BLACKSTONE

March 2008
Sr. Managing Director at BLACKSTONE
 Reviewing potential purchase of $6.11bn pool of leveraged loan from Citi group
 Most of these loans for LBO
 In num of cases, BLACKSTONE was considering equity investments
o Due diligence & research done already —> confidence boost for Sr. MD to
understand risks in loan portfolio
 TGP —> another PE —> considering parternering with BLACKSTONE in purchasing pool of
loan —> researched & participated in LBOs

Subprime mortgage crisis

 Leveraged loans
o Trading below par
o Subprime mortgage crisis of 2007 —> re-pricing of debt instruments
 Cause of repricing —>
 Risk had been underestimated in credit boom of 2000s
 But as per Goodman —> re-pricing was driven by
o risk aversion of investors and retrenchment from risky
assets
o Fire sales
o Lack of liquidity in financial markets
 An opportunity —> to generate superior risk adjusted returns by investing in
large pool of underpriced portfolio of credits
 This will require —> BLACKSTONE —>
 to value and manage a highly opaque and illiquidity fixed income
assets
 Large amt of funding
 Capacity to hold their position for an extended period till debt values
recover
Citi Group facilitation plan
 For a part of loan purchase —>Citi group will provide —> debt financing for purchase of loan
pool
 For another part —> BLACKSTONE will provide funds and willl stand in first loss position
 Protection for Citi —> debt secured by loan pool
 Citi group required —> loan pool to be marked to market &
 when the value of loan falls below a particular threshold—> Citi group has the right to
request additional collateral.

Goodman and Tripp Smith & Drug Ostover—> GSO

 Closed sale of their firm “GSO Capital Partners’ to BLACKSTONE for $1bn
 GSO —> credit and distressed division of BLACKSTONE (others —> PE, Real estate & Fund of
funds business)

Nature of investment

 Investment —> seemed attractive but the very dislocations that gave rise to opportunity also
brought substantial risk
 Hard to imagine Events in Fin markets —>
 o Few days ago —> collapse of Bear Sterns, an IB —> bought by JP Morgan for a small
fraction of its value an yr earlier
 Economy —> deep recession

CITIGROUP’S LEVERAGED LOAN EXPOSURE

Second half of 2007

 Signs of considerable stress brought on —> in large part by rising default rates on residential
mortgages and decline in value of residential mortgage backed securities
 Nov 4, 2007 —> Citi announced that probable decline in fair value of its $55bn US subprime
related direct exposures could be as much as 20%
 End of 2007 —> Citi Fin results affected by —>
o Write downs related to subprime exposures
o Leveraged lending
o Slowdown in Investment banking
o Collapse of private label securitisation market
o Net income down 83%
o Stock price down 47%
 From regulatory capital perspective —>citi was well capitalised but capitalization ratios kept
falling

CITI GROUP’S CONCERN

 Large portfolio of ~ $22bn of leveraged loans primarily for LBOs announced in 2007 & 08

CITI’s goal
 Profit from underwriting fees & selling bulk o loans to syndicate of investors (incl. MF, Hedge
funds, banks, insurance companies, CLOs and CDOs)
 Part of underwriting process —>
o Commitment to fund the buyout even if it was unable to place loans with other
banks and institutional investors
 LBO —>USED SENIOR UNSECURED NOTES IN ADDITION TO LOANS
o Notes —> lucrative promised loucrative underwriting fee and Citigroup was willing to
fully guarantee funding by committing to issue a bridge loan to makeup any shortfall
in financing
 Funding guarantee —> facilitated the transaction but posed risk for citi group in the event it
couldn’t place debt
 Fall of 2007 —> securitization market shut down & inst investors reluctant to invest in large
loans and notes —> risk realised —> citi leveraged loan portfolio swelled to $22bn
 Ci committed to another $21bn loans

CITI’s leveraged loan exposure —> challenges for bank

 1st —> leveraged loans were costly from regulatory capital perspective since they received
100% risk weight
o In contrast —> real state loans —50% risk weight & highly rated securities – 20%
o Capital requirement —> 8% —> implies $80mn of capital for every bn dollar of
leveraged loan
 o Hence, to ease capital requirement —> reducing leveraged loan portfolio but might
need selling loans below fundamental value, possibly at fire sales prices
 2nd —>accounting treatment of the holding loans
o Substantial fraction of these loans were intended to be sold —> classified as “held
for sale” under accounting requirements —> were marked to market as per rules
o Leveraged loan index fell by 97 cents on the dollar in fall of 2007 —> citi group had
to recognise $1.5bn losses on its leveraged loan portfolio for FY ending dec 2007
o Mar 2008 —> LCDX dropped 92 cents on dollar —> analysts expected that the write-
downs on the leveraged loan portfolio for the 1st quarter of 2008 could be as high as
tot losses for prev FY
o Volatility in pricing of leveraged loans —> volatility into citi groups earnings and
stock price
o

