Submitted by David Stockman via Contra Corner blog,
This eruption of late cycle bubble finance hardly needs comment. Below are highlights from a Bloomberg Story detailing the recent surge of leveraged recaps by the big LBO operators. These maneuvers amount to piling more debt on already heavily leveraged companies, but not to fund Capex or new products, technology or process improvements that might give these debt mules an outside chance of survival over time.
No, the freshly borrowed cash from a leveraged recap often does not even leave the closing conference room - it just gets recycled out as a dividend to the LBO sponsors who otherwise hold a tiny sliver of equity at the bottom of the capital structure. This is financial strip-mining pure and simple - and is a by-product of the Fed’s insane repression of interest rates.
The ultra-junk paper which funds these leveraged recaps is bought for one reason alone: money managers are desperate for yield and as the cycle nears its peak, they simply close their eyes and buy bonds that have an overwhelming chance of default. They then comfort themselves with a wholly specious financial figure called the current default rate which presently happens to be running under 2%. It was also running under 2% in 2007 and in 1999 and in 1990!
Each time the Fed sponsored financial bubble eventually burst. Then junk bond prices cratered, yields soared and default rates reached double digits levels. In fact, we are now on the cusp of the fourth junk bond crash since 1989. Needless to say, these now well-choreographed cycles of boom and bust would not occur on the free market.
Money managers wouldn’t need to close their eyes and grasp for “yield”; they’d be able to find investment grade credits with a decent rate of return. The number of LBOs available to become host to leveraged recaps would be drastically smaller because market-set interest rates on junk bonds would be so high as to eliminate most of the upside captured by private equity speculators. The latter are not really equity investors at all—just speculators in what are essentially call options on the Fed’s predictable cycles of bubble finance and unsustainable economic rebound.
Ironically, the recent surge in corporate lending by banks is being cited by Wall Street’s perma-bulls as evidence that the long-awaited “escape velocity” is about to materialize. But most of the up-tick in corporate loans has been for leveraged lending—an exact repeat of 2005-2007. And that, alas, means that the bubble cycle is in its final innings—not that economic nirvana is about to break loose.
The highlights from today’s Bloomberg story on how “private equity firms are borrowing money to pay dividends like its 2007″ might well have been zeroxed from Chapter 24 of the Great Deformation, which is entitled “When Giant LBOs Strip-Minded the Land” and which analyses the same phenomena during the 2007 cycle as highlighted by Bloomberg below for this one—namely PIK bonds, leveraged recaps and the evaporation of credit standards in the form of so-called “cov-lite” debt issues.
The excerpt which follows, in fact, makes abundantly clear that this time is not different. Its actually completely the same.
“PE Firms’ Dividend ‘Epidemic’ Intensifies Junk-Debt Alarm”
Companies owned by private-equity firms are borrowing money to pay dividends like it’s 2007, adding to concern among regulators that excesses are emerging in the riskier parts of the debt markets.
Borrowers including Madison Dearborn Partners LLC’s mobile-phone insurer Asurion LLC obtained almost $21 billion in junk-rated loans this year to enrich their owners, the most in seven years, according to Standard & Poor’s Capital IQ LCD. Some of the least-creditworthy companies are even selling notes that may pay interest with more debt, which BMC Software Inc. did for its $750 million payout to a group led by Bain Capital LLC.
With defaults by the neediest U.S. borrowers approaching record lows, buyout firms are taking advantage of the Federal Reserve’s (FDTR) easy-money policies to extract payouts by piling more junk debt onto the companies they own….
“It’s kind of like an epidemic,” Martin Fridson, a New York-based money manager at Lehmann, Livian, Fridson Advisors LLC, who started his career as a corporate-debt trader in 1976, said in a telephone interview. “Once an investment banker sees that, he’s going to go to his clients and say, ‘Here’s a window of opportunity, you can take a dividend and get away with it.’”
The amount of loans used for dividend deals this year is exceeded only by the pace in the start of 2007, when $31 billion was procured, according to S&P LCD. Investors are searching for yields as average borrowing costs on investment-grade debentures of 3.15 percent compares with a 10-year average of 4.85 percent, Bank of America Merrill Lynch index data show.
The payout for the Bain-led ownership group was financed entirely with $750 million of debt known as payment-in-kind notes, which enables Houston-based BMC Software to pay interest with extra borrowings instead of cash. More than $3.5 billion of such notes have been raised in 2014, also the most in seven years.
Junk loans are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P. A record $1.1 trillion of the debt was issued last year, according to data compiled by Bloomberg.
