The Next Financial Crisis? Private Equity Leverage

Okay, welcome back to The Deal Room where I'm joined by Stephen. And just before the show, I was like, Stephen, what have we got today? And there was rumbles of leverage, layers of leverage, the potential brewing of a big problem in global financial markets. And I was like, okay, yeah, I'm interested now. What are we, what are we discussing here? Um, yeah, give me a flavor. What have we got?

Yeah, well, we've had some good news over the last few weeks and I didn't want us to have too many positive episodes in a row. I think the last few we've been talking about successful IPOs and first day pops and, you know, people getting very excited that the IPO market has opened again. Interest rates have remained stable in the UK and the US, and maybe everything's going to be okay. But we are going to talk today firstly about private equity. We're going to build the story of private equity and their use of leverage across the value chain of private equity. This is a, this is a big story already, but it's going to get bigger and it's really, really important. And then we're going to talk about the Federal Trade Commission and how they're trying to block a lot of deals, including the Microsoft and Activision deal, but are not having a great deal of success. Amazon is the next big company in the FTC's crosshairs, and we're going to discuss their chances of success. With that as well.

Okay, sounds great. So look, let's kick it off then. So can you remind me what is the typical model? I think let's start at the foundation level. What is the typical model of private equity?

Yeah, so private equity is a fascinating asset class. And just, you know, to take a very, very quick step back, private equity, as we've discussed on the pod before, It covers quite a lot of different investment strategies. It is any equity investment in a private company. And you put out a post a few days ago about the spectrum of risk-return from a private equity perspective, all the way from the least risky, your kind of traditional, maybe your traditional low-levered buyout fund, all the way to your most risky, which is your venture. Very speculative early-stage businesses. But often when we talk about private equity, we talk about buyout funds. So this is a fund that is dedicated, a fund raised by a private equity firm from institutional investors and pension funds to buy out entire companies with the intention of improving them, turning them around, and then selling them for a lot more. And making a return on the investment. So the way that leverage is used, and leverage is not a bad thing, let's be honest. You know, when used appropriately, it is the kind of the secret sauce that powers the majority of this industry and the majority of investing. We'll stop. So the way that a private equity fund works is there's a total amount of equity, let's say a billion dollars, and you want to go out and buy a bunch of companies. I could just use equity to buy these companies, but I wouldn't be able to buy many companies, right? So, you know, if I'm looking at two, you know, two $500 million targets to buy, that would just be two companies in the fund. Not great. What I could do instead is I could use a combination of my own equity in the fund plus raising financing, raising debt at the target company level, i.e., putting debt into the company that you acquire in order to be able to spread my equity in order for my equity to go further. It's a little bit like taking a mortgage out on a house. You buy a company, you buy a house with percentage of equity and then a percentage of debt. And this is absolutely traditional. Right. You know, I might buy my $500 million company with $200 million of equity and $300 million of debt. And if everything goes well in good times, you know, the private equity funds get to work. They make the company more valuable. They sell that $500 million company for a lot more. You know, they repay the debts, they get a load of return on their investments. The institutional investors, the limited partners that have invested in the fund, they get a nice little return and everything goes for— goes well. You know, those are the good times. And it's been good times in the private equity industry for the last 13 or 14 years.

But, but I guess that the search in anything to do with finance is you have that consistency and you're like, yeah, but can we, can we get more? And I'm thinking like, I always have this vision of Jenga Jenga blocks when it comes to, uh, um, the kind of idea of the subprime crisis and how they were starting to think, right, okay, so I use the analogy of the housing market. It's like housing market, yep, everyone typically aspires to own and buy a home, so it's high volume. But then you're like, okay, how can I pump some steroids into this situation? Um, but yeah, let's talk about nav financing because That's something which gets associated with this conversation a lot, but I'm conscious of not everyone will know what NAV financing is and why it's important.

