Distressed debt: Clever ways to do the dumbest things

Excess liquidity sabotages the capital markets’ mission of efficiently allocating funds to their most productive users. Instead, markets spew up cheap funding over anyone holding their hand out. Today, the exuberance of the structured credit markets, evident in tight pricing and easy availability to even the most questionable borrowers, is propping up asset prices across the board.

Talk to participants in the credit markets and they will all tell you how sophisticated they have become as banks have been replaced as the chief suppliers of loans by a raft of new institutional players: so sophisticated, it seems, that they can find all sorts of clever reasons for doing the dumbest things.

Large numbers of new institutional credit investors – mezzanine funds, hedge funds, CLOs, CDOs and distressed debt funds, including even leveraged distressed funds – all compelled to deploy hefty volumes of capital in search of the high returns they promised to end-investing clients, are disguising the true level of stress and distress among borrowers at the riskier end of the credit spectrum. In some cases, they might even be exacerbating it.

In portfolio-building mode, they are forced buyers of credit, the higher yielding and riskier the better.

It used to be that banks lent companies money with a view to being repaid in full after five years, making a judgment on credit quality across the cycle. Then after a while some of those companies encountered problems in their businesses and, if these could not be worked out, that threatened their ability to repay loans. Loans sometimes began to change hands at below par on the secondary market. Today, companies hit difficulties and just go and get new loans to repay the old ones, or even to pay dividends to the private equity buyers who saddled them with debt in the first place.

“The dynamic of the distressed market has changed substantially in Europe,” Simon Mansfield, head of the European special situations group at Goldman Sachs, told the Euromoney seminars distressed debt symposium this November. “What would once have been distressed credits trading in the secondary market in the 80s are coming to the primary market. 

"Investors, instead of buying in the secondary market with 20 points of call protection, are buying newly issued PIK notes at yields up to 15%. Investors need to be aware of missing call protection and that they will see lower returns in the distressed market until it normalizes. Even if credits are in trouble, they can get refinanced.”

Bad companies are getting financed, and so too are good companies with bad balance sheets. These include some that would already be facing debt restructuring in a normal credit market, or outright insolvency accompanied by substantial write-downs of creditors’ claims.

“Look,” says one market participant, “we are at a point, with alternative investment managers, including multi-strategy managers with extensive credit funds, preparing themselves for trade sale or IPO where it’s not in their interest to have companies in their portfolios go bankrupt. In those circumstances a creditor might agree a restructuring or refinancing that doesn’t really make sense.”

Schefenacker, the troubled German auto components maker, is being closely followed by distressed debt market participants as it seeks to conduct a debt restructuring in the UK. The company and its creditors, including London-based hedge fund investors in second-lien notes, might be able to force a deal past minority dissenting stakeholders, and one where the company’s directors might avoid liability for not declaring formal bankruptcy that they might otherwise face in Germany. It’s a test case of forum shopping that has all the lawyers very excited.

The company’s problems arose from the business difficulties of the auto sector, not the overstretched finances of an aggressively leveraged LBO. But Schefenacker might also provide a warning signal to investors in stressed company financings. The company has been through two rounds of financing since it first encountered difficulties in 2004 when the largest part of its debt was a bank revolving credit raised through Citigroup. In 2004 it extended its funds with a high-yield bond, and when it again ran into troubles in 2005, it raised second-lien financing, paying a very wide margin over Libor.

Second lien is typically junior secured financing, which ranks behind conventional senior secured lenders but above unsecured bondholders and subordinated debt investors in such instruments as mezzanine.

Each round of new financing postponed the day of reckoning for Schefenacker and appeared to bail out the previous group of lenders. But with the second-lien lenders in place, by the middle of November bondholders faced being crammed down into the new equity under a distressed debt restructuring. While the company’s second-lien debt trades in the low 80s, the bonds trade in the 30s, having at one point traded down even to the 20s. It now looks as if it would have been much better for bondholders to have forgiven a portion of their debts back in 2005 and to have fully restructured the company’s balance sheet.

