The Rude Awakening
Laguna Beach, California
Friday, June 1, 2007 ------------------------- - Private equity follows dot-com to maniacal heights,
- Three stages of public spectacles and how to identify them,
- The inconvenient combination of low tides and no trunks and plenty more…
------------------------- Eric Fry, reporting from Laguna Beach, California… A friend recently told the following joke: Question: What are the most common final words of a redneck? Answer: "Hold my beer…Watch this." In other words, just because you CAN do something, doesn't mean you SHOULD. That's what I'm always thinking when I watch the annual hotdog-eating contest on Coney Island. And that's also what I'm thinking when I watch investors flock to financial manias. For every hotdog-eating "winner," there must be dozens of losers with gastro-intestinal discomfort. The financial markets are no different. Every mania produces a handful of winners…and thousands of losers. But manias are seductive. Profitable investing seems effortless. Money is very easy to make and very hard to lose…as long as you continue to trust the mania. (Experienced investors can never bring themselves to trust a mania, however, which is why the "dumb money" always seems to excel during these manic phases). But the world is not configured to make EVERYONE into a millionaire. Instead, it reserves that status for a few lucky - usually cautious - individuals. Therefore, when "everyone" is making money, "everyone" is usually about to start losing money. Over the last few months, the stock market has been treating investors very generously. Too generously. Money-making has been easy. Money-making has become so easy that an entire industry has sprouted to capitalize on the phenomenon. That industry is called "private equity." Because private equity firms are paying rich premiums for public companies, investors begin to imagine that the stock market is "underpriced." Therefore, they bid up share prices of the companies that they think the private equity firms might buy. These trends feed on each other until, before you know it, you've got a mania. "What we know is that private equities, like hedge funds, have taken on a speculative mentality," observes our colleague, Bill Bonner. "Deals are put together…then flipped from one private equity firm to another. The objects of their attention - actual, profit-making companies - are loaded down with debt so the private equity investors can take out the profits. And then, the deals are sold back to the public - at a big premium. As more and more money chases quick profit, standards slip; the deals degenerate…from super-prime to subprime. Until investors come to their senses. "Every public spectacle is amusing in its own way," Bonner continues, "but all have the same basic theatrical elements: each begins with legerdemain or an outright lie, it progresses into a farce, and ends in disaster." Private equity investing begins with the lie that borrowing money to buy richly valued companies is an intelligent investment strategy. Private equity then becomes a farce when investors buy certain stocks, just because they think a private equity firm might buy the company later for more money. Private equity ends in disaster when - at some unknown point and in some unknowable way - the mass stupidity ends as Dan Amoss explains below. ----------------------------------- Swimming Naked
By Dan Amoss Financial markets are not as cyclical as they are tidal. Bull markets ebb and flow. As share prices respond to these tidal currents, investor exuberance surges for a time, then recedes. High tide lends buoyancy to almost every stock, while concealing the flaws of misguided investment strategies. But as the tide of easy money and exuberance ebbs, billions of dollars of stock market wealth wash out to sea. Only then do we discover which investors have been swimming naked. You'll also want to make sure that low tides will not leave you exposed to capital losses. It is now high tide in the U.S. financial markets. All assets seem to attract enthusiastic demand from investors. Junk bonds, as well as junky stocks, float on the high tide of optimistic expectations. Atop these buoyant currants, the S.S. Private Equity charts a profitable and seemingly safe course. The delusion that private equity funds will buy out any and all companies trading on public exchanges is growing in popularity. Those that buy into it believe that an expensive, overbought stock market should remain on a permanent upward trajectory until deal after deal removes every last share from public hands at premium prices. EZ credit is fueling the boom. The real factor behind the wave of private equity deals -- and the calls for higher stock prices across the board -- is bond investors' insatiable appetite for income and their complete disregard for default risk. They are pouring money into anything not nailed down, including the "me too" private equity funds that are setting up shop as fast as mortgage brokers were in 2005. Ray Dalio from Bridgewater Associates explains in a recent Barron's article: "Hedge funds and private-equity firms today are like the dot-coms in 2000: Ask for money and you'll get it. They bid up the prices of everything. The amount of money flowing is almost out of control, and it's making everything overvalued. A client of mine said it's like there are 11,000 planes in the sky and only 100 good pilots -- an accident is bound to happen. Just like the dot-com bust, the winners and losers will be sorted out…practically all good managers are closed to new investment." We're in an environment where too much money is in the hands of mediocre managers. So I wasn't shocked to see one of these private equity funds decided to take a flyer on IT products distributor CDW Corp. Earlier this week, CDW received an offer to be taken private by Madison Dearborn Partners LLC. CDW basically resells computers, software, and networking equipment to small businesses and government agencies. A leveraged buyout of a low-margin distribution business is an investment with very little room for error, but Madison Dearborn lowered their chances of success even further by paying such a high price -- 12 times EBITDA; to put this price into context, ConocoPhillips sells for 4 times EBITDA. Which business would you rather buy and hold on a levered basis for the next 5 years? Madison Dearborn would not have made this offer if it hadn't been able to raise debt on such attractive terms. The chart below depicts the stock price of CDW Corp. (CDWC) and the 12-month yield of the Blackrock Corporate High Yield Fund (COY). As you can see, these two lines tend to move in opposite directions. 