Yeah. So, you know, going back to the traditional business model of private equity, as we said, in the good times, the asset that is bought gets sold for a profit and you return money to your limited partners. Those are the institutional investors that invest in your fund. And that is incredibly important. Because this, you know, private equity is a very, unlike public markets, it's a very illiquid asset. As an investor in a private equity fund, I might have a tie-up of 4 to 5 years, but after that period of time, I'm going to want to see some money returning, right? In normal times, that money returns because you sell the company or the company that you own within the private equity fund, IPOs or something like that. But unfortunately, over the last 18 months, these have not been good times. And now the problem for private equity funds is that since interest rates started rising, exits at attractive valuations have become fewer and far between. So we all know that interest rates affect everything, right? But at the core, they affect the cost of capital, which in turn depresses asset prices. So if interest rates are high, investors need to be compensated with a much higher rate of return to invest in risky assets, which actually lowers asset prices. So what's happened over the last 18 months is when a private equity fund has looked to exit one of its companies, maybe that company that it bought for $500 million, instead of, well, I mean, it could try and sell, But the danger with selling is that it might not sell for as much because valuations have dropped and exit opportunities have been lower. So, you know, if I'm in a situation where I'm a fund that likes to report positive return on investment, and I'm suddenly looking at selling a $500 million asset for $300 million, that doesn't seem particularly attractive. So what these companies are doing, what these private equity firms are doing is kind of saying, look, I know that my institutional investors want to get their money back, but I also am hoping that in a couple of years, the markets will return. IPO market will open back up. Valuations will bounce back. If only I could find something to bridge this gap. If only I could find something to bridge the gap between, all right, I'm going to have to sell this thing at a massive haircut. And, you know, maybe in 2 or 3 years' time, I could get all my money back. In comes net asset value financing, the kind of bridge. So now, so, so nav financing is what I would call the second layer of the private equity leverage cake. The first layer is debt at a company level, traditional vanilla, normal, fine. Now a lot of private equity firms have been taking out this nav financing, which is basically borrowing money at the fund level, secured against the equity within the fund in order to pay the limited partners who are starting to want to get their money back, having had a significant tie-in period. So it's that bridge financing at a fund level to help release some equity because they can't exit a lot of these companies.

So has there actually been casualties at this point in a sense of you're highlighting these risks, but then we saw with SVB that happened. I mean, interest rates were lower than what they are at the moment and you know, that unfolded pretty quickly at the time. So how are they, or has there been, and I'm just not aware of it, real struggles? With rates being at where they have been or where they are at the moment.

Yeah. So there's, there hasn't been any major casualties. There hasn't been a kind of canary in the coal mine incident yet. And this might well be because we are kicking that canary down the road by using this NAV financing. So, you know, there are serious structural problems in the private equity industry. And this is represented by the fact that we are using this extremely expensive form of debt to try and keep investors happy, keep limited partners happy, whilst acknowledging that a lot of the investments that I've made at a fund level are going pretty far south. So this net asset value financing, financing at the fund level feels like a bit of a bandaid And just to throw a couple of stats out there, the interest rates, the interest rates on some of these net asset value financing loans, fund-level loans, the interest rates are, can be anything from low teens to 19%. Right. So these funds are willing to pay 19% interest on a loan that they take out in order to pay their limited partners, in order to pay their institutional investors in the vague hope that the asset prices of the companies that they're trying to exit are going to recover. So whenever you see double digits and, and, you know, and high teens in terms of interest rates, you know, the higher the interest rate, the higher the risk for the lender, you're starting to smell something a little bit fishy. And this is certainly pretty fishy.

I think just given the large demographic of the people who listen to our show being in study at the moment, the one worrying thing I'd say looking long term is that if I was coming into the industry now and I'm seeing what you're describing, it's become normalized. And actually this, this way of business and surviving through— let's say it all goes to plan, valuations come back, the economy picks up, natural kind of cycle. They've kind of got out of it by this utilizing this strategy. And then that's that same mentality that you could say that caused previous instances in traditional markets in a sense of, of like the financial crisis and, and so forth, where you kind of, the worst thing you could do is, is kind of create these, I mean, you can never bet against human ingenuity, right? In terms of finding ways to, to find solutions to problems. But the problem is, if you do that in a highly leveraged situation and you get away with it, what do you do the next time? Of course you do the same again. And people coming into industry are thinking, well, this is normal. So then where do we go? We keep raising the bar each time.

