Another Inconvenient Truth

graphics failed acquisitionsOur two Foreign Exchange students (sisters – 1 year each) came from Culiacan Mexico.  Their father Humberto, was a Sinaloa legislator with a sweet demeanor and sharp mind.  He liked to argue.

My most memorable discussions with Humberto put me on the wrong side of  arguments over American Exceptionalism.  10 years later, I must agree that a core problem impacting everything from schools to public health is how we are giving away the very heart and soul of our nation each time a Bain Capital buys another outgrown American Family business.

Humberto’s argument was that American Capitalism had shifted from businesses founded by real people, delivering real products and important services, to large capital organizations that absolutely do not care about the people, products, or services being delivered by the entities that are acquired.

I argued with Humberto that the Warren Buffets of our world really did care about these things.  Humberto challenged me to name names.  How many Warren Buffets can you give me?  His position was that Mitt Romney, junk bonds, and Bain Capital were the driving force in American Capitalism today and not Warren Buffet.

The article that follows is concise and powerful and has clarified the tortured thoughts that man has visited upon me.

How to get beyond the parasite economy

It is the middle of the night between Friday and Saturday, and I am thinking about Guitar Center.

parasite economyIf the above sentence appears strange to you, we are in the same boat. I do not know how bizarre and random your life appears to you, but mine is definitely some sort of mysterious fractal. About four months ago, I was elected by the Internet to the position of United Nations Ambassador to Guitar Center. I made a simple, off hand comment about how I was surprised that the company was doing poorly despite all of the gear I bought there, and then the two separate streams of my life – music and business analysis – slammed together. Thousands of people began conflating my life as a somewhat decent bassist with my expertise in strategic forecasting. Now, with every development in the musical instrument industry, I have a flurry of emails and phonecalls from all levels of the business. It is surprising, fun, and as I now discover, significant of a much larger story.

I never paid too much attention to the musical instrument (MI) business in my profession of strategic analysis; it simply does not represent enough cash flow to have significance in national economies. For example, the global MI industry is around $13 billion a year. I used to do high-level analysis of the market for antipsychotic medication, something most people know nothing about, which has the same annual sales revenue in the US alone. My only interest in musical instruments was for pleasure, so when I was suddenly elected The People’s Analyst of the Industry, (current salary: $0) I had a lot of catching up to do.

After much deliberation, I see the MI industry as a microcosm of every other problem in the global economy. To borrow from the analysis of Thomas Piketty in his brilliant “Capital in the 21st Century,” the monied interests of society have expanded their reach such that they can concentrate and dominate almost every area of human endeavor, and the deleterious effects are now evident to all.

In the end, this story isn’t about a big box music chain, but how a small number of citizens can subvert every product made, every job offered, and every purchase decision – and how we can regain control of our lives, starting with the musical instrument industry.

News on Guitar Center’s finances – and what it means

If you are a regular reader you know that I have been keeping close tabs on the finances of the Westlake, CA-based retail behemoth. Had their executives never made visits to my Facebook page, I never would have thought that it was worth any research, but my experience is that if you see unusually emotional behavior from technocrats, a bigger story lurks. Confirming my instincts, a perfunctory analysis of the company’s finances showed gargantuan debt structure and a liquidity crisis (also known as being broke.) Because the company is/was owned by a holding company created by private equity firm Bain Capital, it was impossible for me to deduce exactly the structure of their ownership and debt covenants. To summarize the story for those who don’t have a taste for corporate finance, just imagine you had $65,000 in credit card debt financed at a crappy rate, and that you made around $80,000 a year. Things on the horizon would look bleak, and you would be forced to either change your lifestyle or declare bankruptcy and get a fresh start. As such, irrespective of the contradictions inherent in the big box model and the general draining of wealth from their supposed middle class customers, I figured that these guys would be lucky to make it a few more months.

