The Great Deformation (95 page)

In fact, during mid-2004 Dex Media was taken public at a value of about $3 billion for the equity on top of the LBO debt which remained at its original level. So on an apples-to-apples basis, the IPO was valued at approximately twice the $1.5 billion equity investment that its private equity owners had made only fifteen months earlier.

This saga of quick riches only got better, rapidly. As the Greenspan bubble gathered momentum in 2005, the Washington insiders who ran the Carlyle Group might have sent the maestro a case of champagne. In October of that year, they sold Dex Media to another yellow pages publisher, the venerable R.H. Donnelley & Sons, for $4.3 billion plus the assumption of all the LBO and dividend debt.

So the whole investment life cycle consumed only about forty months, but the rounds of debt upon debt were stunning. There was a huge $6 billion debt issuance at the time of the LBO; another large debt issuance to
fund the quickie dividend; and then an M&A takeout by a heavily leveraged company that for all practical purposes was a publicly traded LBO. The post-merger company, in fact, had about $11 billion of debt.

A cascade of debt thus built up inside the company and its successor. In the meantime, the private equity sponsors were favored with a CEW extraction of startling magnitude. During their brief interval in the yellow pages business they pocketed more than $5 billion from the dividend and the sale of their Donnelley shares shortly after the merger.

That amounted to 3.3X their original investment for adding no detectable value. On an organic basis, the sales and EBITDA of these scattered yellow pages operations continued to decline, meaning there is little evidence that the Carlyle Group and its other private equity sponsors did much (or could have) to put Dex Media's three-hundred-odd local phone directories on a life extension program.

What is indisputable, however, is that Washington reduced the tax on capital gains and dividends to a historic low of 15 percent at the beginning of their holding period. Carlyle and its other investors were thereby enabled to harvest their multibillion-dollar windfall essentially tax free.

This private equity windfall bore another distinctive hallmark of the speculative tide then cresting; namely, that the deal amounted to a fraudulent conveyance in economic terms, if not as a legal matter. Indeed, the underlying business reality was that the deal from which Carlyle extracted the preponderant share of its cash winnings, the ultra-leveraged merger with R.H. Donnelley, had been destined for a crash landing from the start.

On a post-merger basis, Dex Media and Donnelley combined had $2.8 billion of revenue and $1.1 billion of operating income compared to a debt load in excess of $11 billion. Even the proverbial “cash cow” type business on which LBOs had originally been predicated would have been hard pressed to sustain an 11 to 1 leverage ratio across an entire business cycle.

In fact, by January 2006 when the merger was completed, the yellow pages already had the aspect of a milk cow heading for the great pasture beyond. Their revenues and cash flow were being inexorably Googled away.

Worse still, there wasn't much magical merger “synergy” to exploit because Dex Media was twice the size of Donnelley, and its LBO sponsors had already picked its cost structure to the bone. Accordingly, pro forma operating margins were already at 40 percent and there was little evidence elsewhere in the industry that they could be pushed much higher.

At length, nearly every single yellow pages publisher has stumbled into bankruptcy after years of bravely insisting it could make the transition from cellulose to silicon. R.H. Donnelley suffered the same fate, but it was
symptomatic of the 2005–2008 financial mania that lenders had ever believed otherwise.

This thoroughgoing suspension of disbelief contrasted sharply with the LBO business only a decade earlier, when annual LBO volume for the entire industry had been less than R.H. Donnelley's debt. In these more sober times, my colleagues at Blackstone had considered any traditional business being stalked by the Internet as strictly off limits. These businesses were not only seen as the equivalent of a dead man walking, but they had also been avoided for another reason: Alan Greenspan had not yet thrown in the towel on irrational exuberance and mainstream investors did not yet assume that the Fed had abolished the business cycle.

In short, a sunset industry was no place to become trapped with a boatload of debt. Yet that is exactly where the yellow pages business stood after the turn of the century. That it was a dying industry was no state secret, but investors now assumed that the risk of any business cycle downside was in the nature of a rounding error. Owing to the Great Moderation, therefore, five- and ten-year loans would get repaid before the yellow pages ran out of cash.

