Change of Seasons

I have always believed markets have seasons. The seasons themselves are not as interesting as the change among seasons. We appear to be currently undergoing one of the more interesting changes in years. The June Federal Reserve (Fed) announcement concerning the beginning of the end of its QE3 (quantitative easing) bond buying program this September promises to have major corporate finance implications. The Fed seems concerned that QE was creating market distortions, and was no longer needed.

The market response to the announcement was dramatic. It triggered a substantial stock market correction. More importantly, however, it produced a major bond market rout. The bell-weather 10 year Treasury (T10) jumped by 80bps almost overnight to 2.5% a level not seen since 2011. Credit spreads on other private debt instruments jumped even more. For example BB bonds credit spreads widened by almost 140bps. As a rough rule of thumb, bond prices drop by 1% for each year of a bond’s duration for every 1% increase in rates. Duration (Duration) is in effect a bond’s beta. Investors had been reaching for yield by going further out on the yield curve (i.e. taking increased duration exposure) for the past year to offset artificially low interest rates due to the QE3. Hence,  duration for many investors and bond funds exceeded 5 years. Thus they suffered massive June market value losses of more than 4% - even more for leveraged bond funds. Investor withdrawals from bond funds were large. PIMCO, a major bond fund sponsor for example, suffered billions of withdrawals in June as the market re-priced. The severity of this re-pricing rivaled the 1994 Fed surprise rate adjustment. Furthermore, the expectation for rates is a continued rise as markets adjust to a world without QE. Rates could increase to a more normal 3.5-4% pre-crisis level over the next year.

Consequently, investor bond appetite has declined, and issuers are curtailing bond offerings as the market adjusts. Some implications of these developments are as follows:

1)    Debt financed stock repurchases and recaps will slow as the relative cost of debt rises compared to equity. The impact on pending deals like Dell should be interesting.

2)    Decline in use of aggressive debt features such as PIK, covenant lite and second lien. Issuers will focus on more investor friendly straight debt instruments.

3)    Increased funding risk for debt-financed cash acquisitions involving non investment grade buyers. This will favor better financed strategic buyers over financial buyers.

4)    Debt capacity will decline as rates increase. This will depress purchase price and funded debt multiples.

5)    PE fund raising and exits will decline from near record 2Q13 levels.

6)    IPO and M&A volumes will suffer.

The abrupt market change highlights again the value of financial slack -“excess” capital and liquidity. Firms with slack will weather the adjustment process without any major disruptions. Additionally, they will have the capacity to engage in opportunistic transactions to capitalize on market mispricing.

Firms need to recognize the end of the multiyear QE based bond bull market. The means adjusting to new investor demands when designing instruments and transactions. It was great while it lasted, but he bull market bond summer season is over. This is not necessarily bad - it just means things will be different. These changes are what good corporate finance professionals are paid to recognize, improvise on, adapt to and overcome.

j

Honey-I Shrunk the Covenants

A booming leveraged loan driven by yield hungry bank and non bank investors is supporting private equity transactions (Market ). Leveraged loans are also benefitting from a shift away from related high yield bonds into loans given their relative interest rate credit risk superiority. These developments are reflected in falling yields and looser terms and conditions for leveraged loans. This is especially true for loans with minimal covenant protection otherwise known as covenant-lite, which now represent more than 50% of the non-investment grade leveraged loan market new issuance year-to-date. Bank regulators have expressed their concerns over weak terms and covenant- lite loans (FDIC). Covenant-lite supporters dismiss such concerns.

Covenant-lite loans have minimal financial maintenance restriction. They are similar to pre-crisis “no doc” mortgage loans. Typical financial covenants require a debtor to maintain a certain multiple of earnings to interest expense to protect against default risk. An additional leverage covenant, expressed as a ratio of debt to equity, is included to provide a cushion limiting the creditor’s loss in event of default. A well designed covenant package allows creditors to preserve the original credit quality of the transaction. It allows them to force a loan restructuring should the debtor’s performance decline while there is still sufficient remaining debtor enterprise value to cover the loan. Thus, covenants serve surveillance and control functions in loan agreements.

