Is that a mea culpa I read from Michael Milken?
Not on the face of it. Mr Milken, pioneer of high-yield bonds and early backer of leveraged buy-outs, insists in an article in today’s FT that the old principles of financial markets still obtain, despite the upheavals of the past year:
Properly applied and regulated, the market innovations of the 1970s disperse risk and create jobs. The disruption of the past two years was caused by other factors, including unrealistic ratings that failed to reflect underlying credit risk, government encouragement of questionable investments, flawed underwriting practices and deployment of excessive leverage by financial managers who did not see the need for credit research.
Still, he acknowledges that companies can get over-leveraged at the peak of financial cycles and the ratio of debt to equity can affect a company’s value (despite Modigliani and Miller‘s 1958 academic work which held that the value of a firm was independent of its capital structure):
. . . But markets’ future health requires investors to avoid errors that prolong and deepen global downturns. These include inaccurate assumptions that loans against real estate are high-quality assets, interest-rate movements can be predicted, capital structure has little effect on a company’s value, emerging-market sovereign debt is without risk and high leverage is best for maximising profit.
An example of the way in which over-leverage can have unpleasant consequences is reported in detail in today’s New York Times. It describes the likely bankruptcy of the Simmons Bedding Company after it was bought by Thomas H. Lee Partners, the buyout firm in 2003.
The NYT article is light on the competitive pressures behind the company’s problems and implies that all of its ills were to do with the rapaciousness of private equity, which I am not sure I believe. Incidentally, David Carr, an NYT columnist, also has a blast at private equity in his column this morning.
That said, Simmons does appear to be one of the companies that were over-leveraged at the peak of the cycle by private equity firms, which added debt to companies they already owned to finance dividend payouts to the equity holders.
That is one reason why, as this FT article this morning notes, private equity companies are finding it hard to raise debt from banks to take part in new acquisitions.
Even Michael Milken thinks that financial leverage can be taken too far.