In the US, where Chapter 11 bankruptcy protection permits company managements to restructure debts under a stay of protection against lenders and to raise new working capital, cynical distressed debt traders deride companies that manage to reorganize themselves so poorly that they have to go into Chapter 11 a second time – as for example US Airways did – as Chapter 22s. Does that make Schefenacker a Chapter 33?

“All the second lien did was delay the crunch,” says one market participant. “It gave Schefenacker enough money to pay interest to bondholders, to whom it had promised to achieve €100 of ebitda back in 2004, but it could not repay principal. Now there’s a game of chicken between the second lien, who want the bondholders to take equity, and the bondholders, who are demanding an economic incentive to do so. So is this next restructuring going to cure the problem? I hear that the company is producing ebitda far, far below €100 million. Even now, the high price on the second lien reflects no risk to the expectation that the family will put in new equity, and a complex restructuring will be completed in the UK.”

Although strong corporate earnings, abundant liquidity, healthy balance sheets and macro-economic stability are combining to keep default rates very low and grinding already tight credit spreads in further, lenders – even to strong investment-grade credits – must worry that in the good times today they are piling on tomorrow’s bad loans.

Not that senior investment bankers seem to be too concerned. Euromoney recently met the CEO of one of the world’s largest banks. He believed the credit cycle was set fair, that record leverage levels should not be of major concern. Why, then, was he and every other CEO frantically building up distressed debt operations? He simply smiled. Perhaps the fees available in the new forms of financing are sufficient to mask the risks involved.

At the riskier, more leveraged end, suppliers of financing are already working furiously just to postpone the inevitable restructurings and defaults. The worry is that in the process of postponing distress they might in some cases be ensuring that it will be worse when it eventually happens, by piling on more bad loans.

“It’s the greater fool theory,” says Edward Eyerman, managing director in Leveraged Finance at Fitch Ratings. “You can see from the bank plans, many of these leveraged financings are not designed to go to term; they don’t show the debtor being de-levered and the debt repaid out of cash flow. Rather, the projections typically show revenue and margin expansion, irrespective of cyclicality, such that the net debt profile de-levers modestly in three to five years and the market assumes refinancing for the B and C tranches will be available. Consequently, everyone is just bridging to the next refinancing with the expectation that the required cash generation will be realised and the market will be as buoyant as it is currently.”

How can market participants convince themselves that this is credible? Eyerman says: “Recent vintage transaction structures provide a fair amount of cash-flow headroom because debt amortization is back-ended, especially with more B, C and second lien D bullet tranches, and the interest burden benefits from flexed pricing on the senior and second lien as well as increasing capitalized interest in mezzanine coupons and junior PIK mezzanine. The default risk is therefore very low in the early life of these transactions yet the refinancing risk is substantial and practically the whole market is vulnerable to modest changes in profitability and loan market liquidity.”

A source at a leading investment bank describes a deal he worked on recently for a stressed company that included a partial write-down of existing debt and the provision of new funding. Was he confident, at the underwriting stage, that the write-down of the old debts had been deep enough to make the new structure sustainable for the medium term? “The hedge funds underwrote it: you know, they are disintermediating the banks. We didn’t underwrite it.” Oh, really. Why not? “Because this would never have got past our credit committee.”

Michael Guy, managing director, special situations, at Credit Suisse, says: “There’s a lot of event postponement. There have only been a couple of defaults because there always seems to be someone prepared to write a cheque. In a more liquidity-constrained environment, some of these very leveraged capital structures would be being wound up.”

Troubled companies that find conventional funding sources – the bank loan and bond markets – closed to them can still raise substantial funding. Last year, Tiscali, a standalone broadband internet provider, found itself struggling in the hugely competitive marketplace. It was forced to sell off certain of its national businesses around Europe to fund its continuing operations and pay debt and, most worryingly, it saw looming a maturity of equity-linked bonds falling due in 2006 that it simply could not meet.

