Corporate defaults: The LBO zombies set to stalk the market

Louise Bowman

Thursday, October 30, 2008

A wave of corporate defaults will follow the onset of a vicious global recession as sure as night follows day. But this time, that night will see zombie companies stagger the earth, dragging their uncovenanted leverage multiples behind them. Louise Bowman explains.

Blight of the living dead:

SPEAKING AT A Loan Market Association (LMA) conference in October, Ian Cash, head of Alchemy Partners’ £300 million ($509 million) Special Opportunities Fund, drew an alarmed gasp from an already rather anxious audience by revealing that his five-year expectation is for default rates in the European high yield market to rise to an eye-watering 50%. This prediction is doubly startling considering the figures involved. According to Fitch Ratings, €145 billion B-rated corporate debt is due to refinance in Europe by 2016, €86 billion of which is highly leveraged, pre-crunch LBO debt. In the US, $1.7 trillion high-yield loans were written in 2006 and 2007 alone. Clearly, if default rates range as high as Cash is suggesting, this could become a very big problem indeed. Recovery rates are likely to be much, much lower than historical experience as well.

Headline-grabbing as default predictions such as this are, they conceal the fact that, in this downturn, even some corporates that don’t default could be as much of a concern as those that do. Those companies become zombie companies – firms that are underperforming but refuse to die because the lax documentation that crept into the lending market in the boom years acts as a life support machine to a terminally-ill patient. Given the unprecedented leverage that many buyout firms are operating under, even a marginal deterioration in performance can have a serious impact on their ability to service their debt. But the recent widespread adoption of covenant-lite (predominantly in the US) and covenant-loose loan documentation means that the traditional triggers that would prompt these firms to restructure are not there. They might, therefore, become the living dead, staggering on under a huge debt burden but not forced to the table to sort out their problems.

This bleak prospect is a very long way from the premise on which the debt that might now drag down some of these firms was written. The rise in leverage multiples and risk tolerance among LBO investors in recent years has been well documented, as have the aggressive business plans on which the loans were made. The ease with which firms were able to refinance during the market’s height has only exacerbated the problems that many of them now face. Michael Guy, managing director, special situations, at Credit Suisse, spoke to this magazine in November 2006 and observed: "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." Now there is no one prepared to write a cheque, and it is hard to see how many borrowers can fend off the inevitable. "We have seen distressed prices in the leveraged loan market for almost a year but not many distressed companies per se," observes Ed Eyerman, head of leveraged finance at Fitch Ratings in London where he oversees shadow ratings on more than 300 European leveraged credits. "Now we are starting to see distressed companies," he warns.

But in contrast to other cycles, the level of actual defaults so far has been relatively restrained. According to Standard & Poor’s, just 15 speculative-grade companies defaulted in the year to mid-September 2007. The agency’s preliminary estimate for the US 12-month-trailing speculative-grade default rate in September 2008 is 2.68% but it expects this to escalate to a mean forecast of 4.9% by August 2009, but it could reach as high as 8.5% if economic conditions are worse than expected. Worrying as these figures are, what has really got the market spooked is how difficult it will be to predict just how defaults will play out. Stephen Phillips, partner in the financial restructuring and insolvency practice at White & Case in London, believes that looser documentation has already resulted in lower default rates than would historically have been expected. "It is quite surprising, given the shocking news that has come through over the last six months, that there have been relatively few defaults in Europe," he says. "If default settings had been where they were a few years ago, we would definitely have seen more defaults."

But corporate defaults will come; it is just a question of how long it will take. This marks the next phase in the downturn – the phase where the problems in the stricken banking sector directly affect the real economy. Having lent way too much to leveraged buyouts using covenants that you could drive a bus through, the banks are facing the next big drain on their battered balance sheets. Rather than being able to use their new capital injections from governments to make new loans to companies and households, many will see that new capital disappear into a wave of corporate distress of their own making.

Trapped by complexity

Speaking at the LMA meeting, Philippe Lautenberg, director in the European Special Situations Group at Credit Suisse, warned that the complex LBO structures of recent years would be very difficult to unwind. The prospect of getting perhaps 100 different constituencies with very different agendas together to drive an insolvency process is not one to relish. Lautenberg also warned that the impact of looser covenants and multiple equity cures will be a lot of zombie credits for which there is no upcoming event and the sponsor has a number of quick fixes. "If you operate in an over-levered environment you under-invest in R&D and capex and there is a loss of trust along the supply chain. You are also unable to attract the right people," he says. "Loose structures mean that as and when the business breaks down it will be much, much worse."