Yeah. And this has been— this has been— this is a huge, a huge story over the last generation within the financial industry. The way that cycles have traditionally worked is that you have to feel some pain at the bottom of the cycle.

Yeah.

In order to eventually recover, recover in a less inflationary environment. And the problem with private equity and the problem with a lot of asset classes is in 2008, when they're overlevered and undervalued, or valuations are tanked, they're bailed out by the government by quantitative easing. Same bubble was happening in 2020, bailed out through the COVID you know, massive, massive quantitative easing and helicopter payments and interest rates and things like that. So if you're being a cynic about this, the industry might just be using nav financing to buy time until the next catastrophe. And again, what is happening? You're transferring risk or you're transferring debt from private into public. That happened in 2008, happened in 2020. There, you know, and these private equity masters of the universe are not getting any poorer all the way through this. They're still collecting their 2% management fee. Let's remember this. It's an $11 trillion industry. So maybe they're just waiting. Until another bailout or another kind of global event.

So you've mentioned so far that there's been two tiers to this cake. So where do we go from here?

There is a third tier. There is a third tier.

Tasty tier. It's getting more spicy as we go up the cake, it feels.

Yeah. Yeah, it's feeling more and more like a wedding cake. Now, so the third tier, So these are called Mancolones or management company loans. And if you read the literature on private equity or if you read the news, there's been a lot spoken about nav financing over the last year or so, and the concerns about piling an extra layer of debt on a leveraged buyout investment model. That's really quite concerning. But the third tier The third tier is when the actual top company, the management company, borrows at a top company level. So if you think about the way that a private equity fund works is you've got the private equity firm at the top, let's call it Carlyle. Then Carlyle owns a bunch of funds, you know, European Buyout Fund 1, and then that fund will own a lot of companies. Now we've seen debt at the company level. We're seeing debt at the fund level, and now we're seeing significant amounts of debt at the management company level. So this is basically borrowing money at the top company level based on the fees and the profits that are filtered up through the funds to the top company. And they're borrowing money at the top company level in order to do things Yeah. In order to do things like raise enough money to start a new fund. So think about that for a second. Think about the kind of web of leverage that's going on here. In order to start a new fund, the private equity firm, which is also called the general partner, needs to put down like a base amount of money, right? They need skin in the game and they're borrowing money at the Manko level to put skin in the game for new funds. Okay. But they're also borrowing this money and it's secured against the success of the funds below it, and therefore the success of the companies below that. So think about this three layer of leverage. That's all actually relying on the success of the base investments sitting right at the bottom, right at the foundation level. Of this cake.

Uh, so I guess the big question then is, we now know, as you've very eloquently described the cake, so what could be a— give me a scenario whereby the cake just gets absolutely destroyed. Like, what, what would be a hypothetical that could then make all of this just tumble down? Because it feels like it's one layer built on the next, and What would that look like in a, in a real life scenario?

Yeah, I think it, I think it's so like with any tower or, or whatever analogy you want to use, the foundations are the thing that's going to bring the rest of the, the rest of the tower down. And in this instance, it is the performance of the underlying assets. So, you know, there are, so as we've said before, private equity is a very illiquid asset. But there is a secondary market. It's super illiquid and it's very slow and stodgy, and price discovery is not nearly the same as in public markets. But there is a secondary market and we are seeing, you know, if a private equity firm wants to try and sell some of their, some, or a limited partner wants to sell some of their fund commitments on a secondary market, we are seeing haircuts of 40 to 50%. In terms of what they thought it was worth relative to what they can sell it for. So if you think about the performance of the underlying assets, if companies, let's say there's a major worldwide recession, right? And the companies that underpin these funds start performing extremely badly. Now, if they perform extremely badly, they may not be able to service the debt that they've got at a company level. Which might mean either some form of bankruptcy or at least a renegotiation where finance is going to cost a lot more. And therefore there's going to be less profits that are going to be generated up to the fund level. If there's less profit generated up to the fund level, or at least lower asset values at the fund level, then the fund doesn't have the money to service the net asset value financing, doesn't have enough money to service that debt. And there might even be margin calls if the asset value of the security drops due to the poorly performing companies. And then all the way at the top, if the funds are struggling to service their debt and they're not returning any, returning any capital up to the management company, then the management company won't be able to service the debt that they've taken out in order to underpin new funds, and the whole thing comes tumbling down. So the canary in the coal mine might well be a mid-tier, mid to large-tier private equity firm collapsing. Now we haven't seen it yet. And it's unlikely, you know, it's unlikely to be one of the big 4 or 5 that we talk about a lot, but we might well get to see, you know, there's a lot of rumblings about consolidation in the industry. And you know, there only being 10 to 15 big players left over the next 5 or 10 years, that's because of this, right? Because the business model is pretty shaky at the moment. And again, I'll say the stat again, it's $11 trillion of assets under management, and the investors are pension funds, institutional investors, insurance funds, you know, so this is big stuff. That we really, you know, it's not a kind of esoteric alternative area of the market anymore. It's properly mainstream. Okay.

