The following is an excellent excerpt from the book THE GREAT DEFORMATION: The Corruption of Capitalism in America” by David A. Stockman from Chapter 25 on page 527 and I quote: “The HCA Private Equity Plunder: State Policy Run Amok – At the end of the day, the circumstances of the $33 billion HCA buyout are a screaming indictment of current policies of the state. HCA is the nation’s largest hospital chain, but it thrives only by dint of the $15 billion it collects each year from Medicaid and Medicare. These revenues are vastly inflated compared to what HCA would obtain if it had to compete for patient dollars in an honest consumer-driven market.
Worse still, the KKR-Bain deal had thrived only because an effort by the Bush administration to reform the rickety machinery of hospital reimbursement under Medicare has been shut down by a mighty crony capitalist coalition of hospitals and other medical vendors at the time of the HCA buyout in 2006. The Bush reform effort would have reduced the payment rates for DRGs (diagnostic review groups) by upward of 33 percent for certain high-cost hospital services such as Cardiac, Neurosurgical, and Orthopedic.
The Medicare DRG rates for these services became drastically inflated over the years and now accounted for upward of 70 percent of hospital profits in institutions like HCA. These bloated profits were also gifts that had originated way back in the Reagan administration, when in desperation we had resorted to a disguised system of hospital price controls to curb the explosively growing Medicare budgets.
We had been warned at the time that the DRG system was not the great reform it was cracked up to be. Yet we embraced it because it was a significant improvement on the prior system which paid hospitals a per diem rate based on their actual costs—a system which obviously rewarded unnecessarily long stays and padded cost structures. By contrast, the DRG scheme established a lump-sum payment per case, regardless of the length of stay, for about 450 distinct diagnostic groups such as heart surgery, and was based mainly on systemwide cost factors rather than the hospital’s own costs.
This arrangement did reduce the worst incentives of the old daily rate approach, but the problem was that hospitals would soon learn to game the system. In a phenomenon called “DRG creep” sophisticated procedures were developed by hospitals to “code” each admission to the DRG with the highest payment rate.
Needless to say, these DRG rates were bureaucratic prices, not market prices. Consequently, the rate-setting process (i.e., price controls) was tailor-made for manipulation by crony capitalists and their hired K Street lobbies. Every species of impacted vendor—from manufacturers of artificial hips to general hospital chain operators—was fully engaged in this bureaucratic price fixing.
Moreover, in this instance crony capitalism was actually a family affair. Fully $1 billion of the equity capital for the HCA buyout was supplied by the estimable Thomas Frist, the original founder of HCA and energetic foe of the very Big Government on which his fortune was based. In waging this campaign the Frist family left no stone unturned, placing Bill Frist in the US Senate and seeing to it that he eventually became majority leader.
Needless to say, the Senate majority leader required no schooling as to why Federal bureaucrats needed to be prevented from reducing payments for stent surgery by 33 percent, or cutting the Medicare payment for a defibrillator implant from $30,000 toe $22,000. In fact, the entire proposed DRG reset was designed to drive these kinds of expensive specialty treatments away from high-cost general hospital chains like HCA and toward a medical version of low-cost, high-volume “focused factories.”
The estimate at the time was that this sweeping change in the Medicare reimbursement regime could have reduced its hospital payments by 30 percent and would have struck a mortal blow at high-cost general hospital chains like HCA. Stated differently, much of the inflated EBITDA which was absorbing HCA’s $2.0 billion annual interest bill would have been clawed back to the benefit of taxpayers.
As it happened, Bill Frist retired from the Senate at the end of 2006 in a blaze of glory for numerous deeds which had allegedly taken a nick out of Big Government. Among these was a congressional kibosh on the proposed Medicare reimbursement reforms, an action that actually made Big Government fatter by tens of billions per year; a favor it bestowed upon the Frist family fortune as well.
With the Medicare reimbursement spigot locked in the “wide-open” position by congressional mandate, HCA has generated a healthy 5 percent growth in revenues since 2005 and a 5.5 percent annual gain in EBITDA. This has permitted it to service its $2.0 billion per year interest tab and still make the huge dividend payments described above.
Still, the fact that $28 billion in debt can be serviced in this manner is only possible owning to the interest rate repression policies of the Fed and the tax deductibility of interest payments. This case makes self-evident that together these policies have fostered an insanely leveraged capital structure that would never see the light of day in a genuine free market with neutral rules of taxation. Moreover, the regime of “too big to fail” now adds insult to injury by encouraging banks to fund reckless self-dealing dividends which would have been shocking even to the LBO industry one decade earlier.