Is that a company in stress, or distress? Whatever the correct definition, Tiscali found a way through this crisis in August 2005 by raising an €150 million senior secured loan from credit opportunity hedge fund Silver Point Finance, €100 million of which would refinance the maturing bonds and €50 million of which would provide working capital. The loan pays Silver Point Euribor plus 600bp and keeps Tiscali, which is rated CCC by Fitch, still in the brutal game of competing with larger telecom and broadcasting operators such as Sky and BT.

One year later, in August 2006, Tiscali was able to tie up with VideoNetwork, bringing it more content. Fitch didn’t change its ratings on the news, merely pointing out that “the standalone broadband business is looking increasingly uneconomical”, and that it “considers further market consolidation to be likely”.

In the secondary market, valuations for distressed debt are being kept high. One investor points to the example of Ripplewood-backed Honsel, a maker of light metal parts for cars. “This is a company, levered at five times debt to ebitda, that has already sought a covenant waiver, and yet its senior debt still trades as high as 98. To me, this market is several standard deviations away from normality.”

Distressed debt specialists – the growing number of flow and prop traders at the banks, the specialist investment funds, the restructuring advisers to troubled borrowers, the insolvency practitioners at the law firms seeking to be hired by committees of creditors – are marshalling their forces and hovering over the market waiting for it to blow. And they are all focusing in one particular area of the credit market.

Ian Cash, who runs the distressed debt special opportunities fund at Alchemy Partners, told the same Euromoney seminar: “In the past, European distressed debt investors have relied on fallen angels, the unpredictable one-offs, the unexpected regulatory change, the corporate malfeasance. Going forward we have a much bigger and different market: the leveraged debt market, which today is around $600 billion, up from just $50 billion in 1998.”

Right now, as elsewhere across the credit markets, default rates even in leveraged finance are low. Patrick Lynch, managing director and head of credit trading at Morgan Stanley in Europe, says: “The distressed debt market is tiny. In fact, if you take out the autos and auto component sector, almost nothing is distressed.” That’s true, as long as you accept that a credit that has negotiated a covenant waiver from its lenders, maybe attracted some more financing from them, or even raised new money that it doesn’t have to eat into its earnings to service because all the amortization is back-ended, is not in distress. Technically, of course, it isn’t.

J Soren Reynertson, managing director and head of European restructuring at UBS, puts a different slant on things. “People say there is no distressed debt. Well, there is: it’s just not trading at distressed prices.”

While headlines in the leveraged finance market are dominated by the largest public buyouts, the market is in fact made up of a large number of smaller deals, many of which are privately financed by traditional bank lenders, specialist mezzanine funds, hedge fund investors in second-lien notes and PIK notes, and increasingly by institutional investors in senior loans. So abundant is this financing that many deals are now completed without public high-yield bonds. But even though neither the issuers nor the funding arrangers need to seek ratings for these leveraged finance deals, the CLOS and CDOs that typically buy the riskier portions of the senior loans do require agencies to come in and rate them – often after the funds have bought them.

The ratings agencies then periodically update ratings at the investors’ request, based on new information disclosed to these investors by the borrowers without the agencies getting into any bun-fights with borrowers themselves and their arrangers. The CLOs and CDOs worry a lot about ratings because if they were to breach their own limits on lower-rated holdings they might be forced to unwind funds. Hence they are quick to sell on distress.

The ratings agencies are a valuable source of insight into the workings of the leveraged finance market. They see at least four worrying trends.

First of all, the LBO market is now largely a B-rated market, whereas it used to be closer to BB three years ago. That deterioration comes not so much from the downgrading of older deals as from the preponderance of lower-rated new deals. Initial leverage levels are very aggressive as private equity funds seek to take advantage of the abundant risk appetite and the array of flexible new structures in the credit market to get the best deal possible for themselves. By the third quarter of 2006 the average debt to ebitda multiple in the European leveraged finance market had hit 6.5x, up from 5.5x at the start of 2005.

That would be OK as long as companies that had undergone LBOs were able to grow cashflows from improved margins or volumes or both, so as to manage these debts. But have they been ale to do that?