The other shoe dropped a few weeks back when the main holder of Guitar Center’s debt, Ares Capital Management, stepped up to take ownership in place of future bond payments. The business media reports this arrangement as an alternative to bankruptcy, which sounds about right. I expected as much, because this model is in a slow death spiral, and the only way to extract the millions of dollars owed will be to run the Bain playbook, only harder and faster. As such, my forecast is for the $500 – 600 million of inventory to be sold at cheap prices while employees and vendors get squeezed for every nickel. This is no different than the past six years of company management, according to my sources, it’s just that this time, there is a time-sensitive goal – to get the most money out before the whole thing collapses.

The latest update: More details about the Bain-Ares handoff came out around 48 hours ago. They revolve, unsurprisingly, around a restructuring of senior PIK (payment in kind) notes that offered money up front with huge balloon payments on the back end. Under the current deals, GC would owe over $950 million in 2017 alone, an amount that would be impossible to pay off. I was skeptical about any form of refinancing, since the ratings agencies have compared their debt to scratchers tickets. But Ares is charging ahead and is preparing a bond offering to the market despite all the hullaboo:

Westlake Village, Calif.-based Guitar Center is further revamping its capital structure by launching an offering of $940 million in senior notes that will be used to repay debt connected to its buyout.

The proposed offering will include $615 million in senior secured first-lien notes, which Taylor said she expects will price around 6%, as well as $325 million in senior unsecured notes, which Taylor expects will price around 8%.

Moody’s rated the proposed secured notes at B3 and proposed unsecured notes at Caa1 in a March 25 report.

Guitar Center would use the proceeds from the notes offering to repay a $675 million term loan that backed its Bain buyout. The term loan, which is priced at Libor plus 600 basis points and matures on April 9, 2017, had $617.5 million outstanding at Sept. 30, according to a regulatory filing.

Guitar Center would also repay a portion of its $375 million in 11.5% senior unsecured notes due Oct. 15, 2017.

So Moody’s is still calling GC’s debt “subprime,” for those of you who remember that term from a little financial crisis a few years back – but that doesn’t mean that it won’t find a buyer. In fact today I saw news of GC’s bond issuance tucked in between some other deals from an online publication that follows the corporate bond market for traders:

Guitar Center’s two tranches followed suit. The 6.5% secured notes due 2019 and 9.625% unsecured notes due 2020 were both pegged at 98.5/99 this morning, from 98.9 at offer apiece, according to sources. Bank of America led the bookrunner quartet, with issuance under Rule 144A for life. As reported, the deal is part of a broad recapitalization effort whereby vintage-2007 buyout loans and some bonds held by Ares Management are repaid in full, a portion of cash-pay opco bonds are swapped into equity, and all holdco PIK notes are swapped into holdco equity.

Then, it hit me. I think I threw my head back and laughed. Chances are, Ares Capital Management will find buyers for Guitar Center debt at 6 – 9% interest, because for financiers today, higher risk just means higher returns, not actual risk –  just like back in the mid-2000s. Because of wealth concentrated in the financial sector, the dynamic is almost identical to what destroyed the mortgage market: Complexity obfuscated the true risk of financial instruments, which was being fobbed off onto other parties until the whole thing blew up.

Complexity: the financial structure of this operation seems absurdly complex given their business of selling guitar amps. To truly understand the structure of the Guitar Center business, I have had to consult professionals with a much deeper expertise – CEOs, CFOs, people with masters degrees in finance. Almost every one has looked at various details of the company and said, “That’s a pink zebra right there,” or, “Wow, I’ve maybe heard of that kind of thing one other time.” To understand some of their SEC filings, I had to drag up papers from the finance department of the Wharton School of Business. When you look up the corporate structure from which Bain Capital invested in Guitar Center, you find it (as of 2009) located as 3.34% of a billion-dollar investment corporation based offshore in the Cayman Islands, wedged into a financial partnership structure with a dozen other corporations.

