Retail Bonds and Private Equity.
Imagine an old black and white film with obvious good guys and bad guys, you know: a classic John Ford Western with a Henry Fonda or John Wayne pitted against black-hatted scoundrels like a Jack Palance or Charles Bronson. Or Maybe you prefer the small-town hero genre of the simple good guy against the greedy, heartless loan shark—like the 1947 classic “It’s a Wonderful Life.” In short, think of any obvious drama between good and evil, or “The Force” vs. “The Dark Side.”
Now I want you to think about modern Private Equity firms and the retail sector, because the same dynamics Jimmy Stewart faced in 1947 Pottersville are playing out right under your nose. It’s frankly rotten.
It’s Not a Wonderful Life
The modern plot in today’s lauded Private Equity scam (of which so many of my fancy classmates and diploma-gathering wunderkinder love to casually reference their elite membership) comes down to forcing retail chains into debt, squeezing them at MBA knifepoint for payouts (nicely described as dividends) and then sending them into a bankruptcy in which the retailers (and the coerced retail bonds you bought from them) get clobbered while the PE lenders (“sponsors”) walk away with a nicely (and legally) re-structured payout (i.e. fat profit).
It Starts with the Mother Ship
All bad guys come from some version of a “Death Star,” robber’s cave or a horse-gang. You know: the home base. In the current PE/Retail plot, the modern Death Star begins (where else?) at the Federal Reserve, of which I can’t seem to ever ignore…
This really is a bad place, and our kids will one day read about its dangers in history the way we studied other seminal moments, like Watergate or the Gulf of Tonkin. For despite Yellen and Co’s claim that all is well in the wake of 8+ years of a central-bank manipulating money supply and cranking interest rates to the zero-bound, nothing could be further from the truth.
Yes, I’ve written elsewhere (ad nauseum) how such central bank policies are directly responsible for distorting and corrupting stock prices, Treasury yields, and almost every other aspect of real (rather than artificially stimulated) market dynamics, from real estate markets, auto sales, retail stocks and tech bubbles to the VIX and risk management.
So it will come as no surprise at all that this same Federal Reserve Death Star, with its dark force of effectively taking over the bond market in one fat perma bid and single-handedly destroying yield in the credit space, is the where the evil begins in our modern Private Equity tale.
And Then Comes the Stormtroopers
And what would Darth Vader be without his storm troopers? That is: What would this plot of Darth Yellen be without the help of the little rogue private equity shops (after all, not all PE shops are bad) and their many eager, bonus-hungry, stormtroopers?
Sometime in 2009, from a galaxy far, far way…, Darth Bernanke flipped a switch on the maga weapon, printed trillions of dollars out of thin air while simultaneously compressing interest rates to zero. The Dark Side had thus begun it’s opening act and salvo—destroying yield in the bond market in one grand, laser-like gesture.
Thereafter, nervous investors scattered throughout the investment galaxy looking for a way to get yield.
What to do?
Well, a dark niche of the PE stormtrooper class, loaded with recent MBA’s and eager to whip out their new business cards and impress their mentors (and get that year-end bonus), emerged. These are clever folks, and they put all those 2 years of B-school networking (and some studying) straight to work.
And what plan did they come up with?
Squeezing Yield in a World Without Yield—the Retail Pawns
It’s actually very simple. They found a wounded animal—the retail space—and then used uber-leverage [i.e. easy money thanks to Darth Bernanke’s (and later, Darth Yellen’s) Fed Death Star] to buy their stores (the sexy term is “Retail LBO”), and then forced those same stores, which they knew Amazon (up 1000+%) was about to kill anyway, to take on more debt to pay their PE loan sharks a series of fat (i.e. painful) dividends.
Thereafter, most of those poor retailers were forced into taking on more and more in debt by issuing more and more junk retail bonds (which more and more investors, pension funds and mutual funds bought recklessly).
In 2010, for example, retailers under the knife of their PE owners issued $90+B in junk bonds and levered loans just to pay “special dividends.” More than 20% of that figure went straight to their PE loan sharks as a “carried interest.”
In the end, the majority of those sad retail Gary Coopers and Jimmy Stewarts were forced into bankruptcy, where those same smart PE “sponsors” (i.e. Bain Capital to Golden Gate Capital and their Potterville-like law firms) stepped in to paper a restructuring deal in which the PE shops made even more money as the retailers (from J-Crew to Gymboree, Payless Shoes, Safeway et al) to whom they originally “lent” money were (or soon will be) carried out on their shields.
That, in a nutshell, is how the sexy, revered PE model works in some dark shops today. That is: PE shops take no risk, assume no legal responsibility, make initial (and painful) loans which force retailers into debt, and then even greater debt to repay those loans along with contractually added dividends to the PE sponsor. The retailers eventually issue layer after layer of bogus retail bonds before going broke.
And so the movie ends with retail stores closing all over the country, retail bond holders (i.e. investors) and credit markets soon to be seeing lots of red, and PE shops sneaking off with all the profits. In short, no one wins except the loan sharks (aka PE guys) who took no risk and added no value to the “deals” they papered.
The Desperate Search for Yield Creates Bad Guys and Bad Bonds
But this is what happens when the market is desperately seeking yield in a world where the Fed has eradicated it. The good guys (i.e. retail borrowers) have no chance against the much more clever (and far less conscience-burdened) PE mind set, who have legally found ways to strip mine struggling enterprises, rob them of their cash flow and send them into chapter 11, where the sponsors profit even more.
What Happened to the Ol’ Good Guys?
When I was a young lawyer and later a finance guy, I had once thought that the PE side of the street was about building businesses, not poaching them. But desperate markets bring out the best and the worst in human nature. Most will say it’s not personal, it’s business. But I personally wouldn’t do business this way.
In any case, the bond market, increasingly loaded with junk retail bonds / paper, is just one more log on the soon-to-be raging pyre of an artificially sustained market place heading higher by the day and thus poised to fall further than any market I’ve traded.
Never has risk management, market signals, macro watching and carefully hedged trading been more important to you.
Not Our Dad’s (Or Jimmy Stewart’s) Bond Market
As always, please know that today’s bond market is not our dad’s bond market. If you think it’s a safe allocation in times of unease, please think again. At the very least—and whether you’re watching retail bonds or government paper, keep your eye on that 10-year Treasury: when its yield holds above 2.6% and climbs, the bond market won’t be a safe place to hide.
Unless, of course, you’re a limited partner in a PE firm that went over to The Dark Side…