Well, look, I'll rest easy this evening. No, it'd be really interesting because I remember when it all kind of unfolded in 2008. I think by visibility of these being all quite public companies that we were monitoring at the time, it was quite easy to see the dominoes kind of falling. What's interesting here is this little bit, a little bit more cloak and dagger behind closed doors. So it'd be really fascinating if that were to materialize, about the speed and how it would unfold. Because remember, SVB, it was like one day and it was just like— and that behavior, because it's just reflected in market price right there and then, it was just an absolute kind of bank run on regional banks. And then all of a sudden You know, it kind of ran away with itself, and then within about— interestingly, within a week, it was kind of over.

Yeah, and I would say, I would say that this— the dynamics are definitely different from public markets where there's contagion, or, or banks where there is this kind of, this, this, this, um, this run, the run on the bank, uh, and the fundamental business model of a deposit base. Um, the other thing that I'd say that might, you know, this might be death by a thousand cuts, is that a lot of the lenders to these funds are private equity firms themselves. So Carlyle and Ares, you know, a lot of these big private equity firms have private credit arms, basically replacing the role of a banker in terms of taking on riskier loans. And Carlyle and Ares are the two biggest nav financiers. So they are, they have no incentive for the whole thing to go south very quickly. There'll be a lot of restructuring of debt, there'll be a lot of wrangling and negotiation before the house of cards comes tumbling down.

Too big to fail, Stephen. Let's not worry about this issue here.

Yeah, you will rest easy.

All right, well, look, let's move on and let's talk a little bit about the FTC. And I guess in the context of the regulatory environment, why is this important? What type of precedent does it set and why students should be aware of this type of thing and how it will benefit them would be a good place to start. So yeah, tell me about, tell me about Linda Kahn, because, uh, quite a character. So yeah, what's the background? Yeah, Linda.

Yeah, so, so Linda Kahn is the chair of the Federal Trade Commission. She's an American legal scholar, and she is an incredibly important figure in the world of US and therefore Western business, because she is setting her stall out as the chair of the Federal Trade Commission to take a much harder stance on antitrust and on competition law. Now, this is super important for any student, whether you are an economics student, uh, doing their A-levels or whether you're a finance and business student at university or, or whether you are in a job. You know, the regulatory environment within which businesses can operate and flourish is, is super, super complex. And it is all about how do you ensure that consumers are protected against the dominance of businesses that are becoming too big businesses that are becoming monopolistic businesses that are displaying anti-competitive tendencies that tend to wipe out other competition in the market. And now previously in the US, you know, from about the 1980s, from kind of Reagan onwards, the FTC has been incredibly weak and there has been very, very little desire for the FTC to ruffle big corporate feathers, right? Uh, and this has resulted since the early noughties in the growth of these absolutely mega companies, right? The big 4 or 5 that you talk about a lot on the Friday podcast. Now, Linda Khan's come in really quite a strong character. I mean, very, very Well hated in the kind of, you know, the smoking rooms of US big business, you know, and lobbyists and things like this because she's trying to take it to the big companies. You know, so we're going to talk, I think we'll talk about Microsoft and Activision because that's a big one. We'll talk about the pharmaceutical industry. We'll talk about Amazon as well. She's really, you know, I don't think she sleeps because she's putting together these pretty mega cases. Against these big firms.