In my experience, complexity of this sort is meant to keep casual analysts, regulators and journalists guessing – not unlike what we saw with the mortgage market eight years ago. And just so I had a good active comparator, I pulled the annual report for ExxonMobil, a company with a $290 billion market cap. Compared to GC, its filings are a relative oasis of simplicity and clarity, with the whole business laid out and finances making basic sense without enormous leaps of logic. Then again, it’s easier when you’re profitable.

Risk: None of the guys behind this deal have what Nassim Nicholas Taleb calls “skin in the game.” Nobody making decisions will lose their family fortune if it goes badly, and everybody in management stands to make substantial fees, bonuses and salaries. You see, Guitar Center used to be a musical instrument company, but now it is just one more imperial outpost for the spare financial capital of the top 0.1% of the population. For the people now supplying GC with liquidity, risk is a tool for cash flow, not a concern for survival.

When I recognized how much the financial markets have become like 2006, I finally figured out why some other financier could shell out $50 or $100 or $300 million for Guitar Center junk bonds.  For the customers of private equity, a few million isn’t that much money. These investors actually need some higher-risk assets in their portfolio, rather than let their money sit around in a zero-interest rate environment. They might be like Warren Buffett and already have huge stakes in sensible things like Too-Big-To-Fail banks, railroads or Coca-Cola. This just rounds out their overall position. Make 6-9% with the chance that the company could finally go tits-up? Why not! If it pays out, then great, and if it doesn’t – tax write off!

  • This is absolutely one of the best things I’ve read this year and I’m thrilled it’s going viral. People need to understand this. How could even Republicans think an economic parasite like Mitt Romney was morally fit for office?

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      Because the Republicans support the policies that make this kind of thing possible: de-regulation, privatization, cutting the budgets of federal agencies that oversee business, tax cuts for the wealthy, and welfare cutbacks for the poor.
      As far as the Republicans are concerned, what Romney did to Guitar Center is what they want to see happen everywhere.
      (Yeah I know your question was rhetorical. But I felt like chiming in anyway.)

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    I’ve read a lot about PE firms buying solvent co’s, saddling them with debt, sucking them dry and bankrupting them. What I’ve never seen described is the exact mechanics that make this work. In particular: How do they get people to buy the debt? It seems like if people know the game plan, they know the debt is worthless. Even at 10%, the company would need to be paying the interest for quite a while before you could get your principle back plus some non-zero interest. In this specific case, why would Ares fund this? How do they get their money out reliably? They know Bain’s game plan, presumably.

    I’ve read the the tax code makes this workable, and you allude to changes in the tax code being an approach to fixing this, but I’d love to see a concrete (if simplified) example if how this works, and in particular, how does the original creditor not get left holding the bag?

  • Thank you for that. Truly. It’s a whole lot bigger than the MI industry. Just ask Mitt Romney. He knows all about it.
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    In this XXI century world, large corporations are building power above those of any national state. We as consumer shall use our consuming choices as the “new way of voting”. They keep propping our lives to accommodate capitalism goals… so let’s get ourselves informed on corporations and DO NOT consume ANYTHING from parasite corporations. 2cts.

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    Hmm. Boycotts PE firms. Okay. I agree in principle. Please provide a list. And update it daily.

    Alas, If guitar maker companies are anything like power tool manufacturers or organic food producers, then these companies have all long ago been taken over and are in the process of having their brands monetized and goodwill exploited (crapified as Yves says).

    I recall Peavy (just an example) switched to Chinese production a while back. We can assume Gibson and Fender both have been steadily eroding quality in incremental ways, while also creating consumer confusion with their parallel discount lines (surely their ownership long ago passed to corporate raiders).

    A walk through Guitar Center reveals a long line of mostly cosmetic model options and meaningless gadgets, plus an overwhelming array of brands, some of which offer surprisingly inexpensive models ($150 for a guitar? $300 for an amp?!). Key indicator of an industry in the process of crapification.