The Loan Portfolio Transaction

 Approached many large investors incl PE, HF to buy their leveraged loan portfolio
 BLACKSTONE with its partner TPG —> expressed interest in a portfolio of 10 diff issuers with
total Face value of $6.11bn out of total $22bn
o Most of the portfolio was comprised of debt used to fund deals reviewed by BS and
or led by TPG
o 25% —> largest —>was debt to fund the 2007 buyout of all tel sponsored by TPG &
Goldman Sachs’s capital
o Riskiest in portfolio —> Harrah’s senior unsecured notes to fund 2008 LBO sponsored
by TPG and Apollo —> comprises 3% of portfolio
o
 75% of portfolio —> senior debt
 25% —> unsecured bonds
 Weighted average coupon of portfolio —> LIBOR+309
 Weighted average of senior secured loans —> LIBOR + 277
 On avg, loans in portfolio —> B/B-

Financing —>

 Portfolio —> $6.11bn

 Purchase price —> 83 cents per dollar —> 0.83*6.11 = $5.07bn
 Citi group —> providing 80% leverage for senior secured loans & 60% for unsecured note
 Overall —> 75% of purchase price —> debt financing by citi
 BLACKSTONE + TGP —> $1.26bn
 Loan by citi = 3.81 & cost of financing = LIBOR+100
 Equity from bs =1.26
 TENOR —> MATCHED that of loans in portfolio
 Interest payment —> not due until coupon payments received from portfolio loans
 Recycling provision —>blactstone can do reinvestment in any asset upto a limit of 3.81bn
credit
o Men’s BS could further diversify its portfolio by selling some of their positions and
reinvesting the proceeds in other loans
o Availability of recycling provision —> 4 yrs from loan closing
 Collateral for $3.8bn—> underlying loan portfolio
  If value of loans fell below 66.4% of its face value (80% of purchase price_)—> BS & TGP
would have to post additional collateral

Assessing the Deal

 BS advantage —> undervalued portfolio

 BS carefully selected the portfolio —>expected default rates would be smaller than those for
average B rated securities which were historically estimated at 5.91% for 1st year

MCI COMMUNICATIONS CORP

MCI —> TELECOM —> AT&T IN COMPETITION

1974 – 1983
 REVENUES —> $ 1bn in 1983
 Profit —> 38.7mn to 170.8mn
Last 2 yrs —> stock price 5x

1974 —> antitrust settlement b/w US DoJ and AT&T

 compete on equal quality-of-service terms with MCI
 it promised to eliminate certain MCI cost advantages and increase AT&T’s competitive
flexibility.
 Still MCI was committed to reach and capacity


Brian Thompson —> economies of scale and scope are everything in this business
 In long run—> owning the facilities for basic services is imp and leveraging them to provide
value added services

COMPANY BACKGROUND

FCC —> policy change —> new competitors to enter market for special long dist call services (esp
private lines) for large telephone users

MCI —> incorporated in response in 1954 and by 1972 it began construction of its own telecom n/w

Funding
 6mn shares in common stock @ share price of $5 —> $30mn
 Net proceeds after expenses and commission = $27.1mn
 Line of credit from 4 banks group (headed by first national bank of Chicago)—> $64mn
 Loan from private investors —> $6.45mn @ 7.5% —> subordinated notes with warrants
 Bank loan int rate —> 3.75% + commitment fee of 0.5% on unborrowed amount

2 years
 Route miles —> 2280
  15 metros
 Shortfall —> 11600 route miles from plan in 1972
 Subscribers to MCI transmission centres in metro —> use of AT&T n/w
o AT&T resisted
o MCI unable to generate significant subscriber revenues
 1973 —> MCI suspended all const activities and pursued legal and regulatory remedies
 1974 —> antitrust lawsuit against AT&T
o FCI ordered to allow MCI full access to range of interconnection facilities as of May
1974
 MCI resumed construction

FY1975 —>
 Revenues = $6.8mn
 Losses —>$38.7mn
 Sept 1975 —>
o n/w = 5100 route miles
o 30 metro
o Net worth = -$27.5mn
o Accumulated op deficit = $87.3mn
o Share price = just below $1
 Line of credit exhausted & renegotiated the credit agreement to defer int payments
 Still defaulted in many provisions of revised credit agreements
 Public sale —> 9.6mn shares with 5 yr warrant and exercise price of $1.25
o Net proceeds = $8.2mn or 0.85 per share + warrant, compared to prevailing market
price of $0.875 per share
 MCI enabled to survive

o
o
1976 —> the turning point

 Execunet —> a service introduced in winter 1974 —> a service comparable to long dist calls
 With cust having random access to MCI n/w —> attracted small business subscribers unable
to afford expense of dedicated pvt lines (pvt line cust were large corporations with large call
volumes)
o Enabled MCI to yield subs revenue —> 28.4 in 1976 to 62.8 in 1977 (half from
Execunet)
o Int payments to consortium of banks resumed
o MCI 1st profit —>$100000 in sept 1976
o FCC won a court order that restricted Execunet to existing subscribers; this order was
not lifted completely until May 1978.

