Private Equity's Dark Cloud?
Throughout 2016 and 2017, a rail terminal built to accept crude oil for the largest East Coast refinery often sat idle, with few trains showing up to unload.If you ever want to understand why private equity has an image problem, keep this article in mind. There's a reason why the book The Iron Triangle is still popular for people trying to understand the enormous power private equity firms yield.
Although little oil flowed, plenty of money did.
Under a deal Philadelphia Energy Solutions (PES) signed in 2015, the refiner paid minimum quarterly payments of $30 million to terminal owner North Yard Logistics LP - even if little crude arrived. Much of that cash, in turn, flowed to the investors that own both PES and North Yard, led by the Carlyle Group, a global private equity firm with $178 billion in assets.
The deal in effect guaranteed lucrative payouts to Carlyle regardless of whether the refinery benefitted from the arrangement. When oil market conditions made the rail shipments unprofitable later that year, the refinery took heavy losses while its investors continued to collect large distributions for two more years.
The rail contract exemplifies the financial demands Carlyle imposed on PES in the years leading up to the refiner’s bankruptcy in January. The Carlyle-led consortium collected at least $594 million in cash distributions from PES before it collapsed, according to a Reuters review of bankruptcy filings. Carlyle paid $175 million in 2012 for its two-thirds stake in the refiner.
(For a graphic detailing how PES went bankrupt, see: tmsnrt.rs/2BzYUW2 )
More than half the distributions to the Carlyle-led investors were financed by loans against PES assets that the refiner now can’t pay back, the filings show. The rest came from the refiner’s operating budget and payments PES made under the terminal deal to North Yard, a firm with no offices or employees that PES spun off in 2015.
PES has blamed its bankruptcy on environmental regulations that require all U.S. refiners to cover the costs of blending corn-based ethanol into the nation’s gasoline. But the ill-fated train terminal deal and other large payouts to investors played key roles in the refiner’s collapse, according to filings and five current or former PES employees who were involved in the refinery’s decision-making. The employees spoke to Reuters on condition of anonymity.
The investor payouts, along with a slump in refining economics, left PES unable to cover its obligations under the decade-old U.S. Renewable Fuel Standard or the loans it took to finance the distributions to Carlyle, the filings show.
PES had $600 million in debt and $43 million in cash on hand when it filed bankruptcy last month. It now hopes to restructure and continue operations, which employ about 1,100 people.
Carlyle Group spokesman Christopher Ullman declined to comment on whether the distributions or the rail-terminal deal contributed to the refiner’s bankruptcy. PES spokeswoman Cherice Corley defended the payments to Carlyle and said the biofuels regulations played a “significant” role its collapse.
“We feel our capital structure was appropriate, and any suggestion that it was the cause of our restructuring is completely ignoring the significant effect of the flawed Renewable Fuel Standard (RFS),” Corley said.
Other refiners and Pennsylvania officials have also blamed biofuels regulation for the South Philadelphia refinery’s failure, triggering renewed debate about the program on Capitol Hill.
Refiners without the necessary blending facilities, such as PES, are required to purchase regulatory credits, known as RINs, from firms that do such blending. The cost of compliance for PES rose from $13 million in 2012 to $218 million in 2017 as prices increased for the credits, which are traded in an open market.
The refiner, however, failed to pay a large portion of that obligation. In addition to its conventional debt, PES still owes the U.S. Environmental Protection Agency (EPA) regulatory credits worth about $350 million, an amount tied to the fuel it produced over the past two years, according to filings. The firm stopped buying RINs last year - and instead sold them to other refiners for what likely amounted to tens of millions of dollars, Reuters reported in November.
The corn and ethanol lobby has pushed back on the argument that biofuels regulation sunk PES, pointing out that other refiners governed by the same law are raking in their highest profits in years. The refinery’s failure had more to do with the hefty profits it paid to Carlyle as its cash reserves dwindled and its debt soared, said Brooke Coleman, head of the Advanced Biofuels Council.
“The Carlyle Group looks more like a corporate raider than a savior in this deal,” Coleman said.
Carlyle would not lose any of its gains on the PES investment under the refiner’s proposed restructuring plan, which has the support of almost all creditors, according to filings. PES also asks the bankruptcy court to entirely absolve its $350 million obligation to the EPA.
