Saturday, October 20, 2012

It’s a Helluva Town

Risk culture?
New York, New York
A wonderful town
The Bronx is up, and the Battery’s down
The people ride in a hole in the ground
New York, New York!
It’s a wonderful town!


Manhattan women are all in silk and satin,
So the fellas say
There’s just one thing necessary in Manhattan,
When you’ve got just one day:
Gotta pick up a date
Maybe seven or eight on your way
In just one day!

— “New York, New York,” On the Town

Hey, girls, get ready! It’s Fleet Week, and the drunken sailors are spending money like there’s no tomorrow. You’d have to be a stony-hearted harridan not to offer them a little fun and companionship, right? Especially since they’re buying.

* * *

Articles are beginning to appear in The Wall Street Journal and elsewhere documenting the return of the slightly disreputable and mildly creepy uncle of the financing world, the dividend recapitalization, or recap. I can already hear the sucking of teeth and clucking of tongues among disapproving maiden aunts in the mainstream media and blogosphere.

An article Friday in the Journal lays it out for us:

Debt issued to fund private-equity dividends has topped $54 billion this year, after a flurry of deals earlier this month, according to Standard & Poor’s Capital IQ LCD data service. That is already higher than the record $40.5 billion reached in all of 2010, when credit markets reopened after the crisis.

For private-equity investors, the deals produce payouts amid a slow market for initial public offerings and acquisitions. “It’s hard to be anything but happy” about the dividend boom, said Erik Hirsch, chief investment officer for Hamilton Lane, a Philadelphia firm that manages more than $163 billion in private-equity investments.

Likewise, many debt investors are happy to collect yields as high as 10%.

Critics say the dividends, which are disclosed in offering documents, saddle a company with debt, potentially burdening its operations, while reducing a private-equity firm’s investment exposure.

Also some of these deals involve a risky type of debt known as “payment in kind toggle”—or PIK-toggle—bonds that give companies the choice to defer interest payments to investors. Instead, they could opt to add more debt to the balance sheet. The default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn’t use the bonds, according to a study by Moody’s Investors Service.

Six companies have sold PIK-toggle bonds to pay private-equity dividends in September and October, double the number sold in the previous 14 months.

Our Lady of Perpetual Fiscal Rectitude is surely spinning in her grave at these revelations.

* * *

But just as there are creepy uncles and creepy uncles, there are dividend recaps and dividend recaps. The PIK toggle example the article cites—Hellman & Friedman’s $525 million issue to fund a $600 million dividend for a recently purchased drug developer—looks pretty anodyne upon closer inspection. H&F bought the company last December, when lending markets were stressed, using approximately 50% equity and 50% debt.1 Raising debt to dividend out $600 million leaves the company with approximately $1.35 billion of equity supporting an enterprise valuation and capital structure of $3.9 billion. At 35% equity-to-total capital, the resulting leverage ratio is pretty standard for a leveraged buyout and, pace any specific unusual risks in the company’s business model or operating prospects, should provide a pretty safe and secure capital cushion for the creditors.

This is no wild-eyed sailor barebacking his way through the alleys of Bangkok. Hellman & Friedman overequitized the purchase at closing because it had to (and because it could; that is, it had an extra $600 million lying around), and it simply came back to market under currently more attractive conditions to fine tune its portfolio company’s capital structure. It was the prudent, responsible, and appropriately fiduciary thing to do. Plus, the new PIK holders get a nominal yield of 9 7/8% on a fresh buyout undergirded by $1.3 billion of equity from a respectable financial sponsor. What’s not to like about that in an environment where fixed income investors are lucky to find yields in excess of 3%? Those pensioners’ medical bills won’t pay themselves, you know.

The same cannot be said, however, for the debt Leonard Green and CVC Partners raised to pay a $643 million dividend to themselves (i.e., to their funds and hence their limited partner investors) for the buyout of BJ’s Wholesale Club last year. According to the article, this debt repaid the entire initial equity investment the sponsors made to purchase the company in the first place, which means, essentially, that they and their fund investors are now playing with house money. Depending how much equity Leonard Green and CVC shared with current management and other co-investors, their funds now control something like 75 to 85% of the equity of a $2.8 billion corporation at a net cost of zero dollars. Pretty sweet, huh? I’d like a few of those deals myself.

