The End of Structural Transformation and Contemporary Private Equity
Financial services gained immensely from the sweeping deregulation that President Reagan pushed for in the early 1980s. The rapid innovation that followed spurred the “Roaring ’80s” frenzy for junk bonds and mergers and acquisitions. Since then, according to my calculations, the wealth creation of our economies has increased the total US debt as a proportion of GDP from 50% there in 1970s to over 400% now. Before taking into account the enormous coronavirus bailout, that is.
This growth in credit availability is not merely the consequence of rising demand from borrowers, including businesses, households, and government entities. An expanding number of lenders were aggressively promoting credit packages. Several lenders pioneered novelties throughout this period, some of which became well-known during the global financial crisis (GFC): subprime mortgages, securitized bonds, off-balance sheet collateralized loan obligations (CLOs), and structured investment vehicles (SIVs).
The Originality of Private Equity
Private equity (PE), one of the most significant users and benefactors of leverage, developed its own cutting-edge strategies to increase transaction volume and investment returns. Early in the new millennium, the sector accepted a new product that offered more credit flexibility to PE firms, the sponsors, and their portfolio companies, the borrowers. Cov-lite, or “covenant-light,” was the name of the new item.
A covenant is a requirement that a debtor must satisfy to demonstrate that it maintains its creditworthiness. Maintenance covenants are frequently evaluated, often once every three months. A covenant gives lenders the right to surveillance so that risk within a loan portfolio and, in a larger context, across the economy is adequately monitored. This surveillance may take the form of a financial metrics (such as an interest coverage ratio: EBITDA-to-net interest expense) or of information-sharing (e.g., providing a trading update).
In the years leading up to the GFC, one in 4 leveraged loans was cov-lite. In certain situations, the borrower might either entirely forego reporting to its lenders or merely do so with regard to a small number of covenants. For example, music company EMI, which underwent a drastic debt-strapped acquisition in 2007, was required to report on its overall leverage ratio, or net debt-to-EBITDA, quarterly, with no further requirements to its primary lender, Citi.
Leniency to insolvency
Citi had to wait for the music industry giant to break its only financial commitment before holding the borrower accountable because it needed other tools to hold EMI and its owners, the fund manager Terra Firma, responsible. At the time, “equity cures” were another instrument added to leveraged buyouts (LBOs). This allowed the sponsor and borrower EMI to contribute additional capital, netting them off the overall debt amount used to determine their financial ratio. In order to “fix” four breaches of something like the net debt-to-EBITDA covenant in 2008-2009, Terra Firma invested new stock in EMI.
Some notable examples of agreements with loosely defined covenants that failed include the biggest buyout ever, the $40 billion closeout of Texas energy firm TXU by KKR and TPG, and the operator of Caesars Entertainment, which was bought by Apollo and TPG together. Because they could not pay off debts worth billions of dollars, both pre-GFC agreements experienced extreme stress. Before declaring bankruptcy, the PE owners of EMI, TXU, and Caesars attempted to restrict the creditors’ ability to seize control of the firms.
Restructuring the balance sheet and converting costly interest-bearing loans into equity, canceling out the ownership holding held by financial sponsors in the process, is frequently the best conceivable survival option for an overstretched stressed organization. Yet, PE firms might continue to receive managerial and board fees by postponing a Chapter 11 filing. To them, corporate restructuring, workforce reductions, equity remedies (paid by the fund investors rather than the fund managers), and capex deferrals make sense. The short-term fee-earning gains these rules provide the PE owners outweigh the long-term harm they do to the core portfolio firms and the job prospects of their workforce.
Private Debt’s Chance
During the credit boom of 2004–2007, post–Lehman commercial banks returned to cautious practices and asked for the adoption of covenant-heavy loan arrangements. In actuality, more stringent regulations had pushed them to do that. The most active financiers sought refuge in the underregulated private capital sector during the previous ten years due to government agencies’ stricter banking industry regulation.
