed by the multibillion-dollar private-equity industry, particularly through excessive leverage levels and subsequent trading in the debt and credit markets. … The more debt that can be piled onto a company, the better the return the private-equity firm will get when it sells the asset. As private-equity companies have bought ever-larger firms, banks have lent at historically high ratios of debt … Because the debt is traded and risk hedged via ‘opaque and complex’ practices and an increased use of credit derivatives, precisely who owns what is unclear and could exacerbate financial risk in the event of company defaults, it said.” Cauchi, M., “Market Risk Is Cited in Equity-Deal Debt,” Wall St. Journal (Nov. 7, 2006).
UPDATE: An article in today’s Wall St. Journal reported on the case of Radnor Holdings Corp, a supplier of foam cups to restaurants, Wysocki, B., Jr., “New Breed of Hardball Investors Makes Loans, Takes Control,” Wall St. Journal (Dec. 12, 2006). An investment firm named Tennenbaum Capital Partners LLC bought $25 million of Radnor’s stock and lent it an additional $95 million, on what evidently were onerous terms. Despite this infusion, Radner nonetheless failed, and filed for bankruptcy. Tennenbaum’s loan was secured by a lien on all of Radnor’s assets, on which it foreclosed, thereby becoming the owner of the company. While an ordinary bank certainly would be capable of foreclosing, it’s most likely it then would try to sell the assets to someone else; it never would consider becoming an operating owner. Tennenbaum, however, had no difficulty in segueing into this role.
“What happened to Radnor is an increasingly common side effect of the explosion in private finance that’s helping reshape Wall Street. Hedge funds and private-equity firms, groups that control billions in investments, have piled into distressed debt and high-risk loans to troubled companies. But unlike traditional banks, which often have little alternative to seeking repayment, these new players are often quite willing to take over if things go sour.”
The problem, of course, is that such a maneuver freezes out the equity shareholders, because secured debt always will have priority not only over unsecured debt, but also equity, which basically is at the bottom of the pile. Sure enough, Radnor’s junior creditors filed a lawsuit accusing Tennenbaum of a “deliberate plan to load up Radnor with debt, force it into default, and then acquire [its] valuable assets and business operations in a fire-sale process at a discount price.”
In short: Tennenbaum’s investment really was an equity investment, masquerading as debt.