Given recent geopolitical and macroeconomic events we are surprised at how well credit markets have been in 2014. The world continues to be awash in liquidity and investors are chasing yield seemingly regardless of risk. Leverage levels in the United States are increasing and rose by almost a full third over the past year while spreads between IG and HY are ~250 basis points below the 20 year average. Thus, the market is not assigning a significant premium to riskier assets. We continually ask whether the fundamentals in the global credit markets are healthy and sustainable. Frankly, we don’t think so.
– From Carlyle Group’s 1Q14 Earnings Conference Call yesterday
Over the weekend, I published a Guest Post on the bubble in the junk bond market titled: Is There a Massive High Yield Credit Bubble? If you haven’t read it already, I suggest doing so before reading the rest of this post.
The following piece builds on that prior one by highlighting some of the most absurd practices currently going on in the less creditworthy areas of the bond market. Signs that prove without question there is some sort of dangerous bubble already percolating throughout the credit markets.
The first of these are known as “dividend deals.” For those of you who are unfamiliar with them, you might not believe what they actually are. Basically, dividend deals are when companies owned by private equity firms tap the credit markets, and then a sizable percentage of the money borrowed is used to cut a check to the private equity owners themselves. Often times, the remainder of the debt is used to refinance existing debt.
Yes, you heard that right. The money earned from credit issuance isn’t used to expand operations, it isn’t spend on R&D, or anything productive whatsoever. Rather, funds are used to pay money directly to the private equity owners. From a private equity owner perspective, this is free money and of course they will take it. The insane thing is that creditors are willing to buy this garbage, and buying it they are. By the billions. In fact, you might own some in your mutual fund or pension fund. Who fucking knows, but this is insane.
The second sign of insanity is the increase in “payment-in-kind” notes. What this means is that interest on the debt can be paid back in, wait this is no joke, more debt! Even crazier, we are seeing examples of “payment-in-kind” notes being issued for the purpose of paying out dividends to private equity owners. I want to know which fund managers are buying these notes, and you should too.
Bloomberg recently covered the credit insanity in their piece: Dividend Deal ‘Epidemic’ Intensifies Junk Alarm. Here are some excerpts:
Companies owned by private-equity firms are borrowing money to pay dividends like it’s 2007, adding to concern among regulators that excesses are emerging in the riskier parts of the debt markets.
Borrowers including Madison Dearborn Partners LLC’s mobile-phone insurer Asurion LLC obtained almost $21 billion in junk-rated loans this year to enrich their owners, the most in seven years, according to Standard & Poor’s Capital IQ LCD. Some of the least-creditworthy companies are even selling notes that may pay interest with more debt, which BMC Software Inc. did for its $750 million payout to a group led by Bain Capital LLC.
“It’s kind of like an epidemic,” Martin Fridson, a New York-based money manager at Lehmann, Livian, Fridson Advisors LLC, who started his career as a corporate-debt trader in 1976, said in a telephone interview. “Once an investment banker sees that, he’s going to go to his clients and say, ‘Here’s a window of opportunity, you can take a dividend and get away with it.’”
That says it all right there. Why is private equity rushing to do these deals? Well, why does a dog lick its balls? Because it can.
The amount of loans used for dividend deals this year is exceeded only by the pace in the start of 2007, when $31 billion was procured, according to S&P LCD. Investors are searching for yields as average borrowing costs on investment-grade debentures of 3.15 percent compares with a 10-year average of 4.85 percent, Bank of America Merrill Lynch index data show.
The payout for the Bain-led ownership group was financed entirely with $750 million of debt known as payment-in-kind notes, which enables Houston-based BMC Software to pay interest with extra borrowings instead of cash. More than $3.5 billion of such notes have been raised in 2014, also the most in seven years.
Rather than refinancing at lower interest rates or to fund expansion, dividend loans offer private-equity firms a way to recoup their investment while increasing the debt burden of the companies they control.
Platinum Equity LLC, a Beverly Hills, California-based buyout firm raised a $262 million payment-in-kind bond to pay itself a dividend a week after closing on its takeover of a rental unit from Volvo AB in February.
I want to know who bought these notes.
“The banks and sponsors continue to push the envelope because of continued demand for yield-generating products,” Newfleet’s Ossino said. “If someone’s willing to lend to a company, it’s difficult for borrowers not to accept the loan.”
Moving along, KKR’s Go Daddy is another example of a low quality credit borrowing in order to pay cash to its private equity investors. Here are some excerpts from a Bloomberg article:
KKR & Co.-backed Go Daddy Operating Co. is seeking a $1.1 billion loan to refinance debt and fund a dividend to its private-equity owners, according to a person with knowledge of the transaction.
About one-third of the loan will be used to fund the dividend, while the rest will go to refinance an existing term loan, according to the person, who asked not to be identified without authorization to speak publicly.
Go Daddy’s loan is covenant-light, the second person said, meaning it lacks financial-maintenance requirements that can help protect investors.
Hahahahahaha. You can’t make this stuff up.
Looking ahead, in light of Carlyle’s comments and the following article published this morning, one has to wonder whether the tide is starting to turn…
From Bloomberg:
The tide is turning in the market for speculative-grade loans as investors refuse to buy some deals deemed too risky.
Rocket Software Inc. pulled $725 million of loans from the market this week that would have refinanced debt and paid for a dividend to its co-founders and private-equity firm Court Square Capital Partners LP, according to data compiled by Bloomberg. The deal is at least the third to be withdrawn in the last month, with cable TV provider WideOpenWest Finance LLC canceling $1.97 billion in loans and Dutch LLC, which does business as women’s apparel company Joie, scrapping a $200 million debt offering.
The loan market is starting to show signs of tightening more than six months after the Federal Reserve and Office of the Comptroller of the Currency sent letters to banks telling them to improve their deteriorating underwriting standards. Investors are demanding better terms and pulled cash from leveraged-loan funds the last two weeks, snapping an unprecedented 95 straight weeks of inflows.
Junk-loan mutual funds had their first outflow in the week ended April 16, according to Bank of America Corp. data. Investors pulled $320 million, and withdrew another $160 million the next week.
Borrowing costs for issuers are going up. New leveraged loans sold to institutional investors, such as mutual funds, paid an average coupon of 3.94 percentage points more than benchmark rates as of April 24, the highest since July and up from 3.71 percentage points in February, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data.
Keeping dancing serfs.
In Liberty,
Michael Krieger
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I shouldn’t be surprised at each new stygian depth of financial industry behavior and yet I am. How do these guys at Carlyle and Bain sleep? Do they have trouble putting up a condescending front when dealing with us proles knowing that they’re no better than common crooks? At least when Tony Soprano was busting out a company in the HBO series, simply looting it, just like the boys at Carlyle and Bain, he didn’t look down his nose at normal people he dealt with. But then the Soprano crime family might’ve been quite a bit more honest than the Carlyle mob or the Bain syndicate.