Fitch Ratings describes zombie companies as those with unsustainable capital structures, yet no near-term default triggers to force a restructuring. For such companies, restructuring might therefore only be an option when underperformance is so severe that it threatens a cash shortfall. Alternatively, it might not even be triggered until the B and C tranche LBO debt matures – which for deals done in Europe at the height of the boom will not be until 2013 or 2014 (see chart).

Deferred funding

High-yield debt amortization peaks deferred until 2013/15 in Europe

Source: Fitch

Covenant-lite lending was not nearly as widespread in Europe as it was in the US, so the presumption should be that its impact should be more muted on deals closed in the region. But Simon Davies, vice-president at Blackstone Group, explains that there is no such cause for complacency. "There was more true covenant-lite lending in the US than Europe but there was still significant covenant loosening (in Europe), which is enough to create zombie companies," he says. He adds that if and when companies do default, recovery rates are likely to be far lower than historical comparisons would suggest. "Loans with covenants are the early warning signal that should get everyone round the table, but this has been diluted," Davies adds. "Now the fire alarm will ring late and loud."

The seeds of the problems that the loan market faces today were sown over the past few years. In a research piece published in September 2006, Standard & Poor’s pointed out the risks inherent in the looser covenant structures that were creeping into the European loan market. "Taken in aggregate, a wide range of seemingly small changes to loan agreements in recent years... has resulted in a significant rebalancing of risks, rights and rewards toward borrowers and away from lenders," the agency observed. In addition to the absence of maintenance covenants and amortization (because of the dominance of term loan B and C structures), the market saw less restrictive cash sweeps, weakened lender voting rights, greater freedom to make acquisitions and disposals and the ability to use cash proceeds from other non-operating activities. In the US, where full covenant-lite lending approached 40% to 50% of the loan market at its height, the trend was further exaggerated. Two years later, however, the market is realizing just what the impact of this weakening could mean.

A survey published in June by Standard & Poor’s revealed that cash coverage ratios for LBO firms in Europe had fallen from four times debt in 2003 to 2.5 times in 2007 and 2.2 times debt today. As the economic climate rapidly deteriorates across the region, that already wafer-thin ratio will be further squeezed. The S&P data reveal that while leverage multiples in buyouts larger than €500 million fell from 6.3 times in 2007 to 5.5 times in the first quarter of 2008, for smaller deals (less than €500 million), multiples actually increased, from 5.8 times in 2007 to 6.95 times in 2008. This can only mean that there is a lot of debt out there that might need restructuring soon. "Business models and covenant structures were predicated on a rise in earnings – companies were supposed to grow into their capital structures," says Phillips at White & Case. "In this climate increasingly there are a lot of companies failing to meet their base case models. Loose covenants may help extend the equity option for a period but if the downturn is sustained the covenants will be tripped."

For deals with very loose covenant structures the most likely covenant breach could therefore actually be insolvency itself. A traditional maintenance covenant package, where the trigger is set at 25% above base case, means that performance only has to deteriorate to that point for problems to be addressed. Clearly, if a loan has weak or no covenants, performance can deteriorate down to zero without any remedial action. "A company is always in a more difficult position if a restructuring is triggered by liquidity concerns rather than covenants," says Dominic Ashcroft, executive director, high yield capital markets, at Goldman Sachs. "Particularly in today’s market where market liquidity is so limited." This is not only because the company will have been underperforming for longer and therefore destroyed more value but also because lenders will be faced with bankruptcy almost immediately. "In the new environment there isn’t time for the senior banks to get together to make a credit decision and obtain information in an organized way," says Davies at Blackstone. "So not only will defaults increase but there will be a much greater likelihood of needing an insolvency process." That process will likely take the form of a pre-pack administration for which court approval is not required and the company can continue trading.

What can the lenders do?

