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Fall is here, stagflation is in the air, and Bloomberg terminals are aflutter with news of a great “reckoning” for private equity, triggered by Federal Reserve rate hikes.
“I don’t think the spigot reopens,” David Sambur, co-head of private equity at Apollo (a favorite subject of the Prospect’s private equity reporting) told Bloomberg TV’s Sonali Basak at a closed investment conference on September 14, adding that he felt Wall Street remained “early in the hangover” caused by Fed chair Jerome Powell’s shocks.
Sambur referenced a signature example of what he called the “reckoning”: the embarrassing scramble of banks to find buyers for bonds associated with the $16.5 billion leveraged buyout (LBO) of the enterprise software firm Citrix Systems. Banks loaned “affiliates” of Vista Equity Partners and Elliott Management $15.5 billion to close the deal back in January, but interest rates have risen an unheard-of three percentage points since then, and even with generous assistance from Sambur’s employer, banks have been forced to raise the yield on Citrix bonds commensurately to convince anyone to buy them.
“Everyone was getting comfortable in August again but unfortunately Jackson Hole happened and then everything went haywire,” a banker close to the Citrix deal told the Financial Times, referring to Federal Reserve chairman Jerome Powell’s indications in a speech at the annual Jackson Hole Economic Policy Symposium that rate hikes would continue indefinitely.
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Private equity giants were notably unruffled by the Powell shocks until a week or so ago. Big funds like Ares Capital Corporation have said that the Fed funds rate, currently 3.25 percent, would have to reach 6 percent to hurt their investments. In their most recent investor calls last month, the big four publicly traded private equity firms mostly talked about how unconcerned they are about rate hikes, given their abundance of fee income and dry powder (investor money that hasn’t been deployed to purchase companies).
“It’s important to understand the vast amount of our fee revenue is agnostic to asset market’s valuations,” then-CEO Kewsong Lee told investors in the Carlyle Group’s publicly traded stock on its second-quarter call. “We’re not at a point where our ability to finance transactions is impacting our ability to get things done,” echoed KKR investor relations chief Craig Larson. Apollo’s chief financial officer emphatically declared that “market driven declines” had produced “only an approximate 1 percent drag on our management fees.” Blackstone made similar assurances.
But you don’t have to take their word for it. A closer look at the diabolical details of the Citrix deal highlights all you need to know about why the average LBO bro doesn’t seem too fazed by the Powell shocks, even if the rest of us should be.
CITRIX SYSTEMS IS A 33-YEAR-OLD DEVELOPER of enterprise software that enables remote work. Its profits and stock price soared in 2020, then crumpled in 2021, when vulture investment firm Elliott Management began accumulating a 10 percent stake in the company, apparently using derivatives as opposed to regular shares to evade regulatory scrutiny and/or juice returns. Elliott had more than doubled its money by “activist” investing in Citrix during the Trump years, when it controlled a board seat on the company. It sold its stake early in the pandemic, only to be lured back in October 2021 amid a surge in private equity tech buyouts, driven by the underlying premise that converting software sales into a subscription business was a new fail-safe proposition.
None of the private equity firms involved are likely to book any loss on the debacle, which has already wiped out a thousand jobs and $700 million of the banks’ precious fee revenue.
Meanwhile, the Austin-based private equity firm Vista Equity Partners—hot off the heels of successfully selling a business software firm called Wrike to Citrix—was shopping around Tibco, another software company it had purchased in 2014. Finding no takers, Vista decided in October 2021 to exploit the still-booming junk bond market, having Tibco acquire a software robotics firm called Blue Prism.
Then in December, the news broke that Elliott’s private equity arm and Vista were proposing to merge Citrix, Tibco, Blue Prism, and Wrike, in a deal that would value Citrix at $13 billion, a roughly 30 percent premium to its stock price. The merged entity would eventually borrow $15.5 billion to consummate the deal, while raising an additional $2.5 billion in “preferred” equity shares from four private equity firms: Apollo, Blackstone, Carlyle, and Oaktree Capital Management. Elliott and Vista’s contribution to the transaction, meanwhile, seemed to be generally limited to the firms’ pre-existing shares in Citrix and Tibco.
The four software companies together had a combined EBITDA (earnings before interest, taxes, depreciation, and amortization) of roughly $1 billion in 2021, giving the deal a debt-to-EBITDA ratio of at least 15. The average 2021 vintage software LBO had a ratio around seven, which itself is very high. Some $741 million had to be earmarked to pay the fees associated with the brilliant underwriters who signed off on this transaction, plus another $375 million in dividends to the preferred equity holders. Even if Citrix could have borrowed all $15.5 billion at the going 2021 rate of 5.55 percent—and it doesn’t work that way—the first interest payment would have sent the company into default.
As it was, Citrix didn’t even get that far; a week into September, Vista and Elliott convened a conference call to inform lenders the company had run out of cash in the process of trying to come up with severance payments for the thousand employees it was trying to lay off. Says an analyst who worked briefly on the deal: “I honestly don’t know how they managed to get $15 billion in debt financing, that should never have happened.”
