:LPE:

I’m just reading this book now, which although about Milken, is tantamount to a popular history of the leveraged buy-out era in the ’80s. The book contains a summary of the LBO strategy pioneered by Milken which came to epitomize that round of consolidations, which makes interesting reading.

Milken’s firm typically provided mezzanine finance for these deals (banks provided “top” or secured debt, Milken the middle or mezzanine or less/unsecured debt at higher yields, and a thin slice of equity would be the lowest chunk of the financing). His strategy appears to have been targetting businesses with sufficient cash flow to support the debt repayments on the mezzanine financing, so as to permit the takeover of the corporation. Notice the focus on cash-flow, not earnings: cash flow is earnings plus depreciation and amortization, non-cash expenses on the financial statements. Any firm with high depreciation and amortization costs could actually be hiding a significant cash flow. When he found one of these businesses, he would then get a network of institutional and even retail investors interested in buying the mezzanine debt, which paid very high yeilds, and finance the takeover, forcing the cash out of the corporation to pay the debt, and, if things went well, counting on retiring the debt through the cash flow, which in effect, took money away from replacement costs of capital (as in, plant, machinery, equipment, etc.). Some time down the road, there would be another cash crunch when that needed replacing, but it was some way off. If things did not go well, then the company would be stripped of assets to pay the senior debt and, if lucky, some of the mezzanine debt, leaving little else. This investment or deal technique was the background for the movie Wall St.

These techniques are often called ‘innovations’ in credit (the margin account was the innovation in the 1920s), although some, like JKG, pointed out that they have some very similar features. We might make a comparison to the current interest in income trusts in Canada: they are sold on the strength of their distributions to units which itself is based on cash flow, measured by EBIDTA (earnings before deducting interest, depreciation, taxes and amortization), this market is now being driven by a wider array of investors including retail investors, at leats one commentator has called it a “bubble”. Companies are being converted (sometimes in the context of a transaction, such as the Yellow Pages deal) to income trusts, the IPOs for which often see a premium paid to equityholders (including management) of 10-30%. The key issue here is that distributions, like payments on bond debt, must be made. The short term-problem can be cash flow to pay for distributions, which has to come out of operating earnings, which could be subject to any number of ups and down in a business, and the the long-term problem can be replacement of capital. (Income trusts were orinally meant to structure depleting asset investments, like mines or oil wells). Some income trusts have worked very well, but there are stories of others having to go back to the market to finance the payments on the first set of units. There is a name for that kind of scheming, and it begins with a P. At some point, there is a cash squeeze, and then you have to look around and see who is holding the debt, which is typically a long-term investor. Milken’s investors had typically moved their mezzanine debt to others within 12 months of the deal.

Parenthetically, the LBO was not the first round of debt-driven mergers and acquisitions in the modern era: the first took place in the 1890s after corporate laws were forced / amended to permit consolidation in industries like steel and oil; the second in the period after WW I until the stock market crash in 1929, which saw secondary manufacturing consolidate in a rising bull market for equities driven in part by retail investors, which in turn prompted the creation of securites acts and generally accepted accounting standards; the third in the late 1960s which featured the creation of ‘conglomerates’, that is, businesses that did not merge as much as be bought by common owner, also driven by a bull markety in equities featuring an innovation called “chinsese paper” which effectively deferred the costs of acquisition; the third took place in the late 1970s after the equity crash of 1974 and high inflation which made equity prices cheap; and finally the LBO era of the 1980s, which were driven by high-yield debt and cash-poor mature industries in the U.S. The late 1990s saw another round of M&As, again driven by rising equity prices and low interest rates, and rudely interrupted by a crash, but this time focused more in the ‘new economy’ and dotcom startups. This period (1985 to 1995) also saw a significant portion of corporate Canada taken private). We may be in the midst of the sixth or seventh merger movement (depending on your view of the 90s), with the recent activity in private equity deals and debt provided by new financial intermediaries, notably hedge funds. The troubling thing about this round is that so much of the market, like Milken’s market, is private (unlisted), and as a result, occurs outside typical disclosure norms and standards. We simply don’t have very good estimates of the leverage out there, and what the pattern of risk associated with these deals looks like.

The National Labour Relations Board in the U.S. (a politicized tribunal board: 3 Republican appointees, 2 Democrat appointees) has determined that many nurses may not join unions. If, for as little as 10% of their full duties, nurses assign other nurses to do work or otherwise direct work being done, they are “supervisors”, not employees, for the purposes of the Labour Relations Act, and as such, may not join unions because they enjoy the perogatives on management. For nurses, those perogatives do not include setting salary or any real disciplinary power, the power to hire or fire, or, most likely, any significant remunerative perquisites of supervision. Link.