Rather than refinancing at lower interest rates or to fund expansion, dividend loans offer private-equity firms a way to recoup their investment while increasing the debt burden of the companies they control.
“Dividends are an easy way for a private-equity firm to quickly and efficiently monetize their investment and lock in returns for their clients,” Frank Ossino, a Hartford, Connecticut-based money manager…. Bloomberg data show….Bain and other buyout firms extracted a dividend out of BMC Software seven months after buying the computer-network software maker in September.
Platinum Equity LLC, a Beverly Hills, California-based buyout firm raised a $262 million payment-in-kind bond to pay itself a dividend a week after closing on its takeover of a rental unit from Volvo AB in February.
Default rates on speculative-grade companies have fallen to 1.7 percent in the first quarter, the lowest level since February 2008, according to Moody’s. The credit rater expects that measure to rise to 2.4 percent by year-end, below the historical average of 4.5 percent….
“The banks and sponsors continue to push the envelope because of continued demand for yield-generating products,” Newfleet’s Ossino said. “If someone’s willing to lend to a company, it’s difficult for borrowers not to accept the loan.”
Excerpt From The Great Deformation on the nearly identical 2007 explosion of PIK bonds, leveraged recaps and equity harvests by LBO sponsors. (pp. 502-508)
THE DERANGEMENT OF LEVERAGED FINANCE: $100 BILLION IN LBO DIVIDEND RECAPS
The wherewithal for financial engineering came from the leveraged loan market that had been on death’s door after “risk” went into hiding during the dot-com bust. But when the Fed caused interest rates to tumble to lows not seen for generations, the market for leveraged finance literally exploded.
Issuance of highly leveraged bank loans plus junk bonds leapt higher by $1 trillion annually, rising from $350 billion in 2002 to $1.35 trillion by 2007. Funding available for LBOs and leveraged recaps thus quadrupled. Alto- gether, a total of $4.5 trillion of so-called high-yielding debt was issued dur- ing this six-year interval. This astounding number exceeded all of the high-yield debt ever issued in all previous history.
Moreover, the surging quantity of available high-risk debt was only part of the story. The deterioration in quality was even more spectacular. The riskiness of leveraged loans is usually measured by the interest rate spread over LIBOR; the more risk the larger the spread. This LIBOR spread on leveraged bank loans, for example, dropped from 375 basis points to 175 basis points, meaning that compensation to lenders for the risk of loss posed by highly leveraged borrowers virtually disappeared.
Likewise, under a euphemism called “covenant lite” traditional borrower restrictions were essentially eliminated from junk bonds, transformingthem into financial mutants. Under standard bond covenants, company cash could not be paid out to common equity holders who stood at the bottom of the capital structure unless bonds were well covered. But under “covenant lite,” private equity sponsors could suck huge self-dealing cash dividends out of a company, bondholders be damned.
Implied default risk also increased sharply as measured by average deal multiples, which rose from 7X cash flow to nearly 11X. Moreover, near the end of this leveraged lending spree an increasing share of junk bonds were of the “toggle” variety. This meant that if the borrower came up short of cash it could just send the lender some more IOUs (bonds); that is, it could borrow to pay interest just like under “neg am” home mortgages.
The ultimate indicator of the drastic deterioration of loan quality during this period, however, was the eruption of leveraged “dividend recaps.” LBO companies were able to issue new debt on top of the prodigious amounts they already owed, yet not one penny of these new borrowings went to fund company operations or capital expenditures.
Instead, the newly borrowed cash drained right out of the bottom of the capital structure and was paid as a dividend to the LBO’s private equity sponsors. This sometimes permitted sponsors to recoup all of their initial capital or even book a profit within a few months of the initial buyout transaction, and long before any of the initial debt was paid down.
Leveraged dividend recaps during the second Greenspan bubble (2003– 2007) were off the charts relative to all prior experience. Thus, more than $100 billion was paid out during this period, compared to generally less than $1 billion annually in the late 1990s. Since private equity sponsors normally are entitled to a 20 percent share of profits, a couple of dozen buyout kings and their lesser principals pocketed $20 billion from these payouts.
The real trouble, however, was not so much the greed of it as it was the sheer recklessness of it. Most of these dividend recap deals were done by freshly minted LBOs, some of them so fresh, in fact, that they had hardly gotten to their first semiannual coupon payment.
So the feverishly overheated leveraged loan market was the real culprit. Investors were indiscriminately devouring any high-yield paper offered, and for the worst possible reason. As the 2003–2007 Greenspan bubble steadily inflated, fund managers became convinced that the monetary central planners at the Fed had truly achieved the Great Moderation; that is, recessions had more or less been banished.
