The Great Deformation (98 page)

Lender permission to strip dividends out of a revolver would have been scarcely imaginable only a few years back. By 2010, however, the Fed's embrace of “too big to fail” had induced the great LBO banks of Wall Street to permit borrowers to raid their own vital liquidity lines (i.e., credit revolvers) like a piggy bank. In previous times the Wall Street banks had at least insisted that unsecured or subordinated lenders be tapped for the honor of fronting the dividend money. Now, in its desperate post-Lehman efforts to encourage “risk on,” even that had gone by the wayside. The Fed had thus unleashed the financial Furies.

At the end of the day, the multiple HCA dividend recaps underscored that the world of junk debt and LBOs had taken on a whole new modus operandi. The great Wall Street banks no longer even worried about repayment risk because the Fed was now vividly confirming that redemption of debt wasn't necessary.

Instead, under the Bernanke dispensation corporate debt was meant to be perpetually refinanced. Not coincidentally, these “evergreen” pools of debt, like HCA's $28 billion, would also favor Wall Street with a constant stream of underwritings and refinancing fees.

Furthermore, the job of the Fed under this perpetual refinancing régime was to stand ready with a liquidity hose, prepared to fund any amount of faltering debt that Wall Street banks might be choking on during periods of “financial crisis.” Such bad debts historically had caused banks to suffer painful losses and accountable executives to get fired. Now such failing credits had been redefined as evidence of a new financial disease called “contagion” and “systemic risk” which needed to be combated at all hazards, even if it rewarded the perilous breach of sound underwriting standards so blatantly evident in the HCA dividend episode.

At it happened, by the spring of 2011 things got even better for KKR and Bain. The Bernanke bubble now had the risk asset market so cranked up that HCA was able to launch an IPO, with most of the proceeds again going into the sponsor's bank accounts rather than into the company's coffers to pay down debt. Based on the previous dividends, the IPO stock sales, and the value of their remaining stock at the $30 per share IPO price, KKR and Bain stood to harvest a windfall profit of $3 billion each on their original $1.2 billion equity contributions to the deal.

THE HCA PRIVATE EQUITY PLUNDER:

STATE POLICY RUN AMOK

At the end of the day, the circumstances of the $33 billion HCA buyout are a screaming indictment of current policies of the state. HCA is the nation's largest hospital chain, but it thrives only by dint of the $15 billion it collects each year from Medicaid and Medicare. These revenues are vastly inflated compared to what HCA would obtain if it had to compete for patient dollars in an honest consumer-driven market.

Worse still, the KKR-Bain deal had thrived only because an effort by the Bush administration to reform the rickety machinery of hospital reimbursement under Medicare had been shut down by a mighty crony capitalist coalition of hospitals and other medical vendors at the time of the HCA buyout in 2006. The Bush reform effort would have reduced the payment rates for DRGs (diagnostic review groups) by upward of 33 percent
for certain high-cost hospital services such as Cardiac, Neurosurgical, and Orthopedic.

The Medicare DRG rates for these services became drastically inflated over the years and now accounted for upward of 70 percent of hospital profits in institutions like HCA. These bloated profits were also gifts that had originated way back in the Reagan administration, when in desperation we had resorted to a disguised system of hospital price controls to curb the explosively growing Medicare budgets.

We had been warned at the time that the DRG system was not the great reform it was cracked up to be. Yet we embraced it because it was a significant improvement on the prior system which paid hospitals a per diem rate based on their actual costs—a system which obviously rewarded unnecessarily long stays and padded cost structures. By contrast, the DRG scheme established a lump-sum payment per case, regardless of the length of stay, for about 450 distinct diagnostic groups such as heart surgery, and was based mainly on systemwide cost factors rather than the hospital's own costs.

This arrangement did reduce the worst incentives of the old daily rate approach, but the problem was that hospitals would soon learn to game the system. In a phenomenon called “DRG creep” sophisticated procedures were developed by hospitals to “code” each admission to the DRG with the highest payment rate.

