Early on Monday, Cramer put up a piece called, “KKR: Cut the Hubris, Start the Healing.” Good piece generally, but it got me thinking. One reason I was an effective corporate bond manager was the way that I treated my brokers. I had a few rules:
- My brokers must always be paid. Doing me favors is nice, but I want your long term loyalty, and confidentiality.
- If a broker makes a mistake in your favor, give him back a portion of the error if he asks (20%-30% of the price difference).
- Hold good on my commitments, even if it hurts.
- If the broker is way out of the market context, tell him. It earns loyalty.
- Use brokers to their highest ability levels. Know who is sharp in a given market, and use them there. Don’t waste their time on names they don’t know.
- If their risk control desk is forcing them to kick out a position, try to help them. This is an Androcles and the Lion situation, so be a good Androcles. They will often offer you some good deals for helping them, beyond that, that will help you when you need it.
- Don’t take advantage of them in obvious ways. If you must flip newly issued bonds, do it through the syndicate (with a polite explanation that your analyst doesn’t like the deal, or that your risk controls are forcing you), or through a quiet third party.
- Be as transparent as possible without giving away the real secrets of what you are doing. You can get better execution if they know you are not acting on private information that they don’t possess.
- Be sharp. Show them that they can’t take advantage of you, but don’t be arrogant about it. Let your performance speak for itself.
That was a long digression, but here’s the point: focus on the long term value of the business relationship. Most bond managers and traders are very short term in their orientation, and it keeps the Street wary of them. The Street holds them at arm’s length, and the handshake is not friendship, but a check for weapons up the sleeve, as in the old days.
So what does this have to do with private equity and the banks? The private equity firms that have financing guaranteed by the banks have the banks over a barrel. At the same time, their deals are delayed, because the banks are dragging their feet. The solution isn’t hard, but it means that the private equity firms must give up a little in the short run to get the long run. Give up 20-30% of the loss that the banks are taking in order to soften the blow. Do it in a way that allows the banks to spread the loss, if you are clever enough, by agreeing to covenants, or other non-interest-rate means of improving the position of the banks.
The banks will groan, but they know that this is the best that they will get, and will take the deal. The log jams will begin to break, and the market will return to “normal,” though with more covenants and fewer guarantees on future deals. That is, until the next craze hits.
Therefore, I wasn’t surprised when KKR agreed to a minimum EBITDA covenant (earnings available to pay the creditors). That’s what is needed to allow the banks to “save face,” and do the deal. There are a lot of pending commitments in the loan market, perhaps as high as $540 billion. If you are a major private equity firm, and you have multiple deals being held up, these small compromises will grease the skids for not only today’s deal, but all of the deals in the pipeline. For those few that don’t compromise, yes, the deal will get done eventually, but you will sour relationships on the Street.
Now, the banks may get some help as they seek financing for the deals. This is one place where the vultures are lining up. Private equity, hedge funds, hedge fund-of-funds, and banks are setting up funds to take advantage of the dislocation. This “crisis” will likely resolve more easily than the troubles over in mortgage finance.
In closing, five more random bits on private equity:
- When I look at the stock chart of Blackstone, it makes me want to find a black stone and toss it in to a pond to watch it sink. Quite an untimely stock offering.
- The rise in financing rates will cost private equity on future deals, and as they try to harvest their existing deals when they come to maturity.
- Now, private equity funds with uncommitted capital can benefit by purchasing deals cheaply from firms that are exiting.
- Here is an excellent article from Going Private on the concept of liquidity within private equity financing. It’s long but good, and my commentary can’t improve on it, so enjoy it.
- Finally, private equity is concerned about financing, but should be concerned the possibility of recession as well. After all, junk bonds and bank debt are very sensitive to slowdowns in economic activity.
As I said to a friend of mine once, it often pays to give up a little to get long term advantages. Private equity needs to show a little mercy here in order to do well in the long run. Investment banks are powerful friends to have, and they remember who has helped them, and who has hurt them.