Thursday, October 19, 2017

Private Equity's Asset-Stripping Boom?

Wolf Richter of Wolf Street blog posted a comment, Asset-Stripping by Private Equity Firms Is Booming:
Here are the numbers. Peak chase-for-yield by institutional investors?

Most of the brick-and-mortar retailers that have filed for bankruptcy protection to be restructured or liquidated over the past two years have been owned by private equity firms – including the most recent major casualty, Toys ‘R’ Us. Part of how PE firms make money is by stripping capital out of their portfolio companies via special dividends funded by “leveraged loans” – more on those in a moment – leaving these companies in a very precarious condition.

So just how much have PE firms paid themselves in special dividends extracted from their portfolio companies? $4.76 billion in the third quarter, bringing the year-to-date total to $15.3 billion. So the year-total for 2017 is going to be a doozie.

In all of 2016, this sort of activity – “recapitalization,” as it’s called euphemistically – amounted to $15.7 billion, up from $10.5 billion in 2015, according to LCD, of S&P Global Market Intelligence. LCD’s chart shows the quarterly totals (click on image):


“This high-profile recap activity is a sign of the times in today’s still-overheated leveraged loan market,” LCD says:
Deals such as these typically proliferate when there is excess investor demand, allowing borrowers to undertake “opportunistic” issuance, such as corporate entities refinancing debt at a cheaper rate or, here, PE firms adding debt onto portfolio companies, then paying themselves an often hefty dividend with the proceeds.
As private-equity-owned retailers that are now defaulting on their debts have shown: this type of activity where cash is stripped out of the portfolio company and replaced with borrowed money is very risky.

Leveraged loans are provided by a group of lenders to junk-rated over-indebted companies. They’re structured, arranged, and administered by one or several banks. But leveraged loans are too risky for banks to keep on their balance sheet. Instead, banks sell the structured products to loan mutual funds or ETFs so that they can be moved into retirement portfolios, or they repackage them into Collateralized Loan Obligations (CLO) to sell them to institutional investors, such as mutual-fund companies.

A record $947 billion in leveraged loans are outstanding. They trade like securities. But the SEC, which regulates securities, considers them loans and doesn’t regulate them. No one regulates them.

So why can PE firms strip record cash out of their portfolio companies while loading them up with this risky debt? Because credit markets have gone nuts.

After years of yield repression by the Fed and other central banks, there is huge demand for products that yield just a little more, regardless of the risks. “Excess demand scenario” is what LCD calls this phenomenon. “Hence the relative surge in dividend deals, which are popular with private equity firms, for obvious reasons.”

Despite the risks, as LCD gingerly points out, “institutional investors are keen to maintain strong relationships with private equity shops, which borrow frequently, so in bull credit markets these deals continue to find a home.”

And these already risky leveraged loans have been getting even riskier for investors: In the first half of October, 82% of all leveraged loans issued were “covenant lite,” almost matching the full-month record of 84%, in August, according to LCD. As of September 30, 72.9% of all US leveraged loans outstanding had a covenant-lite structure, the highest proportion ever. So $690 billion in leveraged loans were covenant lite.

This chart shows the surge in the proportion of covenant-lite loans to total leveraged loans over the past three years (click on image):


So what’s the big deal? When there is no default, there is no problem. But when defaults do occur – as they have a tendency to do – or before they even occur, investors in covenant-lite loans have less recourse and fewer protections, and losses can be much higher. As long as investors clamor for risky debt in their energetic chase for a little extra yield, these covenant-lite loans are going to fly.

The leveraged loan market has been sizzling. The S&P/LSTA US Leveraged Loan 100 Index has now set an all-time high on every single day from September 25 through October 15. And that’s how it has been pretty much since the recent low on February 11, 2016 (click on image):

In this kind of Fed-engineered credit market, where risks no longer matter, and where institutional investors are chasing yield and plow with utter abandon other people’s money into risky assets, it’s logical that PE firms are stripping as much cash as they can from their portfolio companies before these companies – like so many retailers now – are toppling.

Why is anyone still buying retailers from private equity firms? Read…  IPO in March, Crushed Today: PE Firm Pushes another Retailer into Brick-and-Mortar Meltdown
Let me first thank Dimitri Chalvasiotis for bringing this comment to my attention. I added Wolf Street blog to my extensive blog roll and will keep an eye out for interesting comments like this one.

A couple of days ago, I wrote a comment where I critically examined those who defended private equity at all cost, going over many issues that rarely see the light of day, including private equity's  misalignent of interests and how buyout firms regularly exaggerate their performance.

The comment above discusses an important source of private equity's returns, namely, dividend recapitalizations (recaps) and links this activity to the hot and bustling leveraged loan market.

You'll recall five years ago, in October 2012, I discussed why private equity is eyeing dividend recaps as credit markets were boming in Europe and elsewhere.

The idea is simple, booming credit markets allow PE firms to borrow cheaply which in turn allows them to saddle their portfolio companies with debt as they "extract" a special dividend.