This year, Standard & Poor’s conducted a survey of the incidence of covenant breaches and waivers among LBOs funded in 2005. Covenant waivers – where a borrower fails to perform to business plan over maintaining a key credit metric and seeks relief from lenders from being declared in a technical default – are a tried and trusted indicator of problems ahead, with default rates rising significantly in the years and months following a rise in covenant breaches. 

It usually takes some time after an LBO for any underlying business failure to express itself through covenant breaches. Deals typically make it through the first two years without too much difficulty and year three is the crunch time when principal debt repayments start to fall due.

S&P found a trend for covenant breaches to appear much earlier in 2005 vintage LBOs, even within the first 12 months of a deal being completed. That’s particularly worrying given that covenant packages that creditors have been able to insist on have generally been getting weaker and deals have been structured to allow plenty of cashflow headroom in the early years. It suggests that the due diligence conducted in the lead-up to new deals is poor, allowing more bad transactions to slip through the net.

The third worrying trend is the growing use in capital structures of new credit instruments, including second-lien financing, mezzanine debt with back-ended amortization and capitalized interest and holding company PIK notes. The danger here for companies is that the availability of such financing is tempting equity investors to bolt on more debt all across the capital structure, including, in addition to these junior pieces, more senior debt. Halfway through this year, when average debt to ebitda multiples were around 5.9x, deals with second-lien financing had already progressed to 6.5x levered.

Investors might be drawing some comfort from relatively high initial issuer default ratings on these instruments. They shouldn’t be fooled. Issuers aren’t likely to default any time soon on debt that doesn’t demand payment of interest or principal before 2008. Investors should be paying more attention to the very low likely recovery rates in the event of default.

“We’re worried about second lien, because whatever the inter-creditor agreements and security packages say about pre-emptive rights and the responsibility of senior secured to the second lien holders, a second claim on nothing still isn’t worth very much,” says Eyerman at Fitch. “But we are even more worried about mezzanine, because it is increasingly out of the money and essentially equity risk at historical enterprise value multiples.”

In a credit world largely populated by investment-grade names it makes sense for rating agencies to devote their energies to issuer default ratings. But for a sub-investment-grade world, where the rating migration history suggests that defaults are already likely even as soon as the ink is dry on some new deals, attention should turn to likely recoveries. 

The agencies have begun to assign recovery ratings to the various parts of the capital structure for speculative-grade companies. In September Fitch stress tested the market and found that 71% of senior debt had a likely recovery rate of 71% to 100%. Meanwhile 80% of junior instruments – second lien and mezzanine – had a recovery rating of just 0% to 10%. Fitch calculated a range of likely enterprise values for the nearly 400 leveraged companies it rates and found that, at the lower end of this range, mezzanine holders would get back nothing.

“People under-appreciate these changes in recovery rates,” says Lynch at Morgan Stanley. “These unsecured pieces now sit under more top-heavy capital structures. And even for the senior secured, recovery rates could come in well below what’s often thought of as the historical experience of 70%.”

As for the most junior of the new pieces in the capital structure, HoldCo PIK notes, it’s a bit of stretch even to call these debt claims on the borrowers at all. In most LBOs, the sponsor creates a holding company that owns equity in a subsidiary operating company that contains the earning assets of the company and that issues the senior, high-yield and mezzanine debt. Creditors want claims on the operating company because it has the assets and the earnings.

Holders of payment in kind (PIK) notes issued by the holding company have almost no claim on the assets of or even the cash generated by the operating company. Dividend blockers prevent cash being passed up from the operating company to the holding company. The ratings agencies would never downgrade a borrower because it has taken on the additional debt of HoldCo PIK notes. One credit investor describes them as “leveraged equity”. Sponsors have often used them to take cash out. The first ones in Europe in early 2005, for Cognis, Jefferson Smurfit, Eco-Bat and Avio, were all used to fund payouts to shareholders. When Jefferson Smurfit issued its subordinated PIK notes, its own senior unsecured debt was rated B+, the PIK notes were rated CCC+. In 2006, PIK notes have been issued as part of the initial LBO structure and also to fund shareholder payments, working capital and acquisitions.

