Have Your Cake and Eat It Too

The smartest guys in the room just had another field day.

In the height of the leveraged buyout boom, financial intermediaries like investment banks hungry for deals were hawking around with cheap and "covenant-lite" loans as investors could not resist a few extra basis points in interest they would earn with these loans. They all seemed to conveniently forget what might happen to the principal if things went wrong. Or they were simply caught up by peer pressure and crowd behavior? As former Citigroup CEO Chunk Prince said, when the music is playing, you have to get up and dance; and you don't know whether you would have a chair when it stops. Private equity firms were too smart not to take advantage of the greed (or stupidity) of the capital market, and borrowed mountains of these cheap, loosely-underwritten loans.

Now time has changed. With the credit crunch, banks are dumping their leveraged loan holdings in an attempt to repair their capital base and balance sheet, often at a significant discount. And that presents a unique and unusual opportunity to the borrowers. By buying back its own debt at a discount, a private equity portfolio company pays down its loan with less money than originally required. The debt reduction boosts the company's equity value, in turn benefiting its shareholders. Guess who are the shareholders? The private equity firms that used cheap loans to buy the company in the first place. Typically a private equity firm uses two schemes to increase its equity value: 1) selling a portfolio company to another firm or the public at a higher price than what it has paid (known as multiple expansion in the industry); 2) paying down the debt through operating cash flows. The new practice is similar to the latter scheme and the difference is that the gain is now from clever financial trading rather than operating.

So far the losers are the banks that had to mark down their loans and sell them off. Of course, they are not happy about being the loser. In the TDC story reported by FT, the banks were alleging that TDC, the borrower, violated the loan agreement by buying back its own debt at a discount. Whether the banks can recoup some of their losses through legal challenges is yet to be seen. Right now, private equity firms seem to outsmart their counterparts.