The times are good for traditional buyout shops, right? Deals are getting done with speed and relative ease; the debt markets, though they may have pulled back a tad since the beginning of the year, are still eager to hand out loans amounting to 5x to 6x EBITDA; and more and more funds continue to hit their hard caps as institutional dollars flood the market. And despite the phrase “seller’s market” becoming the cliche of 2005’s private equity scene, buy-side confidence has never seemed so high.
But the mainstream buyers are not the only ones smiling at the market’s current state. Players in the distressed debt and turnaround markets are taking a hard look at what’s going on in the market and are optimistic that it’s only a matter of time until a number of companies fall from their highly-levered grace.
Currently, industry pros say the visible signs that distress is on the way are subtle but compelling, including a slight up-tick in the high yield default rate, recent hikes on interest rates, excessive leverage and the cyclical nature of the market. Whatever the drivers are, investors and market researchers are betting that 2006, 2007 and 2008 will end up being prime years for acquiring companies out of bankruptcy or those in default to their creditors.
Stephen Moyer, director of research at Imperial Capital LLC, a boutique investment bank in Los Angeles, says the new wave of distressed companies can already be seen, and one need not look back too far to find its origins. “We’re seeing troubled companies right now that are from deals completed just months ago. When markets forget the past, companies end up being financed up to 5x to 6x leverage, and there are only a handful of companies out there that can really handle that kind of debt.”
“On average, three years after a big year in high yield issuance, there is an echo boom in bankruptcies, restructurings and turnarounds,” says Michael Psaros, a founding and managing principal at KPS Special Situations Funds. And according to information compiled by UBS, the high yield market has been booming for just about three years. In 2003, $135.7 billion in new junk bonds hit the market (at the time, the second-largest amount ever next to 1998’s $150.6 billion), and that was followed by 2004’s record-breaking high of $154.5 billion in new issuance, while 2005 saw about $85.5 billion in high yield bond issuance as of the close of the third quarter.
But while there have been some prominent bankruptcies lately, including Delphi Corp., Delta Air Lines Inc. and Northwest Airlines Corp., at the moment they are typically seen as one-offs that are not indicative of the rest of the market and the overall numbers seem to reflect this assessment. According to Moody’s Investors Services, the trailing 12-month high yield default rate is only at 1.91%, while the forecasted default rate for one year down the road is currently set at 3.4%, still below historical averages.
Martin Fridson, publisher of Leverage World, a research service focusing on the high yield market, says these low default rates are probably the result of the higher quality of junk issuers in 2001 and 2002. Throughout that two-year period, Fridson says, only 40% of junk bond issuers were rated B or CCC, while the remaining 60% were rated BB, the highest grade available in the high yield market.
Conversely, though, from 2003 to the present, Fridson says that issuer quality has become a mirror image (60% B and CCC; 40% BB) of what it was, meaning that the default rate is probably bottoming out right now and is likely to climb in coming years. “I think we’re likely to see a peak in default rates in 2008,” Fridson predicts.
But high yield isn’t the only thing investors are looking at when they surmise that distress is on the way. The second lien market, which has only really been developing over the past few years, has captured the attention of small and mid-market turnaround players. From 2002 to 2004, the market for second lien loans has grown from being a $630 million marketplace to one worth nearly $12 billion, according to CIBC World Markets.
“We believe that the key investors in second lien (hedge funds) are not emotionally involved, and when things go bad, there will not be buyers for that debt,” Psaros says. “Plus, as a legal matter, there is no real history of second liens being litigated in the bankruptcy courts, so there is no precedent to be followed.”
Distressed Minds Think Alike
In the meantime, both full- and part-time distress players are getting their houses in order and readying their war chests in their efforts to time the liquidity cycle.
In July, WL Ross & Co. closed on about $1.1 billion for its WLR Recovery Fund III LP, the firm’s largest distressed fund to date. The Blackstone Group last month closed on more than $500 million for its inaugural distress-focused fund-the first investment vehicle for the firm’s recently formed Blackstone Distressed Debt Advisors-and Avenue Capital Group, which typically invests in debt obligations and other financially distressed companies, is readying for a final close on its $1 billion Avenue Special Situations IV LP later this month.
“There is a bunch of money being raised for distressed funds; it’s a true cycle-play,” says Stephen Presser, a partner at Monomoy Capital Partners. “Over the past two years there has been a tremendous amount of liquidity in the larger and high yield markets, and people are beginning to look at those credits and figure that with all that leverage, even a slight ripple could put those bonds in trouble.”
However, some market pros hold that this level of interest in distressed debt could bring the market to previously unseen levels of efficiency, a factor that could have adverse affects on returns.
“At the moment, there is more cash out there than distress to invest in,” says one market analyst speaking on condition of anonymity. “In 1990 and 91, you had no distress-dedicated capital out there, so when things went bad there was a lot of unclaimed paper out there that was bought up for very cheap. The same thing happened in 2001, when the price of defaulted bonds was worth about 25 cents on the dollar. But now, with all the demand we’re seeing, it’s more like 50 [cents] to 60 cents on the dollar.”
Such admonitions, however, seem to fall by the wayside of firms like The Carlyle Group that are bent on investing in distressed assets. Carlyle is reportedly in the market to raise a $400 million fund geared toward investments in bank loans, public debt and structured equity of distressed companies. The firm hired Brett Wyard to serve as managing director and co-head of its distressed investing group.
Coincidentally, Wyard was hired away from private equity turnaround firm Oaktree Capital Management, which also just wrapped up its own fundraising drive in November. OCM Opportunities Fund VI LP closed with $1.77 billion in limited partner commitments.
Is This Really Happening?
But while billions of dollars are raised for what some anticipate being the business world equivalent of The End of Days, hundreds of traditional private equity firms continue to raise new funds and churn out highly-levered deal after highly-levered deal, which begs the question: Why?
“I don’t see any sign that [a downturn] is around the corner,” says David Lobel, a managing partner at Sentinel Capital Partners, “There are certain dislocations, however, such as the auto market and airline industry. But if you take a look at the macro, this economy is quite resilient despite all the recent hits it’s taken, such as [Hurricane] Katrina and [the war in] Iraq.”
Indeed, Moody’s issued a caution last month noting that the anticipated credit cycle peak that’s driving all this activity could be a mirage. It notes that the historic record “warns against extrapolating too much bad news from a mild rise by the U.S.’ high-yield default rate.”
Citing a recent example, Moody’s says that amid a previous credit cycle upturn, the U.S.’s high-yield bond default rate temporarily rose from March 1995’s 1.4% to the 3.8% of February [through] March 1996. “Thereafter,” Moody’s says, “profit margin widening and the enhanced coverage of interest expense would lower the speculative-grade default rate to April 1997’s localized bottom of 1.7 [percent].”
That said, nobody is willing to bet that the market will remain unscathed for a protracted amount of time. Lobel notes that with companies as highly levered as they are today, even a 2% slip in the economy could have disastrous affects on a number of them, and he went on to say that Sentinel-which does make investments in distressed lower-middle-market companies-has begun spending more time and resources looking at the sector, as of late.
“The thing in distressed you have to be careful for is getting in too early,” Lobel says. “It’s like trying to catch a falling knife. You never want to try and catch a falling knife. You want to let it fall first, and then pick it up. If something has negative momentum it will take you down with it a lot faster than you can pick it up.”