Accordingly, within a few years an annual allowance typically of 2 percent in DRG rates to compensate for general inflation would end up producing an actual 6 percent gain after allowing for the “DRG creep” of the caseload into high-paying categories. The only real solution, therefore, was regulatory vigilance and a periodic downward reset of DRG rates for the most abused procedures.

Needless to say, these DRG rates were bureaucratic prices, not market prices. Consequently, the rate-setting process (i.e., price controls) was tailor-made for manipulation by crony capitalists and their hired K Street lobbies. Every species of impacted vendor—from manufacturers of artificial hips to general hospital chain operators—was fully engaged in this bureaucratic price fixing.

Moreover, in this instance crony capitalism was actually a family affair. Fully $1 billion of the equity capital for the HCA buyout was supplied by the estimable Thomas Frist, the original founder of HCA and energetic foe of the very Big Government on which his fortune was based. In waging this campaign the Frist family left no stone unturned, placing Bill Frist in the US Senate and seeing to it that he eventually became majority leader.

Needless to say, the Senate majority leader required no schooling as to why Federal bureaucrats needed to be prevented from reducing payments
for stent surgery by 33 percent, or cutting the Medicare payment for a defibrillator implant from $30,000 to $22,000. In fact, the entire proposed DRG reset was designed to drive these kinds of expensive specialty treatments away from high-cost general hospital chains like HCA and toward a medical version of low-cost, high-volume “focused factories.”

The estimate at the time was that this sweeping change in the Medicare reimbursement régime could have reduced its hospital payments by 30 percent and would have struck a mortal blow at high-cost general hospital chains like HCA. Stated differently, much of the inflated EBITDA which was absorbing HCA's $2.0 billion annual interest bill would have been clawed back to the benefit of taxpayers.

As it happened, Bill Frist retired from the Senate at the end of 2006 in a blaze of glory for numerous deeds which had allegedly taken a nick out of Big Government. Among these was a congressional kibosh on the proposed Medicare reimbursement reforms, an action that actually made Big Government fatter by tens of billions per year; a favor it bestowed upon the Frist family fortune as well.

With the Medicare reimbursement spigot locked in the “wide-open” position by congressional mandate, HCA has generated a healthy 5 percent growth in revenues since 2005 and a 5.5 percent annual gain in EBITDA. This has permitted it to service its $2.0 billion per year interest tab and still make the huge dividend payments described above.

Still, the fact that $28 billion in debt can be serviced in this manner is only possible owning to the interest rate repression policies of the Fed and the tax deductibility of interest payments. This case makes self-evident that together these policies have fostered an insanely leveraged capital structure that would never see the light of day in a genuine free market with neutral rules of taxation. Moreover, the régime of “too big to fail” now adds insult to injury by encouraging banks to fund reckless self-dealing dividends which would have been shocking even to the LBO industry one decade earlier.

In short, the KKR and Bain buyout of HCA makes for a fitting tombstone on free market capitalism. In a world in which the financial maneuvers described above can happen, the discipline of the free market has long since disappeared.

THE DEBT ZOMBIES KEPT ON COMING

All the founders of the LBO industry—KKR, Blackstone, Apollo, TPG, and Bain Capital—have been stuck in giant deals that have turned into debt zombies. Accordingly, the outbreak of mega-LBO mania during 2006–2007 was not simply the result of one or two firms becoming overly exuberant.
Instead, it reflected a financial market deformation that sowed mania and recklessness across the entire private equity space.

The eventual result might best be described as turnkey bidding wars. Syndicates of the big Wall Street banks offered turnkey financing packages consisting of multitudinous layers of secured, unsecured, and exotic “toggle” and “second-lien” debt to competing private equity bidding groups. The latter only needed to “slot-in” a 20–30 percent equity commitment at the bottom of these turn-key debt structures in order to reach a total bid price for giant companies put up for auction by other groups of Wall Street investment bankers.

