PRIVATE PARTS April 17th, 2007 Timothy J. Gramatovich, CFA We had a good quarter; however, before we get too excited, it seems to me that some of this is an issue of timing. The underperformance for 2006 was a little misleading, as the portfolio holdings didn’t change too much during the past quarter. So as always, it’s rarely as good as it appears, nor is it as bad. Interestingly, even though many pundits have claimed that high yield was overvalued, it outperformed all of the major indexes. Nonetheless, we are off to a solid start to 2007 and we will pursue selective opportunities while being cognizant of the current state of affairs. “A Rolling Loan Gathers No Loss” I am indebted to Jeffrey Rosenberg of Bank of America for this little gem. But far from being just clever, it is a very apt description of the state of affairs in the leveraged finance game today. The expectation that credit standards will continue to be eased and relaxed (comatose may be a more accurate take) in the future is baked into the system. The idea that a loan would amortize principal is something from the stone ages. So don’t worry, we’ll be able to refinance you out in the future. In the bond market, we are learning new phrases like “PIK Toggle.” This is a wonderful new instrument that allows the lender to switch from paying cash interest to bondholders to “paying in kind” (more bonds) and increasing the rate. So at a time when the company can’t afford to pay the interest, the bondholder gets more bonds that can’t pay. Sounds interesting, but we’ll pass. I already saw that movie back in 1989 with terms like “split coupon” and it ended badly. Then and now, this is nothing more than a technique created by investment bankers to help their clients overpay for companies. Now turning our attention to overpaying, we spend the bulk of this letter describing the craziness in the private equity game. Private Parts I want to start this section with the following quote I picked up in the March issue of a major money management trade magazine1: The retirement system aims to have 37.5% of assets invested in private markets- real estate, infrastructure and private equity-which will generate stronger and more stable returns over the long term by removing some of the volatility of public markets… This statement was made by the director of a very large ($40 billion+) municipal retirement system. Though we will keep the individual and plan nameless, this thinking has now 1 source: Pension and Investments, March 2007 become the prevailing “wisdom” of the institutional investment community. Get out of the stock and bond markets and into “private markets.” And this will reduce risk? WOW. Too many constituents have drunk from the same punch bowl that the definition of risk is correlation or volatility. It seems to us that risk always means, “How much money can I lose if I’m wrong?” It also seems to us that there appears to be a disconnect on the notion of liquidity as it relates to assessment of risk. In today’s market, liquidity seems to be assumed. However, some of us have witnessed real estate recessions (or depressions) where there is simply no bid regardless of the asking price. So at a time when too much money is chasing too few deals in “private equity,” driving up valuations to insane levels, the institutional investor community is piling in as never before. When we talk about “private equity,” we are referring to the leveraged buyout (“LBO”) game. Overall, I have been favorably disposed to investing in the debt created by such transactions, as you tend to have a motivated management team along with a single private equity sponsor who could potentially invest more money into the company if it runs into problems. However, as is the case with most things, moderation is the key. Moderation in the valuation is important, as overpaying is anathema in this game. Let’s turn our attention to the use of “insane” to describe valuation levels. As we discussed in our last letter (“Destruction of Corporate Credit”), HCA became the largest buyout in history, surpassing the RJR Nabisco transaction. We didn’t have to wait long for that number to be surpassed, as at the end of February, KKR (along with Texas Pacific Group) announced its bid, which is still pending regulatory approval, of $32 billion for TXU Corp, the large Texas utility. However, it was the recently announced (April 2nd) First Data Corporation bid of $29 billion by KKR that really has our heads shaking. Anatomy of an LBO To see just how crazy things have become, I want to slowly walk through the numbers for the First Data Corporation and what the financing is likely to look like. I have had a considerable amount of experience with the LBO game, beginning with my stint at Drexel in the 1980’s. We watched as valuations in the late 1980’s pushed the bounds of reason at 8x EBITDA, which now seems like a bargain. It is important to understand that historically, the return for the equity sponsor has come from paying down the debt borrowed to buy the target company over a 5-7 year period. At the end of this, the sponsor has a few choices, including re-leveraging the balance sheet to take out cash in the form of a dividend to themselves or selling the business to a strategic or another financial sponsor. The game now appears to be one in which the sponsor hopes to find a larger sucker to pay