There was a little stir over at RealMoney over an article printed in Friday’s Wall Street Journal regarding Leveraged Buy-out [LBO] quality. Both Jim Cramer (video) and The Business Press Maven, Marek Fuchs, disagreed with the premises of the article. So who was right? Let’s start with the case made by the Wall Street Journal. It can be summarized in three points:
- There are a few LBOs in trouble. This is notable because it is happening early in the tenures of the deals. There are unique things going wrong in the each of the four deals mentioned.
- Cash interest coverage ratios are at levels not seen since 1997.
- Some of the bonds and loans used to finance the deals are trading below par.
So what do Cramer and Fuchs do with this? They attack the weakest part of the argument, that there are only four deals mentioned to be in trouble out of thousand or more deals. Now, before any credit crisis hits, typically credit metrics have deteriorated, but few deals seem to be in trouble. Why? The companies in question are usually in good shape at the time a LBO takes place, and if not, the financing obtained typically has additional cash to re-liquefy the company.
Typically, it takes 3 years from the time that loans/bonds are sold before defaults start happening. In years 1 and 2, defaults are few, and notable because they look incredibly dumb in hindsight. Point one of the WSJ article does not of itself prove that a crisis is coming. But if they couldn’t point at some bad deals, there would be no article to write.
The more serious issues are loan pricing and interest coverage.
Interest coverage of 1.7 times cash flow is very low, and akin to what one gets on CCC-rated debt, except that the loans are typically secured by the assets of the company, which lessens the severity level of defaults. Further, for loans to trade below par when there is hot demand for loan collateral from Collateralized Loan Obligations, implies that something is amiss. Now, what do Cramer and Fuchs do with these issues? Not much. Cramer doesn’t deal with it, and Fuchs says:
“For an article that implies a turn in the pace and fate of LBOs (did I mention the graph titled “Less Breathing Room”?) there needs to be more and better evidence. To make a point in journalism, you do not need the rigors of a scientific sample. Daily journalism simply has to move faster than that.“
In short, he dismisses it without any significant comment.Now, I generally appreciate most of what Cramer and Fuchs write, but in this case, they didn’t seem to get the most significant points of the article (2 and 3 as I number them). That said, the WSJ emphasized point 1 the hardest, probably because they didn’t want to bore their audience, so perhaps they both can be excused.
Credit metrics deteriorate before defaults happen, and it takes three years afteer the peak of issuance to see how bad it will be. We are seeing record loan issuance combined with deteriorating fundamentals at present. It may be as late as 2010 before we see the bad results of this in full, but I would not cavalierly dismiss the problem simply because there are few distressed situations now. Within three years, we will have more than enough distress to overwhelm the sizable resources of vulture investors.
A serious rise in defaults may be 3 years away as you suggest, but would you expect to see credit spreads widen substantially between now and then?
Yes, I would expect them to widen, but not linearly. The banks and hedge funds are still very willing to fund LBO debt at these levels, and perhaps tighter. Spread widening should be gradual until we get an big event that changes the perceived riskiness of lending to LBOs.
Do you know how the relationship between classes of LBO funders works? In particular, I’m wondering who exercises functional control if things start looking spooky. The senior rated tranches obviously have first call on proceeds, but how are they treated in terms of pre-default functional and operational control?
If it turns out that the senior holders have control, presumably they’d be inclined to call a deteriorating play early. Junior holders would be 100% at risk early in the process, so would presumably try to push default into the future, even if it prejudices the position of senior holders.
The private equity controls the company until it goes into default, and a reorganization plan approved by the bankruptcy judge reapportions the ownership of the firm to the debtholders.
The class of debtholders that would gain control would vary. It is usually the class that would receive partial payment if there was a liquidation (with the more junior class getting zero, and the more senior class getting full payment).
The tightest debt covenants belong to the senior bank financing. They will look at a firm in crisis and ask the following: if we let this run, how likely and how big would any impairment of capital be? If we waive the covenants for now, what payment or additional security can we receive? Let the junior debt suffer, we are in the driver’s seat.
Those that offer junior debt financing are often at the mercy of the banks on the one side, and the private equity on the other. They rarely get control unless the company goes through the bankruptcy process.
Thanks, that’s helpful.