Tuesday, November 4, 2008

Surprisingly Superficial New York Times Article on Troubled Private Equity Deals

(Naked Capitalism) A story by Andrew Ross Sorkin and Michael de la Merced, "Debt Linked to Huge Buyouts Is Tightening the Economic Vise," covers the fact that private equity deals, which as a matter of course feature high leverage, are starting to hit the wall as the economy sours. This is hardly surprising; it's happened in past downturns.

The story does a workmanlike job in providing details on some of the companies now in trouble, yet stunningly omits a couple of key details, namely, that the fact that many of these deals had so-called cov-lite debt, plus the fact that DIP (debtor in possesion) financing is now almost impossible to obtain. DIP financing is often necessary to help companies keep making payments as they go through the Chapter 11 process. With DIP financing scarce, lot of these deals are likely to end up not in Chapter 11, but as Chapter 7 liquidations, causing vastly more damage than past LBO hangovers. These the omissions are striking given that Sorkin covers the deal beat on a daily basis.

First, some of the key bits of the NY Times article:
Private equity firms embarked on one of the biggest spending sprees in corporate history for nearly three years, using borrowed money to gobble up huge swaths of industries and some of the biggest names — Neiman Marcus, Metro-Goldwyn-Mayer and Toys “R” Us.

Linens ’n Things, a big retailer owned by the private equity firm Apollo Management, filed for bankruptcy protection this year.
The new owners then saddled the companies with the billions of dollars of debt used to buy them. But now many of the loans and bonds sold to finance the deals are about to come due at the worst possible time....
Yves here. The notion that LBO debt issued in the last three years (which is when the bulk of the deals were done) is maturing now does not sound at all right. LBO debt usually has a longer maturity. Is this misleading drafting, or are the problems of a small subset of deals being conflated with others facing the market?

Back to the article:
If history is any guide, the worst may be yet to come. Steven N. Kaplan, a professor at University of Chicago Graduate School of Business, found that nearly 30 percent of all big public-to-private deals made from 1986 to 1989 defaulted. Afterward, private equity players were called to testify before Congress, and movies like “Wall Street” and “Other People’s Money” depicted financiers as greedy criminals.....

Many industry insiders and analysts contend that companies backed by private equity will not suffer nearly as much as those in the late 1980s because the firms pushed for better financing conditions that allow them to keep operating even if they cannot make their debt payments.
This is the ONLY allusion to the cov-lite issue, and a very one-sided one at that.

Traditionally, bond deals (except for very short term deals with stellar credits) contained provisions called covenants. The borrower agreed to do certain things over the life of the bond. Typical sorts of covenants were minimum net worth, maintaining certain interest coverage ratios (as in net income had to be at least x times interest charges), not incurring any new debt senior to the bond offering.

If the issuer (the borrower) violated these covenants, the bondholders had the right to accelerate the debt (demand immediate repayment). That, of course, would not really happen, but it gave the creditors the ability to force the issuer to renegotiate the deal (at a minimum) and in more extreme cases, to restructure liabilities in a more encompassing fashion and push for operational changes (for instance, restrictions on capital expenditures until earnings or net worth reach a certain level). It gives the creditors a chance to intervene in a deteriorating situation and put the company on an even shorter leash.

Instead, look at what happens with no covenants, and stunningly, Sorkin and Merced present this as a plus:
For example, in an effort to save cash, six of Apollo’s portfolio companies, including Claire’s Stores, Harrah’s and Realogy, have announced this year that they will pay some of their bonds’ interest by issuing more debt.
So we have a company that is worried that it might run out of cash if it pays interest, so the answer is to borrow more money. Now admittedly, some debt renegotiations wind up in a similar place (interest payments are reduced but the foregone interest is added to principal), But current creditors can also structure a payment schedule (or payment triggers) specific to the company's situation, and the terms of debt forgiveness from them might not be as onerous as that from new creditors (the initial group is motivated to try to save its original loan and not trash the company).

Sorkin and Merced fail to acknowledge the scenario that most foresee for cov-lite deals where the company starts to get into trouble. In the old days, the banks could apply the brakes and force restructurings, sometimes forestalling a bankruptcy filing, or alternatively, trying to steer the company towards Chapter 11 while there was still something there to save. Now, the company has no checks, and the private equity investors have every reason to carry on until the company defaults because it really has no more cash. That means it enters bankruptcy in a much more weakened state than if the banks had been able to intervene to try to protect their loans.

And the new wrinkle is debtor in possession financing is scarce, thanks in part to GE's departure from that market, making it much harder for companies to avail themselves of Chapter 11 bankruptcies. As the Wall Street Journal explained last month:
Credit has gotten so tight in recent weeks that companies contemplating a bankruptcy filing can't find the cash needed to get through the process.

This multibillion-dollar corner of the lending market -- debtor-in-possession and exit financing -- has been rocked by General Electric Co.'s recent, undisclosed decision to largely halt lending to companies in bankruptcy-court protection or near it, said several bankruptcy lawyers and financial advisers. GE is one of the world's largest such lenders, last year doing $1.75 billion in restructuring loans.

Debtor-in-possession, or DIP, financing is essential for the lawyers, layoffs and other restructuring necessary for a company's rebirth. Exit financing is used when a company "exits" reorganization. Banks have been eager to take part in this market because the loans are the first to be paid back and command high interest rates.

Without the lending lines, companies that would normally survive bankruptcy will have to quickly sell assets. Potential buyers may not be able to borrow either, meaning companies could be forced to liquidate immediately instead of working out their problems. That could cost tens of thousands of jobs across the economy....

"It is a struggle, a real struggle to find DIP financing," said Jonathan Henes, bankruptcy attorney at Kirkland & Ellis LLP in New York. "In the old days, like early 2007, the banks would do an origination and syndication model, where hedge funds and [loan funds] would gobble up those loans, but they don't have the capital. They are out."

Data provider Dealogic estimates lenders provided $24.24 billion on 40 restructuring deals in 2008, a 38% increase from the $17.59 billion on 18 deals in 2007. Major banks do much of the work, with GE typically among the top five or 10 lenders each year. Despite the tight credit markets, DIP lending is up this year because of the overall increase in bankruptcy filings since 2007. Little has been done in the past few weeks.

Interest rates for bankruptcy financing have doubled to the London interbank offered rate plus 5% to 7% or higher, compared with Libor plus 2.5% last year, said Mr. Henes and others...

Several companies are trying to raise DIP financing in case they need to file for bankruptcy reorganization, but have struggled to find any takers, said bankruptcy observers.
In other words, there are good reasons to think that the typical cyclical overleveraged deal failures that the private equity foists upon the wider world on a regular basis will lead to even worse outcomes than usual. Yet Sorkin, who ought to know better, omits key details that would raise even more questions about the prospects for these investments. One can only wonder why.

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