The order repercussions

 Growth slowed —> to 18% b/w 77 and 78
 Order lifted —> revenue growth rate annual —>50%
 Emp —> 3x from 1977 to 1981
 Plant —> 136.6mn to $410mn
 Profitability improved
 After tax earnings —> from a loss of 1.7 to profit of $21.1mn
 TAX LOSS CARRY-FORWARD EXHAUSTED by end of FY81
  Equity = $148mn

1980 —> execunet service offered to residential customers on trial in Colorado

 Successful —> plan to offer to households nation wide
 Growth restriction —> lack of capital —> but became available in substantial quantities
 Revenue double to $506 in FY1982
 with acquisition of western union intl from Xerox for $195mn in June 1982 —> revenues
again 2X —>$1073mn in 1983
 Income from operations = $295mn; net earnings = 170.8mn
 New products such as email grew the profit

FINANCIAL POLICY

UNTIL 1976
 REQUIRED FUNDS FOR CONTINUING OPERATIONS
 1976 —> court order prevented Execunet services to new customers —> growth opp
restricted —> reduced need for investment funds
 Restrictive covenants for bank loans from syndicate (headed by First national bank) —>
reduced the capital raising capability for expansion

1976 to 1978 —>Lease financing of new fixed investment was only source of funds —> mostly used
in capacity expansion in existing markets

May 1987 —> withdrawal of court order for Execunet

 Opened way for accelerated growth given the funds availability
 Wayne —> in 1978 —>
o Made the lending banks agree to public offering of securities —> proceeds will retire
their loans
o he arranged for the loans of those banks which refused this accommodation to be
bought out by private investors
o Converted a number of warrants and loans held by pvt investors earlier
 1978 —>MCI entered Public markets for 1st time since equity issue of 1975
o Offered convertible preferred stock which raised $25.8 million (net of expenses)

 1979 —>2nd convertible preferred offering in September 1979 raised $63.1 million
 1980 —> October 1980 netted $46.7 million.

WHY CONVERTIBLE PREFFERED STOCK

 1 —> need for some form of equity capital,

 2 —> WAYENE’S CONVICTON —> “it was always our conviction that issuing more common
would knock the props out from under the stock.”

Conversion price on preffered stock —>rose with each offering

 Dec 1978 —> $2.1875
 Sep 1979 —> $5
 Oct 1980 —> $9
 Dividend —> 85% tax deductible to corp investors
 o Earnings sheltered —>No cost to MCI due to tax loss carry forward

Features of preffered stock —> CALL option

 Enabled MCI to force investors to convert to common stock —> hedge against drain of
preffered dividend on CF
 Call opinion —>
o If market price of MCI common stock > conversion price by 25% for 30 days —> MCI
could call unconverted preferred stocks for redemption at 110% of issue value
o Owners of PS —> would prefer to convert rather than repurchased
o Raising stock price —> enabled MCI to call for redemption of all 3 PS

Proceeds from preffered offerings —>

 Used to retire loans —> short term and intermediate term

 Issue further debt of long term
 Leasing decreases
 July 1980 —> raised $50.5mn through public sale of 20 yr subordinated debentures

FY 1981 —> demand for investment funds intensified

 Financial policy change —> shifted from PS to convertible bonds
 Apr 1981 —> $102mn from straight subordinated debenture issue
 Aug 1981 —> $98.2 from CD
 May 1982 —> $245 min from CD

Features of Convertible Debentures —> CALL option similar to that of PS

 MCI forced conversion —->

o May 1982 issue in Dec 1982
o Aug 1981 issue in Feb 1983
o Led to additions in common equity
o This in turn led MCI ti undertake even greater debt
 Sept 1982 debenture issue —> yielded $209 mn
 Mar 1983 CD issue —> produced $400mn

FY 1982 and 1983 —>PUBLIC sale of securities —> raised $1050,n

 All initial issues —> oversubscribed
 Interest costs —> high
 Wayane’s view —> primary is availability of funds and costs are secondary
 Since profitability increase > int expense —> int coverage increased
o This was remarkable achievement than other companies

FCC response to AT&T antitrust settlement —> uncertainty on MCI continued ability to raise funds
The AT&T Antitrust Settlement and Other Developments

