Monday, September 29, 2014

No-This Time is Not Different

Leverage is increasing. YTD 50% of LBOs have FDX (funded debt multiples - Funded Debt/EBITDA) greater than 6X - 15% have FDX greater than 7. Additionally, creditor structural protections like financial covenants are disappearing. The driver is the increase in PPX (purchase price multiples - purchase price/EBITDA). Current LBO PPXs have increased two full turns to 11.5X since 2013. This reflects the increased pressure from competing strategic acquirers, a strong stock market and a recovering M&A market. PPX always increase to absorb any rise in debt capacity. Just as the Cash Burn Rate is important for venture capitalists so is the PPX for private equity sponsors - it represents a LBO burn through of value.

Some believe this time is different and the increasing debt levels are affordable. They believe an improving economy, low rates and low spreads translate into strong interest expense coverage and low default rates. They do, but this is a cyclical business and these pleasant facts can quickly change as we saw during the financial crisis when defaulted or restricted loans rose to double digit levels.
FDX greater than 6X mean you cannot retire principal during the original term of the loan. This means the ultimate repayment source is either a refinancing or trade sale of the company. These depend on markets remaining open and liquid - which is clearly not always the case. We have moved in Minsky terms from a hedged phase (2009-2013) in which debt principal and interest can be serviced from internal cash flow to a speculative phase. During this phase only interest can be covered from internal cash flow. The final Minsky phase before a correction is the Ponzi stage in which neither interest nor principal can be internally covered. Instead they must both be refinanced as was the case the last Ponzi stage of 2007. We are, hopefully, a few years away from this, but no one knows for sure when markets will turn. All we do know is they can and do turn violently when the refinancing wall is hit.

This situation has been noticed by banking regulators. They have strongly signaled that transactions with greater than 6X FD ratios will be subject to greater review. Last year they criticized over 40% of the large syndicated loans, known as shared national credits or SNC, which are heavily weighted towards leveraged transactions. Recently, they have signaled out Credit Suisse for underwriting loans exceeding the 6X guideline. This is understandable as CS is a major LBO loan sponsor with a 13% market share and generating over $400mln in loan fees this year alone. CS will push to defend its market position. Regulators may require CS to hold more capital and criticize banks participating in their loan syndicates via the SNC review. Ultimately, this will push more of origination effort to non banks just as most of the ultimate holders of leveraged loans are now non bank CLOs.

This will not end well. As Hemingway stated about bankruptcy - first it happens slowly, then suddenly. It is difficult for banks like CS to resist getting dragged into the fray. How can you choose not to play the game on the field especially when your competitors are doing so?  Citi’s Chuck Prince noted, as long as the music is playing you have to keep dancing. The regulators are trying to turn down the music. Whether they succeed this time is questionable.


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