Wait and see
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"Even when the market was functioning we could see that these were very poor quality assets – a deal that is a pig at par is still a pig at 96" |
NOBODY WAS GOING to win any prizes for guessing that the cheap money fuelling the leveraged buyout boom of the past few years would not last for ever. Even as the stream of ever more audacious deals continued to hit the market in the first half of this year (and long before) many firms – indeed often the same firms that were sponsoring these buyouts – were working on how best to exploit the inevitability that some of these deals would not survive. So the market is now seeing such firms as Kohlberg Kravis Roberts planning to buy up loans at a discount from investment banks that have been unable to sell on the deals they underwrote for the likes of ... err ... KKR. When these firms describe themselves as multi-strategy, they clearly aren’t joking.
But the private equity sponsors are not the only ones that have been thinking ahead. As soon as the contagion from ABS CDOs spread to CLOs in August, many loan buyers could see a clear opportunity. It had been the CLOs that had facilitated the LBO credit boom (see How CLO managers muscled in on the LBO market, Euromoney,June 2007), and if they were gone that meant that the banks were going to have a big problem – 70% of the investor base in the US and 50% in Europe had evaporated.
They were right, and US banks were quickly stuck with a $300 billion hung pipeline while in Europe the equivalent figure was about $100 billion. The opportunists piled in: one US banker recalls that in August "we were seeing seven or eight proposals a day". By November, $70 billion of equity had been raised in the US for credit opportunity or dislocation funds in the US (which if you add a turn of leverage to it means maybe $150 billion of new money). According to Standard & Poor’s LCD, roughly 18% of the buyers of US leveraged loans are now new entrants since 2006. According to Lehman Brothers, the CLO’s share of the primary market for institutional loans has shrunk to 21% since July while hedge, high-yield and distressed funds have doubled their market share from the first half of this year to 57%.
Many of these new entrants are hedge funds – but not all of them. Along with firms such as Oak Hill Advisors and Canyon Capital Advisors, substantial new allocations have come from existing US high-yield mutual funds. It is this demand that has taken the market by surprise. "US high-yield mutual funds have become the largest buyers of senior debt in this market," says Malcolm Stewart, head of European leverage capital markets at Merrill Lynch in London. "Three things have happened which have allowed them to start buying these loans: margins have increased, original issuer discounts (OIDs) have been offered and call protection has been added." Stewart reckons that high-yield mutual funds and hedge funds account for 70% to 80% of leveraged loan buyers in the US – almost exactly replacing CLOs, which were reaching those levels before the crisis.
KKR, which is understood to be working with Citi on a fund that could reach $10 billion targeting the hung pipeline, is one of many sponsors rumoured to be doing just this. Oaktree Capital Management, Blackrock, Eaton Vance and Texas Pacific Group (TPG) have all been named as planning similar ventures. For private equity firms that have raised large amounts of money that need to be put to work it is an obvious way to go.
But there could be pitfalls. "Private equity is a completely different mentality to distressed debt," observes one investor. "Distressed buyers constantly marvel at the inability or unwillingness of sponsors to address problems. Private equity firms always handle distressed situations badly as either their equity is worthless or they have taken all their money out via a dividend." But more of them should now be brushing up their skills. "I am surprised more private equity funds are not doing this to hedge themselves against the pipeline of easy deals and cheap debt drying up," says one private equity sponsor.
Not to be outdone, the banks are also targeting these loans. While Citi and Goldman are looking at potential opportunities, Lehman Brothers announced the launch of a $3 billion loan opportunities fund at the beginning of October, but this is the only fund to emerge so far from a number of rumoured proposals. "We came up with the idea for the fund in August in response to the turmoil in the market at that time," Mike Guarnieri, former global head of credit research at Lehman, who will be managing the fund, tells Euromoney. The fund has raised $670 million of equity and will lever up three and a half times. "The loan market was going through a period of indigestion and the magnitude of the backlog meant that the market was due to reprice."
Not enough opportunity to go around
What was looking like a failsafe bet as the market tanked in August has, however, not lived up to expectations. Anyone expecting the bulging $300 billion LBO pipeline to be puked into the secondary market at the low 90s has been sorely disappointed. "The opportunity was exaggerated," says Stewart at Merrill Lynch. "There was an Indian stand-off (see Leveraged Loans: No pain, no gain Euromoney, October 2007) but once the market began to gain some traction [with deals such as First Data and Allison Transmission], that subsided. People did not expect such a robust reaction from high-yield investor."
But Guarnieri maintains that the market has behaved in the way that he expected. "There were a number of funds that were contemplated that were expecting the banks to sell loans in the low 90s," he says. "But we felt that the banks generally were comfortable with the credit quality of these assets. We set an expectation that the banks would be sellers at around the level that we are seeing now."