When the shark bites

Date: Monday, May 7, 2007
Author: David Olive, Toronto Star

A coterie of buyout shops, hedge funds and private-equity firms are on the prowl for prey like Ragged Tooth sharks stalking their dinner.

If the world's biggest bank frets over talk of a hostile buyout, nobody can feel safe from the recent takeover feeding frenzy. But haven't things gone a little too far?

  Unnamed executives at Citigroup Inc. let it be known last week that they fear their financial services colossus is vulnerable to a hostile takeover.

When the world's biggest bank, with a stock-market value of $260 billion (all figures U.S.), fears that even it might be a target in the current wave of debt-financed takeovers sweeping North America and Europe, it's a sign either that (a) no company's independence is safe, or (b) this trend will soon peak, if it hasn't already.

All the signs are there to suggest it's the latter case.

A rapid proliferation of buyout shops, hedge funds and private-equity firms has resulted in too many prospective buyers chasing too few worthwhile acquisition targets.

That same proliferation of wannabe takeover artists is pushing up the price of remaining acquisition candidates to ludicrous levels, requiring successful bidders to pile ever higher levels of debt on acquired firms, and pushing the point at which deals turn profitable out to the point of infinity.

As the above would suggest, the return to investors from these takeover marauders is in steep decline.

Then there are the regulators, always late to the party, but on the scene now, asking the bankers who finance takeover deals if they are prepared for a worst-case scenario. And asking the investment-banker handmaidens to the dealmakers the same question, in the context of lax margin requirements on the Niagara of credit that has been made available to takeover specialists.

And there is the greed factor – the growing realization, and in some case indignation – that hedge funds, private-equity firms and the like skim off a management fee equal to 2 per cent or 3 per cent of the portfolio's assets regardless of its performance.

Which would help explain why, in these latter stages of the mania trend, the takeover artists have few qualms about departing from the previous, disciplined criteria they applied when assessing an acquisition target.

Let it not be said that so-called activist hedge managers have lacked influence in reshaping the corporate landscape.

An obscure South Carolina private-equity investor named Jerry Zucker succeeded in purchasing the iconic Hudson's Bay Co., not long after counterpart Eddie Lampert pounced on venerable Sears, Roebuck & Co. and merged it with his Kmart Holdings Corp.

Carl Icahn, playing the same game that was denounced as "greenmailing" back in the 1980s, agitated for change at media giant Time Warner Inc. – "change" meaning a hefty dividend windfall for investors like Icahn. Kohlberg Kravis Roberts & Co. (KKR), another name from the past, has spearheaded an audacious takeover bid for BCE Inc., parent of Bell Canada. BCE is thus "in play": the only question is who will end up buying it, at what price and when exactly will BCE lose its independence.

Arbitrageur Nelson Peltz, yet another blast from the past, has used minority stakes in H.J. Heinz Co. and Cadbury Schweppes PLC to force asset sales at the former, and a break-up into its confectionery and beverage components in the latter.

And the innocuous-sounding The Children's Investment Fund (TCI), actually an activist hedge fund, has pushed for the breakup of the 183-year-old ABN Amro Holding NV, one of Europe's largest banks. Worn down by TCI, the Dutch bank succumbed earlier this year to the blandishments of suitor Barclays PLC in a proposed $91 billion deal – the biggest cross-border corporate merger in history.

But TCI is not satisfied. At this writing, it is pulling for a still higher $98 billion bid for ABN from a consortium of European banks led by Royal Bank of Scotland. Meantime, TCI is contesting in court routine ABN business dealings that meet with TCI objections. "ABN has become the toy of hedge funds and I deeply regret that," ABN CEO Rijkman Groenink told a Dutch judge during a TCI-ABN courtroom tussle late last month.

No longer clear on who owns your local paper? Blame the investment-fund agitators, like Tweedy Browne Co., which triggered the unraveling of Conrad Black's newspaper empire. Knight Ridder Inc., the former No. 2 U.S. newspaper chain, finally gave in to outside agitators and sold itself to a much smaller chain, which has subsequently sold off Knight Ridder's biggest properties. And mighty Tribune Co., owner of the Chicago Tribune, the Los Angeles Times, many other papers and 23 TV stations, was forcibly sold last month to a buyout consortium led by retired real estate developer Sam Zell.

Which makes the fears at Citigroup that emerged last week entirely credible. True, factoring in the usual takeover premium, a $350 billion takeover of Citi would be a stretch – a deal worth about three times the GDP of Ireland.

As with the Royal Bank of Scotland's carve-up scenario for ABN, a syndicate of half a dozen global banks could post the financing for a Citigroup and promptly recover their investment by hacking Citi into its four major components: U.S. consumer finance; offshore consumer finance; investment banking; and wealth management.

