Money Stuff: Everyone Wants Debt, Not Equity

Two stylized facts about contemporary financial markets are:

1. Private equity funds are having a hard time selling companies. The markets for mergers and for initial public offerings are choppy, and it is harder than usual to bring private equity portfolio companies back to the public markets. A private equity fund is supposed to hold a company for a limited period, then sell it and return cash to its investors; now, though, it is harder than usual to sell the companies, and the investors are anxious to get their money back. Private equity owners have been reduced to selling portfolio companies to each other, or selling them to themselves (a “continuation fund”), or giving philosophical disquisitions about how actually they’re Berkshire Hathaway and want to hold companies indefinitely. 
2. Private credit firms are having an unbelievably easy time raising money, there is a huge rush to private credit, and the only real problem is how to deploy all of the cash in the private credit funds.

One way to jointly describe these facts might be “there is high demand for risky debt and lower demand for risky equity.” Or as Steve Schwarzman — the founder of a private equity firm that is increasingly a private credit firm — once put it: “If you can earn 12 per cent, maybe 13 per cent on a really good day in senior secured bank debt, what else do you want to do in life?”

The obvious synthesis of these two facts is “the private equity funds should sell their companies to the private credit funds.” That is not quite technically correct — private credit funds are supposed to make loans, not own companies — but you can get arbitrarily close. Just have the portfolio companies borrow lots of money and give it to the private equity owners as a dividend. Lenders often try to limit highly leveraged companies from paying their owners big dividends, but if the company is in good shape it’s probably fine, and anyway the point here is that the private equity owners want to get money and the private credit lenders want to deploy money, so there is a mutually beneficial trade. Bloomberg’s Claire Ruckin reports:

As buyout funds struggle to sell businesses in a moribund M&A market — not helped by President Donald Trump’s tariff gyrations — many are turning to cash-rich credit investors for money to pay dividends to themselves and their backers. A few are getting back as much as they first invested, if not more, in effect leaving them with little or no equity in some of their biggest companies.

Already this year, more than 20 businesses in the US and Europe have borrowed to make payouts to their owners, according to Bloomberg-compiled data, meaning they’ve less financial “skin in the game” if things ever go sour.

Car battery maker Clarios International Inc. raised debt to pay a $4.5 billion dividend to its buyout-fund backers, one of the largest such payouts on record. That paid for a distribution to investors, including Brookfield Asset Management Ltd. and Caisse de Depot et Placement du Quebec, letting them take the equivalent of 1.5 times their equity out of the deal, according to people familiar with the matter who asked not to be identified because the deal is private. …

These “dividend recap” deals are proving attractive to lenders, who are desperate to deploy cash, and some senior bankers say they’re a valuable way to rework the finances of stronger companies when public markets are constrained. Clarios, for example, had lifted earnings, and paid down $1.6 billion of debt over its past three fiscal years, a person with knowledge said. …

“In the absence of an exit via a sale, it’s no wonder PE sponsors are looking to leverage market dynamics to return capital to investors through further borrowings,” said Sabrina Fox of Fox Legal Training, a leveraged finance expert. “The question is whether capital structures can tolerate the additional leverage. Absent a shock to the system, perhaps some can. But we’re by no means guaranteed no shocks to the system.”

I’m being a little too cute; actually these companies often raise money in the regular public credit markets, not from private credit. (Clarios did leveraged loans and high-yield bonds.) But the basic dynamic of “it’s easier to sell debt than equity at prices you like” seems to be true in many cases. “Whether capital structures can tolerate the additional leverage” is partly a question of capital structures and cash flows, but it is also a question of market demand: If people really want to lend you money, you will want to take it.

A simple model of long/short equity hedge funds is that there are some stocks that you should be long (the ones that will go up), and other stocks that you should be short (the ones that will go down), and hedge funds are engaged in a scientific quest to find them. The hedge funds are good at this, but the quest is hard, and each hedge fund analyst can only find one or two stocks, and each hedge fund only employs so many analysts. It makes sense to specialize, and trade: I work very hard to find one stock that will go up, and my buddy at another hedge fund works very hard to find another stock that will go up, and I call her and say “I found one” and she says “me too” and we swap names. I buy both stocks, she buys both stocks, they both go up, and we are both happy.

