A story by Andrew Ross Sorkin and Michael de la Merced, “Debt Linked to Huge Buyouts Is Tightening the Economic Vise,” covers the fact that private equity deals, which as a matter of course feature high leverage, are starting to hit the wall as the economy sours. This is hardly surprising; it’s happened in past downturns.
The story does a workmanlike job in providing details on some of the companies now in trouble, yet stunningly omits a couple of key details, namely, that the fact that many of these deals had so-called cov-lite debt, plus the fact that DIP (debtor in possesion) financing is now almost impossible to obtain. DIP financing is often necessary to help companies keep making payments as they go through the Chapter 11 process. With DIP financing scarce, lot of these deals are likely to end up not in Chapter 11, but as Chapter 7 liquidations, causing vastly more damage than past LBO hangovers. These the omissions are striking given that Sorkin covers the deal beat on a daily basis.
First, some of the key bits of the NY Times article:
Private equity firms embarked on one of the biggest spending sprees in corporate history for nearly three years, using borrowed money to gobble up huge swaths of industries and some of the biggest names — Neiman Marcus, Metro-Goldwyn-Mayer and Toys “R” Us.
Linens ’n Things, a big retailer owned by the private equity firm Apollo Management, filed for bankruptcy protection this year.
The new owners then saddled the companies with the billions of dollars of debt used to buy them. But now many of the loans and bonds sold to finance the deals are about to come due at the worst possible time….
Yves here. The notion that LBO debt issued in the last three years (which is when the bulk of the deals were done) is maturing now does not sound at all right. LBO debt usually has a longer maturity. Is this misleading drafting, or are the problems of a small subset of deals being conflated with others facing the market?
Back to the article:
If history is any guide, the worst may be yet to come. Steven N. Kaplan, a professor at University of Chicago Graduate School of Business, found that nearly 30 percent of all big public-to-private deals made from 1986 to 1989 defaulted. Afterward, private equity players were called to testify before Congress, and movies like “Wall Street” and “Other People’s Money” depicted financiers as greedy criminals…..
Many industry insiders and analysts contend that companies backed by private equity will not suffer nearly as much as those in the late 1980s because the firms pushed for better financing conditions that allow them to keep operating even if they cannot make their debt payments.
This is the ONLY allusion to the cov-lite issue, and a very one-sided one at that.
Traditionally, bond deals (except for very short term deals with stellar credits) contained provisions called covenants. The borrower agreed to do certain things over the life of the bond. Typical sorts of covenants were minimum net worth, maintaining certain interest coverage ratios (as in net income had to be at least x times interest charges), not incurring any new debt senior to the bond offering.
If the issuer (the borrower) violated these covenants, the bondholders had the right to accelerate the debt (demand immediate repayment). That, of course, would not really happen, but it gave the creditors the ability to force the issuer to renegotiate the deal (at a minimum) and in more extreme cases, to restructure liabilities in a more encompassing fashion and push for operational changes (for instance, restrictions on capital expenditures until earnings or net worth reach a certain level). It gives the creditors a chance to intervene in a deteriorating situation and put the company on an even shorter leash.
Instead, look at what happens with no covenants, and stunningly, Sorkin and Merced present this as a plus:
For example, in an effort to save cash, six of Apollo’s portfolio companies, including Claire’s Stores, Harrah’s and Realogy, have announced this year that they will pay some of their bonds’ interest by issuing more debt.
So we have a company that is worried that it might run out of cash if it pays interest, so the answer is to borrow more money. Now admittedly, some debt renegotiations wind up in a similar place (interest payments are reduced but the foregone interest is added to principal), But current creditors can also structure a payment schedule (or payment triggers) specific to the company’s situation, and the terms of debt forgiveness from them might not be as onerous as that from new creditors (the initial group is motivated to try to save its original loan and not trash the company).