What this skeleton outline does not reveal, however, is data which might explain why new debt investors decided to lend so much money in the first place. I have explained in the past that creditors principally base their decision to lend to a corporate borrower on what they calculate it can afford to pay, appropriately adjusted for risk, uncertainty, and the unexpected collapse of Americans’ compulsive desire to buy 50 gallon drums of olive oil for $19.95 apiece. There may be very strong operating cash flow support for the new and existing debt of BJ’s, I don’t know. But if I were an investor in the debt funds or a pensioner in the pension funds which bought these bonds, I would be very curious to find out.

The reassuring thing to consider in this scenario, from the lenders’ point of view and that of kibitzing journalists, is that the financial sponsors, while certainly facing a reduced risk profile, have not abandoned all incentive to make the buyout work by taking their initial stake off the table. Consider: returning your LPs’ entire initial investment after one year may be comforting, but it represents a return on capital of exactly zero percent (less if you adjust for the risk of tying it up for a year). No private equity firm can survive if it makes that its core business model. No, financial sponsors operate on an investment model that generally targets total returns of 2.5 to 3 times their investors’ money (more if they can get it, of course) over the course of 3 to 5 years. If they deliver that, they make their limited partners very happy and themselves very rich. Leonard Green and CVC have every incentive to work with management to make BJ’s a huge success, and BJ’s creditors know this. In part, they are relying on it.2,3

* * *

When they are not simply delayed borrowings designed to adjust the capital structure of an LBO to its original intended optimal state, like the H&F deal, dividend recaps are risk adjustment tools for private equity firms. They convert the risk profile of the investment from a pure equity-like one—where you participate one-for-one in the increase of value of the firm but can lose your entire investment if the company goes bust—to one that looks much more like an option: limited (or zero) downside below the threshold of the amount borrowed and one-for-one participation in the upside.4 If you can buy yourself and your investors such an option for a reasonable price (i.e., interest rate), why wouldn’t you?

And that is the point, and one of the key reasons financial sponsors are beating a path to the doors of high yield investors nowadays. Lenders are selling these options cheap because their investment alternatives suck. Furthermore, unlike the prelapsarian glory years of 2006 and 2007, high yield investors have fewer opportunities to invest as part of the initial capital structure of leveraged buyouts and other acquisitions now because M&A volumes are way down. Deals aren’t getting done, so lenders have to lend to the people who are asking for money. On the flip side, financial sponsors are coming to lenders for dividend recaps hat in hand because there is so little M&A activity they cannot sell their portfolio companies for love or money. Financial sponsors are increasingly trapped in aging investments they can’t sell to strategic corporate buyers, because corporate boards and CEOs are still hiding in their executive washrooms sucking their thumbs in paralysis over global economic uncertainty. And they can’t sell their companies to public equity market investors via IPO unless they can persuade somebody their widget manufacturer is really a social media powerhouse.

So, tongue clucking and tut-tut-ing aside, dividend recaps are surging because they’re the only game in town. The girls are horny, and the Navy is in town. Deal with it, Aunt Betsy.

Related reading:
The Rape of Persephone (January 29, 2012)

1 The article does not disclose whether H&F was able to assume existing company debt “on the balance sheet” or had to raise it afresh. It doesn’t matter for the purposes of our discussion.
2 More to the point, they are relying on their own due diligence that the company itself can support the entire debt load placed on it in a way that gets their loans repaid timely and in full. From a creditor’s perspective, it is reassuring to know someone lies beneath you in the capital structure to cushion your fall if the wheels come off the bus, but you’re much more concerned to get comfortable that the chance of said wheels leaving said bus is very slight in the first place.
3 The wicked person in me wants the BJ’s deal to fall apart, because it would create an entire sub-industry of off-color joke telling in my business. “Did you hear about the BJ’s deal? It sucked!”
4 In effect, you buy a put option from the lenders for residual liquidation values of equity below the amount borrowed. The option premium is simply the cost of borrowing. The payoff looks like a call option, or, what is the same thing, a long equity + put option combination.

© 2012 The Epicurean Dealmaker. All rights reserved.