    How is one to select the pearls from all that swine? How is a casual buyer to know when your favorite old-line or boutique brand has sold out to a PE firm? How is the casual buyer to know that the wood used for that neck is now a little less “choice”, the fingerboard a couple millimeters thinner, the electronics now “lovingly” installed by a suicidal twelve year old Malaysian slave worker? Which one fudged on the kiln time, which one skipped a coat of varnish? Which one devised some way to make the product less robust in as-yet undetectable ways? How is a buyer to know that that Fender amp is cranked out by a firm that doesn’t give a crap if it works or works well, since they only care about marketing. High rates of returns are expected; higher rates of customer malaise and resignation are counted on; who gives a crap: move product, the stuff costs pennies to produce anyway.

    How can I tell which artisan brand is really an artisan brand, which one is in its peak pre-takeover form on the come, which one is now a self cannibalizing PE zombie, and which one is an astroturf fraud from day one?

    Then, having spent scores of hours educating myself about the current state of guitars in order to make a purchase, I must then go home and do the same for power tools, home appliance, food producers, and auto
    makers. Then clothing makers, shoes, computers, stereo, TV, credit card agreements, bicycle, clock radio, mobile phone…

    see more

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    How can the consumer know wether a company is owned by a private equity firm or not ? We need a seal (like Fairtrade coffee) checking to tell me, the average guy, if they are parasites or not; if they pay taxes or not, etc. That or an parasites directory website.

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      I found out about Guitar Center on Wikipedia. I am guessing that they will have this info for most retailers. Bain Capitol even had their own page highlighting their business practices and history. Additionally, just about any ebay retailer or online retailer with less than 3 stores in their market, will be free of this type of corruption. I have found TONS of brand new instruments and gear at ebay that is not even available at GC, and if it were, would most definitely have a mark up in the 60% margin arena. Funny, but when you look at the Bain Capitol listing and see this sentence… “The company, and its actions during its first 15 years, became the subject of political and media scrutiny as a result of co-founder Mitt Romney’s later political career, especially his 2012 presidential campaign” …you know they are BAD NEWS! LOL!

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    So boycott Guitar Center in order to save Musical Instrument Retail? Sadly, GC “IS” Music Instrument Retail. The economies of scale are such that, much like mom and pop record stores, no other business entity is viable. Given the competition from the likes of Amazon/Musicians Friend/Sweetwater (eventually just Amazon of course as the rest simply fold their operations under Amazons umbrella), MI Retail is going to go the way of Big Box Retail in General, which is to say, IT’S GOING AWAY. Guitar Center is simply the last expression of a business model that’s already dead on it’s feet.

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      For the record, Musicians Friend is owned by Guitar Center. As are: Music123, Woodwind and Brasswind, Music & Arts, and Harmony Central.

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      Peel that onion back a bit though and ask why? What you will find is a self-fulfilling process that assures industries are destroyed in the process of being plundered.

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  • You are criticizing the vultures for circling the soon-to-be-dead. The better question is what shitty financial decisions the management of GC did to get themselves so in debt to attract the vultures that now plan its tasty demise.
    Bain and its ilk are the agents of decomposition that will wring the dead of all the money that they can get out of it, and discard the husk in bankruptcy. The real blame lies squarely at GC’s feet – it was their company to lose.

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      It was an LBO (of sorts), that’s where the debt came from. Bain bought GC, but instead of using their own money they borrowed it from Ares. Ares loaned them the money at hefty terms (10+%, and I believe some of the notes are as high as 16%).

      This is a very steretypical case of why LBO’s are bad. The majority of their debt was not from the operating model, but was instead from the financing of the original Bain purchase. Nice, eh?

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        Exactly, the PE firms forces the target to shackle itself with a killing debt load, that is how the transaction is made possible. Then, while the zombie company struggles to make the interest payments, the PE firms and its hired hacks, gut the company from the inside. It is like the lion that runs down its quarry from behind, then sinks its teeth into its spine while splitting open its guts with its hind claws. It’s all over but the crying. Except the PE firms are not lions, they are weasels; scavengers that owe their existence to tax laws.