Non bank investors represent the largest investor class in leveraged loans. Unlike banks, they place reduced reliance on covenant protection. Rather, they depend on the ability to liquidate their positions in the loan secondary trading market should they become uncomfortable with the debtor’s performance. Unfortunately, as many investors learned during the 2008/2009 crisis, liquidity is not always there when you need it. Thus, secondary market liquidity should be viewed as a complement to and not a substitute for structural protection provided by covenants.

Covenant- lite proponents contend that covenants provide limited protection. This is based on a 2011 study showing recovery rates for covenant lite loans issued in the 2005/2007 time period to be similar to other loans (Moody's Report). The reason given for this surprising performance is that recovery rates depend more on initial junior capital support, equity and subordinated debt, than on covenants, which protect against future erosion of the support. Unfortunately, this explanation is suspect for several reasons.

It is based on a limited sample covering one short time period. As the study notes, extrapolating from such a sample is very dangerous. Also, keep in mind the massive Federal Reserve liquidity intervention during since the financial crisis, which supported the rapid recovery of financial markets. This allowed many troubled firms to restructure their loans by refinancing. This may mask the performance characteristics of covenant- lite loans as they were never seriously tested against deteriorating collateral values and changing debtor behavior. Bottom line, there is no iron law that future covenant-lite recoveries will be as favorable in the next downturn. Market conditions, Federal Reserve support (e.g. Quantitative Easing) and underwriting standards can change quickly leading to vastly different recovery experiences. Investors need to examine the entire package-issuer quality (e.g. cash flow and junior capital cushion), instrument terms and conditions (e.g. covenants), yield, and market conditions when evaluating loans.

Consequently, the continued attractiveness of covent-lite loans depends. Knowing what they depend on is what separates the adults from the children. The current market cycle characterized by investors reaching for yield in a low rate environment has shifted the risk- reward dynamics in the issuer’s favor. This is reflected in lower quality issuers, looser terms and compressed yields. Risk is being priced for the perfect calm. We may, however, be facing a storm with the coming end of Federal Reserve QE resulting in potentially violent market changes. Investors should beware of these facts as we enter the adults only swim time in the leveraged loan market when considering covenant-lite loans.

J

Industry Merger Waves

In February, we talked about Motives for Mergers.  We followed up on this theme in March writing about Catalysts for Merger, discussing shocks that lead to merger waves within an industry:

"So what are these shocks, these catalysts?  Common catalysts include: shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology."

As a result of these shocks mergers occur in waves, both in the aggregate economy and within industries.  We'll leave the aggregate waves for another discussion and today talk about waves within an industry.   Current examples include old technology firms, banking, pharmaceuticals, and energy.

An interesting research piece on industry merger waves is by Jarrad Harford of the University of Washington.  Harford uses a novel measure of merger waves and extends our knowledge about the necessary conditions for a wave.   

Harford calculates merger waves in a statistical fashion, defining a merger wave within an industry as a twenty-four month period with a statistically unusual level of activity.  He identifies 35 merger waves in 28 industries over the 1981-2000 period. A list of these industry waves is contained in the article.  

While Harford notes that shocks do indeed precipitate merger waves, he also notes that shocks are not enough.  In particular, Harford notes that "There must be sufficient capital liquidity to accompany the asset reallocation.  The increase in capital liquidity and reduction in financing constraints that is correlated with high asset values must be present for the shock to propagate a wave..." (p. 1)

The abstract of the article entitled, "What Drives Merger Waves" is below.

Abstract: What Drives Merger Waves, by Jarrad Harford     

"Aggregate merger waves could be due to market timing or to clustering of industry shocks for which mergers facilitate change to the new environment. This study finds that economic, regulatory or technological shocks drive industry merger waves. However, the degree of capital liquidity determines whether a shock initiates a merger wave. This macro-level liquidity component causes industry merger waves to cluster in time even if industry shocks do not. Market-timing variables have little explanatory power relative to an economic model including this liquidity component. The contemporaneous peak in divisional acquisitions for cash also suggests an economic motivation for the merger activity."

The complete article can be downloaded here.

All the best,

Ralph

  

2013 - Year of the Deal or Year of the Snake?

