Leveraged Finance Market Developments

Leveraged finance involves an ecosystem of parties funding leveraged buyouts and acquisitions resulting in noninvestment entities. It includes originators like private equity firms. Also includes financial sources such as bank arrangers like JP Morgan Chase, Collateralized Loan Obligation (CLO) Funds, the end takers of bank arranged leveraged loans (they hold > 2/3rds of the term loans), and high yield bonds. The market is highly cyclical. Thus, it expected to benefit from the sharp surge in deal activity.

Leveraged finance activity so far, however, has been disappointing. The crowding out of PE by strategic acquirers has been previously discussed.  Leveraged activity is down almost 50% from prior year. Additionally, regulatory developments impacting banks (e.g. GECC) and CLOs has made traditional participant reluctant to bring new deals to market. Some of the major changes include the following:

1)     Basel III: new higher capital requirements for higher risk transactions may “spook” some capital sensitive banks like Deutsche.

2)     U.S. Regulatory Guidelines: joint agencies directive frowns upon transaction leveraged more than 6X FD/EBITDA. This concern is understandable given banks are using subsidized government guaranteed short term deposits to fund long term highly leveraged borrowers. Leverage levels seem to be behaving by hovering around the 6X limit. This makes it difficult to match the high price bids by strategic acquirers.

3)     CLOs: the Dodd Frank Act retained interest rules (effectively requiring more capital) are forcing CLO to restructure and possibly raise new capital.

Hard to tell how this all is going to play out. It is a work in process and it is still on-going. Nonetheless, some preliminary observations are:

1)     High Yield Bonds (HYB): HYBs are substituting for bank loans in the capital structure. Issuers can swap back from fixed to floating. HYBs are, however, less flexible than loans on matters such as early repayment.

2)     New Non Bank Lenders (AKA Shadow Banks): include brokerage firms like Jefferies, which is in the top 10 of leveraged loan arrangers. Jefferies is less leveraged than a bank. Additionally, it is much smaller than the major bank arrangers. Finally, it has suffered some setbacks like the Rue21 transaction. So the jury is still out.

3)     Business Development Corporations (BDC): another specialized non bank lender. BDCs have special tax and leverage traits which may limit their application for large deals. Traditionally, they focused on smaller higher risk middle markets deals where they can get the extra spread needed to compensate for their lower leverage. The irony is both brokerage houses like Jefferies and BDC are funded by banks via warehouse lines. So the banks may still be exposed to highly leverage deals.

Some serious unresolved issues:

1)     Revolving Credit Facilities: banks are needed to provide revolvers. Less desirable alternatives include prefunding a liquidity reserve (expensive) and bank revolver carve-outs (messy inter-creditor issues).

2)     Securitization: still going to need warehouse facilities probably funded by banks.

3)     Non Banks: need larger participants to achieve scale to fund larger deals. May need to return to Drexel  (the firm not the school) style Highly Confident Letter  in lieu of firm bank type underwritings

4)     PE Accept Lower leverage: impact their bidding ability to compete against strategic acquirers.

These changes represent the third act of leveraged finance. The first being the entry of large arrangers like Bankers Trust in the 1980s. The second being the shift towards capital market style instruments to facilitate the entry of non bank investors. The current regulatory induce changes will take time and result in new winners and losers as this dynamic market continues to change.

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Finance Debt Fetish?

The go-to recommendation from many consultants and academics is to lever up your firm to increase your tax shield, lower your WACC and fend off activists. This approach may fit for some mature firms. It is, however, less well suited for other firms.

A useful approach to setting debt policy as reflected in a firm’s actual or implied debt rating is based on a firm’s life cycle. Consider the following:

1)     Early and growth stage firms: most of their value is reflected in growth opportunities from assets not yet in place. They have negative free cash flow due to operating losses, high business risk and high CAPEX. Hence they need flexibility to complete their investment plan and maintain access to capital. Such firms have high financial distress costs. Furthermore, they have limited taxable income i.e. tax shields have limited value. Such firms should and do have low debt levels.

2)     Mature firms: generate more cash than they can profitably invest due to high operating income and reduced investment needs. Business risk has decreased and the need for financial flexibility is low as is business risk. Additionally, they have high taxable income in need of tax shields. Finally, agency/incentive issues become prominent regarding investment allocations. In these circumstances, increasing debt makes sense. Witness the “old” tech firms like Apple that have pressured by activist to increase debt level to reduce the risk of misallocated capital. Also confirmed by consumer non durable firms which spend time on tax planning, including use of debt related tax shields, to reduce their tax burden.