EPA spokeswoman Liz Bowman declined to comment on the delinquent PES credit obligations, citing the bankruptcy proceedings.
CARLYLE RECOUPED INVESTMENT WITH DEBT
Carlyle bought its stake in PES as many other East Coast refineries were closing down because of weak margins. The previous owner, Sunoco - now Energy Transfer Partners (ETP.N) - contributed the refinery’s assets and became a non-controlling partner.
The $175 million Carlyle paid was its only investment in PES, filings show, and the firm soon recouped its acquisition costs through a loan against the refinery.
PES then spent $100 million building the rail terminal that year and $30 million in 2014 to double its capacity. At the time, U.S. oil production was skyrocketing as improved drilling technology unlocked new reserves in places such as North Dakota. Carlyle saw an opportunity to tap this cheaper supply and wean PES off costly imports.
The plan worked well at first, in 2013 and 2014, and PES posted earnings of about $500 million for the two years combined.
In January 2015, PES spun off the terminal, creating North Yard as a separate firm. PES then signed a ten-year agreement with North Yard to pay $1.95 for each barrel unloaded and agreed to a minimum quarterly volume of 170,000 bpd, guaranteeing the $30 million quarterly payments to North Yard. For any barrel PES unloaded above the threshold, the refinery paid North Yard 51 cents.
The system was designed to reward PES for success, but had no contingency plan to protect the refiner against the failure that would quickly follow the deal. The rail terminal has averaged just 58,000 bpd since the contract was signed, according to figures provided to Reuters by energy intelligence service Genscape, because Carlyle and PES could no longer access crude at prices low enough to make the rail shipments profitable.
That left PES paying millions of dollars to Carlyle, through North Yard, for oil shipments it never received.
BAD BET ON CHEAP CRUDE
Carlyle’s purchase of PES and the rail terminal investment were bets that U.S. oil would remain cheap relative to imports. A glut of domestic production had caused U.S. crude to sell at a deep discount to imported barrels, with the gap averaging about $8.60 between 2012 and 2015.
But by late 2015, an oil price rebound slashed the domestic discount to less than $3 a barrel – not enough to cover the cost of a long rail journey.
PES nonetheless continued to pay North Yard a total of $298 million between 2015 until August 2017, filings show. The Carlyle-led investor group received $151 million, in eight distributions, of the total paid to North Yard.
In November of that year, PES took on more debt to finance more payouts to investors, borrowing a total of $160 million in two loans against the rail terminal and delivering the proceeds its Carlyle-led backers, filings show.
Corley, the PES spokeswoman said terminal investment more than paid for itself during its more profitable period. But for last two years, PES said in filings, the refinery remained largely cut off from the cheap crude it needed to survive.
“Perversely, it became cheaper to transport crude oil from North Dakota to points in Western Europe than it was to transport the same crude oil to Philadelphia,” the firm said.
At the direction of its investor-controlled board, PES borrowed $550 million in March 2013 and paid $200 million of that to investors, according to bankruptcy filings.
Now, investors in Carlyle's funds might read this and think "great, who cares if Philadelphia Energy Solutions (PES) went belly-up, as long as we receive great returns, we're not going to complain."
And to be sure, they're right, this isn't an isolated case, private equity firms routinely load companies up with debt and extract a pound of flesh. It's all part of PE's asset-stripping boom.
Moreover, certain environmental groups and people living near the refinery worried about their health are rejoicing, thinking they can't wait to see it shut its operations for good.
Still, global pensions investing in private equity are increasingly worried about the optics of these deals because in theory, they're long-term investors looking to create, not destroy jobs.
There is also a problem of private equity's misalignment of interests which I've discussed in the past and the need to make sure there is robust alignment of interests between GPs (general partners: private equity funds) and LPs (limited partners: institutional investors).
But while I welcome critical thoughts, there are a lot of myths in private equity too which is why I wrote a comment back in October defending the industry but with a critical eye.
Still, criticism of private equity abounds. In his latest comment, "Private Equity", Josh Brown of the Reformed Broker blog took on a lot of claims that private equity will continue to generate outsized returns and notes the following (added emphasisis mine):
A few things worth pointing out – as a very experienced private equity portfolio manager explained at our Evidence-Based Investing conference this fall, the multiples PE investors are paying for companies are systematically higher than anyone ever thought possible. Massive amounts of capital coming into the space have fundamentally changed the starting point at the mid to high end for valuations, and it’s not possible to say that this won’t have an effect on forward returns.I will let you read Josh's entire comment here as he ends with a bunch of links to make his point on why he's skeptical that private equity will continue to generate great returns.
