Signs of the Times
Optimism, adventurousness and unworried behavior characterized the pre-crisis period, and investor behavior reflected those attitudes. In my memo "It's All Good" (July 16, 2007), just before the onset of the crisis, I mentioned some of the warning signs in the credit markets:
Unlike the historic norm, it's routine today to issue CCC-rated bonds. It's easy to borrow money for the express purpose of distributing cash to equity
holders, magnifying the company's leverage. It's so easy to issue bonds with little or no creditor protection in the indenture that a label has been coined for them: "covenant-lite." And it's possible to issue bonds whose interest payments can be paid in more bonds at the option of the borrower.
The first requirement for an elevated opportunity in distressed debt is the unwise extension of credit, which I define as the making of loans which borrowers will be unable to service if things get a little worse. This happens when lenders fail to require a sufficient margin of safety. . . .
The default rate in the high yield bond universe is at a 25-year low on a rolling-twelve-month basis. Under such circumstances, how could the average supplier of capital be expected to maintain a high level of risk aversion and prudence, especially when doing so means ceding all the loan making to others? It's not for nothing that they say "The worst of loans are made in the best of times."
The inspiration for today's memo came as my pile of clippings began to swell with indications that pre-crisis behavior is coming back. Here are excerpts from a few, with emphasis added in each case:
On covenant-lite loans –
Are debt investors just stupid? That might help explain why they're buying covenant-lite loans again. These deals, which carry few restrictions on borrowers, became a standard bearer for easy money. They may have helped some companies limp through the downturn – but they've left lenders saddled with lots of risk and little return.
It's easy to see why companies like covenant-lite loans. . . . But for owners of the debt, the attraction is far less clear beyond the familiar short-term reach for yield. . . .
Lyondell Chemical is paying [Libor plus 400 basis points] on its recent $500 million covenant-lite deal. And the energy refiner will emerge from bankruptcy with a much slimmer debt load than before it filed for Chapter 11.
Lyondell's terms are better than 2007's crop of covenant-lite loans, to be sure, but lenders still are essentially relinquishing their right to force companies into paying them more money, or exiting the loan entirely, should their creditworthiness tumble.
So why are lenders doing it again? Lyondell Chemical's answer: investor demand for higher yielding assets. This is a familiar mantra while official interest rates remain low. But lenders should be mindful of loosening standards or risk finding themselves once again on the short end of the stick. ("Don't call it a comeback," breakingviews, April 5)
On payment-in-kind loans and flexibility –
Clint Eastwood's Dirty Harry character famously held a gun to a suspect and asked: "Do you feel lucky?" Investors in credit markets seem to be saying yes, if Cerberus' refinancing of Freedom Group, maker of Remington firearms, is any indication.
A deflating gun bubble backfired on the private equity firm's plans last year for an initial public offering of Freedom. Now trigger-happy credit investors are taking off their safeties and letting Cerberus unload some of its stake.
The $225 million of notes are useful ammo for Cerberus. They allow Freedom to either pay the interest in cash or half in cash and half in additional notes at the company's discretion. The financing allows Cerberus to get cash back on its investment today by buying back preferred
stock held by the private equity group ahead of an eventual IPO. . . .
The buyers of these notes, though, are taking their chances. Freedom doesn't look overleveraged according to its historic cash flow – the company's debt level is about three times "adjusted EBITDA" for 2009. But sales of rival gun-makers are continuing to fall. . . .
Moreover, these sorts of notes are notoriously difficult to price. The investor has to figure out the risk of the company encountering cash flow problems, whether the firm will actually pull the toggle trigger, and how much the PIK feature may reduce their potential recovery in the event of default. Indeed, many investors took drubbings on similar notes issued at the top of the credit boom. Caution is warranted when investors remove their trigger locks. ("Do you feel lucky?" breakingviews, March 31)