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Why would anyone buy PIK notes? If hedge funds like a company and its underlying story but have no access to the underlying equity, which is reserved for sponsors, they might buy PIK notes as the next best thing. Sometimes, sponsors will even offer a small sliver of equity as an incentive to buy them. Typically the notes require no payment of interest until maturity and, if a company performs to plan, will be called and refinanced with cheaper debt before they mature. One banker says: “Refinancing is basically the only way these guys are going to get repaid.”

If a company doesn’t perform to plan, and the sponsor has used proceeds to withdraw cash, then watch out. “We have people trying to market some notes to us now at 23%,” says an unimpressed-sounding principal investor. “Clearly that’s not debt: it’s equity. And however you perfume that particular pig, it’s still a pig.”

The greater complexity of capital structures and the proliferation of new buyers promises that the next wave of distressed debt will be a lawyer’s dream, as investors in different parts of the capital structure jockey for the best recoveries.

Investments are already being game-theoried. “I don’t see a natural investor base for second lien: it’s more an opportunistic one that is, I think, paying a lot of attention to inter-creditor agreements,” says one banker. Second-lien holders might be gambling that they can enforce first rights of refusal on asset disposals by senior lenders in a liquidation, to prevent the senior secured from quickly recovering enough to meet their own dues and hanging the other creditors out to dry. Of course a delayed restructuring often recoups less value. Do second-lien holders hope that senior secured will pay them off to push deals through. Either way, it threatens lower recoveries for the senior lenders. “Already we are seeing creditors take a tactical blocking stake in one part of the capital structure in order to improve an outcome for another part of the capital structure where they have more at stake,” says one banker. “And while in the past we have seen disputes between different layers of the capital structure pitting senior against subordinated, we are getting hints of potential disputes within the senior debt among investors in different tranches.”

The final worrying trend is the use company owners, notably private equity firms, are making of the abundance of funds dedicated to these new asset classes. Instead of realizing their returns by improving companies’ operations, de-leveraging and undertaking IPOs, they are increasingly recapitalizing them at even higher leverage levels to recover the value of their initial equity investments with debt-funded dividend payouts. Companies are being sold in secondary and tertiary buyouts, often with new debt being put on. Fitch notes that the recycled LBOs being completed in the first half of 2006 had enterprise value to ebitda multiples of 9.7x compared with an average of 7.3x in the initial or preceding buyouts. That’s an acceleration of the trend from 2004/05 when recapped LBOs were being done at ev/ebitda multiples of 9.3x compared with 7x in the preceding deals. It also exceeds the overall market average multiple of 8.8x.

Private equity assets, the underlying companies, are being churned. This process, and the diminishing role of bank lenders, threatens to loosen the traditional disciplines of the leveraged finance market. In the days when a private equity sponsor might have 10 or 20 corporate investments, with each purchase funded by loans arranged, underwritten and partly held by the same small group of banks, there were obvious incentives, if one or two of those portfolio companies got into trouble, to support them, even at the cost of injecting new equity, so as not to sour relations with the banks.

Now private equity firms are running larger, more diversified portfolios of companies, purchased using funds from a wide array of lenders. If one company hits trouble, and if the sponsor has already recouped its initial investment through a leveraged dividend recap, there’s far less reason to devote time and money to supporting that one company for the benefit of lenders. Sure, the stub equity has residual value, rather like warrants, but why waste time on it when losses have been capped and there are better returns to be made elsewhere on successful deals?

Permira bought out German auto components maker Kiekert in 2000 but, in distress (or perhaps we should say stress), has chosen to leave it to restructure its debts with creditors. Similarly, Duke Street Capital, which had already taken out three times its initial investment in Focus Wickes by 2003, has little incentive to bail out lenders to the UK do-it-yourself retailer now renamed Focus DIY, whose low cashflow generation relative to its debt, following recapitalization in 2005, eventually prompted a downgrade by the agencies in September 2006 to CCC, with its mezzanine notes at CC.