While implausible it nevertheless caused a drastic mispricing of junk bonds. They carry a high yield owing to their embedded equity-type risks,the most important of which historically had been the sharp impairment of cash flows and rise of default rates triggered by business cycle downturns.
Now that the risk was attenuated or even eliminated entirely, high-yield bond managers started acting as though they owned a Treasury bond with a big fat bonus yield and commenced buying junk bonds hand over fist. The demand for new paper became so frenetic that Wall Street underwrit- ers virtually begged private equity sponsors to undertake “dividend recaps” so they would have product to sell to their customers.
This was another sign of the reckless speculation induced by the Fed’s bubble finance. During seventeen years in the private equity business, I never observed these firms reluctant to scalp a profit when, where, and as they could. But most firms believed the prudent strategy was to get a new LBO out of harm’s way as soon as possible by paying off debt and ratchet- ing down the initial leverage ratio. Rarely did sponsors think about piling on more debt in the initial stages, and certainly not to pay themselves a dividend. Even during the final red-hot years of the first Greenspan bubble (1997–2000), dividend recaps were rare, with volume averaging only $1.7 billion per year.
During the second Greenspan bubble, by contrast, annual volume soared to $25 billion. Junk bonds and leveraged loans were so cheap and plentiful and the overall financial euphoria so intense that even the great LBO houses succumbed to violating their own investing rules. In fact, $100 billion of dividend recaps on the backs of dozens of companies already groaning under huge debt loads was not just a violation of time-tested rules—it bordered on a derangement and madness of the crowds.
This eruption of leveraged dividend payouts dramatically exposed one channel by which cash from CEW was recycled to the top 1 percent. More importantly, however, it also laid bare the whole self-feeding web of bubble finance that the Fed’s monetary central planners unleashed while attempt- ing to levitate asset prices.
In this instance, the stock market bust of 2000–2001 and the modest eco- nomic slump which followed brought the excesses of leveraged finance to a screeching halt. Accordingly, the secondary market for high-yield debt cratered, new loan issuance slumped badly, and LBO activity stalled out at low ebb.
The financial market was attempting to heal itself for good reason. De- fault rates on leveraged loans soared from an average of 2 percent of out- standings during 1997–1999 to 10 percent during 2001–2002. These high default rates, in turn, sharply curtailed the investor appetites for junk bonds, causing new issues to drop by two-thirds between 1998 and 2000.as it had been practiced during the late 1990s boom years when the cash flows of buyout companies had been drastically overleveraged.
Not for the last time, however, the Fed refused to permit the financial markets to complete their therapeutic work. When the federal funds rate was slashed to 1 percent by June 2003, the collateral effects on the junk bond market were electrifying, precisely the opposite of what the doctor ordered.
During the twenty-four-month period between mid-2002 and mid-2004, junk bond interest rates plunged from 10 percent to under 6 percent. Since bond prices move opposite to yield, the value of junk bonds soared and speculators made a killing on what had been deeply “distressed” debt. In- deed, in a matter of months, a class of securities that had been a default- plagued pariah became a red-hot performance leader.
This massive windfall to speculators was not the result of prescient in- sights about the future course of the US economy. Nor was it owing to any evident “bond picking” skill with respect to the performance prospects of the several hundred midsized companies which constituted the junk bond issuer universe at the time. Instead, junk bond speculators made billions during the miraculous recovery of leveraged debt markets during 2003– 2004 simply by placing a bet on the maestro’s plainly evident fear of disappointing Wall Street.
Wall Street underwriters, in turn, had no trouble peddling new issues of an asset class that was knocking the lights out. These gains were not all they were cracked up to be, of course, because junk bonds had not become one bit less risky (or more valuable) on an over-the-cycle basis. But the Fed’s interest rate repression campaign made these gains appear to be the real thing, demonstrating once again the terrible cost of disabling free mar- ket price signals.Moreover, when the rebounding demand for risky credits enabled the issuance of nearly $3 trillion of highly leveraged bank loans and bonds during the three years ending in 2007, the result was a “dilution illusion.” The junk debt default ratio fell mainly due to arithmetic; that is, the swelling of the denominator (bonds) rather than shrinkage of the numerator (de- faults).
Thus, by the end of the second Greenspan-Bernanke bubble the total volume of leveraged debt outstanding was nearly three times higher than in 2001–2002. At the same time, the temporary credit-fueled expansion of the US economy caused new junk bond issues to perform reasonably well. Due to this happy arithmetic combination, the measured default rate plummeted sharply, dropping all the way down to 0.6 percent by 2007.