AT&T with MCI

 Serious competition but services provided

o AT&T provided most necessary part of MCI —>supplied MCI with connections to
subscribers thru local telephone networks
 MCI paid negotiated rates in 1978 —> $230 per month per access line of $
172.7 min per year by 1983
o Also AT&T provided long dist facilities to reach in markets not yet captured
 MCI paid $ 137.2mn

MCI’s principal competitor in market for interstate long dist services —> AT&T long line divisions

 95% market share

 reimbursed local operating companies for access lines, —> rate is 3x of MCI and other
competing carriers (GTE & ITT)
o justification —> MCI cust dialect 20 digits for long dist numbers
 11 digit for AT&T customer —> for superior access pay more

Settlement of antitrust suit between AT&T and the Justice Department in January 1982

 Separated AT&T from its local operating subsidiaries

 AT&T retained long line division and interstate long dist facilities for local companies
 Separation happened in 1984
 All long dist operations consolidated in AT&T communications
 AT&T communications —> competitor of MCI and other long dist companies on n equal
basis
 Settlement terms —> by 1986 the newly independent local telephone companies provide
equal quality of access to all competing long distance providers.
 FCC will phase out differential in acces charges b/w AT&T and others —-> increasing fee paid
by MCI and others
 Equal access —> phased over 2 years or 3 years
 FCC initial plan —-> 80% increase in MCI access charges in 1984
 MCI —> contradicting results
o Gain by acquiring equal access
o Loss of existing cost advantage

Value of equal access for MCI

 Large business customers —> small fraction —> already enjoyed equal access through
electronic switchboards had features that would automatically route calls via MCI lines
whenever the usual 10- or 11-digit long distance number was dialed.
 Equal access trial in IOWA —>immediate increase in MCI share of long dist market —> from
5% to 20%
 No severe competition from players other than AT&T
 AT&T still paid more in access fees
Impact of equal access charges on market share—> difficult to judge

 Under FCC plan —> AT&T’s access pricing flexibility was expected to increase as deregulation
of the long distance market
 Deregulation —> ultimate goal of FCC
 Thus AT&T would be able to reduce its prices to prevent further erosion of its market share.
 With 95% market share —> no economic sense for AT&T to cut prices for sake of preventing
anything lesser than massive loss of market share to MCI and other comp


n 1972, MCI sold 6 million shares of common stock at $5 per share, which provided the company
with $27.1 million after expenses. However, this injection of funds wasn’t sufficient to support the
expenses incurred to maintain a viable network. Therefore, MCI turned to a group of four banks to
obtain a $64 million line of credit and further loans from private investors amounting to $6.45
million.

In 1975, MCI had exhausted the whole line of credit due to rapidly rising costs that sales growth
could not keep up with. With a massive operating deficit, the firm had to renegotiate the covenants
associated with the previous credit agreement in order to defer interest payments. The firm
managed to survive by raising $8.2 million through a common stock issuance with warrants. Each
share had an associated 5-year warrant with an exercise price of $1.25, which was higher than the
market price of 85 cents. This was the only way to raise capital since debt was already extremely
high, as seen with the leverage ratios presented in Exhibit 1. Moreover, regular common share
issuance would be dilutive and would not be well received by potential investors because of their
priority of claims. Including an incentive to the issuance of equity proved to be the only way to
attract investors as MCI was in bad financial position. Between 1976 and 1978, due to the restrictive
covenants associated with the bank loans, MCI could only use lease financing of new fixed
investment to expand capacity. With the withdrawal of the order restraining the potential of
Execunet at the end of 1978, MCI needed capital to finance the future growth of the service.
Therefore, with the firm converting several outstanding warrants and loans, it was able to enter the
public capital structure again and raise 25.8 million by issuing convertible preferred stocks. The
issuance of preferred equity lowered their debt to asset ratio (refer to exhibit 1) while not raising
significant loss of tax benefits as preferred stocks were 85% tax deductible. MCI could also force the
conversion of preferred shares into common stocks, therefore eliminating the need to pay dividends
and reduce the outflow of cash. With the MCI’s stock increasing in value, management wasable to
convert all the preferred stocks into common stocks by late 1981. The preferred offering stabilized
the financial position of MCI and allowed it to retire short-to-intermediate term bank debt and to
issue longer-term debt

In 1972, MCI sold 6 million shares of common stock at $5 per share, which provided the company
with $27.1 million after expenses. However, this injection of funds wasn’t sufficient to support the
expenses incurred to maintain a viable network. Therefore, MCI turned to a group of four banks to
obtain a $64 million line of credit and further loans from private investors amounting to $6.45
million. In 1972, MCI sold 6 million shares of common stock at $5 per share, which provided the
company with $27.1 million after expenses. However, this injection of funds wasn’t sufficient to
support the expenses incurred to maintain a viable network. Therefore, MCI turned to a group of
four banks to obtain a $64 million line of credit and further loans from private investors amounting to
$6.45 million.