Fitch calculates that Focus has senior secured debt of £186 million ($350 million), £810.3 million of total senior debt including lease obligations, mezzanine debt of £100 million and shareholders’ funds of £129 million. Meanwhile it suggests it might have a liquidation value of £115 million, or in a more optimistic distressed case, a going concern value of £236 million. Even at the most optimistic value, while senior secured lenders might recover 87%, mezzanine investors would still get nothing. Caveat emptor.

It seems that private equity sponsors, liberated from the discipline imposed by banks to protect a company’s credit profile through the cycle, feel less beholden to the 25 or so large mezzanine funds, and the myriad hedge funds and CLOs now supplying them with funding. It’s a sponsors’ market. Are the sponsors getting over-optimistic? One banker says: “We certainly seem to see business plans for companies in what have been historically quite cyclical sectors – chemicals for example – predicting volume and margin growth for the next three to five years. They are getting financing that would normally be reserved for the best growth companies.”

This is a bubble. That’s not in doubt; less obvious is what will burst it, when it will burst and what will the bursting be like. Bubbles can persist for years, as did the one in Japanese real estate. And the credit markets broadly and the leveraged finance market more particularly have shown great resilience to shocks: the credit markets when they shrugged off the junking of General Motors and Ford in mid-2005, the leveraged finance market more recently when hedge fund Amaranth, having been brought low trading in natural gas futures, was forced into the fire sale of a couple of billion dollars-worth of leveraged finance assets. The market absorbed it all in two days with barely a shift in prices.

What could knock it all over? A hard landing in the US, depressing the global economy would be most worrying; continued rises in interest rates to contain inflation and a steepening yield curve would also hurt. Simon Mansfield suggests it will be simply, “the weight of poor deals, rising defaults among recent new issues that will depress returns and erode confidence”. But that might not be until after repayments start falling due and refinancing risks rise in 2008 and 2009.

Distressed debt players insist that they don’t need Armageddon for their business to take off, just a return to more normal default rates in the 4% to 5% range. For now, with corporate earnings so strong, it all seems a distant prospect. But Armageddon could be what they eventually get from a market in which both the suppliers of finance and the borrowers have become highly levered.

When the cycle turns it is not the large-cap high-yield bond issuers that will be most vulnerable, as in 2001 and 2002, but the smaller, privately financed LBOs. Katherine McCormick, head of the distressed business at JPMorgan, told the Euromoney distressed debt symposium: “If some of the AAA-rated structured credit pieces become highly volatile and recovery rates on senior loans come in well below expectation, that will be a shock to the system. Because of the very high leverage, the unwind, when it comes, could be quite ugly.”

What will distressed debt investors do until then? They are ready to strike at the first scent of blood in the water. “I can’t tell you just how many hundreds of funds and billions of euros are dedicated to the distressed asset class right now,” says Iain Burnett, executive director and head distressed debt analyst at Morgan Stanley. “It’s noticeable that at the first signs of distress, original lenders – the banks and CLOs and other funds – are out very quickly, but as soon as anything trades down to 95 there’s an enormous bid for it.”

That makes value hard to find and good returns tough to achieve. Hedge fund distressed investors’ response is the traditional reflex: increased leverage and style drift. They are piling into near-par loans. “We have hedge funds in our offices almost every day boasting about how much leverage they are putting into their distressed debt funds,” says one broker dealer “and I guess the bank prop desks are doing much the same.” In the US, prime brokers have typically restricted the leverage available to hedge funds buying senior loans to around four times: anecdotal evidence suggests they might be leveraging much more in Europe.

They are also exploring new jurisdictions, buying more emerging market distressed debt and testing new asset classes, teaming up with specialist consumer collection agencies to go after returns in past-due credit card and consumer loan portfolios.

And, of course, they are deploying capital in leveraged loans. “Two years ago we were 100% in distressed debt, now that’s down to 20%,” says the head of a special situations group. Isn’t he making the rather large mistake of buying expensive problems loans too early, before they actually turn into problems and cheapen up?

“It’s certainly true that while everyone expects us to make a lot of money when the credit cycle turns down, in fact when it does we stand to lose quite a lot,” he says.