Yet this was a preposterously misleading and unsustainable measure of junk bond risk, since it implied that the Fed could prop up the stock market and extend debt-fueled GDP growth in perpetuity. Nevertheless, having quashed the free market’s attempt to cleanse the junk bond sector in 2001– 2002, the Fed had now enabled the leveraged financing cycle to come full circle.
HOW THE GREAT MODERATION SPURRED A DAISY CHAIN OF DEBT
During the final stretch of the bubble in 2006–2007, the junk bond yield stood at about 7 percent and was juxtaposed against what appeared to be negligible default rates. Not surprisingly, this generated a vast inflow of yield-hungry money into the junk bond market, and a blistering expansion of the market for securitized bank loans.
The latter were called CLOs, for collateralized loan obligations, and were another wonder of bubble finance emanating from the same financial meth labs that produced mortgage-based CDOs.
In this instance, however, Wall Street dealers sold debt to yield-hungry Main Street investors that had been issued by what amounts to financial “storefronts.” These shell com- panies were stuffed with LBO junk loans rather than subprime mortgages. The daisy chain of financial engineering was thus extended one more notch: leveraged buyouts were now financed from the proceeds of bank debt which, in turn, was funded with the proceeds of CLO debt. Nor was that the end of the leverage chain. Not infrequently, these CLO “store- fronts” also employed leverage to enhance their own returns.
Thus did the true equity in the system retreat ever deeper into the financial shadows. By the top of the cycle in 2006–2007, the CLO market of debt upon debt upon debt was expanding at a $100 billion annual rate, compared to less than $5 billion at the prior peak seven years earlier. In its headlong pursuit of asset inflation, therefore, the Fed was spring-loading the financial sys- tem with a fantastic coil of debt.
As it happened, however, the miniscule 2007 default rate for junk loans was no more sustainable than had been the initially low default rates for subprime mortgages. By 2009 defaults were actually back above 10 percent, signaling the third junk market crash since 1990.
Accordingly, investors and traders fled the leveraged loan markets even faster than they had stormed into them. Junk debt issuance plunged by 85 percent from peak levels. The CLO market disappeared entirely.
This cliff-diving denouement should have come as no surprise. Near the end of the boom, many issuers were simply borrowing to pay debt service and few had sufficient excess cash flow to withstand a sharp economic downturn. The massive coil of LBO debt fostered by the Fed’s financial repression policies had thus been an accident waiting to happen.
Yet the leveraged finance boom went on right until the eve of the 2008 Wall Street meltdown because risk asset markets had been sedated by the myth of the Great Moderation. If the Fed had indeed abolished the risk of steep and unexpected business cycle downturns, as Bernanke claimed, the corollary was that deal makers were free to push leverage ratios to new extremes. This was a matter of spreadsheet math: the banishment of recessions obviously meant that the cash flows of leveraged business wouldn’t plunge in a downturn.
It also meant that the junk bond interest rate spread over risk-free treasuries would stay narrow, owing to reduced expectation of recession- induced defaults. So the junk market’s read on the Great Moderation was that it meant a floor under cash flow and a cap on default risk. Better still, since many junk bonds now had the “toggle” feature, they couldn’t default; they could just add the coupon to what they owed.
If defaults were thus minimized or eliminated, the hefty yield on junk bonds would be pure gravy. Not surprisingly, the leveraged loan market be- came fearless, happily assuming that the Fed had infinite capacity to prop up the economy and peg the price of risk. Nearly two-thirds of all the junk bonds issued in 2007 were of the so-called covenant lite variety, and that was another canary in the coal mine.
The purpose of covenants is to trap an LBO’s cash flows inside a company’s balance sheet for the benefit of the bondholders. So when these protections were permitted to fall away, it meant that high-yield investors were no longer looking to the borrower’s cash to keep themselves whole. In- stead, they assumed that borrowers who didn’t have the cash to redeem their debts at maturity would simply refinance; that is, investors would get their money back not from original issuers but from the next punter in the Ponzi.
Likewise, purchase prices for larger LBOs soared to more than 10X cash flow, compared to 6.5X when Mr. Market was endeavoring to heal the excesses of the previous leveraged finance bubble back in 2001–2002. Indeed, the light was flashing green for issuance of every manner of risky credit. These included second-lien loans, which effectively meant hocking an LBO company’s receivables and inventory twice.
View the original post at Bloomberg.