Belly Flops

EMI represents one of the biggest private equity losses ever, and it shares some interesting traits with previous big equity wipe-outs.

During the October New York court trial in which Guy Hands attempted to sue bankers at Citi for allegedly duping him into buying EMI, the Terra Firma boss had a pensive moment on the witness stand. He mused sadly that the loss of EMI would mean huge losses for the investors in two Terra Firm funds. He ended these remarks by saying, cryptically, “But all that’s passed now,” and adding nothing further.

Perhaps Hands knew, three months before Citi seized control of the music giant, that the equity in EMI had a snowball’s chance in hell of surviving. The veteran investor had certainly used every trick in the book to preserve Terra Firma’s optionality in EMI, including drastically reworking the company’s operations, injecting in further millions and, in a gambit rarely seen in private investing, suing his bankers.

Unfortunately EMI’s debt load and operating problems conspired to squeeze Terra Firma’s roughly $2.8 billion in equity into nothingness, making it among the largest private equity losses in history. Today Citi accounted that it was taking over 100 percent of EMI’s equity.

Over the last few years, a number of otherwise highly regarded private equity firms have charged into high-profile deals only to come out bruised, humbled and much lighter in the wallet (see table below). The EMI loss brings to mind Forstmann Little’s early-2000s losses in XO Communications and McLeodUSA, two “competitive local exchange carriers” (CLECs) that swallowed up some $2.675 billion in Forstmann Little capital and ultimately brought down what was once among the largest and most prestigious private equity firms.

Every unhappy deal is unhappy in its own way, and yet as one casts an eye across the list of belly flops below, recurring themes emerge:

Great-man risk: The investment committees of private equity firms are supposed to jointly agree on which deals to pursue and which deals to pass on. And yet sometimes firm founders exert an outsized influence over this process because, well, it’s their firm, dammit. Ted Forstmann reportedly overestimated the quality of the CLEC opportunities because he saw an opportunity to become something like the Vanderbilt of broadband. Guy Hands was personally excited about the prospect of revolutionizing the music industry and sank a good deal of his personal fortune into the EMI deal. David Bonderman once sat on the board of Washington Mutual and presumably believed he had insights into the foundering bank that gave TPG a competitive advantage in its resuscitation. If there were partners at these three firms who believed these deals were off-strategy and/or risky, they failed to convince the founders of this. It is important for investors to understand the rules and culture of investment committees before they commit to a fund, because while the involvement of brilliant founders has a clear upside, a lack of checks and balances on these charismatic Great Men poses clear downside risk.

Trophy assets: One can’t help but see in EMI and, before it, MGM somewhat of a clamor for prestige at play. These are high-profile companies that bestow upon their owners a cultural influence and participation that is, frankly, a lot more fun than merely being the head of a private equity firm. The cultural trophy that was Tribune Company was certainly a draw for Sam Zell, whose hometown is Chicago. Finance guys becoming the owners of sports teams has rarely resulted in financial glory. For Terra Firma, EMI was a departure from the kinds of infrastructure-like deals that made the firm a huge success. It might be said that the investors behind MGM were media specialists, but Providence Equity, for example, built its reputation more on telecommunications deals, not content. There are no movie galas and Oscar parties in the satellite-services sector.

Buying the dip: A number of these deals were conceived of as opportunistic rescues of fallen companies. The presumptions were: CD and DVD sales are down – let’s buy the companies and watch sales come back. Home and commercial loans are souring – let’s buy in now and ride the recovery. But these were companies about to be rent asunder by seismic economic shifts, and the “dips” turned out to be mid-way down to the Valley of Death. There was a double-down mentality with some of these deals that brings to mind a guy at the Blackjack table about to visit the nearest ATM.

Black swans: Sometimes the past is not a good predictor of the future. Real estate prices had not fallen beyond a certain range in modern times. Aluminum (Aleris’s product) was not expected to fall beyond a certain price level. CD sales surely were not going to melt like an ice cube. The trouble with black swan events is that the most sophisticated, research-driven people tend to fall victim to them. They know better than anyone the history of certain business trends and project this knowledge expertly into the future.

Vaporized: A Comparison of Recent Notable Private Equity Losses