In short, the KKR and Bain buyout of HCA makes for a fitting tombstone on free market capitalism. In a world in which the financial maneuvers described above can happen, the discipline of the free market has long since disappeared.
The Debt Zombies Kept On Coming – All the founders of the LBO industry—KKR, Blackstone, Apollo, TPG, and Bain Capital—have been stuck in giant deals that have turned into debt zombies. Accordingly, the outbreak of mega-LBO mania during 2006-2007 was not simply the result of one or two firms becoming overly exuberant. Instead, it reflected a financial market deformation that sowed mania and recklessness across the entire private equity space.
The eventual result might best be described as turnkey bidding wars. Syndicates of the big Wall Street banks offered turnkey financing packages consisting of multitudinous layers of secured, unsecured, and exotic “toggle” and “second-lien” debt to competing private equity bidding groups. The latter only needed to “slot-in” a 20-30 percent equity commitment at the bottom of these turn-key debt structures in order to reach a total bid price for giant companies put up for auction by other groups of Wall Street investment bankers.
The heated bidding wars among the top tier private equity houses thus resulted in a “topping-up” of transaction prices which were being set in the yield-crazed debt markets. In this frenzy even the most disciplined private equity houses lost their heads because by now a second fatal assumption had planted deep roots on Wall Street—namely, that the Fed’s Great Moderation guaranteed that GDP would not falter and that financing markets would remain buoyant.
The $28 billion buyout of First Data Corporation, the nation’s largest processor of credit and debit card data for banks and merchants, dramatically illustrates the sheer insanity of these LBO bidding wars. In theory, First Data might have escaped the zombie debt trap since—for better or worse—credit cards have been a growth industry and, in fact, the company’s revenues have risen at a 7 percent rate since 2007, notwithstanding the Great Recession.
But First Data has actually made no progress at all in reducing the $22 billion LBO debt it took on in September 2007 for a single overpowering reason: the speculative climate fostered by the Fed was so frenzied that even the gray eminence of the industry, KKR, was induced to acquire a good company at a preposterous price. The $28 billion price tag thus represented an astounding 51X the pro forma operating income of the company during 2007 and nearly 16X EBITDA.
It goes without saying that the company’s modestly growing sales and cash flow have been no match for $2 billion of annual interest expense. Accordingly, during the eighteen quarters since the buyout, First Data has recorded nearly $7 billion in net losses. After netting capital spending and minority partner payments against income from operations, the company generated less than $450 million of free cash flow during the entire period. Needless to say, at that rate ($25 million per quarter) it would take First Data 220 years to pay off its debt!
In truth, a crash landing has been prevented so far only because billions of LBO debt has been subjected to “extend and pretend.” During the first quarter of 2012, for example, the company refinanced $3 billion of bank debt at higher interest rats, thereby deferring these maturities from 2014 until 2017. At free market interest rates, by contrast, First Data could never refinance its $23 billion of loans as they come due. Keeping the debt zombies alive, therefore, is just one more deformation that flows from the Fed’s financial repression policies.
Clear Channel Communications: Debt Zombie on a “Stick” – In May 2008 Bain Capital and Thomas Lee saw fit to pay fourteen times operating income for a company that was the communications industry equivalent of the proverbial buggy-whip maker. Clear Channel Communications, in fact, had been a speculator par excellence in the humble business of owning what were called radio “sticks,” or FCC licenses, to operate AM and FM stations.
By the time of it $23 billion LBO, it owned 850 radio stations, and it could not be gainsaid that radio stations were profitable. During 2007 Clear Channel had generated about $1.6 billion of operating income, a figure which amounted to a healthy 24.1 percent of its $6.8 billion in net revenues.
Thus, the deal sponsors did not hesitate to pile on the debt, pushing the company’s borrowings from $5 billion to $20 billion in order to fund an $18 billion payday for the current stockholders. This massive debt load was readily raised, however, because radio “sticks” were a favored offspring of the Greenspan bubble era.
Due to abundant and increasingly cheaper debt financing, LBO operators large and small had driven the value of radio sticks steadily higher, from less than $8 per pop (population served) to nearly $20 per pop at the peak in 2007-2008. At that point deals were being valued not on their operating income, but on their resale value; that is, based on stick flipping.
