Oldspeak and newspeak
Private distress is most profitable
Disguising risks in distressed debt
Distressed debt used to be a secondary-market play. Today, it’s a primary-market business. Distressed or stressed companies don’t avoid default by restructuring old debts. They put on new ones supplied by myriad new forced buyers of credit. The product’s already distressed when it goes on the shelf. Peter Lee reports.
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.
Borrowing from Peter to pay Paul
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.”
The sum of the parts maker
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.
Two times stupid, three times crazy
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?