Sorkin and Merced fail to acknowledge the scenario that most foresee for cov-lite deals where the company starts to get into trouble. In the old days, the banks could apply the brakes and force restructurings, sometimes forestalling a bankruptcy filing, or alternatively, trying to steer the company towards Chapter 11 while there was still something there to save. Now, the company has no checks, and the private equity investors have every reason to carry on until the company defaults because it really has no more cash. That means it enters bankruptcy in a much more weakened state than if the banks had been able to intervene to try to protect their loans.
And the new wrinkle is debtor in possession financing is scarce, thanks in part to GE’s departure from that market, making it much harder for companies to avail themselves of Chapter 11 bankruptcies. As the Wall Street Journal explained last month:
Credit has gotten so tight in recent weeks that companies contemplating a bankruptcy filing can’t find the cash needed to get through the process.
This multibillion-dollar corner of the lending market — debtor-in-possession and exit financing — has been rocked by General Electric Co.’s recent, undisclosed decision to largely halt lending to companies in bankruptcy-court protection or near it, said several bankruptcy lawyers and financial advisers. GE is one of the world’s largest such lenders, last year doing $1.75 billion in restructuring loans.
Debtor-in-possession, or DIP, financing is essential for the lawyers, layoffs and other restructuring necessary for a company’s rebirth. Exit financing is used when a company “exits” reorganization. Banks have been eager to take part in this market because the loans are the first to be paid back and command high interest rates.
Without the lending lines, companies that would normally survive bankruptcy will have to quickly sell assets. Potential buyers may not be able to borrow either, meaning companies could be forced to liquidate immediately instead of working out their problems. That could cost tens of thousands of jobs across the economy….
“It is a struggle, a real struggle to find DIP financing,” said Jonathan Henes, bankruptcy attorney at Kirkland & Ellis LLP in New York. “In the old days, like early 2007, the banks would do an origination and syndication model, where hedge funds and [loan funds] would gobble up those loans, but they don’t have the capital. They are out.”
Data provider Dealogic estimates lenders provided $24.24 billion on 40 restructuring deals in 2008, a 38% increase from the $17.59 billion on 18 deals in 2007. Major banks do much of the work, with GE typically among the top five or 10 lenders each year. Despite the tight credit markets, DIP lending is up this year because of the overall increase in bankruptcy filings since 2007. Little has been done in the past few weeks.
Interest rates for bankruptcy financing have doubled to the London interbank offered rate plus 5% to 7% or higher, compared with Libor plus 2.5% last year, said Mr. Henes and others…
Several companies are trying to raise DIP financing in case they need to file for bankruptcy reorganization, but have struggled to find any takers, said bankruptcy observers.
In other words, there are good reasons to think that the typical cyclical overleveraged deal failures that the private equity foists upon the wider world on a regular basis will lead to even worse outcomes than usual. Yet Sorkin, who ought to know better, omits key details that would raise even more questions about the prospects for these investments. One can only wonder why.
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The notion that LBO debt issued in the last three years (which is when the bulk of the deals were done) is maturing now does not sound at all right.
That’s a non-sequitir, Ives. They obviously talk about the burden of servicing the debt rather than maturity. Unless the LBO loans are structured as no-installment lump sums the said companies are struggling to service the debt.
Max,
With all due respect, I worked on bond deals. A bond or loan “coming due” means the bond is maturing. The language is specific: “loans and bonds sold to finance the deals are about to come due at the worst possible time”. That language is not referring to periodic payments (semi-annually for public bonds).
In other words, this is almost certainly inept drafting, although it is possible that some of these deals has some short-term notes along with the loans/bonds. I have not read of such structures, but I wanted to give readers the chance to comment if they knew otherwise.
From my limited knowledge banks provided generaly short term loans that they sold to hedgies, leaving for the borrower to roll over later on or pay out at resale (most companies are expected to be flipped in about 3 years).