        Sure, sometimes this works out and a refocused company emerges. But just as often, the end is a foregone conclusion, and is now simply a matter of vultures plucking out the eyeballs.

        In many cases, being a well-run firm with low debt is like having a giant neon sign begging for a hostile takeover.

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      Not true. Resisting PE once it sets its sites on you is like resisting paying protection to the mob. The game is tilted in their favor, and there is truly no way to avoid being assimilated by the borg. Once the PE firm gets its hooks in you, the script is set.

      Sure, the post-takeover management put in place by the PE firm is cratering the business, that is by design. That’s the business model. It is being cannibalized.

      If we actually want to stop this, we need to remove the tax preferences, cheap Fed money, and regulatory forbearance that provide the PE model its business advantage.

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    I like your article but wish you had gone a little further. It is easy to see the evidence around us that you base your article on. The most important line in your article is, “Massive changes to the tax code need to make labor and entrepreneurship more valuable than financial trickery, but in the meantime, you can help as an individual.”
    I really wish you would expand on this idea with specifics, especially in regards to the tax code changes. As we head into mid term elections there is a lot that groups of individuals could do in wielding the voting axe come November. At the same time few of our politicians who are running have taken a firm stance on anything yet. Let’s give them something to plant a flag on.

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      Tax gains on capital the same as earnings. Remove the carried interest exemption. Cap the interest expense deductibility. To name a few. I am sure there are other more arcane tax preferences that incentivise takeovers and soften the blow when the business eventually fails.

      Other reforms are available on the investor side. To make these sort of takeovers less attractive as a self-fulfilling plan, and make the systematic plunder and looting of formerly successful companies a less attractive business model.

      Other reforms yet on the system that rewards off-shoring and jurisdiction shopping.

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    Fantastic article. It’s extremely frustrating to sit back and watch financial behemoths begin to destroy our industry. An industry that, at its core, is comprised by their polar opposites. With any luck, readers of this article may actually listen to inspire real change. One drop in a bucket may not look like much, but eventually the bucket will overflow…

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    Somehow, because Bain Capital is involved, I’m not surprised they are going out of business… or at least headed in that direction. Anyone want to take bets on how much RICHER the fat cats at Bain got over the whole deal ?

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      Bain didn’t get richer, they made a bet and lost. That said, they made a bet with mostly Ares $ (not their own), so it’s now going to be Ares on the hook (as soon as Ares takes over control from Bain, which will happen in the coming weeks).

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        Hmm. I’d like to see a full accounting on that. I think we’ll find that Bain extracted zillions in transaction fees, management fees, salaries, prime assets, and other stweetheart payments, and now they are walking away from the corpse, leaving the loss to whatever downstream suckers that bought the syndicated debt (i.e. pension funds).

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    Thanks Eric. I’m a piano/keyboard guy. What’s the best way to track down which companies are owned by private equity firms? How do you vet Sweetwater, Musician’s Friend, Amazon, B&H, J&R, etc?

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      Musicians Friend is owned and operated by Guitar Center. Guitar Center bought them several years ago, they shut down the Medford, OR offices a few years ago and it is operated 100% out of GC’s corporate HQ in Westlake Village, CA.

      Same slaps running GC run MF, and they use several shared services (including the distribution center, product catalog, etc…)

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      Here’s a hint: if the company is making very good products that they stand behind, and you feel fortunate to have discovered their products, then that company is within months of being sold and gutted.

      If the owner/founder is getting old or recently died, that’s a red flag.

      If the product suddenly move its production location, overhauls its product line while doubling its offerings and adding a bunch of gimmicks, offers a parallel budget line, keeps pushing out new models and features every year, or glams up its marketing – then you are witnessing the beginning of the end.



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