Faced with this bleak outlook, what, if anything, can be done to stop a wave of zombies stalking the land? Bank concessions on covenants in the boom years are a worry not only from the trigger standpoint but also because of the leeway borrowers have in their activities. One worrying example of this is a rise in asset-based lending, whereby a borrower can use existing inventory to raise finance. This is something that would have been prohibited by a traditional covenant package. And it could destroy the enterprise value of the business if and when the lenders come to restructure. "Equity sponsors of stressed LBOs are being increasingly creative in designing ways to maintain control of the asset through utilizing all tools available to them," says Charles Noel-Johnson, director at Close Brothers Corporate Finance. "It’s gone from traditional measures such as equity cures to things like receivables financing, sale and leasebacks and debt buybacks to prevent covenant breaches."

"Loans with covenants are the early warning signal that should get everyone round the table, but this has been diluted. Now the fire alarm will ring late and loud" Simon Davies, Blackstone

One of the first things that a stressed borrower might do is request a covenant waiver – something that is happening with increasing regularity. "There have been a significant number of waiver requests under the radar," reveals Phillips. "These are being quietly dealt with by lenders." But there have also been a growing number of requests very much on the radar – a high-profile example of which was the recent waiver negotiated by corporate Yell Group on its £4.6 billion senior debt. Interest coverage and leverage ratios were amended in return for a 50 basis point fee and 100bp margin hike. Virgin Media has also recently asked for a covenant waiver on its £5.2 billion loan, which was refinanced in March 2007. It wants to defer amortization on its term loan A until 2012 in return for a 125bp fee and a margin hike of 137bp. "Corporates are beginning to realize just how challenging the financing markets are today," observes Ashcroft at Goldman. "Particularly the credit markets where even good-quality investment-grade companies are going to find refinancing near-term maturities tough. Banks and institutional investors have been supportive of companies who proactively try to solve financing structures earlier rather than later."

But while renegotiating already pretty loose covenants will buy borrowers some time, leverage multiples in recent LBOs mean that in many cases this is unlikely to be enough. And it is clear that covenant waivers are not cheap. UK-based retail group Focus DIY breached covenants on its LBO debt in 2005 but negotiated a waiver with its lenders. However, the cost of the waiver helped to push the firm into default in 2006 – a year when it made underlying profits of £43 million. According to Fitch, two-thirds of operating profit at the company was diverted to meet interest payments. Cerberus acquired the company from Duke Street Capital and Apax Partners in 2007 for just £1 – bondholders on the £100 senior debt having received just 40p in the pound. According to Standard & Poor’s, 135 US corporates are close to breaching their covenants and are likely to face high fees to loosen terms. Lenders have charged 63 basis points for such amendments in 2008, up from 32 basis points in 2007 and just 19 basis points in 2006.

Another course of action for the sponsor could be to inject more equity. This will be a lot easier given the multiple equity cure provisions that crept in under cov-lite/loose documentation, but the banks cannot assume that sponsors will opt to exercise them. Private equity players will be far more prepared to pump additional equity into LBO deals that were completed before 2006/07 and have traditional, amortizing term loan A structures rather than putting money into new deals with higher leverage multiples and no amortization.

A sobering case study is that of Auto Teile Unger (ATU). As a rule of thumb, most LBO structures can ride out the first two years of a business plan regardless of performance, as they have financing in place. Year three tends to be when problems arise. KKR bought the German car repair firm in June 2004 in a deal that incorporated loose covenants and limited amortization. By February this year ATU was forced to negotiate a covenant waiver in return for a €140 million equity injection from KKR and Doughty Hanson. However, ebitda has continued to fall since the equity cure and the debt is still trading in the 40s. "Some consumer discretionary credits had been suffering for more than a year before the sponsors were forced to put more money in, yet performance has not improved and the market has continued to price the debt instruments lower," says Eyerman at Fitch. "Long amortization profiles are becoming medium term." Ian Cash at Alchemy believes that the mettle of sponsors will soon be tested when it comes to equity cures on more recent deals. "With the exception of ATU, we haven’t seen sponsors putting new capital into recent deals that are obviously way out of the money," he says. "But soon they are going to have to make some very difficult decisions. They cannot equity cure for ever. Either they will have to write their investment off or they will have to find a creative way to refinance."