“The notion that LBO debt issued in the last three years (which is when the bulk of the deals were done) is maturing now does not sound at all right. LBO debt usually has a longer maturity. Is this misleading drafting, or are the problems of a small subset of deals being conflated with others facing the market?”
Every report I’ve looked at shows leveraged loan maturities peaking in 2010 and 2011. I suppose it’s possible that they’re referring specifically to 1 or 2 year bridge loans originated just before the credit credit crisis hit. But some of the specific deals mentioned, like Harrah’s, are definitely longer term financings that are simply being hit by cashflow issues.
Few points.
Regardless of maturity dates, a lot of these deals are in trouble. Cash flow is not sufficient to meet cash needs. Realogy and Harrah's are noted in the article and are clearly over-leveraged and heading for a restructuring at some point.
Also, cov-lite applies to senior secured bank debt not high yield bonds. Historically, good covenants allowed banks to bring the borrower back to the table preserving collateral for secured lenders and increased likelihood all debtors receive their P&I back. With the growth of CLOs, private equity sponsors were able to strip away covenants to their advantage. The private equity firms tell their investors that fewer, less-restrictive covenants means they will lose fewer deals to bankruptcies as only a payment default, or non-payment of interest or principal, will cause a default rather than a technical default caused by a covenant breach. We'll see!!
Borrowers repaying their debt with more debt (ie, payment in kind or "PIK") is typical in leveraged finance. A covenant-lite structure does not cause or lead to PIK payments. Instead, covenant-lite deals generally feature PIK instruments within the capital structure.
The bigger issue out there is what happens to these deals as they melt down and the private equity firms owns securities at all points in the capital. As we know, private equity deals are rife with conflicts of interest. However, the prospect of Blackstone's equity group negotiating with its debt group on a portfolio company is interesting to say the least.
Just to really spell it out, this is, mutatis mutandis, pretty much the same mess as speculative house purchases funded by Option ARMs, isn't it? Common assumptions & features: permanent availability of cheap credit for refinancing, permanently rising asset values, permanently available exit route, suitability of non-amortizing loans. The really dire deals surface early because of cash flow difficulties, but also highlight the underlying risky assumptions. Perhaps that's the source of the confusion in the article.
Richard, yes, that seems to be a common feature of all sorts of lending. Many commercial mortgages were for 105% of value to provide a cushion for debt payments because current rents couldn't cover payments. Of course, rents in NY only go up, so no problem there.
Our whole system seems to now be built on assumptions of asset price inflation. Pension funds, which 40 years ago would have been mostly, or completely, in bonds, are now in equities, commodities, complex credit instruments, etc.
There was an article here pointing out that the Massachusetts State pension fund was down slightly less than the S&P 500. They must have been 80-90% in equities.
Same goes for college endowments, Amherst College lost 20-25% in one quarter.
The only backstop the economy has to falling asset prices is the printing of dollars backed by Treasuries.
A couple of takeaways:
First, if a lot of these deals (and there are a lot of them, the notional dollar amount must be trillions at risk) are going to be steered towards Chapter 7 liquidation between now and
2001, these firesales represent another asset class about to be submerged into the debt deflation spiral.
Second, these companies will be so demoralized under the weight of so much debt which they can’t get out from under that they might not be able to think straight ~ as is the case with foreclosed homeowners in CA who walk away not only from their homes but from all their worldly possessions. They just get in the car with the shirts on their backs and drive away. So maxed out in debt, they could not even think clearly enough to even have an estate sale, or to put their belongings into a public storage.
Third, these defaults will exact a heavy toll on job losses the the rising unemployment rate.
I have heard some analysts recently estimating the unemployment rate will rise to 10% before plateauing in this cyclical downturn.
If this estimate is anywhere in the ballpark,and it seemingly is given this latest development, the growing demoralization throughout the country will only fester. And since so many more folks will be out of work and reducing the gubmint tax revenue base, servicing this newly laden several trillion dollar debt exposure to save the banks, uncle sam steps ever closer actual default himself every day.
