The recent 6/28 forum post “The Sky is Falling” may turn out to be a prescient market timing call. Yesterday's WSJ not only highlighted the subprime ratings cuts (which were widely expected), but also pointed out that the markets have balked at 5 separate junk bond
offerings in the past two weeks--and this is before trying to digest the enormous Chrysler and First Data deals. First Data is borrowing to a remarkable 10x EBITDA, which is quite a nosebleed compared with deals we were doing at DLJ, back in the still-blazing 1999 market, at no more than 5.5x. It would be sobering to add up the total amount of bridge loans from the big firms tied up in at- risk deals.
It remains to be seen whether all those deals get done. I hope they do. But what seems more certain is that there will be a big drop-off in announced LBO deals. Behind closed doors in Credit Committee meetings at the big firms, senior bankers must be sweating about the bridge loan commitments they’ve already made. With so much capital tied up in loans that are at risk of not getting taken out by high yield offerings, they’d be reluctant to make additional commitments on behalf of buyout clients.
Take all this July uncertainty, add the fact that the high yield window essentially shuts down in late August (industry-wide vacations), and it would be incredibly gutsy for a bank to commit its balance sheet to a large, highly- levered deal for at least a couple of months.
Over the past two years, when sponsors have craved leverage exceeding long-run high-end levels of 5x-5.5x EBITDA, the solution has been the CDO market. CDOs contain bundles of bonds, providing diversification, and can be structured into tranches so that investors get the level of risk/reward they desire. The growth of the CDO market has opened up the pool of available investors, helping firms get deals done.
Of course, it’s harder to pay attention to important details like covenants (which are notoriously complex, even when analyzing just one issue) when there are hundreds of bonds and loans in the portfolio. The credit risk implied by leverage ratios is actually understated relative to the deals of yester-year that had traditional terms and convenants.
Making matters worse, many of the investors in high yield & leveraged loan CDOs are the same institutions that are heavily invested in sub-prime CDOs. Once stung, you’d expect them to continue to shy away from similar investments. Sure enough, as I sit here typing this, I just scanned today’s headline that Moody’s has cut ratings on $5 billion in CDOs as spillover from subprime.
There’s a silver lining to all of this (continuing the sky is falling analogy).
If the market can digest the deals in the pipeline…
If the banks can avoid another hung bridge loan like the famous “Burning Bed” bridge that crippled First Boston (lent 40% of its capital and couldn't take out the bridge) and caused it to be sold to CS…
Then financiers will count their blessings and lick their wounds, and hopefully regain a bit of financing discipline. Covenants matter. PIK-toggle interest is not the same as cash pay. Double-digit leverage ratios are stratospheric. And hiding a bad loan/bond in a CDO and slicing it up doesn’t eliminate risk; it just redistributes it.
We’ll return to a day of 5x-5.5x leverage ratios for buyouts. The question is how long it will take to get there, how long we go without any sizable new deals announced in the interim, and how much of a hit the market takes without LBO firms able to finance nosebleed deals.
Like I said in my last blog… Schwarzman and James had impeccable timing at Blackstone!
Vince Scafaria
Chief Executive Officer
DealMaven Inc.
www.dealmaven.com