The heated bidding wars among the top tier private equity houses thus resulted in a “topping-up” of transaction prices which were being set in the yield-crazed debt markets. In this frenzy even the most disciplined private equity houses lost their heads because by now a second fatal assumption had planted deep roots on Wall Street—namely, that the Fed's Great Moderation guaranteed that GDP would not falter and that financing markets would remain buoyant.

The $28 billion buyout of First Data Corporation, the nation's largest processor of credit and debit card data for banks and merchants, dramatically illustrates the sheer insanity of these LBO bidding wars. In theory, First Data might have escaped the zombie debt trap since—for better or worse—credit cards have been a growth industry and, in fact, the company's revenues have risen at a 7 percent rate since 2007, notwithstanding the Great Recession.

But First Data has actually made no progress at all in reducing the $22 billion LBO debt it took on in September 2007 for a single overpowering reason: the speculative climate fostered by the Fed was so frenzied that even the gray eminence of the industry, KKR, was induced to acquire a good company at a preposterous price. The $28 billion price tag thus represented an astounding 51X the pro forma operating income of the company during 2007 and nearly 16X EBITDA.

It goes without saying that the company's modestly growing sales and cash flow have been no match for $2 billion of annual interest expense. Accordingly, during the eighteen quarters since the buyout, First Data has recorded nearly $7 billion in net losses. After netting capital spending and minority partner payments against income from operations, the company generated less than $450 million of free cash flow during the entire period. Needless to say, at that rate ($25 million per quarter) it would take First Data 220 years to pay off its debt!

In truth, a crash landing has been prevented so far only because billions of LBO debt has been subjected to “extend and pretend.” During the first
quarter of 2012, for example, the company refinanced $3 billion of bank debt at higher interest rates, thereby deferring these maturities from 2014 until 2017. At free market interest rates, by contrast, First Data could never refinance its $23 billion of loans as they come due. Keeping the debt zombies alive, therefore, is just one more deformation that flows from the Fed's financial repression policies.

CLEAR CHANNEL COMMUNICATIONS:

DEBT ZOMBIE ON A “STICK”

In May 2008 Bain Capital and Thomas Lee saw fit to pay fourteen times operating income for a company that was the communications industry equivalent of the proverbial buggy-whip maker. Clear Channel Communications, in fact, had been a speculator par excellence in the humble business of owning what were called radio “sticks,” or FCC licenses, to operate AM and FM radio stations.

By the time of its $23 billion LBO, it owned 850 radio stations, and it could not be gainsaid that radio stations were profitable. During 2007 Clear Channel had generated about $1.6 billion of operating income, a figure which amounted to a healthy 24.1 percent of its $6.8 billion in net revenues.

Thus, the deal sponsors did not hesitate to pile on the debt, pushing the company's borrowings from $5 billion to $20 billion in order to fund an $18 billion payday for the current stockholders. This massive debt load was readily raised, however, because radio “sticks” were a favored offspring of the Greenspan bubble era.

Due to abundant and increasingly cheaper debt financing, LBO operators large and small had driven the value of radio sticks steadily higher, from less than $8 per pop (population served) to nearly $20 per pop at the peak in 2007–2008. At that point deals were being valued not on their operating income, but on their resale value; that is, based on stick flipping.

Accordingly, Clear Channel's $23 billion LBO reflected the trading value of its massive collection of sticks and billboards, not the company's operating income which had increased at only a prosaic 4.5 percent rate during the four years ending in 2007, and even much of that was due to acquisitions. The magic value gains of radio sticks, however, rested on a double helping of bubble finance; that is, consumer advertising growth and cheap debt.

Radio advertising revenue grew moderately during the bubble era because the heaviest advertisers—auto dealers, home builders, restaurants, and bars—were the beneficiaries of the housing boom and consumer spending obtained from their home ATM machines. In effect, valuations rose because consumers were spending borrowed money which fueled
radio station advertising and cash flow. And then, cheap financing for leveraged radio deals caused stick valuation multiples to be bid up even further.