I wrote not too long ago more than once, in fact, about the lack of covenants in recent deals. The Economist now rings the warning bell again, this time with a series of hard examples. A bit of thinking about the deeper and more subtle points in this "covenant lite" trend has me back to a common theme that keeps bopping me on the head. Public markets just don't seem able to price buyouts well. The question is, can hedge funds? From the Economist piece:
Why have lenders lost interest in covenants? One explanation is that, as bank loans begin to trade in the secondary markets like ordinary bonds, the banks themselves are less interested in preventing borrowers from imploding than when they kept the debt on their books. Another is that the debt market is temporarily frothy. Mr Hirsch says there was a similar change in lending terms before the meltdown of 1998, though even then lenders earned much wider spreads. Some old hands are taking note. Many of the insurance companies and specialised institutions that used to buy these loans are now out of the market, replaced, Mr Hirsch says, by hedge and mutual funds. Must be a brave bunch.
Leveraged debt is beginning to look quite a lot like IPO flipping used to. (And why not? Quattrone is back in the game, after all). By this I mean that the public market are, once again, the greater fools. Two tools seem to have emerged lately to facilitate the dumping of risk onto the public markets, which seem less able to value them. The first is the one-two punch of an IPO followed by a special dividend payment. KKR's Sealy is the example I have noted the most often here, let's revisit it again:
KKR pulled out a $100 million special dividend, basically funded out of the IPO proceeds, along with some $44 million from the shares they sold. Add to this the $11 million in breakup fees for the mangagement agreement, and some earlier fees for management oversight the first and second years after the buyout and they have locked in about 36% of their original investment of $436.1 million. This looks suspiciously like the sort of terms preferred shareholders (read: venture capitalists) would command at the close of an IPO. The difference is that the venture folks often had both a preference, and a liquidity multiple built in. They usually got all their initial investment back as well as some locked in gains. At least KKR here has some skin left in the game. (Note their negative IRR on actual realized gains).
Of course, KKR probably didn't have much of a choice here since selling much more of their stock would have been brutal to the float for Sealy and I doubt any of the other parties involved was going to permit them to let much more out on the market. It will be interesting to see how KKR dribbles out sales of their existing stock. They might have some lockup agreements, I don't know what the terms of any shareholder agreements they have look like. Or they could just be carefully waiting in the wings.
The point is this: Sealy didn't get much (if any) capital from the IPO, as it was primarily used to fund the special dividend and provide a liquidity event for KKR (and partners). Sealy has almost nothing from the offering for operations. KKR managed to lock in some gains at a rather substantial multiple and has a good upside basis already in the stock price of Sealy. Unless there is a major crash in Sealy's stock, KKR has done quite well.
This is but one example. "Special dividends" are all the rage. One reader, "FE" comments thusly in email:
Today's greater fools are those that are allowing [private equity firms] to dividend out all the cash and then payoff the debt burden through the flip IPO - as if any actual improvement in the underlying business took place through the balance sheet games that were played through the dividend recap.
Indeed. But consider what investors get in the Sealy IPO. A firm with significant debt burdens, nothing like an Modigliani-Miller efficient debt ratio firm, a lot of work to do and highly short-term incentives (options and stock price) with huge expectations. Not a formula calculated to maximize the probability of success, in my view.
The second and even more distressing tool is the resort to secondary debt markets. Really, an agency cost that never existed in the market for leveraged finance has been introduced. Now, unburdened by the threat that they will ever have to cope with a failed loan, finance firms cut any deal they like with financial sponsors and offload the debt (along with its covenant lite structure) onto the greater fools in the secondary market. I cannot imagine that the secondary market is pricing these properly, but I have nothing but instinct that tells me so. Looking at the leveraged group of a hedge fund I see 5 20-30something guys and gals writing debt. Are these folks going to take the keys of a foreclosed light manufacturing firm when it breaks? I doubt it. I have a strong suspicion that the incentives structure of the professionals working in this space is tied to the amount of debt placed. This is speculation on my part, but good speculation, I think.
To my way of thinking, the massive inflows of capital to buyout deals and hedge funds with substantial leveraged finance desks have created an interesting effect. The overhang of these uninvested funds puts a huge lag between actual market conditions and the response of firms selling debt. They have money to place in debt, period. They have become placement agents.
Really, after you hit the $750 million mark in a LBO fund, I think you start heading into the waters of the "Placement Sea."