Game Theories: Calling the End Of Cheap Debt
1) Crisis of Confidence;
2) Death by Drowning;
3) A Slow, Clean Leak
June 5, 2007; Page C1
The waves of debt feeding today's buyout deluge will eventually recede. Now's the time to figure out what will make that happen.
This has become the essential question on Wall Street, where even the cocksure ranks of banks, hedge funds, and private-equity firms have begun to doubt lenient standards for lending and deal-making. As Bank of America's own chief, Ken Lewis, admitted recently, "we are close to a time when we'll look back and say we did some stupid things."
You couldn't tell now. Junk-rated corporate loan default rates are at their lowest rate ever -- about 12 times less than historical rates of 3.5%, according to Standard & Poor's.
The markets have changed dramatically since 1989, when a busted deal for United Airlines chilled the debt markets for years on end. At the core of the change is the term "liquidity," a catch-all meaning there's lots of money in the markets for anyone who needs it.
Behind the liquidity is something grander: The culmination of decades of advances in the architecture of financial markets and information technology. The result is a global, instantaneous network of hyperinformed investors, moving money from Dubai, Geneva, or Greenwich into ever-more specialized investments. Need a few billion in a few days? Someone, somewhere, will fill your tank.
Will this global liquidity actually minimize the impact of the inevitable credit downturn? Or is it, in fact, only feeding a bubble?
We won't know until it happens. But theories have begun to form around three different scenarios.
The Big One: This is the realm of the capital letter, meant to express outsize effect: The Asian Currency Crisis or The Russian Financial Crisis. As this theory goes, some big event flips investor confidence in an instant, drying up capital as investors flee to safe havens. These are by their very nature unpredictable and devastating.
Right now, credit markets are at the other end of this spectrum. Bond investors demand next to nothing to own corporate debt. The difference in yield between a risky B-rated junk bond and an ultrasafe Treasury is just 2.4 percentage points, the lowest spread on record. It's a sign of investors' high tolerance for risk. The big event causes them to quickly reassess this tolerance, dumping corporate bonds and pushing out spreads in an instant.
While we have become deeply attuned to the Big One, we have also become increasingly adaptable to them. Sept. 11, of course, was a widely destabilizing force. But from a business perspective, it contributed to years of low interest rates that set the tone for today's lending free-for-all. By the time terrorists targeted London in July 2005, the markets shrugged off the effects. If the subprime lending mess is a crisis, it surely has not spread to the broader stock market, which is posting record highs by the day.
"For this to come down, it has to be something of major, major proportions," says Dennis Drebsky, a bankruptcy and litigation partner at Nixon Peabody in New York.
Death by Drowning: In this scenario, the pullback doesn't come from one outsize event. Instead, lenders and borrowers slowly choke on their own largess. Lenders prop up many companies in a series of refinancings, heaping new debt on old. Eventually, lenders would be compelled to tighten their standards. That's what's happened in the housing market today.
A recent survey of restructuring advisers by AlixPartners found "there's unlikely to be a crash, and more of a gradual increase in companies that just can't refinance the fourth time around," says Peter Fitzsimmons, co-president of AlixPartners.
Right now, we're still in the period of serial refinancing, as shown by video-rental business Movie Gallery Inc. In 2005, it took on substantial new debt to fund the $850 million purchase of rival retail chain Hollywood Entertainment Inc. Within months of winning the deal, the company's business began to shrivel. Its stock, which was trading in the $30s, was worth less than $6 by year's end. By August 2006, the company had hired a restructuring firm and was facing an inevitable "workout."
But that wouldn't be necessary. Not in these markets. In March, Goldman Sachs led a $900 million refinancing secured against substantially all the company's assets. Today Movie Gallery's shares trade at around $2 each. A Movie Gallery spokesman pointed to a March statement saying the deal would provide the company with lower annual interest expenses.
Lenders have found ever-more lenient ways of doling out cash. A private-equity-owned firm called NXP, the former semiconductor business of Philips, is one of many firms that have secured the most popular trend in lending now, known as the "covenant-lite revolver." Revolvers are bank loans usually drawn down as a company's last resort. This is the very moment a lender might want to keep a tight hold on its money, using covenants that test the company's creditworthiness and performance. The covenant-lite variety has fewer of those tests.
As one banker put it, it's like a car that's begun to swerve, and ends off the road entirely before anyone can intervene. "The problem is that you put securities like that in a capital structure and it doesn't instill the discipline to manage their business," says David Resnick, a longtime restructuring adviser at Rothschild North America.
The Slow Leak: The Slow Leak theory is the most benign of the scenarios. It's based around the idea that annual private-equity returns will gradually decline, slowly ending today's ferocious buyout binge, which comprises a third of today's record mergers volume. As private equity firms adapt, they'll pull back the reins on their borrowing, ending the debt boom before it gets too messy.
Investing has already gotten harder for the private-equity groups, which face hostile shareholders and boards of directors demanding more at the negotiating table. Just yesterday, private-equity firms and hedge funds had to cough up an additional $55 million to pay for the buyout of Laureate Education, Inc.
Moreover, new tax rules in Washington could force them to cough up more to the Internal Revenue Service on their profits. And it will be years until these investors realize returns on the deals they're striking today. While they're scrambling to raise ever-larger funds, they're going to have to prove to investors that they can still outpace the market at large.
"The issue is not a meltdown but that they may not get the returns," says Morgan Stanley vice chairman Robert Kindler. Private-equity firms are targeting "high-teens returns, versus mid-20s three to five years ago."
The risk is they borrow even more as they try to make up for faltering performance ... which will bring them right back to scenarios one and two.
Write to Dennis K. Berman at dennis.berman@wsj.com1 |