Accordingly, R.H. Donnelley's $11 billion of debt traded at par, and its stock price climbed by 25 percent within a year or so of the merger. Since it had pioneered the directory business more than a hundred years earlier, speculators in both its debt and equity apparently assumed that Donnelley possessed a secret sauce. But it had none—only the dubious franchise right to sell ads in a shrinking phone book.

What it also had was a book of sales which depended upon the continued willingness and ability of car dealers, bowling alleys, and about 600,000 other mostly small businesses to buy advertising. On those facts alone, R.H. Donnelley's days were numbered.

The roaring bull market paid no note. It priced the company's pro forma earnings of $2.25 per share at $78, meaning that a far-flung set of three hundred local phone books which experienced no organic revenue growth for five years were being valued at 35X net income. This was the “audacity of hope” before the term was invented and before the Fed's bubble economy finally buckled.

In the event, the severe slump in yellow pages advertising by Main Street businesses during the recession caused the company's cash flow to plummet. The resulting balance sheet kill was quick and clean: when Donnelly filed a prepackaged bankruptcy plan in June 2009, its market cap of $5 billion had vaporized and it was forced to write off $6 billion of its debt.

In the course of four years of leveraged deal making, therefore, Dex Media–Donnelley had mounted $11 billion of enterprise value which
proved to be entirely phantom-like when the equity vanished and the bonds were cut in half. In the interim, private equity operators and those stock market punters who got out before Donnelley's share price plunged extracted more than $6 billion in windfall gains. Here was the mark of CEW. These dying yellow pages never would have been leveraged at all on the free market.

THEN CAME THE DELUGE: THIRTY GIANT LBOS

The Dex Media–R.H. Donnelley saga was not an outlier, but a prototype for the string of giant LBOs and the fantastically leveraged deal making at the heart of the second Greenspan bubble. In fact, it was these huge debt-financed deals which drove the stock market and other risk assets skyward during the final phases of the mania.

The mountains of the debt piled upon target companies during the mega-LBO mania could never be sustained in the fragile, credit-addicted economy that the Fed spawned. So the entire mega-LBO boom was the equivalent of a state-assisted fraudulent conveyance. Hundreds of billions of CEW was extracted from the balance sheets of the target businesses and transferred to speculators on the top rungs of the economic ladder. But it was financed with so much debt that most of these deals were candidates for eventual insolvency under any realistic long-term economic scenario.

For that reason, virtually none of these mega-LBO deals, as detailed more fully in
chapter 25
, would have passed muster on the free market. They were the spoils from the central bank's drastic repression of honest market-clearing prices for debt and risk.

The sheer magnitude and speed of this supersized buyout wave is difficult to exaggerate. But we can see its importance through a string of thirty giant LBOs occurring from early 2005 through the spring of 2008. Each was seemingly larger than the previous one but most shared a common fate: they ended up teetering on bankruptcy, undergoing voluntary restructuring, or limping along as financial zombies which labor to this very day under an unshakeable load of debt.

The largest was nearly $50 billion and the average size was $17 billion. This average size for two and one-half dozen LBOs was remarkable because with the exception of the 1989 RJR-Nabisco deal there had never been a single leverage buyout that large. Furthermore, the aggregate value of these deals was a staggering $500 billion, meaning that nearly half of the $1.1 trillion of LBOs completed during this period was accounted for by just these thirty giant deals.

Two data points vivify the enormous financial shuffle embodied in these mega-LBOs. First, approximately $115 billion in new money was invested
by the private equity sponsors, representing about a 25 percent equity ratio in the deals. At the same time, existing shareholders were paid out the staggering sum of $375 billion in cash at the deal closings. That was CEW on steroids. Most of the cash circulated back through the Wall Street–hedge fund complex looking for the next upside speculation.

