Caesars Entertainment and private equity

I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy.  So regard this more of a preliminary drawing than as a finished picture.

When a private equity firm acquires a company, it seems to me it does five things:

–it cuts costs.  The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work.  Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings

–it levies fees to be paid to it for management and other services

–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds.  An equity offering may happen, as well

–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment

–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.

 

Caesars Entertainment has added a new twist to this paradigm.  In 2013, its private equity masters seem to have decided that sink was the more likely outcome.  Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one.  In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.

Junk bond holders sued.  Litigation has been protracted and has reportedly cost $100 million so far.

Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling.  My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that:  these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action.  So I’m not sure what has taken this long.

Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.

 

 

 

3 responses

  1. Pingback: What stocks to invest in = Caesars Entertainment and private equity « PRACTICAL STOCK INVESTING | Stock Investing

  2. While it may seem that a lot of private equity funds do the same things (e.g., headcount reduction, renegotiating of key contracts, balance sheet management), I don’t think you’ll find Caesars Entertainment to be the private equity model going forward.

    For one, I feel there’s a “fool me once, shame on you; fool me twice, shame on me” effect from Caesars on the credit markets. Generally, every credit investors knows that you want your documentation to protect against asset sales & transfers (via negative covenants). I think two factors contributed to the loose credit documentation of Caesars.

    (1) When credit markets get frothy, issuers have more negotiating leverage to demand higher leverage, lower interest rates, and looser covenant terms. Apollo took Caesars private in Jan 2008. If memory serves me correctly, the credit crisis didn’t take full hold till later in 2008 and certainly the Caesars debt financing would’ve been priced with 2007 market data.

    (2) I feel there’s a lack of discipline in the syndicated loan and high yield bond issuance market. Most of the investors subscribing to primary issuance are mutual funds and CLOs (for syndicated loans). They’re focused on minimizing cash drag in their portfolio (no matter how good a debt investment they make, they’ll only return ~5-10%) and want a good allocation of the issuance, so they don’t speak up much when the bank arranging the deal asks for comments on the credit agreement or bond indenture, lest they get bounced out of the deal.

    So I feel that the Caesars bankruptcy and related legal fight is really a vestige of the extraordinary lending environment of 2007 rather than a model of private equity going forward.

    Besides, I feel Apollo is one of the few large-cap private equity firms that would push for such a seemingly innocuous credit term. Most large-cap PE funds are so focused on how they’ll drive growth in their portfolio companies (via cost reduction, strategic M&A, etc.) that they don’t spend time trying to creatively structure in principal protection. “Financial engineering” isn’t a word private equity investors want to be associated with these days

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