It's a great way for PE firms to juice their returns but I believe it's all coming to an end very soon. Have a look at the effective yield on a European HY bond index (from BOFA- Merrill Lynch). That's is not a typo – European junk bonds are yielding 2.2% (click on image):


Stated another way, European junk bond spreads hit their tightest levels since July 2007: 258 bps (click on image):


And it's not just Europe. As Charlie Bilello of Pension Partners notes in his wonderful Twitter account, credit spreads are tightening all over, including the US and emerging markets. 

In fact, Charlie notes US Investment Grade credit spreads at tightest levels since July 2007: 102 bps. And Emerging Market High Yield (HYEM) credit spreads at tightest levels since August 2007: 404 bps (click on images): 



Equally interesting, Charlie shows you how the yield on the leveraged loan ETF (BKLN) is down to an all-time low of 3.54% as the S&P Leveraged Loan Index hits an all-time high for the 21st consecutive day (click on images):



Everything is interelated but it's all coming to and end which is bad news for PE firms relying on dividend recaps to make their returns, but also for big banks like Goldman Sachs (GS) which has been quietly crushing it through its debt underwriting activities.

This is why I am short shares of Goldman Sachs (GS) and other financials (XLF), I see more pain ahead as this debt-fueled frenzy comes to an abrupt end (click on image):


What about shares of Blackstone (BX) and other PE titans? They have great yields and nice bullish weekly charts but here too, I'm cautious and would be taking my profits (click on image):


The most important chart to pay attention to right now is the iShares iBoxx $ High Yield Corp Bond ETF (HYG) which has been on tear as US high yield spreads hit a record low (click on image):


I want you to look at that monster run-up and ask yourself how sustainable is this going forward. In fact, things have gotten so out of whack in credit markets that Lisa Abramowicz of Bloomberg reports junk-bond traders are increasingly just buying stocks (follow Lisa on Twitter here, she posts great stuff).

All this just reinforces my belief that the bubble economy is set to burst and when it does, deflation will hit the US and we will experience the worst bear market ever, crushing many chronically underfunded pensions and pretty much all institutional and retail investors.

The private equity kingpins know all this as do the hedge fund elites. They're not stupid which is why asset-stripping is booming now.

Having said this, I want to be very careful here. I shared the Wolf Street comment above with professor Claudia Zeisberger at INSEAD who is an expert in private equity and she kindly shared this with me:
Correctly describing the situation and demand driving pricing and terms cov lite or cov free. However a lot of data is presented in absolute terms and not relative terms, i.e. relative to a) LBO investment activity (more means more original loans) and b) LBO portfolio holdings (with holding periods lengthening there is more room / demand for Lev Recaps).

More important: Picking Retail (a sector I am quite familiar with) is also a cheap shot as the secular changes from e-commerce/ Amazon are re-rating the whole brick & mortar business, who are broadly screwed with or with or without PE ownership.
I thank professor Zeisberger for sharing her wise insights with me.

I leave you with some questions to ponder for pensions. How will the end of private equity's asset-stripping boom impact the performance of PE funds going forward? How will it impact the overheated leveraged loan market? What about private debt markets and CLOs? What will be the impact in these markets?

These are all important questions to ponder for large pensions investing in private equity, CLOs (like HOOPP's new risk retention vehicle) and private debt markets (like CPPIB and PSP).

Again, if you have anything to add, you can reach me at LKolivakis@gmail.com.

One final note, after reading last comment in defense of private equity, Tom Sgouros of Brown University noted the following on this passage from Joe Lonsdale's article:
The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.
The red part is pretty obviously false if you look at the history of any of the high-profile acquisitions and the guys who engineered them out there. And let's not forget that "redeploying company assets" was often shorthand for "stealing the pension fund."

The PE industry is pretty much why there are so few US pension systems left in private industry. The PE guys make out and leave dust in their wake -- sometimes. Perhaps there are ethical PE companies, but there are lots of them that just steal, and until there is a way to tell the difference, the industry will suffer from a bad name.
You will recall Tom wrote an interesting research paper examining whether fully-funded US pensions are worth it. I sent him the Wolf Street comment above and he replied:
It sounds much better when you call it "redeploying assets" or "enhancing productivity", doesn't it?

I like this line, from a linked article at the same site: "Why are investors still buying brick-and-mortar retailers – or anything – from PE firms? No one knows. But inexplicably, it’s still happening."
Indeed, no one knows, but there is still value in these investments and the best PE funds will be able to unlock it, with or without asset-stripping.

Below, private equity now employs a huge number of employees across the globe, presenting great funding opportunities for firms, says Claudia Zeisberger professor at INSEAD.

Professor Zeisberger is the author of two recently released companion books, Mastering Private Equity: Transformation via Venture Capital, Minority Investments and Buyouts and Private Equity in Action: Case Studies from Developed and Emerging Markets. She knows her stuff and she's right, as valuations in PE soar, operational efficiency is paramount but as shown above, trends in leverage are flashing a warning sign.

Unfortunately, as this bubble economy is set to burst, I would be very careful with all risk assets across public and private markets. I foresee a lot of develeraging pain ahead so be careful.

No comments:

Post a Comment