Update: On April 29, 2014, The New York Times reported Texas Energy Futures Holdings (TXU), the $45 billion deal that was largest leveraged buyout in history, ran out of cash and filed for bankruptcy.

On July 14, 2011, Stephen Morris and Ben Martin at Bloomberg Junk Bond Market’s Big Buyer Goldman Sachs Topples Deutsche Bank in Europe Junk Bond Underwriting that Goldman knocked Deutsche Bank off the junk bond king underwriter pedestal.

“Underwriters made a lot of fees in the first half,” said Janet Tavakoli, founder of Chicago-based Tavakoli Structured Finance Inc., a financial consulting firm. “The high-yield bond rally isn’t sustainable, certainly not in Europe. Now that we have a lot of uncertainty and a little bit of panic in Europe, investors are going to avoid these high-yield deals. You could have impaired earnings for a long time.”

Quiznosis’ LBO at the top of the market was an example of how to quickly ruin a company that might otherwise weather the recession. (It all depends on the deal, of coruse, and that’s why there’s no substitute for reading financial reports.) Ben Bernanke’s low interest rate policy kept the junk market sector elevated, even though growth prospects remain dismal.

In the secondary trading market, investors are held hostage by a handful of traders who try to match off orders between large investor portfolios. Bid / ask spreads are enormous in this dark market, so junk bond investors are gouged coming and going.

Deadly Debt: Underwriters’ High Fees, Investors’ Windfall Dividends

There’s nothing wrong with earning fees. But LBOs are a minefield for investors not involved in the primary deal-making. Beyond deal fees, “dividends” suck needed cash out of troubled companies. LBO proceeds enable insiders to fully recover their initial investment plus a huge windfall return in the form of dividends, before any cash is deployed in the business.

In theory, LBO advocates say that the debt will be financed by retained earnings and internally generated cash flows. In practice, corporations that can barely can make payments during times of high prosperity take on even more debt in an LBO.

When things don’t work out, the company ends up in Chapter 11. When things do work out, the fees and the “deal-makers” destroy the company through liquidation (Beatrice Foods is one example).

The Gravedancer’s Tax Hangover

According to Allan Sloan’s June 18, 2013, Fortune expose (“Zell’s legacy lives on: IRS goes after Tribune”), Sam Zell dubbed himself the Gravedancer. But in the Chicago Tribune’s case, he dug its grave. Thousands of people are out of work and others saw their pension fund destroyed due to crushing debt. Zell not only bankrupted the company—it emerged from Chapter 11 at the end of last year—he played it fast and loose with IRS rules.

If you don’t regularly read Allan Sloane’s articles, you may not know that he reported on Zell’s coming tax mess in September 2009. Zell converted the Tribune from a C corporation to an S corporation as a tax dodge before spinning off the Chicago Cubs. The problem was that all this maneuvering left the Tribune with a corporate gains tax, so Zell tried to disguise the sale through a leveraged partnership. The Tribune retained a 5% equity interest. The Rickett’s family held the 95% controlling interest.

Tribune’s Form Over Substance Meets IRS Challenge

Part of the eyewash included the Tribune’s guarantee of a portion of the partnership’s debt. As Sloane put it: “Hello? A debt guarantee from a bankrupt company? What’s that worth? Can you spell ‘nothing’?”

In both the sale of the Cubs and Newsday, Zell tried a form over substance tax dodge, which sometimes works with the IRS. (These usually work best when more than one country’s tax code is involved.) It’s not working out for the Tribune. The IRS is looking at the substance of the transactions, which don’t look like true sales.

Sloane notes that tax expert Bob Willens of Robert Willens LLC told his clients that the Tribune’s claimed sales of both Newsday and the Cubs would be challenged by the IRS. The IRS’ recently challenged the Newsday deal, which represents a potential liability of around $273 million. Sloane estimated total potential liabilities for both deals at around $600 million. The Tribune will likely negotiate a deep discount as a settlement.

Dividend Recapitalizations

On October 12, 2012, Ryan Dezember and Matt Wirz at the Wall Street Journal estimated that $54 billion in debt was issued to pay dividends to private equity investors ahead of anticipated tax increases.

The beneficiaries are the private equity investors taking part in the buyout, not the buyers of junk debt including PIK-toggle bonds that pay bondholders with more debt (pay-in-kind) when strapped companies can’t make coupon payments. The double digit coupons on junk debt are often a short-lived illusion.