(Bloomberg View) -- Claire’s Stores filed for bankruptcy last week, one of a small but growing cadre of failed private equity-backed retail firms led most notably by Toys ‘R’ Us, which is now liquidating its iconic stores. It shouldn’t have come as a surprise when Toys ‘R’ Us filed for bankruptcy in September when you consider it had a staggering $400 million in annual debt service obligations. As for Claire’s, loading up on $2.2 billion in debt for what is essentially an ear-piercing clinic does not pass the common sense test.
There will surely be more bankruptcies by all types of PE-backed companies, and the debate will intensify around what constitutes an appropriate level of debt. That’s another way of saying people will become very angry as mounting bankruptcies lead to job losses. Then, it will only be a matter of time before popular opinion turns against the world of PE and its extremely well-compensated executives.
Corporate debt has skyrocketed in recent years, partly because of the Fed’s easy money policies and partly due to PE firms going on a leveraged-buyout frenzy with all the cash that was thrown at them by yield-starved investors searching for higher returns in a world of zero interest rates. Assets under management at private equity firms stood at $2.8 trillion at the end of 2017, with buyout funds making up a majority at $1.6 trillion, according to Consultancy.UK.
The U.S. consumer may have deleveraged after the financial crisis, but the corporate sector releveraged, and is probably in an equally precarious financial position as consumers were 10 years ago. Last year, 6.6 percent of all LBO deals had leverage ratios of at least seven times, up from 3.4 percent in 2016 and the highest since the peak in 2007, according to data from LCD, a unit of S&P Global Market Intelligence. S&P Global Ratings says $4.4 trillion of corporate debt will mature between 2018 and 2022 -- just as interest rates are rising.
I had an academic conversation with a PE employee recently about the appropriate level of debt for a company. I am a bit like the Dave Ramsey of corporate finance, so I argued that the appropriate level is zero. He argued the opposite, in that a company should apply as much debt as possible without going bankrupt. The textbooks side with my PE friend, teaching that financial leverage should be maximized to ensure the greatest profits.
The trouble with leverage is that there are cycles and you can’t predict the future. Back when the Toys ‘R’ Us and Claire’s LBO deals were done about 10 years ago, Amazon.com’s sales were a tiny fraction of what they were now and it wasn’t seen as a threat. Keep in mind that Toys ‘R’ Us and Claire’s went bankrupt at the top of the cycle. Imagine what will happen when a recession hits.
And that is my concern, because the optics of all this can’t get much worse. Blackstone Group co-founder Steve Schwarzman took home $786.5 million in pay for 2017. Leon Black, the head of Apollo Global Management, which did the LBO of Claire’s, took home $191.3 million. Given those numbers, I can safely predict that PE firms will be perceived about as well as bankers were in the fall of 2011, when Occupy Wall Street began, if and when default rates rise substantially and layoffs at companies that were purchased via LBOs climb into the hundreds of thousands or even millions. We might get an iteration of Occupy Wall Street.
I’m starting to see some rumblings on social media about these bankruptcies. A quick search on the web will turn up terms like “vulture capital” and “pirate equity” -- much like the use of the epithet “bankster” 10 years ago. Paraphrasing former Citigroup CEO Chuck Prince, here’s some advice for PE firms: Yes, the music is still playing, but for the love of God, stop dancing. The entire American model of capitalism is based on the use of abundant amounts of debt, but that model may fall out of favor, especially as rates rise, and private equity may not be able to survive the onslaught of public opinion that will ensue.
The optimal level of debt may not be zero, but it’s lower than PE firms and most people think, as we’ll come to realize when the cycle turns lower.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World."
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