Distressing Times
Financial sponsors, facing a lull in the LBO market, are launching new funds to capitalize on the credit market dislocation and special situations.
By Kelly Holman April 28, 2008
'Opportunity' is the latest buzzword among financial sponsors, which, as in years past, are moving like a gang of gold prospectors towards what is perceived to be the next big private equity treasure: credit.
The chance to generate solid, risk-adjusted returns by investing in various forms of debt has spurred several big-name private equity firms to launch new debt funds, seeking to invest in the massive backlog of leveraged buyout debt arranged in the past few years, and distressed credits. Bank financing for LBOs is in lockdown mode because of the subprime market collapse, and banking houses are eager to clear their books of debt after massive multi-billion dollar write-downs, while the economic downturn is squeezing corporate earnings of consumer product companies, home builders and retailers, among others.
For some private equity firms, the bank credit conundrum and economic downturn translates into opportunity. The investment prospects for seasoned distressed debt buyers like Apollo Global Management and turnaround firms such as Sun Capital Partners, for example, are as clear as vodka.
Apollo has already jumped at the investment bank debt opportunity, joining Blackstone Group and TPG Capital to buy $12 billion of leveraged buyout loans from Citigroup, which also provided debt financing to support the financial buyers' purchase.
"Some private equity funds have been able to buy un-syndicated senior secured LBO debt from banks at discounts ranging from 84-90 cents on the dollar. This is a win-win because the buyers know the credit quality of the loans is good and the banks have already taken the write-down and want to get the debt off their books," says William Kirsch, a partner at Paul, Hastings, Janofsky & Walker who chairs the law firm's private equity practice. "After giving effect to the leverage on the purchase price, the private equity funds are looking at 20% to 25% annual returns out of the box," he adds.
Borrowing debt to fund the purchases enables private equity buyers to "turbocharge" returns, Kirsch says, since less equity is involved. And, buying a portfolio of leveraged loans is less troublesome than investing in companies nearing bankruptcy, he says.
Since late last year the debt units of private equity houses have moved quickly to raise new investment vehicles to capitalize on the hung bridge financing opportunity. Some funds, however, have taken a much broader tack towards credit investing than simply buying up pre-arranged debt or distressed credits.
One such investor is THL Credit Group, an affiliate of Boston buyout house THL Partners, which held the first close on its new debt-oriented fund last August, marking THL Partners' first direct debt investment effort, following the credit group's formation last summer. The fund, which invests in companies with a minimum $10 million of cash flow, isn't overly keen on buying up bank debt, according to James Hunt, chief executive and chief investment officer of THL Credit. "Hung debt is a problem that's going away quite quickly. We aren't very oriented towards it because it's a moment in time and most of the paper that is hung debt is very highly leveraged."
Hunt points out that much of the debt was arranged prior to last year's credit crunch in a very different economic environment and at different valuations than would be underwritten today.
The overall institutional debt pipeline, comprised of financings slated to hit the market or already in market, totals $74.9 billion, while the overhang of LBO deals stood at $51 billion at the end of March, according to Reuters LPC. That figure might be closer to $39 billion, though, given the recent debt sales by Citi.
Although the amount of debt held by banks may be declining, one thing is for sure: a number of distressed investors are looking for money. Thirty-three distressed debt funds are seeking to raise more than $36 billion of capital, according to data from London private equity data intelligence firm Preqin.
"With a strong supply of new vehicles on the road, and with investor appetite remaining high, we predict that 2008 will again be a strong year for distressed debt, and are estimating that between $35 billion and $40 billion will be raised for the fund type by the end of the year," says Tim Friedman, head of marketing at Preqin.
THL Credit, meanwhile, was set up last summer to deploy capital across a broad spectrum of credit including leveraged loans, mezzanine financing, high-yield bonds, and structured equity and co-equity investments. It seeks returns of more than 20% annually and a circular about the fund notes it is "building a diversified portfolio by investing in a wide range of syndicated and directly-originated securities."
"One opportunity in the times we're in today is investing in the good company with a bad balance sheet," says Hunt, adding, "turnarounds and restructurings, there's too much risk in that."
Another group with a diversified, opportunistic approach is Carlyle Strategic Partners, the distressed investment unit of Washington private equity firm Carlyle Group. Carlyle Strategic recently announced the close of a new $1.3 billion fund, its second, which will invest in different forms of debt securities including bank loans and public debt, as well as both private and public equity of troubled companies in a wide range of industries.
Providence Equity Partners of Providence, R.I., is raising $1 billion for its first-ever debt fund, which initially had a $600 million target, called Providence TMT Special Situations Fund, say people familiar with the investment vehicle. New York's GSO Capital, part of Blackstone Group, is reportedly looking to drum up $510 million to acquire hung LBO debt. Officials for Providence and THL declined to comment on fundraising, while GSO Capital officials did not return calls seeking comment.
San Francisco alternative investment firm HRJ Capital, meanwhile, has found another way to tap into the credit market dislocation. Its newly minted $195 million HRJ Special Opportunities Fund I, a fund of funds, commits capital to US and international private equity funds that invest in distressed debt, restructuring, turnarounds and special situations.
Preqin's Friedman says distressed debt funds closed on average 19% ahead of their fundraising targets in 2007, demonstrating strong investor appetite.
Traditional distressed investing centers around buying distressed debt at a discount and converting it into a control equity investment through a reorganization or pre-packaged bankruptcy or also it can involve acquiring troubled companies out of a bankruptcy auction. Distressed debt is broadly defined as bonds with an interest rate of 1,000 basis points over Treasuries, according to Victor Caruso, managing director and head of Morgan Joseph & Co.'s financial restructuring group.