This model is quite obviously oversimplified in various ways, among them:

• In fact, I have some incentive to keep my trades secret, because if everyone knows the stocks that will go up they will have already gone up. I can only make money by knowing the good stocks that everyone else doesn’t know about. (If I buy my whole position first and think there’s still room for the stock to run, I can share it with my buddy.)
• Conversely, in the real world, “stocks that will go up” is not a natural category that can be discovered by science. Stocks go up because people buy them, frequently specifically because big hedge funds buy them, so when I share my stock picks with my buddy the point is not just “I have made a discovery that I would like to share with you” but also “please buy my bag so it goes up.”
• To the extent all the hedge funds buy all the same stocks — because they independently use similar correct scientific methods to discover the good stocks, or because they all tell each other what they’re buying and buy the same stuff — that is generally viewed as undesirable “herding” or “crowding” and increases risk. (If one of the good stocks turns out to be bad, they all have to sell it at the same time, exacerbating their losses.)
• The hedge funds’ clients are paying them big fees for something — for their special skills, for uncorrelated returns — and would be annoyed if they were all sharing their work and doing the same trades.

And yet there is clearly something to it, and a certain amount of the hedge fund industry is organized around hedge fund investors sharing their work in ways that are not, like, embarrassing. Everyone is aware that there is some list of stocks that “all the hedge funds own.” There are “idea dinners” and conferences where hedge fund managers share their favorite picks with one another. One model of sell-side equity research is that it is a way to coordinate buy-side consensus: The research analyst talks to all the hedge fund analysts, and they tell her what they think about the stock, and her published research notes reflect their views.

Anyway here’s a Y Combinator startup:

Trata gives hedge funds un-biased, unfiltered stock analysis from anonymous Analysts at well-known funds. Our AI agents interview Analysts at multi-billion dollar funds, capture their thinking about the stocks they know and publish it anonymously. …

It takes buyside Analysts at least 3 hours to figure out a company’s key narratives/points of debate - what outcomes are going to drive the share price up OR down? Examples: an ongoing lawsuit, a competitor going bankrupt, an Activist campaign, a new CEO, etc. This involves reading earnings call transcripts, initiation reports, talking to Investor Relations, reaching out to other Analysts, and piecing everything together yourself.

Because of the time it takes to do step 1, would-be winners/inflection points fall through the cracks all the time.

Current solutions (idea dinners, forums like Value Investors Club, Twitter DMs, independent research boutiques and even paid Substacks) are fragmented and biased.

The highest quality leads come from talking directly to fellow Analysts, but there’s never been a way to do this at scale, authentically. Until now.

Apparently the way to do it is to have a robot talk to all the analyst buddies and then summarize their views.

Last year, TD Bank NA paid $3.1 billion in fines for allowing criminals to launder money. We talked about it at the time, and I emphasized the essentially probabilistic nature of anti-money-laundering work. Every big bank is probably used by criminals to launder money every now and then. They don’t all get in trouble. Prosecutors expect banks to try to stop money laundering, to try hard, to take at least industry-standard steps to catch money launderers. What gets you in trouble is not the money laundering, but cutting corners on your efforts to prevent money laundering. (Not legal advice!)

In TD’s case this was very explicit: In announcing the charges, prosecutors made a lot of the fact that TD was trying to save money by spending less on anti-money-laundering procedures. The prosecutors did not like that. I wrote:

One job of a bank is to stop crime, which means that banks employ thousands of people who essentially work for the US Department of Justice. But the Department of Justice has no direct control over how many of those people there are, how much they get paid or what resources they have. Law enforcement agencies cannot directly set the banks’ budgets for anti-money-laundering programs, even though those budgets really are part of law enforcement. It is, perhaps, a frustrating situation: The Justice Department would like banks to spend more money catching criminals, and it can’t quite make them.

Except obviously it can. The Justice Department can’t directly set banks’ AML budgets, but it can do it indirectly, and it just did.

So one view of the TD Bank situation is that it was essentially a budgeting problem: TD Bank got in trouble for not spending as much on AML as the Justice Department wanted.

But here is a Bloomberg News deep dive on “How TD Became America’s Most Convenient Bank for Money Launderers” that suggests that it was also partly a software design problem. One prolific money launderer, Da Ying “David” Sze, was laundering so much money through TD that he had a bunch of associates set up accounts in their names, to avoid drawing too much attention to himself. And then he’d go to the bank himself to deposit bags of cash into their accounts.

