Why Leveraged Buy Outs Bode Ill for Financial Markets

[ByLoSellHi]

Investment Banks Have Too Much Money On Their Hands

http://financial.seekingalpha.com/article/17237

Posted on Sep 20th, 2006 with stocks: AIG, GS, KMI, MS

Phil Davis submits: Morgan Stanley (MS) had blowout earnings yet again! Bad for me but good for the markets. But they say “economic conditions are challenging.” Not enough for me to hang my hat on, but I still say nay! The quarter ended August 31st. Amaranth’s quarter ended August 31st, and they reported $9.2B in assets on that day, a 22% return on the year...

Perhaps I am being quixotic about this, but I just can’t believe that they are making this kind of money in a risk-free environment.

In my quest for overvalued oil companies, I came across Kinder Morgan Inc. (KMI) and this chart, and I was ready to pounce, before I remembered they were being taken private. That’s right, this pipeline company is being bought out for $14.56B, only $1B above their all-time high and a 25% premium to where they were prior to the May announcement.

Should this company have been bought at what may be “the peak"? More importantly, who is crazy enough to make a play like this? Must be someone with way too much money... Turns out it’s our buddies at Goldman Sachs Group Inc. (GS)! But Kinder is more than just a bloated energy distributor; they also have $7B in long-term debt and a negative 2005 cash flow! So Goldman is getting help from American International Group Inc. (AIG) and the ubiquitous Carlyle Group to make this massive LBO work.

CW is so strong that this deal is a go (and it does seem to be) that the Jan ’08 $105 puts are trading at $1.90, and I’m going to take just a few on the off-chance somebody sobers up and either offers a little less or breaks the deal. At this point, it is unlikely to happen, and the option may expire worthless, but it’s a 10:1 bet and, if I'm lucky, I can exit without too much damage if the deal firms up over the next 6 months.

I’m using this bet to cover my new income-producing play of shorting GS and selling the Nov $160 puts for $4.10, as the thing I am most worried about (as a shorter) is that they stop making deals like this!

More importantly though, my main point is that this is what investment houses like GS are doing with all that money they have sloshing around -- paying 350% of book value for a company.

Now you can argue that it’s hard to use book value to judge an energy company. I would also point out the 3.2 debt/equity ratio (pre-buyout expenses) vs. say, ExxonMobil Corp.'s (XOM) debt/equity ratio of .07. Suncor Energy Inc.'s (SU) 1.2., Valero Energy Corp. (VLO) - .3, Transocean Inc. (RIG) - .2, TEPPCO Partners L.P. (TPP) – 1.3... you get the idea...

This is the kind of out-of-control commodity spending that took down Amaranth, only it’s happening in slow motion at the investment houses. Here is an excellent article by Trader Mike on the Amaranth deal, which I maintain is a microcosm of in industry gone wild.

According to the NY Times, “funds operated by Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank and Man Investments all had stakes in Amaranth, as of June 30, the most recent figures available. Those holdings, which ranged from 4 percent to 7 percent of the assets of the funds, are worth far less now than their stated values in June.”

4-7%. What’s 4% of $9B? $360,000,0000. What’s 4% of $4.5B? $180,000,000. How much did MS make last quarter? $1.9B (not bad!). It will be a very interesting earnings report! Gee, I hope they weren’t the ones with 7%...

“Officials at those funds declined to comment yesterday.” I wonder if this will come up at MS's press conference?

I'll be holding my puts until then!

 

[nazzdack]

Be patient. Buy-out fever can only happen near market tops. You'll want to be long-puts soon enough.

 

[Hydroblunt]

You gotta be crazy to short the big boy financials for anything more than a quick short swing trade.

IBs having too much money on their hands, no sh*t. Here is something to think about, remember the fairly recent change in policy that allowed IBs to be combined with commercial banks? Does anyone remember how quickly all the big commercial banks rushed to grab an IB center? I doubt even a few can recall how Chase grabbed JP Morgan and how forceful that merger was. It was a mess that could have been seen from a mile away, but it did not matter how much trouble it was as long as the key goal was accomplished. They are still cleaning up the mess in operations from that merger.

This change in policy went against any common sense when it comes to the concept of "conflict of interest". Ever since, the IBs have flourished, gapping up on earnings almost everytime. Not all of them have blatant structures like JPMorgan+Chase but they all have a direct way to tap into the money faucet of the Fed reserve system, previously being a more problematic and indirect way.

I can only say so much about the new wave of IB deals but you guys ain't seen nothing yet. Some other stuff to keep an eye on, the move of Merrill Lynch to buy Pax Clearing 1-2 years ago.