Throughout the 2010s, non-bank lenders, including personal debt and CLO fund managers, reinstituted liberal terms and weakly covenanted credit products to acquire a footing in the competitive debt markets. It was the solution. Nowadays, non-bank institutions underwrite around 50% of LBO loans. This market change has resulted in 80% of leverage loans being covenant-light. PE fund managers demanded something far more kind from potential lenders who were eager to invest money because they saw cov-lite items as a fundamental, inherent entitlement.
Prior to the Great Recession, equity remedies were a clever technique to keep overexcited lenders at bay, but financial sponsors were unable to continue employing them due to their numerous disadvantages. The worst consequence of an equities cure is that it necessitates more capital to be invested, which lowers the internal rate of return for the PE firm. LBO sponsors decided to add an even greater fudge to drastically reduce the chance of covenant violations without needing more financing. Income before interest, tax, depreciation, and amortization (EBITDA), the primary factor considered in covenant calculations, can be changed through the use of “add-backs.” The items that make up these refashioned earnings range from loose capitalization and payment of expenditures to anticipated cost reductions or synergies.
The coming of the zombies
Given that the vast majority of LBOs provide cov-lite loans and freely employ EBITDA adjustments, we may anticipate that many PE-owned businesses will go under during the upcoming crisis. According to research company Covenant Research, a new change is the addition of a loan clause that permits losses from one-time occurrences to be brought back to EBITDA. If generalized, such nebulous, non-exhaustive wording, which might very well encompass lost income from a global epidemic or any other “black swan,” would give debtors more leeway to manipulate the statistics.
It will be challenging for lenders to compel troubled buyouts to go into foreclosure or undergo restructuring. The process of structural transformation, a cornerstone of an efficient capitalist system, will be impeded by resistant borrowers after having made way for the disastrous development of indulgent debt solutions. Lending syndicates will likely act like many did even during financial crisis in order to prevent too many write-offs. They are willing to modify and expand existing procedures, like distressed debt swaps and evergreening, which loosens the conditions of current loans and offers additional resources to help debtors restructure historical debts they are unable to repay.
Following years of play-acting, the lenders finally took control of EMI Music, TXU, and Caesars Entertainment. Nevertheless, remember that in the middle of the 2000s, these cov-lite deals only comprised a small portion (roughly 25%) of the total LBO loans. Given that four out of every five buyouts employ shoddy financing, the next downturn should have a more extended roster of zombies. The economy will be affected more negatively than PE portfolio performance, albeit both will be affected.
Greetings from Zombie Land
Thousands of leveraged businesses are likely to survive this crisis not because of sound fundamentals but rather because their creditors lack the means to engineer a recapitalization, which is made worse by the commitment made by numerous government lending initiatives and central bank monetization strategies. The COVID-19 loan packages will now be available to PE-backed enterprises, at least for small businesses and the most affected industries: entertainment, hospitality, tourism, and transportation. This comes after a lot of lobbying. Troubled buyouts will, at least, gain from the US Federal Reserve’s rushed move last month to buy up high-yield bond exchange-traded funds, whether or not they take emergency loans, curbs on leverage, or personnel cutbacks (ETFs).
For uncovenanted enterprises that refuse to file for bankruptcy under Chapter 11, a corporate reorganization procedure introduced in 1978 to make marketplaces more adaptive, operating aimlessly and zombie-like for years might become the new normal. To survive and keep their owners from receiving commissions, highly distressed companies may delay payments to suppliers, lower the quality of customer service, reduce salaries and employment benefits, try and negotiate rental income with landlords, postpone R&D spending, and reschedule debt maturities.
Unlike John Shad in 1984, today’s SEC chairman would be more motivated to say: “The more leveraged hijacking and buyouts today, the more zombies tomorrow.” Fund managers manage our economies with the sole objective of maximizing fee revenue, even if that means holding onto defective assets. Private capital corporations have replaced the destructive process of creative destruction with a more pernicious one called endemic sclerosis due to the widespread adoption of cov-lite arrangements, the manipulation of corporate profitability, and government-sponsored bailouts.