As Jason Zweig noted recently, get a few drinks into anyone in the PE space and they’ll start lamenting the lack of reasonably priced opportunities – from this standpoint it’s no different than the public equity markets.
Additionally, the space has become incredibly crowded with intense competitors, which has to make it harder to produce high returns as the alpha is competed away. If every team in the league is the Golden State Warriors, then no team is the Golden State Warriors. People have trouble coming to grips this concept, that absolute skill level is not the problem, it’s a relative skill level game.
Finally, one of the primary reasons so much money is pouring into PE is because the institutions are using the past as their guide for expected returns – and allocating more heavily to a strategy that has produced high returns in the past makes the return assumptions in their model easier to theoretically hit, thus obviating the need for any kind of tough political spending decisions. No need to cut any programs, we’ll just generate higher returns to pay for it all.
A lot of the arguments are all too familiar, like leveraged small cap value is as good as if not better than many private equity funds. I emphasized many because large institutional investors investing in top funds like Blackstone, KKR, Carlyle, Apollo, TPG, Apax, and many more top funds know all these academic arguments.
The reality is that top pension and sovereign wealth funds don't care about academic articles on private equity, they care about maintaining great, long-standing relationships with top private equity funds where they can invest and co-invest sizable amounts to reduce overall fees (you pay no fees on co-investments, a form of direct PE investing).
The critical thing here is to focus on top funds because in private equity there is evidence of performance persistence and it's true, if you can't invest with top funds, you're better off investing in the S&P 500 because median returns aren't worth it once you factor in liquidity and leverage (a lesson CalPERS learned the hard way investing in way too many private equity funds over the years and generating returns which were decent but below those of its large peers investing in a concentrated portfolio of funds).
Are there good mid-sized or smaller private equity funds? Of course, there are. Are all the funds the big PE funds raise generating huge returns? Of course not. It depends on the vintage year and what is going on in public markets where private equity funds exit their investments (if public markets tank, it has an impact on private equity but because they don't have to sell at depressed levels and aren't marked to market, they can ride out a short storm like 2008).
It's also important to remember pensions are all about matching assets with long-dated liabilities. An allocation to private equity therefore makes perfect sense from a liability investing standpoint.
Moreover, by their very nature, private equity funds invest in private markets where there are more inefficiencies to exploit. Yes, they are less liquid and employ leverage, but that means they're less volatile than public markets and are able to generate higher returns over a longer period, which is what pensions are looking for.
If private equity is that good, why not just put all the pension assets in it? Well, pensions also pay out benefits, so they need to manage liquidity risk carefully and strike a balance between public and private markets (private equity, real estate, and infrastructure).
Most of Canada's large pesions invest anywhere betewen 10-12% in private equity, 15% in real estate and roughy 10%-12% in infrastructure (I'm giving you rough approximations, it varies). They all co-invest in private equity to reduce fees and are increasingly doing purely direct deals, trying to compete with PE giants (they will never fully compete with them and will always need to invest in their funds). Having roughly 40% of their assets in private markets is how they generate great long-term returns.
Are there risks in private equity and other issues? Yes, no doubt about it, but sophisticated investors are on top of these risks and issues and they're continuously working hard to improve alignment of interests.
Lastly, take the time to read a CAIA document on investing like Harvard and Yale endowment funds which you can find here. There's a reason why sophisticated investors have adopted this approach, it makes great long-term sense.
But there are issues confronting private equity and some of them are the same issues confronting the digital economy, namely, does private equity destroy more jobs than it creates?
Below, Chris Hughes, who made a fortune as a co-founder of Facebook, told CNBC on Tuesday American workers who make less than $50,000 per year should get a government stipend of $500 per month — paid for by raising taxes on the wealthy 1 percent.
Before you dismiss his idea as socialist hogwash, listen carefully to his views because I think in the not-too-distant future this will become a reality, especially if rising inequality continues unabated, threatening the foundations of social democracies everywhere.
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