A rash of deal activity, especially larger deals, has occurred this month with the Dell, Heinz and Comcast announcements. This increase, which actually started in 4Q12, if sustained, could see 2013 deal flow reach a post crisis level not seen since the credit crisis. Care is needed in M&A predictions, however, as a rebound has been projected for the past several years. This time, the rebound seems likely to last for the following reasons:

1.     Reduced, albeit still significant, macro political and economic uncertainty.

2.     Significant pent-up demand given years of depressed activity.

3.     Pent-up need for consolidating M&A in several industries including tech, consumer products and banking to offset growth and margin pressures.

4.     Improved financing conditions. Bankers and investors, in general, are searching for yield in a low return environment given their improved financial condition following massive credit crisis losses. The focus has shifted to return on capital instead of return of capital. Consequently, the return of cheap and plentiful financial capacity to fund the $23B Heinz LBO at an aggressive 6X funded debt to EBITDA level.

5.     The stock market has finally recouped its crisis related losses after 5 years. M&A and the stock market are both reflections of investor confidence.

6.     Corporate balance sheets and earnings remain robust. Hence, deal and debt capacity are strong and permits larger deals.

7.     Investor reaction to recent announcements has been unusually positive. Buyer shareholders are suspicious of M&A announcement given the propensity to over pay. Thus, buyer stock prices frequently decline. Current deals, occurring earlier in the cycle, appear to have lower price risk and better strategic rationale than deals in general. Therefore, buyer’s share prices have actually increased following the deal announcements. This will not go unnoticed by other potential buyers. Of course, the potential for an over-priced HP-Autonomy deal is never more than a click away.

8.     Momentum feeds on itself. A combination of confident buyers combined with liquidity provided by yield seeking investors will support a herding effect which can last for a considerable period.

The most likely result is an upturn in the M&A cycle which builds over the next few years. The speed and magnitude of the rebound are unknown. As in previous cycles, the best (i.e. reasonably priced) deals are made earlier in the process. It appears 2013 may actually be the real deal. This is good news indeed for revenue starved advisors, banks and investors at least in the short run.

j

Back to the Future Again: The Beginning of a New Debt Bubble?

You cannot blame investors reaching for yield given the current near zero interest rate environment. This has depressed credit spreads and increased the market appetite for higher risk transactions. Plentiful cheap credit has proved to be too much of a temptation for many firms to ignore.  An unintended consequence of this development has been an increase in corporate leverage for both investment grade and noninvestment grade corporate issuers. Much of this increase for investment grade firms is related to shareholder distributions such as debt financed dividends and share repurchases.  Issuers like Costco and others have been issuing new debt to fund these distributions. True, some of this is related to the expected increase 2013 tax changes. Nonetheless,  the net result is investment grade corporate leverage multiples are creeping up to 2X EBITDA.  Just like in the pre-crisis era, firms are scolded for lazy balance sheets with low debt levels and high cash balances. The rise in leverage levels for the noninvestment grade LBO is even more dramatic. Leverage as a multiple of EBITDA has increased to over 5.5X while equity levels have fallen below 35%. These levels are approaching their pre-crisis highpoints.

This is reminiscent of the 'optimizing balance sheets by leveraging up' themes prior to the crisis. The problem with leverage is the benefits are visible while the costs are hidden. This is because risk is difficult to measure. The key benefits are control, usually reflect in share accretion, taxes (because interest expense is tax deductible) and higher equity returns. The tax benefit associated with leverage comes from a value transfer from the IRS by reducing their take in the firm’s cash flows. This benefit was reexamined and revised  downward from the statutory tax rate times the level of debt by Merton Miller in 1977 once the impact of personal taxes are considered.

Leverage costs are reflected by the product of the probability of distress times the cost of distress. The probability of distress is a combination of business risk from factors including cyclicality, regulation, competitors , and others as outline in my previous  November 14, 2012 post "How Much Debt is Right for Your Deal?".  The second component-cost in the event of distress -is much more amorphous and frequently understated if not ignored all together. These included heighten risk of competitor attacks, negative relationship impact on suppliers, customers and employees, and ultimately risk of default and failure. Leveraged firms have simply less room for error. Many firms discovered this fact during the 2008/2009 period.

These firms lost financial market access, were unable to rollover maturing debt, had to curtail investments and dividends, and some ultimately failed. As James Grant has noted all lessons in finance are cyclical and not cumulative. They are continually being rediscovered. What is surprising is how quickly many of the crisis lessons have been forgotten again. They may be painfully rediscovered again.

