“The more leveraged takeovers and buyouts now, the more bankruptcies tomorrow.” — John Shad, chair of the Securities and Exchange Commission (SEC), 1984
When the Reagan administration pushed for widespread deregulation in the early 1980s, financial services benefited enormously. The brisk innovation that followed sparked the junk bond and M&A mania that became known as the “Roaring ’80s”
Since then, the financialization of our economies has, by my calculations, propelled total US debt as a percentage of GDP from 50% in the 1970s to more than 400% today. That’s before factoring in the titanic coronavirus bailout.
This credit expansion is not just the result of increased demand from borrowers, be they governments, corporations, or consumers. Credit products were aggressively pushed by an ever-growing variety of lenders. In the process, these lenders introduced novelties, some of which became familiar in the aftermath of the global financial crisis (GFC): subprime mortgages, securitized bonds, off-balance sheet collateralized loan obligations (CLOs), and structured investment vehicles (SIVs).
Private Equity’s Creativity
As one of the largest users and beneficiaries of leverage, private equity (PE) introduced its own innovative tricks to maximize deal volumes and investment returns.
Back in the early 2000s, the industry embraced a new product that gave PE firms — the sponsors — as well as their portfolio companies — the borrowers — more flexibility when taking on loans. That new product was “covenant-light,” or “cov-lite.”
A covenant is a condition that a borrower must meet to prove that it remains creditworthy. Maintenance covenants are tested regularly, usually every quarter. Whether it takes the form of a financial ratio (such as an interest coverage ratio: EBITDA-to-net interest expense), or of information-sharing (e.g., providing a trading update), a covenant gives lenders a right to surveillance so that financial risk within a loan portfolio and, in a broader context, across the economy is properly monitored.
When the GFC took hold in 2008–2009, one in four leveraged loans was cov-lite. In these scenarios, the borrower could either avoid reporting altogether to its lenders, or it only did so on a narrow range of covenants. For instance, music publisher EMI, which went through an aggressively debt-strapped buyout in 2007, was only required to report quarterly on its total leverage ratio — meaning net debt-to-EBITDA — without any further requirement towards its main lender, Citi.
From Leniency to Bankruptcy
Because it had no other means to keep EMI and its owner, the fund manager Terra Firma, accountable, Citi had to wait for the music major to default on its sole financial covenant before calling the borrower to account.
Another tool introduced in leveraged buyouts (LBOs) back then was what is termed an “equity cure.” This enabled borrower EMI and its sponsor to inject fresh capital to net it off the total debt figure used to calculate its financial ratio. Terra Firma sank fresh equity into EMI in order to “cure” a breach of the net debt-to-EBITDA covenant on no fewer than four occasions in 2008–2009.
Other high-profile names of loosely-covenanted transactions that went sour include the largest buyout ever — the $40 billion delisting of Texan energy producer TXU by KKR and TPG — as well as casino operator Caesars Entertainment, acquired by Apollo alongside TPG. Both these pre-GFC deals came under strenuous stress due to their inability to redeem billions of dollars in debt. EMI, TXU, and Caesars ended up in bankruptcy, not without their PE owners first trying to undermine the creditors’ rights to take over the companies.
Often the most viable survival option for an overstretched leveraged business is to restructure its balance sheet and convert expensive interest-bearing loans into equity, wiping out the equity stake held by financial sponsors in the process. But by delaying a Chapter 11 filing, PE firms can keep on collecting management and director fees. To them, equity cures (financed by the fund investors, not by the fund managers), corporate reorganizations, headcount reductions and capex deferrals make sense. The long-term damage these policies do to the underlying portfolio companies and to the employment prospects of their workforce pales in comparison to the short-term fee-earning benefits they grant the PE owners.
Private Debt’s Opportunity
After straying away from the fundamentals during the 2004–2007 credit bubble, post-Lehman commercial banks reverted to conservative practices, requesting the re-introduction of covenant-heavy debt structures. In truth, that had been forced upon them by stricter regulation.
The tighter oversight by government agencies on the banking system over the past decade led the most aggressive financiers to seek shelter in the under-regulated segment of private capital.
