The Leverage Buyout Overhang
Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD), analyzes credit fundamentals in the high yield market.
Between the very high premiums on many outstanding bonds and the low yields on many newly issued credits, there is plenty to avoid in today’s high yield market. There are also weaker credits that have deteriorating fundamentals or highly levered balance sheets that investors should also steer clear of. By looking into the credit fundamentals, the investor can evaluate the sustainability of the capital structure and assess factors such as use of proceeds. The use of proceeds can include dividends being paid to private equity holders or leveraged buyouts (LBOs). While we are not opposed to LBOs, as they can often produce very supportive private equity partners, what does concern us is when the capital structure is levered up to a potentially unsustainable level due to these buyouts or large dividends to equity sponsors.
For instance, back in 2006-2008, we saw this as private equity investors were leveraging up transactions at insane multiples, issuing a huge amount of bonds and loans in the process. The full effect of those actions has yet to be felt. Yet the bonds issued by these legacy leveraged buyouts (LBOs) are prevalent in both the high yield bond and loan indexes and the passive products that track them. Some of these companies have already gone through a restructuring (primarily bond exchanges) and we expect that more will do so in the future. Looking at a few examples of these LBO companies, the current debt multiples (net debt as a multiple of EBITDA, or earnings before interest taxes depreciation and amortization) are staggering.1
While a very tolerant and forgiving market has allowed many of these companies to extend their loans/bonds, the massive leverage (interest payments) plus capital expenditures don’t allow most of these companies to generate the substantial free cash flow necessary to de-lever. So the sponsors are left with the greater fool game. Maybe equity market players will allow these companies to go public, creating funds for debt reduction (though we didn’t see meaningful delevering in the case of Caesar’s IPO last year), or perhaps their private equity sponsors can sell them to another private equity shop? This sounds like a hope certificate versus an investment strategy.
Just how prevalent are these bonds in the market? Well, with high debt levels come numerous tranches issued, and therefore these become a component in the major high yield indexes. In looking at the largest passive high yield ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG), nearly 7.5% of this portfolio, or almost $1.2 billion, is invested in just these large LBOs that we have listed.3 There are certainly some tranches within each of these structures that will be money good, even in the event of a bankruptcy filing. However, our opinion is that many of them will be impaired or worth less than par in a restructuring or further exchanges. In our experience net leverage above 5x some rational level of EBITDA is generally a recipe for problems.
As we talked about in our recent blog (“Risk Management: The Ability to Say No”), the challenge with portfolios holding these LBOs, or any credit with a capital structure that does not work or has deteriorating fundamentals, is that the passive funds, such as HYG, cannot sell questionable bonds. Again, to no fault of their own, but by their mere structure, they own what fits their policy statement, viable credits or not. It isn’t until after an official default that the credit is removed from the index and subsequently from the funds that track the index.4
As we have noted before, with the ability to analyze a credit’s fundamentals and avoid these sorts of high levered names, investors are better able to manage the risk within their portfolio. With active management, not only can you avoid certain securities, but you can make sure you are getting paid for whatever credit risk you are taking on. This involves determining the appropriate price/yield based on the company’s fundamentals. With passive funds, when your mandate is to just hold what is in an index, how can you determine if you are being properly paid/generating an appropriate yield for the level of risk you are assuming without considering fundamentals and price? You can’t.
1Total Net Debt/EBITDA statistics for the following companies sourced from company specific reports from J.P. Morgan published on the indicated date: First Data Corporation (10/29/13, p. 2), Caesars Entertainment Corp. (10/29/13, p. 8, OpCo used), Clear Channel Communications (11/7/13, p. 2), and Intelsat (11/1/13, p. 2). Energy Futures Holdings data sourced from report, “Short Circuit HY Utilities (IPP) October Monthly,” J.P. Morgan North American Credit Research, 10/23/13, p. 11.
2Peritus has not owned, does not own, and is not making any recommendation to own or not to own the securities referenced. The information provided herein represents the opinion of the author and is provided for information purposes only.
3Data sourced from Bloomberg, based on holdings of iShares iBoxx $ High Yield Corporate Bond ETF as of December 10, 2013. The yield statistics use the mid pricing provided by Bloomberg. Duration is based on the ask price provided by Bloomberg.
4In terms of defaults, issuers are not removed from the underlying index until they have been subject to a D rating, which generally occurs after a bond has already defaulted. These issues are removed at the next rebalancing date following the D rating.