Issues & Opinions

Rumored for a while, but announced only today, a private equity consortium including J.C. Flowers, Friedman Fleischer & Lowe, Bank of America, and JPMorgan have offered to buy Sallie Mae (SLM), the largest student loan provider in the US, for $60/share, or approximately $25 billion. (Press release here)

Flowers and Friedman will together own 50.2% of the newly private entity, with the two banks owning half each of the remaining 49.8%. Additionally, JPM and BofA have committed to providing a $200 billion backup line of credit to ensure that, even if the debt market becomes closed to SLM, they’ll still be able to do business.

When transactions like this occur, my normal initial response is to lean back in slack-jawed wonderment, trying to determine what it is that the PE players (ignore the banks - more on that in a bit) saw in the deal that the public market didn’t, causing them to offer a price that’s a 50% premium to the price of just last Thursday, April 12. (ignore the fact that I skipped Friday’s price - more on that in a bit) A $20/share premium? Was that really necessary?

Might as well deal now with the price jump on Friday, from Thursday’s close of $40.75/shr to Friday’s of $46.76/shr - clearly, word of the deal was leaked, and speaking of slack-jawed wonderment, I’m also impressed when the market rumor mill that can generate a one-day 15% gain, up $5 on the open. Of course, it’s possible that nobody traded on the news before the 8:30 reporting Friday by, surely among many other places, at the WSJ Deal Blog. But I’m sure that, in their spare time, the NYSE, SEC, and perhaps most importantly, the SEC’s options watchdogs, will be piecing together the tapestry of who bought and sold what, when. Once the regulators start sniffing around, there may be a perceptible increase in pucker factor. Or not, but it should be interesting to watch either way.

As you can see from the chart up there, this thing has been taking on water for some time, and there are reasons for that. First, there’s the matter of the recent investigations into student lending practices, conflicts of interest, and other skullduggery. SLM paid a fine as part of a settlement in the matter of deceptive sales practices with NY A.G. Andrew Cuomo’s office.

Another problem is the government’s move to reduce federal support for student lending, which encouraged more “private loans”, unsupported by federal guarantees. From the NYTimes article linked just above:

With tuition costs soaring and financial aid budgets remaining flat, students increasingly turned to banks and other lenders to bridge the gap. Because these loans did not receive government subsidies, Sallie Mae and other private lenders could issue them at a higher interest rate. At an average rate of 10.5 percent, more one and half times the guaranteed loan cap, they were far more profitable, even if the potential losses could be larger.

And, at an average rate of 10.5%, it seems, the best way to sell those loans to students & families trying to close the gap was for college lending officers to lie to them about what was in their best interests. (see “skullduggery” link above).

The business was under pressure, and no amount of growth through acquisition (they already have 27% of the student loan market), nor expansion into other related lines of business (debt collection, for instance, which makes up 20% of its earnings) seemed to have any effect on the market’s judgment of its prospects. In fact, only a month ago (March 13, 2007), one firm practically induced explosive decompression (though admittedly only in whatever small segment of the market actually follows their recommendations) by downgrading the company from “buy” to “strong sell”. Such moves are rare, generally indicating either news from the company that something really bad happened or that the analyst in question just woke up and remembered s/he was covering the company.

So what of it? Are the continued changes in federal student loan support going to kill the company? Not likely, though I suppose they could. The methods typically used to market 10%+ credit are more closely linked to the sub-prime lending market than they are to the historically somewhat staid guaranteed student loan market, but if SLM is able to fully manage the transition from one to the other, they could benefit.

Getting away from federally guaranteed student loans has another downside, however - one that Sallie Mae shares with Freddie Mac and Fannie Mae: the imprimatur of government sanction. When Sallie Mae was founded in 1972, it had a “special charter”, much like the two mortgage giants, allowing it to borrow more cheaply than its rivals. (That charter expired in 1997) In addition, there was the cachet effect (NYTimes):

“Much as Fannie Mae and Freddie Mac use their role in home ownership as a political asset for leverage, Sallie uses its historical role in providing student loans as a political asset,” notes Jonathan G. S. Koppell, a Yale University professor who studies the politics of government-sponsored enterprises.

As it becomes more focused on non-guaranteed private lending, it won’t need all its lobbyists, which is offset by the fact that its lobbyists would no longer have any particularly resonant heart-strings to tug on anyway.

In all, it looks and sounds like management, led by its CEO Thomas Fitzpatrick, has spent the last 18 months desperately in search of a clue. One could infer (and I do) that the smarmy sales practices weren’t unrelated to the stock ownership (in SLM and others) by various college lending officers, and that SLM (and others) actively encouraged advisory malfeasance, amounting to theft, on the part of those college lending officers. (Note: BofA and JPM are each, individually, in receipt of subpoenas {WSJ, subscr. req’d} from Mr. Cuomo’s office on the matter of the deceptive lending and kickback investigation)

Yet here we get to the head-scratching part - the new owners expect to leave current management in place. Some of the several comments at the WSJ Deal Blog item linked above provide a totally unscientific indication of market sentiment related to SLM management. From the press release linked above:

Upon closing, Sallie Mae’s current management will continue to lead the company, ensuring that it will continue to adhere to the New York Attorney General’s Student Loan Code of Conduct, which Sallie Mae adopted April 11. Sallie Mae will continue to originate student loans under its internal brands and will remain headquartered in Reston, Va.