Financial markets still face considerable macro headwinds which could result in their closure to some firms. This could severely impact their strategic investment programs - their main source of shareholder wealth creation - and especially the flexibility to capitalize on market disorder by profiting from competitor weakness. That is why capital structure decisions must be tied to overall strategy. Also, they must be consistent with an appropriate debt rating and liquidity levels.

Less leverage and more liquidity are not mere redundancies or insurance. Rather, they represent opportunistic investments. Firms sometimes under estimate their liquidity and capital needs during bullish markets. Apart from tax shields (which may be overstated) leverage does not create value-it only magnifies short term results.  In addition, offsetting costs of financial distress are difficult to estimate. See Nassim Taleb’s recent book “Antifragile -Things That Gain from Disorder” (Random House, 2012) for a more philosophical approach to this topic.

Cautious Joe

p.s. Best Buy (original post November 19, 2012 “Not Sold on Best Buy LBO") update: The firm has granted its largest shareholder and founder an extension to next February to make a bid. This another sign of the difficulties associated with the planned buyout. As the saying goes, good deals get done right away, while bad deals don’t.


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We won't post next week, but will return Jan 4.  We wish all of you a wonderful holiday season and a fantastic 2013!

Joe and Ralph

De Ja Vu All Over Again-The Return Of The Spring Menu

Numerous Federal Reserve actions, including QE3 and Operation Twist, have flooded the markets with liquidity, depressed interest rates and flattened the yield curve. Domestic banks, unlike those in Europe, are well capitalized and have the capacity and willingness to lend. Investors searching for yield, but unwilling to assume equity tail risk have a large appetite for debt securities. Investment grade securities have priced so aggressively that more investors are marching up the risk curve.

The demand for noninvestment grade firms and higher 'risk structured' credit product is growing at a rapid rate. It is starting to feel like the pre-crisis 2005-2007 period. It is a good time to be an issuer/borrower. Hence we are seeing the return of bull/spring market debt capacity enhancing products as outlined in my prior post Back in Fashion Again. These include PIK, second lien loans and covenant lite.

High yield bond issuance (non-investment grade issuers with ratings below BBB-) is up 35%+ over 2011.The inflow of new investor funds into high yield bond funds is driving the demand for these instruments. Equally important is the growth in leveraged (non-investment) borrowers. Volumes are up 25% over the prior. They have reached their highest level since the crisis and the third highest level in history.

The majority of leveraged loans are structured as term loan “B” and sold to nonbank institutional investors. These investors are attracted to the asset because of the high yields LIBOR + 450-525 basis points with LIBOR floors of 125 basis point for the Bs and LIBOR + 900 on second lien loans. Additionally, they like senior secured floating rate features.

The return of collateralized loan obligations (CLO) is another development increasing the demand for leveraged loans. CLO are securitization vehicles that purchase and pool leveraged loans. They then tranche instruments used to fund their investments with lower rated tranches serving as enhancement for the higher rated tranches. CLO volume has increased to over $50B this year compared to just $12B in 2011. This is yet another sign of increased investor risk appetite.

M&A volume is highly dependent on credit. If credit is available bidders will use. This is reflected in rising M&A volumes, elevated purchase pricing and larger transactions. A current example is Freeport-McMoRan’s combined $10B acquisitions of two oil and gas firms at significant premiums. Although remaining marginally investment grade at BBB/negative outlook and a stock market beta of 2.3, JPMorgan felt comfortable enough to act as sole initial underwriter for $9.5B of loans.

It is important to remember that these market windows of financing opportunity can close abruptly-especially for lower rated firms and higher risk structures. Significant macro headwinds including the fiscal cliff, slow growth and Europe still remain. Therefore, I strongly suggest the following:

•  Locking in your financing with as few lender outs as possible. Borrower bargaining power has increased.

•  Be prepared to assume pricing and structure flex clauses in commitment letters. These allow lenders to increase pricing and reallocate portions of the loan if market condition change to clear the market.

•  Try to build financial flexibility into your merger agreements.

You can only take what the market offers. Currently the credit markets are in a holiday mood and offering a lot. So take it while you can, but be prepared should conditions change.

J