Debt burden

"In the past, businesses needed restructuring when they were in operating difficulty," observed Yushan Ng of Linklaters at the LMA conference. "Now, because of the amount of debt stacked on to a good business, they have problems much earlier. You can have a good ebitda-generating business that is in default. So this is a different game being played out. You are not trying to get cash out of the business, you are trying to get equity in. You are trying to shift value from stakeholders to senior lenders."

Debt servicing requirements have reportedly seen several sponsors draw on their entire revolving credit facilities simply to use the money as a sinking fund to meet interest payments. And, not surprisingly, the toggles attached to many of the PIK tranches that were included in recent LBOs have also been exercised, allowing the borrowers to meet interest payments with additional debt. Indeed, some suggest that borrowers might actually now try to convert some of their debt to PIK debt in order to ease cashflow pressure. "One concern is that in an attempt to avoid taking significant write-offs, the lenders may not push for fundamental debt restructurings. It is possible that we are going to see stretched amortization, reset covenants and small equity injections that fail to address the real problem, which is overleveraging. Long-term this is not a great idea but you could argue that it is what happened at Eurotunnel for years until the last restructuring," says Phillips at White & Case.

Given that leverage multiples are at the root of so many companies’ problems, it is not surprising that debt buybacks are proving popular. They have become a contentious issue, however, particularly as looser documentation has permitted both sponsor and borrower buybacks (see Leveraged loans: Sponsors buy their own loans,  Euromoney June 2008). The conflicts of interest associated with having sponsors buy back their own debt will become readily apparent around any restructuring table. For example, continuing negotiations surrounding Canadian door and fibreboard maker Masonite, which breached its covenants in the second quarter of this year, have become complicated by the fact that owner KKR has also lent to the company via KKR Financial and is therefore unlikely to be unenthusiastic about renegotiating tougher terms with the company. According to Bloomberg, buyout firms in the US own more than $80 billion of debt in the companies they have bought.

But – again – this is something that looser covenants have allowed. And with secondary loan prices being forced ever lower by redemptions and margin calls on hedge funds, sponsors have been able to take advantage of buying back their debt on the cheap. Blackstone, for example, bought back €25 million of subordinated debt from its €1.3 billion purchase of Kloeckner Pentaplast from Cinven and JPMorgan Partners in May 2007 earlier this year at between 20 cents and 30 cents on the euro. Another sponsor that has adopted this approach is Bridgepoint Capital, which purchased ski and sportswear chain Fat Face for £360 million from Advent International in July 2007. Bridgepoint bought back £5 million of the £190 million debt outstanding at between 60p and 65p on the pound in May this year, and, according to Bloomberg, purchased a further £21.8 million debt at the end of September, when the loans were trading at 52.3p on the pound. Bridgepoint has agreed to subordinate the debt that it has bought back.

The institutional response

Not only will this default cycle be very different because of the looser loan documentation of recent years; it will also be very different because of the changed nature of who bought the loans that might now default. Institutional investors were buying nearly 50% of loans in Europe and up to 70% of loans in the US, so how they react to an operational downturn is of vital importance to the performance of many private equity-owned businesses.

"As the macroeconomic environment deteriorates so we’ll see a raft of corporate downgrades forcing many CLOs to sell holdings, putting further downward pressure on senior debt prices" Matthew Prest, Close Brothers

Before the recent LBO boom, the largest buyout that the market had seen was the $25 billion buyout of RJR Nabisco by a KKR-led consortium in 1989. That deal was sold to S&L buyers and Japanese banks – both constituencies that were subsequently beset with difficulties. It took 15 years for the LBO market to reach such dizzy heights again with the $32 billion purchase of TXU by KKR and Texas Pacific Group, but this time the investors were CLOs and hedge funds.

First, CLOs. Unlike banks, CLOs have no internal liquidity and are therefore not in a position to either buy back loans or extend new money. They might therefore have a very destabilizing influence in a stressed situation. But it is very important to distinguish between vehicles in trying to assess what their impact will be. From a borrower’s perspective, the worst type of vehicle to be facing in distress is a market value CLO, as these vehicles liquidate as soon as their triggers are tripped. Macro credit hedge funds and total return swap/repo-funded loan funds are also a concern as the TRS provider can force liquidations to meet redemption requirements. Unlevered loan funds can also force redemptions but they will likely be far less severe. But cashflow CLOs have the distinct advantage in the current environment that they are not affected by market value declines. If there is a default, they enter amortization and wind down rather than liquidate, so there are unlikely to be forced sale bid lists emanating from cash CLOs.

