Guy Fraser-Sampson, Author, "Private Equity as an asset class" presentation at Warwick Business School 23/11/2009 Has the financial crisis changed for ever the way in which we view and use leverage, or is it just a temporary blip?

1. Warwick Business School
Guy Fraser-Sampson
Fraser Sampson
23 November 2009

2. The banking crisis in context
• History of banking crises, e.g. 1991
• Over 700 Savings and Loan institutions
failed
• C t the US G
Cost th Government (taxpayer) over
t (t )
$120 billion to sort out
• Led to corporate bank debt totally drying
up in 1991 on both sides of the Atlantic
1991,

3. Some similarities
• S&L f il
failure was sparked b l i l ti
k d by legislative
changes which allowed them to change
the fundamental nature of their business
• A factor was a large increase in p p y
g property
values sparked by passive investment
• Knock-on effect of residential mortgage
debt into the banking sector
• B k stopped l di
Banks t d lending
• Collapse of corporate bond market

4. But important differences
• In 1991 there was nothing fundamentally wrong
with the banking system
• In 1991 the direct effect of the crisis was
confined largely to the US (
g y (though big indirect
g g
effect elsewhere when international syndication
dried up))
• In 1991 there were very few credit derivatives
• In 1991 the banks were not over-lent / under-
protected

5. The Asian Crisis 1997
• Catalysts was Thai government’s decision
to let the Baht float after they were unable
y
to defend its peg to the dollar
• Most observers thought Thailand was
already effectively bankrupt because of its
large fforeign debt at high interest levels
• Caused mainly by a real estate bubble,
fuelled by debt

6. Similarities
• National bankruptcy Thailand / Iceland
• Bankruptcy of hedge funds (LTCM)
• Fear of global banking meltdown
• Political fall-out (Suharto in Indonesia)
• High unemployment
• Prolonged recession / slow recovery
• Criticism of role of hedge funds

7. Differences
• At lleast i iti ll a currency problem, not a
t initially, bl t
debt problem
• Local problems causing global contagion
e.g. Argentina 1999 onwards
g g
• Little long term impact on the banking
system in Europe / US
• No significant role for credit derivatives
• No major government intervention in
Europe / US

8. Key Points of present crisis
• H
Huge gearing effect of credit derivatives
i ff t f dit d i ti
• Persistent short-selling by hedge funds
g y g
• High leverage in buyout and real estate –
massive leverage in hedge funds
• Partial collapse of banking system
• Need f massive government intervention
for
to stave off global meltdown
• US sub-prime the catalyst, but proved to
be simply the first domino of many
py y

9. The three stages of banking
• Caterpillar
• Pupa
• Butterfly

10. Caterpillar
• Banks take in depositors’ money
• Make loans to business and retail
customers
• M k money on th diff
Make the difference b t
between
the interest rates
• Classic banking model, thousands of
years old
• Driven by interest spread

11. Pupa
• I t
Interest spread deemed no l
t dd d longer sufficient
ffi i t
• Banks move to charging fees for granting loans
• To drive higher fees, banks underwrite whole
funding packages, offer higher risk products
(e.g. mezzanine), l d at hi h valuations, and
( i ) lend t higher l ti d
take less protection (cov-lite)
• L t also earn f
Later, l fees by creating credit d i ti
b ti dit derivative
products
• F income earned used as b
Fee i d d benchmark f l
h k for levell
of individual bonuses (no claw back!)

12. % Global Buyouts with total debt
> 6x EBITDA (S&P)
40
35
30
25
20
15
10
5
0
2000 2001 2002 2003 2004 2005 2006 2007

13. Butterfly
• Banks greedy for more money beyond fees
• Begin trading derivative p
g g products, including
g
those that they have created themselves
• Risk may pile on risk, as also extending high
leverage to hedge funds who may be taking the
same derivative position
• Banks are by now more like flies, feeding on
their own vomit
• Revenue model now heavily trading driven