Caruso says today's players in distressed debt are aiming for returns of 25% or more. In what industries will investment opportunities appear?
"The restaurant, consumer, certain media properties and retail companies are going to be very ripe for restructuring," says Randy Lampert, a managing director at Morgan Joseph, which is involved in restructuring advisory work and distressed debt trading.
Apollo is believed to have carried out the first major, institutional distressed debt investment in 1991 when it purchased $185 million of Gillette bonds at a discount from insurer First Executive, according to restructuring veterans.
"Apollo really led the way in terms of having an organized distressed effort. Up until that transaction it had been done on a one-off basis, but Apollo institutionalized it and bought a portfolio of assets," says Morgan Joseph's Lampert.
It followed with other distressed investments in companies like Vail Resorts Management Co. in 1991, Telemundo in 1992 and SpectraSite in 2003, among others.
Apollo officials declined to comment for this story, citing quiet period restrictions around their firm's recent filing to hold an initial public offering.
The firm's IPO filing itself indicates that Apollo is still interested in investing in the distressed sector as it was at its inception. Over the last 18 years, 30% of its private equity investments involved distressed buyouts and debt.
Like other private investors raising new opportunity funds, Apollo has taken a broad approach to investing in the area. For instance, its registration document notes the firm is pursuing distressed securities investments in financial services, media, packaging and transportation companies. In addition, it is looking to acquire debt securities of companies that are performing well, but are attractively priced because of last year's debt market disruption, and use "creative structures" to de-leverage a company's balance sheet and acquire a control position.
Apollo invested $9.5 billion in total, largely in distressed buyouts and debt in the rough economic cycles of 1990 through 1993, 2001 to 2003, as well as the third quarter of 2007 through the first quarter of 2008, according to its prospectus.
The private equity firm and other distressed players, though, might face a different challenge in the latest business cycle.
Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth, thinks today's default environment may not mirror past periods. Determining just exactly who owns what piece of distressed paper from various tranches of CLO debt, he says, isn't going to be as easily identifiable and there are likely to be more parties at the table.
As a result he says "this distressed cycle may look more like investing in distressed securities looking for recovery, rather than investing in distressed securities for control."
Alternatively, Blaydon says financial buyers may seek to buy troubled companies directly out of restructuring rather than negotiating with a creditor.
Another reason the current period might be different from past recessionary periods is that the inclusion of aggressive financing structures like payment-in-kind (PIK) toggle notes - financing which pays the investor in additional bonds rather than cash - in terms loans arranged in the last two years is going to stretch out defaults.
"Covenant lite structures along with PIK toggle notes, refunded and zero coupons give companies more flexibility and longer time to default," says Morgan Joseph's Lampert.
As Moody's Investors Service notes in new research, "the likelihood of tripping loan maintenance covenants would appear to be low by historical standards given that over $100 billion of speculative grade 'covenant lite' bank loans that had no maintenance covenants were issued in 2006 and 2007."
By contrast, $26 billion worth of covenant-lite loans were issued in 2006 and $79.3 billion of such loans in 2007, according to Reuters LPC.
One marked difference between today's economic downturn and past recessionary environments is that corporate balance sheets are generally in better condition, not withstanding over-leveraged companies in certain sectors, relative to corporate America in past recessions, according to Moody's.
If research from Moody's offers any indication, the restructuring wave may not arrive until 2009. The rating agency noted that only $12.5 billion of debt will come due in 2008, which makes up a mere 4.3% of all US speculative-grade issuers tracked by Moody's. While it had previously projected global speculative-grade default rates to increase 5% from its current 11.5% year-end projection, it has since scaled back its 2008 default forecast to peak at 3% to 4%.
The revised projection implies there will be six to eight defaults on average each month over the next nine months, which is well below the 15 defaults in the first quarter.
Moody's also noted that corporate default rates were over-predicted during the 2005 to 2007 timeframe. But, it expects corporate balance sheets will become stressed in 2009, and that a number of companies will face negative free cash flows as debt comes due in 2009 and 2010. Default rates, meanwhile, have remained low despite increases in high-yield bond spreads.
Not for everyone
When it comes to the distressed debt investing, observers say, investing in troubled businesses isn't for the faint of heart.
"It really takes both skill, knowledge of the restructuring process in some very technical ways, and a clear headed, tough mindedness. Unless you build a team that really has both the legal and financial skill set to handle these very complex negotiations, it's very tough to play in this game," says Blaydon.
Meanwhile, investment managers have been adding experienced professionals in the distressed debt area.
Boston's Babson Capital acquired Murray Capital Management's distressed debt operations this past week, taking control of a New York business stewarded by 21-year distressed investment veteran Marti Murray.
Murray says about 20% of high-yield bonds are trading at distressed levels, while about 70% of the high-yield market isn't distressed but nonetheless are stressed credits. That, in turn, spells investment opportunity for Babson and Murray, which invests up and down the capital structure from bank debt, unsecured bonds and secured bonds to trade claims and equities of reorganized companies.
Other financial advisory firms are gearing up for restructuring.
Moelis & Co., the New York firm named after former UBS investment banking president and ex-Donaldson Lufkin & Jenrette corporate finance executive Ken Moelis, recently hired restructuring veterans and bankers Thane Carlston and William Derrough, who will join the firm in July to serve as co-heads of its restructuring practice.
Jefferies, which is advising on more than 20 active restructuring engagements valued collectively at more than $25 billion, also has assembled a new recapitalization and restructuring advisory team headed by Michael Henkin and Steven Strom.
For restructuring and troubled company dealmakers the chance to invest in a big wave of distressed companies comes along about as often as a seven-year locust.
All indications are that a slew of new opportunities will be born in the next year.
(c) 2008 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.
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Tim Friedman
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