Private equity: mortgaging their funds to pay investors

It’s no secret that I despise private equity for the damage it has done to thriving companies by borrowing heavily, stripping the funds and running the business into the ground. Now they are pulling a new trick: mortgaging their already heavily-leveraged funds.

What could possibly go wrong???

https://messaging-custom-newsletters.nytimes.com/dynamic/render?campaign_id=4&emc=edit_dk_20240511&first_send=0&instance_id=123042&isViewInBrowser=true&nl=dealbook&paid_regi=1&regi_id=17997770&segment_id=166344&te=1&uri=nyt%3A%2F%2Fnewsletter%2F87b417b3-36fc-5c83-b53d-522e60731734&user_id=d25330475c5279557927aab088ac1836

DealBook

May 11, 2024

A cross-collateral hazard?

Many private equity firms have quietly begun mortgaging their investment funds, piling leverage upon leverage. In other words, they’re taking out loans against the businesses they’ve already taken out loans to buy.

At a time when dealmakers are desperate to raise new cash after the boom of the pandemic era, this mechanism — known as a net asset value loan — is allowing them to do it overnight.

More P.E. firms are using the tool as they set out to raise their next funds, especially those confronting a hurdle during a slow period for dealmaking: They have yet to return cash to the limited partners they tapped for their last round.… [end quote]

So they’re borrowing the money to send to the limited partners because their existing business isn’t creating enough cash flow.

There is about $150 billion in N.A.V. facilities on the market today, according to the ratings agency S&P Global. It expects that figure to double in the next two years. That’s not enough in the grand scheme of things to cause a financial crisis…if nothing goes wrong like happened in 2008 when the pressure points weren’t evenly distributed.

Wendy

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I think I saw a version of this movie before…

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I think a $150 billion dollar oopsie is more than enough to trigger a financial meltdown. At some level, the most important solvency test doesn’t smoothly apply its stresses across all institutions and all asset types evenly and continuously 24x7x365. The most important solvency test isn’t the bogus stress tests applied by the Fed and Treasury against the big banks.

The most important solvency test is the one that happens at pretty much the same time across the country, when every bank has to settle its books for the day and balance them. Every day a bank is open presents an opportunity for its managers to discover they are unexpectedly “short” and in need of cash to even out assets and liabilities. If the gap is only a few million, no biggie, just borrow from your fellow bankers or go to the Fed and take a 1-day overnight loan.

If the gap is a much larger portion of your supposed assets, EVERYONE is going to be asking questions and you become the focus of great fear and people start avoiding dealing with you, further worsening your cash flow. Because this settlement takes place when everyone’s books are closed, the “market” is not as liquid as it might be during the day and everyone who might lend you money has more time to ponder the risk they’re taking, even for a day. As a result, flexibility in the market for a sudden shock is greatly reduced, magnifying the danger of being found in need of money across the entire industry.

The difference between a bad day for one banker at one bank and a meltdown could be purely random. If a few bad bets become apparent on the same day at the same institution with account holders facing these external pressures, a shortfall of a a few hundred million leveraged by a factor of 10x or 20x could easily take down a much bigger bank.

Remember, in 2008, Lehman was thought to have $680 billion in “assets”. Its problems started in 2007 when it wrote off about $25 million of losses when closing its subprime affiliate company. That triggered other traders to begin sniffing around Lehman’s overall positions and dumping its derivatives triggering losses of $2.8 billion for 2Q2008 then $3.9 billion for 3Q2008. For a firm holding “$680 billion” in assets, that should have been survivable but those assets weren’t worth near that amount and it collapsed, then began the larger meltdown. (In fairness, part of the reason Lehman triggered the larger collapse was the attempt by the Fed and Treasury to exert principal and avoid the moral hazard mistake they thought they made minimizing the damage from the collapse of Bear Stearns in March 2008.)

Couple this with the story a few days ago about the top four banks disclosing they have TRILLIONS in additional off-the-book assets that the Fed and Treasury don’t know about and I think there’s plenty justification for sleeping with one eye open.

WTH

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I don’t think so. The Fed wouldn’t even take overnight to cover this small amount, heck, they could do it in max half an hour. Nowadays the only thing that might take a night or two is coming up with a trillion or two.

But creating that much out of thin air might cause inflation, like it did in 20-21. Need to “sterilize” it by taking it away from someone else, so there is only redistribution of the loot, not “helicopter money” for everyone.

Decades ago, there was a short lived TV series about a guy who owned a railroad, that was under construction, didn’t go anywhere yet. Couldn’t meet payroll with cash, so he offered stock in the railroad to the workers. That gives me an idea: take away the Social Security trust fund money to keep the “JCs” afloat, and give the SS pensioners stock in the “JC’s” company instead.

I like horror flicks when I see pure terror in the markets. I can’t wait.

I am not a chicken little. I am a pragmatist.

Better: Kick out the fake JCs and replace them with real JCs. Then no bailout needed.