And so the debt deflation spiral continues in a manner best described by Irving Fisher:
“If liquidation for some reason gets into a stampede, it deflates credit currency, which loweres the price level and reduces profits, which forces business into further liquidation, which further lowers the price and reduces profits, which force business into further liquidation, a tailspin into depression….We now come to the paradox that if the debts get big enough, the very acto fo liquidation puts the world deeper in debt than ever…each dollar represented in teh unpaid balance grows faster than the number of the dollars reduced by liquidation. Such is the essential secret of a great depression…This swelling was by the deflation of the price level, and the deflation was caused by the liquidation itself. Payments could not catch up with the real indebtedness, the more we paid, the more we owed, the peoples real debts are heavier than ever before in all history.
Our debt burdens become heavier by deflating prices
from bn today, PE KKR acknowledges
tough times
KKR Private Equity wrote down the value of stakes in Energy Future Holdings Corp., NXP BV and eight other companies in the third quarter. The fund's net asset value was $3.86 billion, or $18.85 a unit, as of Sept. 30.
“Some of our investments faced reduced valuations during the third quarter as a result of the extraordinary turbulence in the global capital markets,'' Roberts, 65, said in the statement.
Ryan O'Keeffe, a London-based spokesman for KKR, declined to comment.
Mergers and IPOs have ground to a halt as banks, pinched by the credit squeeze, clamped down on lending, and investors shunned new stock. Only one company has held an IPO in the U.S. this quarter, compared with 40 in the same period last year, data compiled by Bloomberg show.
Investors have lost money on Stephen Schwarzman's Blackstone Group LP, the world's largest private-equity firm, which shed more than two-thirds of its value since its June 2007 IPO, or twice as much as the benchmark Standard & Poor's 500 Index.
“Sources of liquidity may be not only more difficult, but also impossible to obtain in the current market environment,'' KKR Private Equity said.
Journalists rarely know much of anything about the subjects they write. If there were ever really insightful journalists in this country, they are gone. Any time I read any article on a familiar subject I end up shaking my head. It doesn’t surprise me the public didn’t see the real estate bubble or the credit bubble coming. The media didn’t see it coming either. Any coverage of those subjects was thoroughly diluted with “fair and balanced” view points from industry shills. Any reporter who is familiar with his subject wouldn’t need to turn to boilerplate industry press releases and industry spokespeople to appear balanced. In the name of meeting deadlines and phony balance, today’s mainstream journalists have made themselves completely irrelevant.
“In other words, there are good reasons to think that the typical cyclical over leveraged deal failures that the private equity foists upon the wider world on a regular basis will lead to even worse outcomes than usual. Yet Sorkin, who ought to know better, omits key details that would raise even more questions about the prospects for these investments. One can only wonder why”
I don’t know why either. But it is fair to say that this “absence” of reporting is typical of the failure of journalism in general to serve the public’s need for actionable information.
A good writer could do a job on this topic -a corporate financing system so corrupted by risk free leverage (read Barbarians at the Gate again) and law changing to achieve lawlessness for their own benefit that it is now on life support with taxpayer funds. And on the values such as journalism and accountability that have been squeezed out, starved for budgetary space on the corporate agenda required to pay their rapaciousness owners/financiers, while corporate employees have had to learn to live in fear of constant mass firings for the last two decades.
This dynamic didn’t require a conspiracy, just the fellowship of global ivy league alum (any reason why the top ivy league universities’ endowment funds should so consistently outperform all other funds through market ups and downs?) and their financing for the end of rules and regulations created to protect the public.
These rules after the 1929 crash did in fact protect the public from the rapaciousness of the likes of KKR, et al. whose profits now constitute an American coup d’éta, a take over so far beyond anything that can be termed ‘earnings’ as to beg the question of who now owns my country? Who has owned it for the last20 years?
“Surprisingly” superficial? You must be a new reader of the NY Times, and especially of Sorkin.