This is a common enough approach that banks are required to keep track and report the person who actually makes a large cash deposit. If you go into a bank to deposit tens of thousands of dollars, the teller will ask you for identification, and she will pull up a form on her computer, and there will be fields for “depositor name” and “account holder name,” and if they don’t match — if your name is not the name on the account — then that might generate a report or a red flag for someone at the bank. (Particularly if your name appears on lots of these forms because you are regularly making large deposits to other people’s accounts.) But since most deposits are made by the account holder, it would be inconvenient for the teller to fill in both of those fields every time. So:

However, the software TD used to generate its currency transaction reports automatically filled in the name of the account holder as the person conducting the transaction. Tellers could update the field with the correct information, but investigators found that in Sze’s case they’d failed to do so more than 500 times. The investigators concluded that, while much of this owed to poor training, Sze also occasionally bribed TD tellers with gift cards to keep the operation running smoothly—sometimes $25 for Starbucks or Whole Foods, according to a person familiar with the matter.

Defaults matter, and if the software automatically fills in “no compliance problem here,” it will miss a lot of compliance problems. 

The Financial Times has a heartwarming story about a guy who has worked at the same company for 25 years, where he has been treated well, made a lot of friends, earned the respect of his peers and made a decent living. His hard work got noticed more broadly, though, and another, fancier, more aggressive company tried to recruit him by “offering life-changing money.” But he really liked his job and didn’t want to leave, so he sat down with his mentor and asked him for advice. The mentor said well, look, obviously we can’t match the money. I’ll see if we can find a little extra money for you in the budget, but we can’t really compete on money. But you like it here, and we like you, and you have a bright future with us, and there are things that are more important than money. This company is like a family, and you can’t buy the feeling of being part of a family.

I mean that’s a roughly accurate summary, though the guy is John Waldron, the company he works for is Goldman Sachs Group Inc., and he makes $30 million a year:

Waldron, Goldman Sachs’ president and chief operating officer, had been approached by Apollo Global Management about a senior job offering life-changing money, even when set against the $30mn he earned the preceding year.

The investment firm was dangling a remuneration package that, over the course of a few years, would be worth several hundred million dollars and could even reach half a billion, according to people familiar with the matter. 

Waldron, 56, informed his boss David Solomon, 63. The two men had known each other for decades and risen in tandem to occupy the bank’s top two jobs. People who have worked with them describe their relationship as almost fraternal, with Solomon the protective elder brother.

It was no secret that Waldron hoped to succeed Solomon one day running Goldman. But privately, some who were aware of the talks with Apollo thought Waldron would be mad not to pursue such a lucrative opportunity, especially given Wall Street’s graveyard of unfulfilled CEO-hopefuls. 

Ultimately, Waldron stayed at Goldman and was rewarded with an $80mn five-year retention bonus — still a fraction of what he stood to earn at Apollo — along with a board seat and expanded personal use of the bank’s private plane. 

Disclosure, I used to work at Goldman and, uh, I left, but I knew some Goldman lifers [1] and I kind of get it? You build up a lot of reputational capital and institutional knowledge in 25 years running various businesses at Goldman; you’re on a bunch of committees with your long-time friends. You move to Apollo and you’re on an entirely new set of committees with strangers, you don’t know the culture, you don’t know the politics, you don’t know who has bodies buried where. These firms used to be clubby partnerships, and they’re not anymore, but at the highest levels they might sometimes feel a little like that, and why leave your clubby partnership just for money? Also come on the money is fine.

Anyway the story is about how Waldron seems to be Solomon’s heir apparent, which has some downsides for Goldman, because a vicious drawn-out succession battle is actually the way you retain ambitious senior bankers:

“This is not the horse race that they had [two years ago] at Morgan Stanley. This is not ‘who is going to follow Jamie Dimon at JPMorgan?’” says [analyst Mike] Mayo. “The real question is how they placate other top executives at Goldman Sachs since succession seems so clear.”

Also a small anecdote. When I was at Goldman, I was a vice president, along with almost everybody else: “Vice president” is a title that banks give out widely to fairly junior bankers. I always assumed that this is a matter of client reassurance: At many companies, “vice president” is a quite senior title, and so when some 28-year-old banker comes in to meet with a manufacturer’s chief financial officer, the CFO will be impressed to learn that the banker is the vice president of Goldman Sachs. (Shh, a vice president of Goldman Sachs.) Sounds fancy! I don’t know that this really works — everyone understands that VPs are pretty junior — but it doesn’t hurt. What about “president”? Also good:

Waldron has previously talked about delineating between his COO role, where he gets into the weeds of Goldman’s operations, and his president title, which comes into play with clients, governments and regulators. “They like the title of president,” he said on a 2019 podcast.

“COO” is a title that describes what he does at Goldman, but “president” is what he tells clients so that they are impressed.