To gain a foothold in the competitive debt markets, throughout the 2010s, non-bank lenders like private debt and CLO fund managers reinstated flexible terms and poorly-covenanted credit products. That did the trick. Today, approximately 50% of LBO loans are underwritten by non-bank institutions.
As a consequence of this market shift, 80% of leveraged loans are now covenant-light. Yet PE fund managers considered cov-lite products a basic, inalienable right and asked for something much more generous from prospective lenders desperate to put money to work.
While, pre-GFC, equity cures were a neat way to hold overstimulated lenders at a safe distance, these capital injections had too many drawbacks for financial sponsors to keep using them. The worse side effect of an equity cure is that it requires more funds to be put to work and, thereby, negatively impacts the PE firm’s internal rate of return.
In order to dramatically reduce the likelihood of covenant breaches without needing further capital, LBO sponsors decided to introduce an even bigger fudge. “Addbacks” enable a borrower to alter earnings before interest, tax, depreciation, and amortization (EBITDA), the main component of covenant calculations. These refashioned earnings can include anything from future expected cost-savings or synergies to the lax treatment of expenses capitalization and provision.
Advent of the Zombies
With the great majority of LBOs issuing cov-lite loans and liberally using EBITDA adjustments, we can predict that the incoming recession will see many PE-owned companies turn into zombies. A recent development, reported by research firm Covenant Review, is the introduction of a loan provision allowing losses from non-recurring events to be added back to EBITDA. If generalized, such vague, non-exhaustive terminology — which could well include lost revenue from a worldwide pandemic or any other “black swan” — would grant borrowers further scope to massage the numbers.
Lenders will find it difficult to force distressed buyouts into foreclosure or restructuring. Having made room for the destructive emergence of indulgent debt solutions, the process of creative destruction, a cornerstone of a well-oiled capitalist machine, will be hampered by uncooperative borrowers.
To avoid too many write-offs, lending syndicates will probably behave like many did during the financial crisis. They will readily accept amend and extend processes, distressed debt exchanges as well as evergreening, that is loosening the terms of existing loans and providing new facilities to enable borrowers to refinance legacy loans that they cannot repay.
After years of brinkmanship, EMI Music, TXU and Caesars Entertainment were eventually taken over by their lenders. But remember that, back in the mid-noughties, these cov-lite transactions remained a minority (about 25%) of the total volume of LBO loans. Now that four in five buyouts use poorly protected loans, the next downturn should see a longer list of zombies. While it will certainly impact the performance of PE portfolios, the most damaging externality will be felt in the economy at large.
Welcome to Zombie Land
During this crisis, thousands of leveraged companies are likely to stay afloat not because of strong fundamentals but because their creditors will lack the tools (or remedy) to engineer a recapitalization — a situation exacerbated by the pledge made by many governments’ lending programs and central banks’ monetization policies.
Following fierce lobbying, COVID-19 loan packages will be made available to PE-backed companies, at least for small-sized businesses and in the most afflicted sectors: leisure, hospitality, tourism, and travel. Whether or not they accept emergency loans and restrictions on leverage or headcount reductions, troubled buyouts will, at any rate, benefit from the US Federal Reserve’s hasty decision last month to start buying high-yield bond exchange-traded funds (ETFs).
Operating for years in aimless, zombie-like mode could become a new normal for uncovenanted businesses that won’t file for Chapter 11 bankruptcy, a process of corporate restructuring enacted in 1978 to make markets more adaptable. This could provoke widespread economic paralysis as highly distressed companies defer payments to suppliers, reduce the quality of service to clients, cut salaries and employee benefits, renegotiate rental payments with landlords, delay R&D spend, reschedule debt maturities, all in a bid to survive and enable their owners to continue charging commissions.
Unlike John Shad in 1984, the head of the SEC these days would be more inspired to pronounce: “The more leveraged takeovers and buyouts now, the more zombies tomorrow.”
Our economies are under the stewardship of fund managers with one goal in mind: to maximize fee income, even if it means holding on to impaired assets. Thanks to the mass-adoption of cov-lite structures, the manipulation of corporate earnings and government-led bailouts, private capital firms have substituted creative destruction with a more insidious process: endemic sclerosis.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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