Private Equity’s Trojan Horse of Debt?

Gretchen Morgenson of the NYT reports on Private Equity’s Trojan Horse of Debt:

Whenever savvy private equity firms sell debt in the companies they own, buyer beware.

That’s the lesson — learned the hard way — for bondholders in Wind Hellas, a Greek mobile phone operator whose parent company defaulted on some of its debt payments last November.

A once-healthy company that is Greece’s third-largest mobile phone operator, Wind Hellas was taken over in a 2005 buyout by two global private equity giants: Apax Partners out of London and the Texas Pacific Group, led by David Bonderman. The two firms larded Wind Hellas with debt before selling it off just two years after they bought it.

Wind Hellas filed for the British equivalent of bankruptcy protection last fall, and now some investors are trying to figure how such a promising enterprise went aground. Apax and T.P.G. officials declined to comment for this column.

But Bertrand des Pallières, the chief executive of SPQR Capital, a London investment firm, was one of the larger bondholders in Wind Hellas. He says the decision by Apax and T.P.G. to heap debt onto the company while simultaneously extracting so much cash from it ultimately contributed mightily to its woes.

“The private equity industry always pitches how constructive it is as an investor force to create jobs and growth,” says Mr. des Pallières. “But there are private equity funds that get rich by breaking companies and making others poor — whether they are creditors, states or employees.”

When the deal to buy Wind Hellas — then known as TIM Hellas — was struck in 2005, the buyers gave it a nifty code name: “Project Troy.” Apax and T.P.G. paid 1.1 billion euros for 81 percent of the company; later that year, they paid 264 million euros more for the rest.

At the time of the buyout, TIM Hellas was a young company with a history of operating growth, regulatory filings show. From 1999 to 2004, the year before the buyout, cash flow at TIM Hellas grew almost 17 percent, annualized. It generated cumulative earnings of 283 million euros for the years 2001 through 2004, and by the time of the deal was serving 2.3 million customers.

The company had little debt — 166 million euros — before the buyout and boasted shareholder’s equity of almost 500 million euros. Then Apax and T.P.G. came calling.

Major banks, including JPMorgan Chase, Deutsche Bank, Lehman Brothers and Merrill Lynch, financed Project Troy. Apax and T.P.G. put approximately 450 million euros into TIM Hellas as equity, but this money was returned to the firms less than a year later after the phone company issued a round of debt.

The private equity firms also received consulting fees worth 2 million euros per year, company filings show. In addition, Apax and T.P.G. received 15 million euros for “business advisory services rendered in connection with debt placement and preparation of business and strategic plans,” according to the company’s 2005 annual report.

Under its private equity owners, TIM Hellas took on debt immediately. By the end of 2005, the company was carrying 1.26 billion euros in long-term debt, almost eight times the level a year earlier. Then came the bond offering of 500 million euros in April 2006 that let Apax and T.P.G. get their money out of the company. After that deal, Standard & Poor’s cut the company’s debt rating to B, citing “the significant increase in leverage and material weakening of free cash flow.”

Still another trip to the debt markets for TIM Hellas occurred in December 2006, when it raised roughly 1.4 billion euros. By the end of that year, the company’s debt load had grown to over 3 billion euros, 20 times the level of two years earlier, before the buyout.

At the same time, the company’s financial performance was declining. Net income at the company rose from 35.9 million euros in 2001 to almost 80 million in 2004 but shifted to losses in 2005. From 2004 to 2008, the company showed losses totaling 155 million euros.

Perhaps the most interesting part of this tale involves a transaction that occurred around the time of the December 2006 debt offering. In that deal, 974 million euros — out of the 1.4 billion euros raised in the offering — went from the company to Apax and T.P.G. The prospectus for that transaction described the 974 million euro payout as a repayment of “deeply subordinated shareholder loans.”

But at the time of the offering there weren’t any such “shareholder loans” listed on the company’s balance sheet. In other words, the company was paying back Apax and T.P.G. for loans that were listed as equity rather than as debts at TIM Hellas.

Adding to the mystery, the repayment was made using a peculiar transaction involving the redemption of “convertible preferred equity certificates” that TIM Hellas had issued. These exotic securities can be accounted for as debt or equity, an option that allows companies that issue them to choose whichever category gives them the most tax advantages in a given country. TIM Hellas classified the certificates as equity.

TIM Hellas had issued such certificates when it was bought out in 2005, and as of April 2006, each certificate carried a value of 1 euro, according to the company’s filings. The company’s 33.8 million certificates outstanding as of September 2006, therefore, had a value of 33.8 million euros.

Company filings from September 2006 seemed to assure potential bondholders that TIM Hellas could redeem these certificates at prices greater than par value or market value only when “the company does not have any other debt liability to pay or to provide for with priority” to the certificates.

On Dec. 21, 2006, however, the certificates were redeemed to pay back those mysterious “shareholder loans.” And they were redeemed for 35.6 euros each, which generated the 974 million euros used to pay Apax and T.P.G.

Just 10 days later, as 2006 was drawing to a close, the value of the equity certificates fell back to 1 euro each, according to company filings.

Why did the certificates suddenly spike in value? Neither Apax nor T.P.G. would say. But their lofty price, according to the debt prospectus accompanying the transaction, was determined by a friendly crowd: the directors of one of TIM Hellas’s own subsidiaries.

These board members weren’t identified, but at the time the board of TIM Hellas itself was very clubby. It consisted of 10 people; six were employees of Apax and T.P.G., and two were company insiders. The other two directors were independent.

In February 2007, less than two months after Apax and T.P.G. snared the windfall from their certificate payout, the firms sold TIM Hellas for 3.4 billion euros in equity and debt.

Last fall, the parent company for the mobile phone operator now known as Wind Hellas defaulted on some of its debts, an unhappy situation that has left Mr. des Pallières, the investor, shaking his head.

“Private equity and banking can be very constructive functions of the economy, but they will destroy this industry if the leading players do not regulate themselves,” he says.

It’s yet another tale for our times.

I thought David Bonderman was actually one of those PE guys who created value. Guess I was wrong. The leading PE funds, and the banks that finance them, are on a rampage and they will end up cannibalizing each other and the companies they purchase as they attempt to squeeze blood out of stones.

Of course, they'll do this using your pension dollars, collecting 2 & 20 in the process of saddling these companies with as much debt as possible before they carve them up and sell them off to the highest bidders. Ironically, in the investment community, we call this "alpha".

***Comment from a senior pension fund manager***

A senior pension fund manager sent me this comment which I share with you:

So the foolish bondies, who actually underwrote a money out financing, are not to blame?? Have we all forgotten we had a credit crisis, because decisions like this by institutional fixed income people?? Private equity owners may have weakened the company, but only because fixed income people allowed it to happen, first the banks, then the bond market.

My observation is that the fixed income business, taken over by derivatives traders, has brought our system to its knees. All the rest is aftermath, and noise. It's game on in the trading area, and absolutely nothing has changed.