Accordingly, Clear Channel’s $23 billion LBO reflected the trading value of its massive collection of sticks and billboards, not the company’s operating income which had increased at only a prosaic 4.5 percent rate during the four years ending in 2007, and even much of that was due to acquisitions. The magic value gains of radio sticks, however, rested on a double helping of bubble finance; that is, consumer advertising growth and cheap debt.
Radio advertising revenue grew moderately during the bubble era because the heaviest advertises—auto dealers, home builders, restaurants, and bars—were the beneficiaries of the housing boom and consumer spending obtained from their home ATM machines. In effect, valuations rose because consumers were spending borrowed money which fueled radio station advertising and cash flow. And then, cheap financing for leveraged radio deals caused stick valuation multiples to be bid up even further.
Needless to say, the music stopped in September 2008. Radio advertising has not recovered from the sharp decline triggered by the violent collapse of the auto and housing industries. And now radio operators are also confronted with gale-force headwinds owing to the migration of advertising dollars from broadcast to the Internet, and to competition from alternate technologies such as Internet radio (e.g., Pandora).
Not surprisingly, Clear Channel’s financial results have headed irrevocably southward. During fiscal 2011 its revenues were still 10 percent below 2007 levels, but, more importantly, the fat profit margins which once reflected the state-bestowed gift of scarce radio spectrum are now beginning to rapidly erode in the face of genuine free enterprise competition.
Thus, by 2011 Clear Channel’s historic 24 percent operating margin had diminished to just 16 percent. Consequently, the double whammy of lower revenues and rapidly weakening margins has taken a huge bite out of operating income. In fact, its 2011 figure of just $1 billion was down nearly 40 percent from the pre-LBO total of $1.65 billion reported in 2007.
So its $2 billion annual interest bill is now double its operating income, meaning that the game of “extend and pretend” is getting increasingly dicey. The company is now leveraged at twenty times its operating income, yet faces a huge debt maturity cliff in the immediate future: $4 billion is due in 2014 and another $12 billion of debt must be repaid in 2016. Yet by then advertising revenues will be in deep secular decline due to competitive venues, and the value of its “sticks’”will be vaporizing. The digital technology revolution is, in fact, turning the company’s portfolio of FCC licenses into the world’s largest collection of buggy whips.
Bernanke’s (Untough) Love Child: The $27 Billion Affair At the Hilton”
(ALL THE COMPANIES NAMED HERE ARE IN PRIVATE EQUITY—KKR, BLACKSTONE, APOLLO, TPG AND BAIN CAPITAL AND MR. STOCKMAN CALLS THEM DEBT ZOMBIES BECAUSE OF THE FACT THAT EVEN TODAY, THEY ARE CARRYING ON BUSINESS AS USUAL, USING HUGE AMOUNTS OF LEVERALGE AND RISKY JUNK BONDS AND EVEN RISKIER UNREGULATED, TOXIC DERIVATIVES. THIS IS ALL DONE UNDER THE DISGUISE OF THE NEW “SHADOW BANKING SYSTEM” THAT TOOK OVER AFTER THE LEHMAN BROTHERS DISASTER AND OTHER SERIOUS PROBLEMS IN AGRICULTURE, SUCH AS MF GLOBAL, WHICH CREATED A WORLDWIDE CREDIT PROBLEM, CONCERNING MISSING MONEY AND PROLBEMS WITH FUTURES TRADERS. A NEWER AND ONGOING PROBLEM IS JAMIE DIMON OF JPMORGAN CHASE COMING UP WITH OVER $6 BILLION IN MISSING MONEY AND HIS FIRM, AS WELL AS BANK OF AMERICA, ARE GETTING CONSTANTLY FINED. NOW, THESE PROBLEMS WEREN’T SUPPOSED TO HAPPEN BECAUSE THE DEMOCRATS PUT IN SOME NEW REGULATIONS, SUCH AS THE DODD-FRANK BILL BUT THE BIG INVESTMENT BANKERS GOT AROUND THAT ONE WITH THE NEW SHADOW BANKING THAT DOESN’T FOLLOW ANY RULES AND I HEAR THE NEWEST AMOUNT THE HEDGE FUNDS AND PRIVATE EQUITY FIGURES ON THE DERIVAITIVES THEY ARE PROMOTING, HAS RISEN TO AN ASTOUNDING FIGURE, WHICH COULD BE AS HIGH AS $1.2 QUADRILLION. SO YOU CAN EASY SEE WHY THE AUTHOR CALLS ALL THESE COMING BANKRUPTCIES “DEBT ZOMBIES.”
LaVern Isely, Overtaxed Independent Middle Class Taxpayer & Public Citizen & AARP Members