The structure of a cash CLO can also be of benefit to a stressed corporate as long as there is still cashflow coming in to the company. "CLOs don’t really mind zombie companies as long as they have good liquidity," Davies at Blackstone tells Euromoney. "As long as the company continues to pay interest on the loans then, for the time being, everything is OK for them." But Matthew Prest, managing director at Close Brothers Corporate Finance, warns that the structure will eventually trip up on downgrades of the firms themselves. "As the macroeconomic environment deteriorates so we’ll see a raft of corporate downgrades forcing many CLOs to sell holdings, thereby putting further downward pressure on senior debt prices."

Hedge funds were not as strong a presence in the leveraged loan market as CLOs, but their deleveraging is proving a pervasive influence in depressing secondary loan prices. According to Citi, there were 62 large fixed-income/sovereign/macro hedge fund failures between June 2007 and August 2008, involving $194 billion of assets. Given where secondary prices are, it cannot be assumed that hedge funds will have sold out by the time that a default occurs. Indeed, given where secondary debt is trading it is increasingly likely that distressed and vulture funds will have bought in. Given that defaults might be some time coming, hedge funds will therefore likely be involved during the pre-default, zombie stage. So how will they behave?

For bankruptcy to be triggered, either liquidity has to dry up, the management or sponsor have to give up, or debt holders refuse a waiver on a covenant breach. But situations could arise where loan-to-own investors decide to force a restructuring. Market dynamics will create substantial opportunities for new money investors. Noel-Johnson expects to see a wave of restructurings where equity sponsors will take a much tougher negotiating stance with the banks and will only inject new monies where banks are prepared to take a significant haircut and to roll over into new structures to stabilize the capital base. "In companies where the debt is materially impaired, there is a significant disconnect between shareholder and management interests and those of the banks. Shareholders will be looking to retain control of the investment and management will be looking to do more than just working for the banks," he says.

Portents

Regardless of how CLOs and hedge funds behave, the key to how zombiefied the LBO market becomes is how proactive the sponsors are prepared to be in addressing problems before it is too late. The portents are not good. "Private equity sponsors today are deeply in denial about the value of the stakes they have in these buyouts," says Cash at Alchemy. "I would not pay more than 10 cents for the equity stakes in 2006 and 2007 deals." But keeping these firms above water until the refinancing market returns is going to become increasingly challenging. "It is ostrich season," muses Eyerman at Fitch. "All the sponsors can do is focus on running the businesses as efficiently as they can in the hope they can deleverage in time for a recovery in the credit markets and achieve a refinancing. They are in a very tight spot as equity valuations have fallen well below their entry levels. There is no gun to their head as yet but private equity cannot save these companies by compromising their long-term returns."

Bleak house

Bid prices on selected European term loan Bs

Source: Markit

Ashcroft at Goldman Sachs explains that sponsors are shifting their focus from primary market activity to reviewing portfolio companies. "They are also looking at the current credit market dislocation as an opportunity to buy loans or bonds in the market." Some sponsors are offering hedge fund lenders cash in exchange for debt reduction. Hedge funds that are holding loans at 20 cents realize that they are not trading up to 60 cents any time soon so selling them to the sponsor could be an attractive option. For funds facing sizeable margin calls the pressure to sell is considerable.

When faced with the prospect of a zombie company in which their equity investment is almost worthless, sponsors will be incentivized to restructure rather than simply work for the banks for years to come. They may, therefore, act sooner rather than later. Noel-Johnson at Close Brothers cites Luxfer’s refinancing of its high-yield debt in 2007 in this regard. The company manufactures high pressure gas cylinders and had a £130 million high-yield bond due in 2009 but agreed new debt facilities and a debt-for-equity swap long before its maturity. "Management incentive was underwater, private equity had a residual interest following several significant asset sales and it was clear the company knew it would not be able to refinance the bonds," he explains. "Putting a proper capital structure in place early allowed the sponsor to exit. We expect a wave of similar transactions in the coming months." Luxfer did, however, eventually default in 2007.