And the United States would thus lose its only global bank, just as Holland is about to lose one of its two world-class banks.

The buyout craze has provoked a revival of economic nationalism in nations like Italy, Holland, France, Germany, Australia and Canada. In the past year or so alone, Canada has seen the disappearance of Inco Ltd., Falconbridge Ltd., Four Seasons Hotels Inc., Fairmont Hotels and Resorts Ltd., Terasen Inc., Dofasco Inc., Algoma Steel Corp. Ltd., Intrawest Corp. and many other firms to foreign buyers.

Politicians in Europe have decried the buyout interlopers targeting their steel, pharmaceutical and banking companies as "locusts." Sage investors like Warren Buffett, scandalized by takeover prices now in nosebleed territory, have decried the mountains of debt the acquired firms now are required to shoulder.

And central bankers worldwide are publicly fretful about a buyout "industry" that is loosely regulated, whose financing methods are convoluted and anything but transparent, and has yet to be tested by hard times – a recession or global credit crunch, for instance. Last Tuesday, Bank of Canada governor David Dodge joined the chorus of concern about "an inexhaustible supply of debt finance ... to take companies out of the public domain."

Some figures give an idea of a movement that's gone about as far as it can.

The number of hedge funds alone has more than doubled since 2000 to a current 9,200 or so. Collectively they wield buying power of an estimated $1.4 trillion to $2 trillion, before accounting for leverage, which in some of the more precarious deals of late amounts to 25 times the hard cash put up by buyout firms.

Last year, hedge funds, buyout shops and individual wealthy investors borrowing on margin were carrying total debt of $4.9 trillion, up from just $1.8 trillion a mere four years earlier. And every year, debt has become a larger portion of the average deal. In 2001, debt and real cash invested by buyout artists in the typical deal were roughly equal. Today debt comprises about two-thirds of the average deal value.

"There's leverage everywhere – whether at corporations or broker dealers or hedge funds or private-equity funds," Tanya Azarchs, senior credit analyst at Standard & Poors Corp., told the Wall Street Journal last week. "It sort of feels like something's got to give."

The ideal target for a buyout specialist is a poorly run firm with a clean balance sheet, whose corporate and industry fundamentals are strong. With new and less complacent management, such firms can be fixed with relative ease.

Trouble is, after years of relentless buying, such firms are now in short supply. "All the fruit on the low-hanging branches is long gone," acknowledged Ken Griffin, head of Chicago hedge fund Citadel Investment Group, in a recent Portfolio interview. "And now you've got to go find a ladder and pick the fruit off the very top of the tree."

As viable deals have become scarce, investor returns from buyout funds have weakened.

In the 1990s, when obscure hedge funds and private-equity players were scooping up obscure companies by the bushel, the average U.S. hedge fund's return to investors was a heady 18.3 per cent. Last year it was 12.9 per cent, a lower return than the S&P500. The previous two years saw dismal single-digit returns.

What happened in the meantime? The deals got bigger and more complex, and rampant competition among the proliferation of predators chased up the price of deals with even borderline appeal.

The top dealmakers themselves are doing fine, however, leaving pension funds and other institutional investors to ask the proverbial question, "Where is the customer's yacht?"

Buyout, hedge fund and other takeover machines do nicely with a typical upfront management fee of 2 per cent of their portfolio, regardless of its performance, which translates into billions of dollars in profit for the dealmakers.

Last year, the top 25 U.S. hedge fund managers pocketed a total of $14 billion in personal earnings, a big enough windfall to finance the 88,000-teacher New York City school system for three years.

The collapse last year of U.S. hedge fund Amaranth LLC, where some $6 billion in assets disappeared in a matter of days, was largely ignored by other dealmakers. But it has galvanized regulators.

The Federal Reserve Board of New York, the U.S. Securities and Exchange Commission (SEC) and other regulators are hastily devising worst-case-scenario models. In private sessions with New York bankers and securities firms, they're asking if Wall Street "can comfortably manage" the collapse of one or more future Amaranths, in the words of Timothy Geithner, president of the New York Fed.

The regulators also want bankers and other lenders to be more discriminate in their lending practices, after years of relaxing their margin requirements in order to drum up business. Annette Nazareth, an SEC commissioner, warned a group of bankers in a speech last year that the SEC and banking regulators now seek to prevent "an environment that encourages a competitive `race to the bottom' concerning margin."

When they were still an emerging force to be reckoned with, an admiring author Tom Wolfe described the new crop of dealmakers as the second coming of the "masters of the universe" he chronicled in his 1980s bestseller, Bonfire of the Vanities. Most of the engaging characters in that novel came to a bad end.

Let's hope the current mania hasn't gotten similarly out of hand, and that a messy end can be avoided.