Secondly, to finance this enormous CEW extraction the balance sheets of these thirty mega-LBOs were freighted down
with $375 billion in debt, an amount nearly four times the debt they carried prior to the buyouts.
As shown below, however, most of these companies were decidedly not good LBO candidates, and almost all the deals drastically overvalued future cash flows.

As a consequence, after five to seven years virtually none of this debt has been paid down in the manner of the classic LBO model. Nearly half of the thirty companies have entered bankruptcy or voluntary restructuring. Most of the remainder are financial zombies which have managed to use the Fed's third financial bubble during 2009–2012 to delay their debt maturities through “extend and pretend” refinancings.

What remains, therefore, is a $400 billion wall of debt that will eventually tumble over during the next recession, or when the corporate pachyderms which are lugging it finally buckle under the weight.

THE FIRST WAVE OF MEGA-LBOS:

$40 BILLION OF CEW AND NINE TIMES MORE DEBT

The first out of the box in March 2005 was Toys R Us Inc. at $7 billion, and the scale-up was steep from there. Next came Realogy Corporation at $9 billion, Univision Communications Inc. at $12 billion, Hertz at $15 billion, and Freescale Semiconductor Inc. at $18 billion. All five of these deals were completed before the end of 2006; none were logically viable candidates for a leveraged buyout; and all have hit the wall or have been consigned to financial zombie land ever since.

The combined value of these five buyouts was $62 billion, and $45 billion of this was funded with new junk bonds and leveraged bank loans. Their dubious suitability as LBO candidates is pointedly suggested by the fact that these companies had only $5 billion of debt among them prior to the transactions. They were the type of enterprise which had historically eschewed leverage, but now they had nine times more debt.

For example, Toys R US was locked in a viciously competitive struggle for market share with Wal-Mart and could ill afford to be weighed down with a millstone of heavy debt service claims on its cash flow. Likewise, Freescale was a pure commodity play in the violently cyclical semiconductor industry that had always been off limits to LBOs.

These deals also aptly demonstrate how mega-LBOs cycled massive amounts of CEW out of business sector equity accounts and into the financial markets. Private equity sponsors invested $17 billion of their new capital hoard in these mega-deals, but at the closings of these five transactions $57 billion of cash flowed the other way, back into the financial markets as proceeds to the selling shareholders. The great CEW raid was on.

STEPPING INTO HARM'S WAY: THE TOYS R US BUYOUT

That these deals were insensible at the time is evident from their struggles for survival ever since. Toys R Us was emblematic. In early 2005 it was a shadow of its former glory with its same-store sales in perilous decline. They had dropped by nearly 4 percent during 2004 and by nearly 10 percent from levels attained in 2001, reflecting Wal-Mart's powerful drive to dominate the toys category and eject Toys R Us from its twenty-five-year reign on top.

It largely succeeded. By the time of the buyout deal, Wal-Mart's 25 percent market share was well ahead of the 16 percent still held by Toys R Us. Indeed, Wal-Mart had already demonstrated that trying to compete against it as an LBO could be hazardous. The second-largest big-box toy retailer, KB Toys, had been put on the LBO bus by Bain Capital a few years earlier and had landed squarely in
Chapter 11
by early 2004.

It was a sign of the mania, however, that not only were these competitive realities ignored, but the deal price was so high as to add insult to injury. When Bain Capital and KKR won the auction they got no bargain, paying an astounding 22X operating income (earnings before interest and taxes). The apparent justification was that if you didn't count depreciation as an expense, then the multiple of EBITDA was only 10X.

This way of reckoning purchase multiples was standard fare in the LBO business. In some cases, however, companies needed to spend every dime of their depreciation on capital expenditure to stay competitive and viable, and a death struggle with Wal-Mart to get fickle consumers in the front door was surely one of those cases.

Worse still, Toys R Us earned 100 percent of its fiscal-year 2004 EBITDA of $660 million in the fourth quarter. So even by this preferred measure of earnings, Toys R Us would be starting its LBO life just one bad Christmas season away from disaster.