Yeah. So we've talked about Microsoft and Activision before, but I'm just conscious that not everyone listens to every episode we put out. So maybe a quick summary of the Microsoft Activision and the Amgen Horizon one, but then maybe we could focus a bit more on the Amazon one, given that that's the one in focus now and given that Amazon's such a well-known and large entity.

Yeah. So Microsoft and Activision, for anyone that's studying M&A or wants to go into M&A, this is kind of the, the platinum deal that you probably need to know something about. And we do a lot of our simulations actually based on Microsoft and Activision and trying to value Activision, see whether it's good value for money. So in January 2022, it's a long time ago, it's almost 2 years ago, January 2022, Microsoft announced the acquisition of Activision Blizzard, the games manufacturer known for Call Call of Duty, amongst others, for $68.7 billion. They're a huge, huge, biggest transaction of the last couple of years by quite some way. And the way that these things go, it gets announced and then you have to get regulatory approval. So they went through this very, very long and complex process getting regulatory approval in all sorts of markets around the world. It got allowed in Europe, in the EU, and then it got blocked by the UK Competition and Markets Authority, and then it got blocked by Linda Khan and the FTC. And the rationale was relatively flimsy. The rationale was, hey, we're a little bit worried about you blocking Activision titles on other consoles and on other games distributors like Ubisoft. And we're also worried about potential monopoly in online gaming. Not a monopoly at the moment, but a potential monopoly. So they're kind of using antitrust to cast their crystal ball into the future. Lots of back and forth. Microsoft ended up taking the FTC's blocking of this deal to court. The FTC are not, you know, they're not the courts, but they are an agency that can recommend and can get things passed. The courts decided against FTC blocking the deal and said, hey, Linda, you've overstretched your mark here. You know, we don't see enough grounds from a core legal perspective to block this deal. So we are going to let the deal through. We're going to override you, Federal Trade Commission. It's the way the power works in these engagements. We're going to let the deal go through. Subsequently, The Competition and Markets Authority in the UK said, hey, look, Microsoft, you've given us a couple of concessions. You've made the deal slightly more maybe competitive. We are going to put the deal through as well. And it is looking, you know, on the 27th of September, 2023, it is looking more and more like this deal is actually going to go ahead. And what's quite interesting, again, any student of M&A, the best thing to look at when thinking about the likelihood of deal success Activision is a listed company, right? And the offer price from, uh, from Microsoft, from Microsoft was $95 a share. So the closer the share price gets to $95 a share, the more likely, or the view of the market, the more likely the deal is going to be consummated. So when the deal was blocked by the CMA back in the summer, Activision share price dropped to $74. $21 below the offer price. This morning when I looked it up, Activision was trading at $94. So almost the $95, suggesting that it's basically a done deal.

Hmm. So at this point though, if you had such a, as you said, there's a flagship deal of that magnitude and you've gone after it to stake your name on this case. And you basically get, you basically get overturned. Why is Linda still there? Like, in any other normal situation— and I know you're going to describe that there's an Amgen-Horizon situation as well— at what point then, I guess my question is, what, what is the political influence? You said there's like lobbyists, things like that, who obviously want business to, to boom, and they've got other interests that might be misaligned. So how does someone like Linda get appointed, and how much does the political side of this come into her dealings? And then how can she— I mean, we're describing 3 here in total, we just discussed 1. At what point is it, well, you've got no teeth basically, and therefore it's a redundant kind of position and someone else has to come in?

Yeah, there's a, there's a, there's a lot going on here. I think it's, it's definitely very political, and there are people behind the scenes saying, look, Biden, if you get in again, uh, in 2024, you're gonna have to, you're gonna have to sack Linda. Like, you know, we're, we're, we're, we're really, really upset with her. She's, she's taking time and money, and, you know, these deals are getting, you know, she's losing cases, and it's just costing everyone time and money, right? So, so there is a lot of, yeah, and I think that if the Republicans get in in 2024, she'll probably, she'll probably be out the door. I think what's worth saying, and it's good, it's best represented with the Amgen and Horizon case. This is one big pharmaceutical company buying another big pharmaceutical company for $28 billion. The FTC blocked it based on the potential for anti-competitive cross-selling where, you know, a pharmacist in the US could basically bundle an Amgen drug with a Horizon drug. And say, look, you can get these two together and we'll give you a discount because it's all part of the same company. Again, very long story short, the FTC lost that in court again, and the deal is going ahead. But to give Linda Khan some credit, during all of these processes, concessions have been made in terms of the structure of the deal to make it more competitive and to give more assurances to the market. That there isn't going to be anti-competitive behavior. And she's also battling in a super conservative environment. She's coming from 30 years where everything just got through. So I think she's almost having to go too far the other way in order to slightly balance the books in order to get competition policy back onto a bit more of an equitable footing and to avoid some of these kind of maybe what one would say abuses from the very, very largest companies in the US today.