14. Causes / Irritants
• R
Repeal of Gl
l f Glass-Steagall A t i US 1999
St ll Act in
• Dramatic increase in size of buyout funds,
y ,
and thus the LBO debt market
• Ditto hedge funds and Prime Broker mkt
• Bonus culture driving deals
• Lax / incompetent regulation of banks
f
• Flight to liquidity in 2008
g q y
• Problems with valuation

15. Private Equity facts
• 75% of all the capital ever raised by
Private Equity funds has been raised since
q y
2000
• And 50% since 2005
• Assuming 70% gearing, this means that
even in 2006 alone, enough money was
raised to require USD1 Trillion of buyout
debt

16. Hedge Funds
• As at the end of 2007 hedge funds had
about USD 2 Trillion under management
g
globally (source: Biz Research)
• Many hedge funds were geared in excess
of 100x (CCC was 32x). Even if the
average was only 10x, this would have
made the global Prime Broker market USD
g
20 Trillion in total

17. Note …
• In 2008 US GDP was just over $14 Trillion
• In 2008 UK GDP was about $2 7 Trillion
$2.7
• …yet nobody seems to have found these
levels of d bt excessive
l l f debt i
• …and t ey do not include c ed t
a d they ot c ude credit
derivatives
• Th G
The Gross Li biliti of Barclays Bank are
Liabilities f B l B k
roughly equal to UK GDP

19. The rise of the LBO market
Swelling
S lli More
Increased
I d
fund LBO
Great returns institutional
sizes firms
appetite

20. 0
100
200
300
400
500
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Global Buyout Fundraising ($B)
2003
2004
2005
2006
2007
2008

21. Top of the Market (World)?
• Cov-Lite lending
• Blackstone goes public
• Blackstone lose $170M in one quarter,
while St
hil Steve S h
Schwartzman spends $3M on
t d
his birthday party
• David Rubenstein (Carlyle) buys Magna
Carta
• Terra Firma buys EMI

22. Dire Predictions …
• In December 2008 Boston Consulting
Group issued a study p
p y predicting that up to
g p
30% of European buyout groups could
disappear in the next three years
• There is regular press speculation that
buyout f
firms could go bust (e.g. New York
(
Times, 8 September)
p )

23. BCG study
• Candover is winding up
• Hermes direct team taken over by
Bridgepoint
• P
Permira’s f t
i ’ future is extremely uncertain
i t l t i
• Ditto Alchemy
tto c e y
• PAI and BC Partners have faced revolt /
resistance f
i t from their LPs
th i LP
• LP/GP relationships have soured
p

25. Key Departures
• Buffini – Permira
• Green – Apax
• Moulton – Alchemy
• Buffin – Candover
…and many now working with no prospect
of carry on current deals, e.g. Hands
(
(Terra Firma / EMI))

26. Is the worst yet to come?
• Much current bank debt is structured until
2011 or 2012
• Banks have been reluctant to allow LBOs
to fall into default
• Banks reluctant to revalue
• Yet most of those 104 buyouts must have
negative equity value
• Restructurings so far look that way

27. Eye of the storm?
• S the banks could be in th eye of th
So th b k ld b i the f the
storm, with a second wave of crisis yet to
come
• Many LBOs to be written down
y
• Many real estate loans to be written down
• What about personal mortgage default?
• What about consumer credit default?
• We may not know the true picture until end
2012

28. What will happen short term?
• Th
Those buyout firms which raised money recently
b t fi hi h i d tl
will husband it carefully, because they know it
might be a long time before they can raise any
more
• Anyone who has to raise money before 2011
may have to go into hibernation to survive
• Many (100?) >$1B buyouts will be taken over by
the banks
• Some 2005 and 2006 vintage year buyout funds
are unlikely to return their capital

29. But,
But long term …
• B
Buyout fundraising will recover (probably f
tf d i i ill ( b bl from
2011 onwards) and continue its upward climb
• The banks will come slowly back into the market
market,
also from about 2011
• Debt will initially be offered at sensible levels
and on sensible terms
• But as the same drivers will be present, the
cycle will repeat itself, though perhaps not so
badly
• Mega buyout returns will continue to struggle,
struggle
and be heavily market dependent

31. Thank You
http://www.guyfs.com
p g y
guyfs@yahoo.co.uk