an even more ridiculous valuation down the road. Let’s begin by reviewing some numbers from the First Data Corporation. All numbers have been taken from the 2006 10-K unless otherwise noted. ($000's) 2006 2005 2004 Revenues $ 7,076,400 $ 6,526,100 $ 6,633,400 EBITDA 1,781,300 1,611,500 2,057,600 Affiliate Earnings 283,100 232,900 163,200 TOTAL EBITDA $ 2,064,400 $ 1,844,400 $ 2,220,800 At first glance, a nice business. EBITDA margins are very healthy and have averaged about 30% over the past 3 years. No adjustments have been made to the numbers. Now, let’s look at the following important valuation metrics: CAPITALIZATION ($000's) Shares x 752,991,558 Price $34.00 Market Capitalization $25,601,713 Plus: Debt $2,516,200 Enterprise Value $28,117,913 The expected total valuation (including those nasty legal and investment banking fees) is around $29 billion. Let’s do some simple math. With 2006 EBITDA of $2 billion and a $29 billion valuation, KKR is paying an implied value of 14.5x EBITDA. I think this deserves another WOW. Now let’s look at how the deal is likely to be financed. This is purely my own guess based on experience. POTENTIAL STRUCTURE ($000's) Equity $ 7,250,000 KKR (25%) Debt $ 21,750,000 Debt Structure EBITDA Mult. 1st Lien Bank Debt $ 10,000,000 5.00 2nd Lien Bank Debt $ 5,000,000 7.50 HY Bonds $ 6,750,000 10.88 TOTAL $ 21,750,000 Interest Cost 1st Lien $ 675,000 L+150 2nd Lien $ 437,500 L+350 HY Bonds $ 725,625 L+550 TOTAL $ 1,838,125 I am being exceedingly generous in my assumptions, but the market is accommodating right now. So the entire debt structure will be levered at just under 11x. Another WOW. Now for the all important look at the cash flows and their use: FREE CASH FLOW ($000's) 2007 2008 2009 2010 2011 EBITDA 5% growth $ 2,100,000 $ 2,205,000 $ 2,315,250 $ 2,431,013 $ 2,552,563 Interest Expense LIBOR fixed $ 1,838,125 $ 1,838,125 $ 1,838,125 $ 1,838,125 $ 1,838,125 Capital Expenditures 3 yr. avg. x 5% $ 178,500 $ 187,425 $ 196,796 $ 206,636 $ 216,968 FCF $ 83,375 $ 179,450 $ 280,329 $ 386,251 $ 497,470 Let’s look at my simplistic and what I feel are overly generous assumptions. I have grown EBITDA and capital expenditures at 5% per year and have not decreased margins at all. So in summary, here is what this transaction looks like for the equity ($000's) TOTAL 5 yr. FCF $ 1,426,875 Beginning Debt $ 21,750,000 Ending Debt $ 20,323,125 Ending EBITDA $ 2,552,563 Potential Multiple 14 13 12 11 10 Enterprise Value $ 35,735,884 $ 33,183,321 $ 30,630,758 $ 28,078,194 $ 25,525,631 Debt $ (20,323,125) $ (20,323,125) $ (20,323,125) $ (20,323,125) $ (20,323,125) Equity Value $ 15,412,759 $ 12,860,196 $ 10,307,633 $ 7,755,070 $ 5,202,507 Compound Ann. IRR 19.00% 10.00% 7.00% 1.50% 0.00% Building in Losses Now I’m pretty sure that the nice offering circulars and powerpoints that will be circulated on this deal will focus on all of the neat and magical things that are going to happen when this company goes private. But there is one point I would like to focus on in the table above, namely that, under my assumptions, IF KKR RECEIVED AN ENTERPRISE VALUE OF 10x EBITDA IT WOULD TRANSLATE TO A LOSS TO THE EQUITY OF $2.3 BILLION OVER THE 5 YEAR HOLDING PERIOD. All of that to say that we believe we are in a financing bubble of epic proportions that is going to end very badly for many stakeholders. We expect that defaults will increase, leverage metrics will return to sanity and for all those jumping on the private equity train late, a great deal of money will be lost. All in the name of “risk reduction.” And it is not just the private equity sponsors who will be left holding the bag. Loan and bond investors who fell asleep in math and accounting the last time around in the late 1980’s are doing it again. Leveraging businesses beyond 5x EBITDA has historically not worked. Interestingly, this entire credit bubble will provide massive opportunities for us as it unwinds. The size of the high yield bond market and leverage loan market continues to grow. It isn’t difficult to envision how defaults will increase when transactions like this are barely going to cover interest costs in the first year. As defaults begin to happen, the psychology will likely change on a dime and we will be there looking through the rubble with very “aggressive” bids. In the meantime, we will continue to exercise extreme caution as to what we purchase for our accounts. Conclusion: If there’s one thing I’ve learned in my 23 years in this business, it’s that bubbles go on longer and push farther than you can possibly imagine. The real estate bubble that was created by the massive cut in short-term interest rates is officially over, precipitated mainly by the easy money (subprime, Alt-A) going away. We expect that the next shoe to drop will be the one on private equity. Transactions are being done at ludicrous valuation levels because there is money willing to finance it. Covenant-lite loan investors and high yield investors need to come out of the ether and demand terms and coverage that make sense. Until then, we will continue to set records for both size and valuation in the LBO game. As always, feel free to call with any questions. Sincerely, PERITUS I ASSET MANAGEMENT, LLC Timothy J. Gramatovich, CFA Chief Investment Officer Peritus I Asset Management Return Disclosure: Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.