3)     Declining firms: here the emphasis shifts from value creation and taxes to value transfers among the firm’s various claimants. Debt holders, often purchasing the debt in the secondary market at a discount, are looking to squeeze-out shareholders and gain control of the firm’s assets in a disguised bargain purchase. Equity holders are seeking to protect their interests. The Caesar’s Palace’s bankruptcy has highlighted questionable transfers by PE firm Apollo to shield assets from creditors.

In addition to life cycle and taxes there are other reasons firms may favor debt. These include:

1)     Information asymmetry discount (AKA Pecking Order Theory ): debt is a contractual obligation v equity which is a residual claim. Hence, there is more informational uncertainty regarding equity, and equity investors require a higher discount to induce them to commit. Managers recognize this fact and exhaust internal funds and debt capacity before issuing additional equity.

2)     Ownership/Control: maintaining ownership and control (ownership v earnings dilution) is very important for private and smaller closely held public firms. Thus, equity is not a preferred funding instrument.

3)     Discipline: agency issues arise whenever management’s interests diverge from shareholders. Debt can provide the discipline needed to hold management’s feet to the fire. This is a driving force behind many LBOs (agency costs).

4)     Signaling: issuing equity for mature firms usually results in a stock price decline. Investors view the raise as a signal that future cash flows will be less than expected. Debt must be serviced (P&I). Management would not issue equity if they thought it was undervalued.  Conversely, management would not issue the debt unless it thought the firm could repay it.  Consequently, debt issues are viewed by investors as neutral.

5)     Value Transfers: see the declining firm discussion above. Creditors attempt to protect against this include seniority, security and covenants. Legal protections include substantive consolidation, fraudulent conveyance and equitable subordination.

The above framework can aid managers seeking to make capital structure decisions.

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The Siren Song of Public-to-Private (PTP) Buyouts

A BC Partners consortium announced an $8.7B PTP buyout of PetSmart out bidding Apollo and KKR. The deal is the largest buyout of 2014 and one of the rare PTP transactions since the Great Recession. The purchase price is 9.1X railing EBITDA and represents a 40% premium to the pre bidding price. Its capitalization includes 20% equity and 7.2X trailing EBITDA in debt facilities underwritten by Citi, Jefferies, Nomura, Barclays, and Deutsche. The aggressive capitalization runs afoul of U.S. regulatory guidance. Perhaps that is why the bank group includes 2 non banks, Nomura and Jefferies, and 2 foreign banks, Barclays and Deutsche. PetSmart had been under activist pressure to improve its lagging stock price, which had only increased by 3% in the past year. The activist identified pricing, ecommerce and cost issues as factors underlying PetSmart’s performance problems.

More interesting than the deal is the possible return of higher risk-lower quality PTP transactions. PTP deals involve a PE firm taking a public firm private. The grand daddy of PTP was the disastrous RJR deal lead by KKR in the 1980s. PTP transactions are the poster boys of boom period deals. They reached almost 50% of the dollar amount of all LBOs before the financial crisis. The performance of PTP deals like TXU and Caesars, among others, caused PE firms and their investors to swear off PTP. Through 3Q14 the volume of PTP fell to less than 15% of LBOs-the lowest level in a decade. 

The issues with PTP include the following:

1)   Size: they involve large companies which entailed significant capital commitments.

2)   Fully Priced: public firms usually involve auctions which increases the risk of the winner’s curse. While PetSmart’s PPX seemed modest in the current market with PPX exceeding 10X-it still is over 15% higher than the median retail PPX over the past 5 years.

3)   Aggressive Financed: needed to offset the rich price.

4)   Limited Improvement Potential: most public firms have picked the low hanging fruit. Thus, the ability to achieve improvements needed to offset a 40% premium plus achieve a 20% IRR is questionable.

So why might PTP deals like PetSmart be returning? The answer is PE needs to deploy its substantial dry powder. LBO volume remains depressed at 2009 levels. A rising stock market and strategic buyers have simply out priced PE firms. Many recent LBOs have been Sponsor-to-Sponsor (STS) or pass the parcel deals. These involve one PE firm buying another PE firm’s portfolio company. Trouble is STS deals tend to smaller in size, and most the upside has been squeezed out by the original LBO buyer. As boilerplate PE documents highlights-GP carried interest depends on performance which means GP’s are motivated to approve more speculative investments than would ordinarily be the case. Yes, GPs are pirates, but at least they are honest pirates and state upfront what they are going to do to LPs.

PE restraint lasts only so long. When pressured by the need to invest GPs can no longer resist. PTP deals represent another sign, along with high leverage, that the LBO market is entering into a more speculative state. 

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