And with Amazon then, because what's the situation there? What's the actual crux of what she's suggesting with Amazon?

Yeah, so this was a really, really new news story. So this came out very, very recently. So Amazon has just received a 172-page complaint from the Federal Trade Commission that is relatively holistic. In its representation of Amazon's business model being anti-competitive. So often when these, when these cases are brought and actually the Department of Justice brought one against Google last week against its search engine and against paying $10 billion to be the native search engine of Safari and things like that, this 172-page claim against Amazon is basically tearing apart the entire business model of Amazon's e-commerce platform. It's saying that it's anti-competitive in a number of different ways, and its fundamental business model is anti-competitive. I.e., you know, and we've known this for quite some time. If you've got an e-commerce platform where you own the e-commerce platform, and you own a lot of the basic products that you're selling on the e-commerce platform, there is an incentive to stop your competitors undercutting you. There's an incentive to stop your competitors in terms of product level, provide being higher up on the search engine. So it actually seems— and by the way, Linda Khan wrote a big paper in this about Amazon in 2017. So it's kind of seemed like this was going to happen. Khan has been kind of teeing this up, And teeing Amazon up as the kind of the one that she wants to go after holistically as opposed to in a deal-specific context. So, and you know, I haven't read much into this. It's a very new story. I think I read this story 5 hours ago. This seems to be a relatively robust case. It's pretty comprehensive. It tackles the fundamental business model. And it's going to be a really interesting one. You know, Linda Khan having failed a few times on a couple of acquisitions, maybe this is going to be the one that determines her legacy. But do not put it past the power of the Amazon lobbyists. You know, they've got so much money, so many lawyers to chuck around to say, by the way, you know, you've interpreted this wrong. We're a lovely company. We're adding value, consumers love us, et cetera.

Yeah, I was just having a look at Amazon share price because as you rightly said before, looking at Activision, for example, or looking at other companies as a marker of the outcome of these events as far as investors' perception. But it's hard to kind of obviously tell because, you know, I'm not tracking Amazon news flow and stock price day to day, but Um, they've been coming off anyway over the last 2 weeks, but certainly there's a lot of headline buzz around this latest one. They did fall, they did drop 4%, which underperformed the market yesterday, but they are also outlaying $4 billion on an AI startup at the same time, which is, uh, not a small amount of money either, uh, which, yeah, can go 2 ways actually from a stock price perspective, in whether you buy into the hype of the future income that that could bring through that acquiring of that technology against actually the cost of the acquisition in itself. But yeah, no, look, super interesting as always. Don't forget as well, just as we are wrapping this up, what I might do, Stephen, I'm going to see if I can find, and if not create, a little three-tiered cake to mark this episode of leverage in the private equity world. I'll see what I can come up with. Also, don't forget that if you weren't aware of it, there is now an M&A Finance Accelerator. We launched it last week and we had to close registrations within 48 hours because it's capped because Stephen runs it live with the rest of the team. It was capped at 500 people and yeah, amazing. So thank you everyone who signed up for that. But we're going to be dropping, uh, some new dates very soon. And actually, if you just jump on our LinkedIn profile account, Amplify Me, um, if you just put your name on our last post, and what we're going to do is we'll slide you a DM soon as that, um, new date gets dropped, and we'll give you 24-hour heads up before it then goes public so you can get in on that action. So yeah, don't forget to do that, uh, Stephen, Thank you for your insights as always, and, um, I'll catch everyone next week.

Thank you, Anthony.