PRIVATE PARTS April 17th, 2007 Timothy J. Gramatovich, CFA

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PRIVATE PARTS April 17th, 2007 Timothy J. Gramatovich, CFA Powered By Docstoc
					                                                  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.

				
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