What does this mean? It means two things. 1) That investor appetite for risk has been increasing for years. In other words, risky stocks like CDWC have been trending higher, at the same time that junk bond yields have been trending lower. 2) Risky ventures, like private equity firms can obtain financing on very attractive terms. In other words, COY's chart is a gauge of investors' willingness to loan money to companies like Madison Dearborn for this deal. COY holds a portfolio of high-yield ("junk") bonds. Five years ago, investors demanded a 15% return to buy the Blackrock Corp. High Yield Fund. Today, thay demand only about half that amount. Clearly, the buyers of COY are not too concerned about delinquencies or defaults from the high-yield borrowers. But just because you can raise debt to fund the purchase of CDW doesn't mean you should. CDW's weathered management team has very good reasons not to load their balance sheet up with debt -- inventory obsolescence, economic exposure, and high working capital requirements to name a few. But regardless of these risks, Madison Dearborn wants to make a leveraged bet on the PC upgrade cycle -- one that's shaping up to be disappointing considering the lukewarm reception of Windows Vista and inventory gluts in key areas of the PC food chain. Fred Hickey, editor of "The High-Tech Strategist," is very bearish on the IT sector. He's followed it closely for decades and anticipates big earnings disappointments in the coming months. In his latest issue, Hickey summarizes his outlook in a single sentence: "A buildup in PC inventories due to weaker-than-expected acceptance of Vista, lower-than-expected cell phone unit sales at the world's top handset makers, a year-over-year decline in total cell phone industry revenues, a slowdown in the high-end computing and storage markets, a sequential collapse in Apple's iPod sales and an unexpected fall in year-over-year iPod revenues, a very weak printer market, continuing inventory challenges and soft sales at the contract manufacturers, soft auto sales, slowing big screen TV sales, sharply lower-than-expected digital satellite radio sales at retail, and continuing softness in telecom equipment due primarily to the ongoing carrier consolidations, are all consistent with the notion that the U.S. economy is heading into recession, led by the not-so-resilient consumer." It will be interesting to see how a debt-laden CDW will weather the next cyclical downturn in the computer hardware industry. This deal reminds me of Warren Buffett's statement at the Berkshire Hathaway shareholder meeting earlier this month: "Investors in private equity funds lock up their money for 5-10 years and buy businesses that don't price daily. It takes many years for the score to be put on the board and the investors can't leave." We may not see the "score" of the CDW deal for a few years. But, no matter the score, I'll bet the partners at Madison Dearborn will fare better than their investors. Buffett bluntly explained why cash seems to be burning holes in the pockets of private equity: "If you have a $20 billion private equity fund and get a 2% fee, you're getting $400 million a year. But you can't raise another fund with a straight face until you've invested it, so there's a great compulsion to invest it quickly so you can raise another fund and get more fees." A recent Wall Street Journal article quoted Carlyle Group co-founder David Rubenstein as saying that "there hasn't been a failure for five years. We need to prepare people for the reality that some deals will fail. Greed has taken over. Nobody fears failure." Another classic Warren Buffett quote applies here: "It's only when the tide goes out that you get to see who's been swimming with their trunks off." At the current high tide, many believe that easy credit can fund the buyout of any company at any price. But as surely as low tide follows high tide, tighter credit conditions will suck imprudent private equity deals out to sea, drowning many investors in the process…and exposing the flaws of an investment strategy that values momentum and pole vaulting. Joel's Note: There's a very good reason you've been seeing more and more of Mr. Amoss in these humble pages of late: He's a darned good financial mind. A qualified CFA, Dan has a hound-like knack for sniffing out the financial farces that line Wall Street's pockets and empty those of regular investors. In his newsletter, Strategic Investment, Dan turns the tables so you get the inside track and avoid the trappings the suits have carefully laid. His latest report will astound you. If you're interested, check it out here: Scams, Schemes and Swindles - Strategic Investment Briefing --- Free Market Investor Special Report --- Income + Growth + Safety = "An Immense Success" Get double-digits returns and income checks…from a secret and super-reliable "pension-payout plan" that's otherwise off-limits to everyday Americans… Read the Full Report Here: The Free Market Investor | 