I wrote last month about a thing I have never understood about X, the social media company that was known as Twitter Inc. until Elon Musk bought it in 2022. When Musk bought Twitter, he paid $44 billion or so for all of its stock. He borrowed $12 billion or so to pay for it, with the remaining $32 billion coming from his and his friends’ equity investments. Therefore Twitter’s equity value was nominally about $44 billion the day before the deal closed, and about $32 billion the day after: Its enterprise value remained the same, but it was more leveraged.

But of course Twitter’s value had actually deteriorated, and its enterprise value wasn’t really $44 billion. And there were soon reports about Musk’s co-investors writing down the value of their stakes. And I never understood those reports, because I could never tell what the baseline was. Like, if you read a story like “Fidelity marks down Twitter by 50%,” did that mean that Fidelity thought the enterprise value was $22 billion (implying $9 billion of equity value, a 72% markdown to the equity), or that the equity value was $16 billion (implying a $28 billion enterprise value, a 36% loss in value)? 

Anyway here’s an answer of sorts: X is doing a financing round and is back to where it started. Bloomberg News puts it this way:

Elon Musk’s social network X has raised close to $1 billion in new equity from investors in a deal that values the company at roughly $32 billion, according to people with knowledge of the matter — a valuation in line with when Musk took it private in 2022.

Musk himself participated in the equity raise, said some of the people, all of whom asked not to be identified discussing private information. The company is considering using some of the proceeds to pay down its remaining debt load, one of the people said.

And the Financial Times puts it this way:

Investors valued the platform at $44bn in a so-called secondary deal earlier this month, in which they exchange existing stakes in the company, according to two people with knowledge of the matter. …

The new $44bn valuation represents a rebound for Musk and the group’s investors, including Andreessen Horowitz, Sequoia Capital, 8VC, Goanna Capital and Fidelity Investments.

So, $44 billion enterprise value, $32 billion equity value, back to where it started.

The rule is that if a public company is doing a securities offering and it puts out “any written communication … that constitutes an offer to sell” those securities, then it has to file it with the US Securities and Exchange Commission and put a legend on it saying in essence “read the prospectus.” (This is called a “free writing prospectus.”) In a world of, you know, public company chief executive officers doing coy weird tweets to sell stock, the filings get weird.

I wrote yesterday about an offering of “perpetual strife preferred stock” by MicroStrategy Inc. (which now calls itself Strategy), whose salient feature is, you know, it’s called “perpetual strife preferred stock.” “I assume it’s the obvious parsing,” I wrote: “If you buy this preferred stock you will constantly be engaged in bitter struggle and conflict.” Here though is a Strategy securities filing, which is also a tweet, which … “explains the name” would probably overstate the situation, but anyway it says:

“When a nation is filled with strife, then do patriots flourish.” Lao Tzu on $STRF.

Okay sure. As a factual matter I am not sure that Lao Tzu was talking about Strategy’s Series A Perpetual Strife Preferred Stock when he said that, in part because it was announced yesterday and he died 2,500 years ago, but I am slowly letting go of the notion that everything, or anything, is securities fraud. Certainly it cleared things up for me a tiny bit.

I wrote yesterday about a proposal from the No Dumb Ideas newsletter to launch an exchange-traded fund to buy lottery tickets. Naturally there was some reader feedback. I should mention two particular points. [2]

First, I assumed that the expected value of, say, a $100 million lottery jackpot is considerably less than $100 million — on the order of one-third of the stated amount — because (1) if you take the payment as a lump sum you get less than the stated amount and (2) taxes. A reader pointed out that actually the jackpot-style lotteries have a lot of smaller non-jackpot prizes (you win the jackpot for matching all the numbers, but you get some money for matching some of the numbers), and if you manage to play every number you will win a lot of those. So the expected value is better than I estimated, though still lower than the face amount of the jackpot.

Second, a reader emailed that “the clear natural conclusion of lottery financial engineering” is lottery collateralized debt obligation, where senior tranches get paid back first and more junior tranches take more risk. He writes (slightly edited):

Senior tranches have their return paid by the higher probability / lower lower return prizes.

Mezz by the medium risk / reward prizes.

Equity banking on the jackpot.

Since Moody’s CDO approach is driven by Monte Carlo probability analysis, it's possible in theory to derive the Moody’s tranche attachment points for a given lottery game structure / pool size. I did this exercise for fun a few years ago for a particularly large Powerball jackpot and then market rates.

I forget what the breakeven pool size had to be for the equity arb to work, but it wasn’t completely absurd! In reality, two month AAA lottery paper might be a tough sell, but maybe one day.

What I said yesterday was: “Why shouldn’t all the technology of finance be applied to emerging asset classes like gambling?” Sure, all of it.

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