“Is Private Equity Having Its Minsky Moment?” is another excellent article from Matt Stoller’s BIG newsletter, something that anyone who is interested in PE and corporate finance should be reading (I referenced a couple of his newsletters previously).
You’ve probably been hearing about salary cuts, furloughed employees, and big losses in health systems around the country. I myself am currently experiencing a sizable pay cut. You may have even heard about the possible impending bankruptcy of healthcare megacorp, Envision. Envision is now drowning because they grew to massive size by buying companies using tons of debt. Because of that massive leverage, if those businesses do poorly, they can’t meet their debt obligations. To give you an idea of how Envision operates, they have less than $500 million in deployable cash on hand to cover $7.5 billion of debt.
Stoller gives a nice summary of why these highly-leveraged private equity companies (and other companies using the same toolbox) are ripe for failure when credit markets collapse.
Private equity is undergoing what the great theorist Hyman Minsky pointed out is the Ponzi stage of the credit cycle financial systems. This is the final stage before a blow-up. As Minsky observed, a period of placidity starts with firms borrowing money but being able to cover their borrowing with cash flow. Eventually, there’s more risk-taking until there’s a speculative frenzy, and firms can’t cover their debts with cash flow. They keep rolling over loans, and just hope that their assets keep going up in value so that they can sell assets to cover loans if necessary. To give an analogy, in 2006, when people in Las Vegas were flipping homes with no income, assuming that home values always went up, that was the Ponzi stage.
Now, what happens with Ponzi financing is that at some point, nicknamed a “Minsky Moment,” the bubble pops, and there’s mass distress as asset values fall and credit is withdrawn. Selling assets isn’t enough to pay back loans, because asset prices have collapsed and there’s not enough cash flow to service the debt. Mass bankruptcies or bailouts, which are really both a restructuring of capital structures, are the result.
I think you can see where I’m going with this. PE portfolio companies are heavily indebted, and they aren’t generating enough cash to service debts. The steady increase in asset values since 2009 has enabled funds to make tremendous gains because of the use of borrowed money. But now they are exposed to tremendous losses should there be any sort of disruption. And oh has this ever been a disruption. The coronavirus has exposed the entire sector.
Everyone wants to make the easy money in a bull market. It makes finance professionals seem competent in running multiple businesses across multiple industries even though their performance often has more to do with the amount of money in the pot driving valuations up. Rolling up companies in high-growth industries by paying top dollar? Piece of cake. But what do you do when the hard times hit? How can your businesses survive when you’ve saddled them to barely function in the best of times?
The business model of the 1980s has been institutionalized in ways that are hard to conceptualize. Sycamore Partners’ takeover of Staples was a recent legendary leveraged buy-out that shows how PE really works. Sycamore Partners is a private equity firm that specializes in buying retailers. Sycamore bought Staples for roughly $1.6 billion in 2017, immediately had Staples take out $5.4 billion of loans, acquired another company, and then paid itself a $300 million payment and then a $1 billion special dividend. Then, Sycamore had Staples gift its $150 million headquarters in the suburbans of Boston for free, after which Staples signed a $135 million ten year lease with Sycamore to lease back its own building.
Healthcare is different because the biggest cost center of most healthcare practices is personnel. And those providers are also typically the only source of profit. This limits the shenanigans you can pull, limits how you can grow, limits the cost floor, and—because of Medicare and agreements with other insurers—limits your profit ceiling. Taking care of people is not a software company or a tech business that can achieve limitless scale at near-zero marginal cost. And what seemed like an easy positive cash flow business isn’t as simple as selling toner.
Tens of millions of people no longer have income, and even those who do are afraid to go back to their old lifestyles. The Fed can’t ultimately can’t print a functional economy. And at the end of the day, no matter how many games you play with debt loads and capital structures, firms have to have customers, and people can only be customers if they have income.
We’re currently in process of bailing out a lot of companies, and low-interest rates will let some of these folks continue borrowing money trying to bide time until they can raise more capital or potentially grow out of their debt. That may not be feasible for long enough to outlast this downturn, especially if the money spigots shut off.
But the issue with bailouts in situations like these is that in recent history they’ve perpetuated a private-profit public-loss business model where PE firms are rewarded for taking on absurd risk because that risk is really on the shoulders of the American people. And without meaningful regulation, this perpetuates the growth of the industry instead of reining in its excesses. Our historically “strong” economy crumbled within about two weeks of the shutdown. That’s overleverage at work.
The actual underlying businesses within these organizations are often still sound once you remove the onerous debt obligations, leasebacks, and other financial machinations. A tiny silver lining of this horrible scenario may be getting some of the rent-seekers out of polluting healthcare.