Disguising risks in distressed debt
Don’t be fooled. The ready availability of liquidity to buy loans of distressed companies in the mid to high 90s is not a sign of health but another symptom of a market that has abandoned rationality.
The distressed debt market is back in business, revived by excessive borrowing at many companies subject to initial and secondary leveraged buyouts, and the woes of select industry sectors, notably autos.
Last month, even as already tight spreads ground in further across the credit markets, TMD Friction, the European brake manufacturer that was bought out by management from BBA Group in 2000, completed the biggest European debt restructuring of the year. It reduced its debt burden by more than €750 million by converting the claims of its mezzanine debt providers into equity in a new company. Its former shareholders are left with just 5% of the new company, which has also raised €375 million in new financing to support a complex operational restructuring that will relocate manufacturing to new low-cost centres, notably Romania.
This is just the tip of the iceberg. Kiekert, which makes locking systems for cars, has also had to ask holders of its senior bank loans and mezzanine debt to agree a new capital structure. Schefenacker, which makes car mirrors, is in the midst of another complex restructuring involving mezzanine debt providers, mainly hedge funds. Back in May, Global Automotive Logistics (GAL), which is hugely dependent on a single customer, Renault, sought bankruptcy protection under French law. And there are many more car parts makers in trouble and asking for covenant waivers.
Investors in the debt of these companies have drawn some comfort from the greater ease with which they have been able to trade out of their problem loans compared with the experience of past credit downturns. The distressed debt market of the early 1990s was characterized by alarming discontinuity of pricing. Back then, most senior loans were provided by commercial banks which insisted that these loans were worth par, even as borrowers’ credit fundamentals deteriorated. Some banks might declare themselves willing to sell loans at 99% or 98% of face value while new money value investors offered only 85 or less. This gap was too great and the market didn’t function.
Finally, when the banks could no longer maintain the pretence that all was well and determined to sell, they might find that the only bid for these problems loans was at 50%.
For specialist distressed buyers this was a gold mine. They would buy loans at 50 cents on the dollar, go back to the borrowers and ask for repayments at, say, 65 cents. Many of the borrowers suddenly found the money to pay, the loans were cancelled, the new buyers made a 30% return in no time: only the original lenders lost out.
Now it is very different. There are many more and varied providers of debt finance: hedge funds, mezzanine funds, CDOs, CLOs. If a bank or CLO decides it wants to sell at 99 or 98 because it is losing faith in a borrower, it may well find a strong bid at 97 or 96. Pricing, even for troubled loans, has not gapped down. It is more continuous. Market participants tell us that the market is more granular.
Don’t be fooled. The ready availability of liquidity to buy loans of distressed companies in the mid to high 90s is not a sign of health but another symptom of a market that has abandoned rationality. Troubled companies are being refinanced when it might be better to wind them up and dispose of the pieces. And while buyers compelled to build credit portfolios now might juice up returns on problem loans bought at 98 with hefty leverage of their own, when the credit market turns decisively down that investor leverage will unwind and those bids evaporate.
And then recovery rates on many of the second-lien and mezzanine loans, even perhaps of the senior secured loans, will be much lower than buyers now expect.