None of the private equity firms involved are likely to book any loss on the debacle, which has already wiped out a thousand jobs and $700 million of the banks’ precious fee revenue. Neither Vista nor Elliott appears to have invested any new cash equity in the deal; as for the preferred shareholders, their “investments” came with a very unusual provision: the right to claim all proceeds of the sale of Wrike, for which Citrix paid $2.3 billion just over a year ago.
A COUPLE OF HIGH-PROFILE EUROPEAN MONEY MANAGERS have made waves over the past few months for likening private equity to a “Ponzi scheme.” Private equity has always been a game of getting your money out of a company early and often enough that you can still turn a profit if the whole thing winds up in bankruptcy court. (The aforementioned David Sambur memorably referred to this as the “cake and eat it too” method during the collapse of the Caesars casino empire.)
But the saga of Citrix is such a paradigmatic example, a veritable walking tour of innovations in juicing returns and avoiding losses, that it should set off alarm bells. Prosecutors (or failing that, the House Oversight Committee?) should probably start sending around subpoenas to the battalion of PE firms, bankers, and executives involved in it, before another American worker is forced to sacrifice his or her job to pay the bonuses of whoever in the world agreed to lend $15.5 billion to a company that ran out of cash before it could make a single payment.
The investigation should also shine a light on other sketchy activities. For instance, there’s last year’s unprecedented surge in junk bond issuance, especially the 220 of last year’s issuers that are already trading in distressed territory. (We have yet to find another instance where Goldman Sachs and Credit Suisse conspired to loan a company five times its annual revenues, but the leading distressed-debt news outlet was bought out by a private equity firm over the summer, and we hear they’ve already hiked subscription costs.)
In the old days, PE firms aimed to cash out of “investments” by taking portfolio companies public in an IPO. But in more recent years, the majority of private equity portfolio companies have been sold to other private equity firms. More recently, a new twist on the secondary buyout trend emerged when private equity firms began offloading portfolio companies to … themselves, via an incestuous innovation known as the “continuation fund” that swallowed $65 billion worth of private equity assets last year.
Alongside these schemes, private equity firms have also nurtured secretive and insular new modes of borrowing, a phenomenon broadly called “private credit.” In private-credit transactions like Citrix’s “preferred equity” sales, corporate raiders make adjustable-rate “hybrid” loans to the types of companies they would normally “invest” in, often to companies that already have too much existing debt to access the bond market. By packaging them as “preferred equity,” the investments don’t add to a company’s paper indebtedness, despite operating much more like loans than equity investments, as evidenced by the unusual arrangement whereby the firms’ so-called “equity” in Citrix turned out to be collateralized by a subsidiary company.
In the absence of swift and meaningful reforms, private equity is poised to once again rake in record returns on the pain it has inflicted on the rest of us.
Even as junk bond issuance approached a half trillion dollars in 2021 on the back of rates and underwriting standards so low a consortium of banks decided to lend $15.5 billion to a company with only half a billion in free cash flow, many of the most prominent LBO titans have announced a shift in their investment focus toward the lending side of the business, both as an extension of their core business model of extracting profits from deeply insolvent companies and a bid to generate a larger portion of profits from fee income. Private-credit fundraising reached $180 billion in 2021.
Both private credit and continuation funds enable private equity firms to keep insolvent portfolio companies out of bankruptcy court and the public spotlight for ever-longer periods, making it harder for workers and other victims to claw back profits. It’s worth noting that corporate bankruptcy filings have slowed to a trickle amid the evaporation of the bond market, even though well over a fifth of the top 3,000 publicly traded companies are officially “zombies,” according to a Bloomberg analysis.
The deadline for Federal Trade Commission review of the Citrix buyout passed before the basic contours of its preposterous financing scheme were apparent. While the agency has never made a practice of blocking mergers solely on the basis that the debt financing would likely drive the relevant company into bankruptcy court, maybe it should start. Because the bankruptcy process currently stands as the only legal venue that exists for curing the disease of toxic Ponzification, policymakers must commit themselves to reforming the process to better protect the millions of victims of these schemes. The Securities and Exchange Commission, too, could cut off the private equity racket’s liquidity hose if Congress would repeal the little-known 1996 statute that gave the biggest psychopaths of the Greed Is Good era access to the pension funds and university endowments that turned a seedy niche underbelly of finance into a multitrillion-dollar hegemony.
In other words, while the Fed’s rate hikes, which may induce a global recession, punish the cheap-money bonanza that pushed private equity to great heights in recent years, nobody should assume that the industry has no recourse on the way down. They have ingeniously constructed a number of escape hatches, ones that need to be scrutinized and regulated.
Because in the absence of swift and meaningful reforms, private equity is poised to once again rake in record returns on the pain it has inflicted on the rest of us, as Blackstone founder and CEO Steve Schwarzman promised during his last earnings call in August. “We expect historically attractive investment opportunities to arise from this dislocation,” he told investors. President and COO Jonathan Gray added, “Give us the ability to take advantage of these opportunities as they emerge.”
