It’s Not You, It’s the Deal

Private equity firms find lots of ways to dump bad deals.

Private equity firms regard themselves not as asset-flipping gigolos but, rather, as sophisticated serial monogamists, always on the prowl for profitable long-term relationships. But their willingness to take a longer view is largely dependent on the supply of cheap money. When cash becomes more expensive and loans arrive with too many strings attached, a beautiful deal can transform overnight into an ugly hag. And so in recent months, as the effects of the credit crunch have rolled through the economy, private equity firms have balked at consummating high-profile deals. In 1975, Paul Simon identified “50 Ways To Leave Your Lover.” Today, buyout barons like Henry Kravis of KKR and Steve Schwarzman of the Blackstone Group are singing a different tune: There must be 50 ways to leave your private equity acquisition target.

Just blame the bank, Hank. In March, Blackstone and GE Capital Solutions, a unit of General Electric, teamed up to acquire PHH, a fleet-management and mortgage company. (The plan: GE Capital would buy PHH and then sell the mortgage operations to Blackstone.) However, as the spring wore on and PHH’s mortgage unit racked up losses, JPMorgan Chase and Lehman Brothers, the banks that had agreed to fund Blackstone’s purchase, grew anxious. And so in September, as Reuters reported, “PHH said Blackstone told GE in a letter that it received revised interpretations on debt availability for the deal from J.P. Morgan Chase & Co. and Lehman Brothers Holdings Inc that could result in a shortfall of up to $750 million.” Translation: The banks yanked the Persian rug from under Blackstone’s feet. Now, for Blackstone’s partners, a mere $750 million may be the cost of a few birthday parties,but if Blackstone couldn’t pay with borrowed money, it couldn’t justify the deal. PHH’s stock now trades at a 30 percent discount to the GE-Blackstone offering price, which means investors have little faith the deal will come good.

See you in court, Mort. In April, JC Flowers, the private equity shop that specializes in financial-services companies, agreed to buy student-loan profiteer Sallie Mae for $25 billion, with the assistance of JPMorgan Chase and Lehman Brothers. But paying top dollar for a lending business seemed less viable as the credit crisis worsened. What’s more, Congress was considering the College Cost Reduction Act, which would reduce the interest rates Sallie Mae could charge on federally guaranteed loans. And so Flowers, eager to date other financial services companies (like Britain’s collapsing Northern Rock), tried to invoke the so-called material adverse effect clause—a provision written into most transactions that allows an acquirer to walk way from the deal, if the target business suffers a significant setback, without having to pay the a breakup fee. (In the case of Sallie Mae, the agreed-upon breakup fee was $900 million.) Sallie Mae strenuously called bull**** on this maneuver, concluding that the new law would reduce net income only “between 1.8 percent and 2.1 percent annually over the next 5 years.” Nonetheless, in September, just before President George W. Bush signed the act into law, the investors told Sallie Mae they wouldn’t go through with the deal. Sallie Mae then appealed to the honor of Bank of America and JPMorgan Chase. (Try to restrain your laughter.) In early October, after Flowers offered to complete the deal at a lower price, Sallie Mae sued Flowers and the lenders, seeking to make them either live up to the original terms or pay the $900 million breakup fee.

Buy a minority stake, Jake. In the spring, when KKR and Goldman Sachs’ private equity arm teamed up to buy electronics company Harman International for about $8 billion,Henry Kravis lauded the company as “one of the world’s outstanding providers of audio equipment and infotainment systems.” But by early September, having got a better look at Harman’s poor outlook for 2008, Kravis decided the company wasn’t so outstanding. Invoking the material adverse effect clause, KKR and Goldman Sachs said they wouldn’t go forward as planned. But the original barbarians acted like comparative gentlemen. Rather than just leave Harman stranded at the altar, KKR and GS Capital Partners agreed to invest $400 million in the company and take a seat on Harman’s board.

Pay the breakup fee, Lee. And set yourself free. Cerberus, the secretive private equity firm, bought GMAC, General Motors’ financing arm, in April 2006, just in time to get nailed by the subprime mortgage mess. In July, it agreed to buy United Rentals, which rents construction equipment, for $4.4 billion, just as the housing morass was getting deeper. Oops. Last month, Cerberus curtly told United Rentals: It’s not you, it’s me. Rather than cite the material adverse effect clause, Cerberus simply admitted that it no longer wanted to go through with the deal at the original price and essentially offered to pay the $100 million breakup fee. The comparatively gallant gesture apparently didn’t assuage the spurned partner. United Rentals is now suing Cerberus.

Sure, that’s only four. But the credit crunch is just starting, the slumping stock market is making the premiums offered for deals earlier this year look less sustainable by the day, and private equity firms are still waiting in vain for bridge loans over troubled waters.