Admittedly, Fitzpatrick, in particular, doesn’t need new incentives, as his 2006 pay of $19.5 million included options on 1 million shares that, if this deal closes, will have a value to him of $18-19million, all by themselves. Of course, those options will be exercised at closing, as the existing SLM stock is extinguished, but I’d expect that he’d be allowed/asked to roll it over into equity in the new entity. The larger question might be, can he and his management team operate in this new, “Joey the Loan Shark”/”Household Finance Corp.” model for student loans?

They’re surely not going to have the debt markets on their side, at least not initially. All three of the major bond rating companies have already weighed in (WSJ - subscr. req’d, alternately, see Business Week):

“The transaction, if consummated, would lead to a multiple-notch downgrade of SLM’s ratings, potentially to speculative grade,” said Moody’s Investors Service in a press release. Moody’s currently rates Sallie Mae A2, the sixth-highest of 10 investment-grade rankings.

Standard & Poor’s, which rates the lender an equivalent A, said while Sallie Mae is adequately capitalized, “there is not much room for additional leverage at the current rating level.”

Fitch Ratings rates the lender slightly higher than its rivals at A-plus, but it also warned that the company faces serious deterioration in its ratings if the deal closes.

Of the $25 billion price tag, JCF & FFL are together (with an unknown split) putting up $4.4 billion in equity, and BofA & JPM are each putting in $2.2 billion. So something in excess of $16 billion of debt is going to be required to close the deal, and the credit markets are understandably twitchy about that. Junk lending is not something reputable financial institutions are well known for pursuing, and cheap public market money can’t be the reason for doing this, because it surely won’t be available again anytime soon.

Now we get to the banks’ role, teased above. Sure, they’re putting in equity, but they’re also going to glom some enticing fees from the relationship, starting with arranging and placing the $16 billion in debt to do the initial deal. According to the WSJ (sorry - subscr. req’d):

In return for their investment in the student lender and for providing a $200 billion secured backup line of credit, they stand to get a lock on Sallie Mae’s lucrative capital-markets business, which packages and sells its student loans to big institutional investors. That could be worth more than $800 million to their shareholders right off the bat.
{…}
In addition, there’s a one-time kicker: Sallie Mae will probably pay the two banks about $25 million for arranging the $16 billion of debt needed to fund the buyout, raising their first-year windfall.

(ellipsis mine) The linked article posits a credible valuation method (at 10X earnings) that justifies the $800 million number above.

Another underlying assumption, also laid out in that same article, is that business is expanding for SLM, as “Boomers kids are marching off to college”. And that may be true, but there’s a limit to the number of 10.5% loans the market can swallow, and that SLM tree surely can’t grow to the sky.

There’s also a school of though that says too many people are already going to college. See Charles Murray’s “What’s Wrong With Vocational School?“, and note, as did the eminent philosopher George Carlin (perhaps among many others):

Just think of how stupid the average person is, and then realize half of them are even stupider!

I repeat - there’s a limit to the market onto which high-rate college loans can be foisted.

So there must be some other benefits that the private equity participants in this deal expect. Slapping a bunch of debt on the deal is de rigueur, because debt seems to focus the managerial mind, and they’ve already got that covered. There must be some operational efficiencies they expect to wring from the deal, and JCF, in particular, has plenty of experience in financial services companies, so if there’s fat to be cut, they’ve likely already found it, to what should be the added shame of present management.

Remember the title? Curious about what “private equity taketh away”? I don’t know that it plays a huge part in this deal, but an indication of the genre can be found in the unfortunate instance of a company called First Marblehead.

The story behind their 24.2% stock price decline today? “First Marblehead plunges on SLM buyout“.

More than a quarter of First Marblehead’s servicing revenue last year came from advising JPMorgan on its student-loan book and helping structure those loans into bonds. About 16 percent of First Marblehead’s servicing revenue came from helping Bank of America.

Whoops. That 27% of the market SLM had could, in fact, be getting bigger, with a tit-for-tat transference of business to its operations, courtesy of its new private equity owners, JPM & BofA.

Anyhow, I don’t think the roughly $5 spread between today’s SLM stock price and the offer price indicates market disbelief. Given the expected deal close late in 2007, the fact that SLM will cease paying dividends from here forward, and the time value of money, the spread’s not likely to narrow too much for quite some time.

Addendum - See also, “Sallie’s Fourth Horseman: Friedman Fleischer & Who?“, particularly as it relates, peripherally, to the other mega-deal of the past several days, Google buying DoubleClick.

Addendum - 4/18/2007 From the WSJ Deal Blog, further details on ownership:

According to LBO Wire story, it was the firm’s connections to Flowers that won FF&L its role on the deal. And as we suspected, Flowers will put up the “overwhelming majority” of the $4.4 billion required of the buyout firms, according to the story. (Indeed, the Times says Friedman Fleischer’s stake will amount to just 1%.)

Addendum - 4/23/2007 From this evening’s edition of Marketplace:

This final note . . .

New York Attorney General Andrew Cuomo has some company in his ongoing probe into questionable practices in the student loan industry. Cuomo announced today attorneys general from Missouri and Illinois have joined his investigation, and that Washington University in St. Louis and DeVry University in Illinois will reimburse affected students.

There’ll be a new College Loan Code of Conduct that forbids kickbacks, too. Massachusetts Sen. Ted Kennedy has promised hearings later this week. He chairs the Senate Education Committee.

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