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Wednesday, April 2, 2014

'Amend and Pretend' or 'Fake it 'till you Make it'?


It seems as if any time companies aren't defaulting in droves, they are "amending and pretending". That is, companies renegotiate covenants and borrowing terms with their lenders to obviate a technical default that would lead to a larger restructuring. 

The Wall Street Journal's Bankruptcy Beat Blog has a new section in which bankruptcy and restructuring professionals opine on a chosen topic. The first one question proffered to the experts was essentially: isn't corporate restructuring on life-support because of low interest rates and maturities being pushed out to 2017 and 2018? I'd encourage you to read the post and the contributors' assessments because they provide a panoply of viewpoints on the matter. You can read all the posts here.

Many argue that companies issuing high yield bonds or leveraged loans have too much debt, and they can only service the debt because lower rates result in low cash interest expense. If you read LCD, you'll see the data corroborating this hypothesis. For example, even with lower rates and higher prices for syndicated leveraged loans, much of the new issuance is "covenant-lite", meaning the credit agreements lack financial metrics that companies must meet at certain intervals. The prevalence of cov-lite loans, along with low rates, was identified as one of the drivers of over-levered corporations. LCD points out, however, that the supply of cov-lite loans as a percent of the loan market is higher now than it was in 2007. Additionally, a greater percent of the loan market is rated CCC now than in 2007.


Continuing on this theme, LCD tweeted this chart that contends that debt/EBITDA ratios of companies in the leveraged finance market are creeping up to 2008 levels. 

So what does this mean for the health of the highly leveraged companies? Does easy financing and higher debt load necessarily mean that we're going to see higher defaults in the future? 

On an aggregate, yes, we should see higher defaults when rates rise. But when it comes to investing, there are those firms that use leverage well, and there are those firms who use it frivolously. I firmly believe in the corporate finance theory of having debt as a way to reduce mismanagement of capital, assuming that managers are accountable for servicing the debt.  

If the debt is used for organic growth via research or capital expenditures, then the extra flexibility that comes with cov-lite loans and low rates may be a way for companies to "fake it 'till they make it", emphasis being on "make it". As a lender, I'd want to see not only free cash flow metrics and ability to service debt, but also reduction of superfluous costs, a strong market strategy, and investment in top-line growth. 

Bank of America Merrill Lynch's High Yield Strategist Michael Contopoulos recently published a report on cap-ex and M&A spending. Here's more:

"Although leverage has increased since the financial crisis, high yield companies today have the highest interest coverage ratios since the beginning of our dataset (1998) and overall leverage is well below the early part of the decade. Additionally, gross margins remain well above pre-crisis levels as the increase in COGS since the financial crisis has been matched by revenue growth...

In absolute terms, capex increased on a yoy basis between 2010 and 2012 as cash balances were drawn down and debt loads increased. High yield CEOs funded capex despite low revenue, using debt as the main financing tool to achieve organic growth. It seems to us, however, that with little return on their investment, we may be seeing a shift in sentiment, as capex spending has decreased and more cash is being layered onto the balance sheet. This is a bad sign for future in-house investment, but we think is a very bullish sign for M&A. CEOs are likely shifting strategies after realizing 2 years of capex funding has done little to improve revenue, and as such, will seek other strategies, namely acquisitions, to increase earnings." BAML

He included the following graphs below to show that high yield companies have more cash on their balance sheets than in 2007, but they aren't using it to for cap-ex just yet.

So are these companies amending and pretending or faking it for the time being? I am less optimistic about cash balances and debt being used for acquisitions than for cap-ex because transaction and integration costs could easily put a strain on liquidity. High interest coverage is fleeting if you acquire a company with lower EBITDA and spend too much cash on the acquisition. 

For companies that haven't made much progress internally to have leaner cost structures and organic growth, I think they're amending and pretending with the extension of terms. For companies who have cleaned up their cost structures and are awaiting the fruits of internal investments, I think they'll come out stronger with help of the easy financing, even when rates rise. 

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