The U.S. economy in February officially fell into a recession for the first time in 128 months. As in past recessions, this current downturn links two distinct asset classes, private equity and distressed debt, in two specific ways. One is obvious, the other perhaps less so.
An obvious link is found in the debt markets. When companies backed by private equity sponsors run into trouble, two key private equity capital sources — leveraged loans and high-yield bonds — are among the instruments that eventually populate distressed investor portfolios.
The second link is the purchase price multiples, or PPMs, that sponsors pay for their acquisitions. PPMs not only dictate the total cost of private equity acquisitions, but they also play a significant role in deciding how much distressed investors will recover from their investments in troubled and bankrupt companies.
Before this current slowdown, the U.S. economy had experienced only two official recessions in the past 20 years. The 2001 contraction lasted from March through November of that year, snipping an estimated 0.6% off of GDP. The Great Recession was significantly worse, lasting from December 2007 through June 2009, and chopping 4.3% from GDP, the largest decline of the postwar era.
During both recessions, leveraged loan and high-yield bond defaults spiked. It is reasonable to expect that the current downturn will again see a spike in defaults, providing distressed investors a target-rich environment.
In fact, a wave of bankruptcies has already begun. Leading the way are sponsor-owned Neiman Marcus and J. Crew as well as Intelsat Corp., J. C. Penney Co. Inc., Hornbeck Offshore Services Inc., and Hertz Global Holdings Inc., to name a few of the better-known Chapter 11 filers of the preceding weeks.
Those targets in distressed investor sights will come, in part, from sponsor-generated loan and bond issuance. Indeed, sponsors have been responsible for more than 50% of the leveraged loans issued since 2005. Private equity's contribution to high-yield activity has been somewhat less, spiking above 50% during the Great Recession, but since then drifting to less than 20%.
Like distressed investors, private equity funds will be searching for investment opportunities during this recession. If history repeats, what may make the sponsor acquisition market particularly enticing is that, not only will earnings of potential acquisitions decline, but the PPMs that sponsors will need to pay also will come down significantly.
As the chart above shows, in the last two economic cycles, PPMs began falling ahead of the recessions (shaded areas), then rose back above old multiple peaks within a few years of each recession's end. The similar behavior around the two recessions is not a coincidence.
As a managing director in a private equity firm succinctly put it, "PPMs are shorthand for [discounted cash flow]. As earnings drop and projected growth rates go down, so do multiples." The managing equity director also noted another factor driving down PPMs: sellers who had the wherewithal to wait went to the sidelines, leaving behind those highly motivated to sell or those in dire need of capital. Neither type of seller attracts top dollar.
Loan and bond recoveries
Through each of the prior two recessions, the recovery values of distressed loans and bonds closely tracked PPMs. The following chart shows that recovery values and PPMs troughed within one year of each other in the 2001 recession, peaked together in 2007, then bottomed out either in 2008 or 2009, before rising again. (As an aside, the slide in loan and unsecured bond recoveries in 1998 may be the result of a tumultuous second half of that year, as investors contended with both Russia's financial crisis and the failure of Long-Term Capital Management LP.)
One reason for the similar behavior of PPMs and recoveries is that PPMs paid by sponsors in the private equity market are an input into loan and bond recoveries in the distressed market.
For bankrupt companies that will emerge from Chapter 11, recoveries to investors in leveraged loans and bonds are calculated based on that company's post-reorganization valuation. Steve Moyer, an adjunct professor at the University of Southern California and author of Distressed Debt Analysis: Strategies for Speculative Investors, addresses how that valuation is calculated: "For bankrupt companies not being liquidated, the most common valuation methodology to determine debt recovery levels is the EBITDA-multiple approach."
The EBITDA-multiple approach entails multiplying EBITDA by the PPMs that sponsors are paying, by public equity EBITDA multiples, or by some combination of the two. As the same forces moving PPMs also impact public securities trading multiples, they tend to move in tandem.
Since PPMs are used to compute recoveries, when PPMs paid by sponsors decline, recoveries to creditors should decline as well. As the prior chart shows, over the past 20 years, that decline happened. When PPMs rise following recessions, recoveries should, too — and they did. Where PPMs went, so went recoveries.
If this linkage holds true in the current recession, its usefulness to both distressed investors and private equity is worth contemplating. It may, for instance, impact the timing with which each of those segments makes investments and influence the timing of bankruptcy cases themselves — when they begin and how long they last. It may also influence where in the capital structure distressed investors will choose to play.
Patience as a virtue
Distressed investors' recoveries are affected not only by their target company's valuation but by where in a capital structure they have invested. Investing higher in the capital structure generally yields more certain, but lower, returns. Those returns require lower post-reorganization valuations to come to fruition.
Conversely, investing lower in the cap structure often yields much less certain, but much higher returns. They require greater post-reorganization valuations.
Since valuations rise with PPMs, if historical patterns hold, then in the current recessionary period, distressed investors who place their bets lower in the cap structure, in theory, might want to delay a bankruptcy filing, or keep a bankrupt company under court protection longer than their higher-in-the-cap-structure counterparts would desire. For those lower down, it pays to wait.
PPMs' role in determining bankruptcy recoveries may directly impact sponsors as well. When a private equity portfolio company goes bankrupt, the sponsor's equity is usually, at least initially, worthless. Yet if historical patterns hold, after this current recession, rising PPMs, coupled with recovering operations and improved earning visibility, could elevate a portfolio company's valuation to the point where the sponsor might find itself back in the money. For sponsors, it may pay to wait too.
For both the lower-in-the-cap-structure distressed investors and equity/sponsors, delaying a bankruptcy filing is not as difficult as it once was. A senior investment banker active during the past 20 years points out that the prevalence of so-called covenant-lite deals today has removed trip wires that would have given a voice — and a weapon — to unhappy creditors.
This banker also notes that low interest rates have lowered debt expense, reducing sponsor/owners' monetary costs as they await a turnaround. Giving owners more time to fix things, and more cushion between cash flow and debt service, raises the option value of both equity and lower-level debt.
Now that the Fed has made it official that we are in a near-zero Fed funds rate regime at least through 2022, low interest rates should be with us for at least the next couple of years. That will likely benefit sponsors and investors lower in the capital structure.
Equity: More than meets the eye
The following chart shows that as PPMs rose through the 2010s, the trend was for sponsor equity contributions to rise as well. But would the extra cash keep troubled sponsor-owned companies from ending up in the portfolios of distressed investors as quickly as they might with a smaller equity investment?
First, the private equity managing director notes that for sponsors, every portfolio company is monitored and treated the same. More equity does not necessarily draw more scrutiny. Second, it is the acquired company's debt load that determines that company's odds of remaining solvent; it is that company's ability to keep debt current that will, in part, determine if it will be a survivor.
The above chart shows that when debt/EBITDA ratios broke above 5x before each of the last two recessions, equity contributions as a percentage of total capital invested by sponsors had hovered in the low to mid-30% range. Then the economy tanked and PPMs fell, along with valuations.
Lenders lowered the multiples at which they were willing to lend. To fill the gap between the lower leverage level and the purchase price, equity contributions climbed to an average of 43% in 2002 and 49% in 2009. When the economy recovered and investor confidence returned, PPMs and debt/EBITDA both rose again, while equity contributions declined once more.
But in the past six years, as debt/EBITDA neared 6x and PPMs climbed into the double digits, the only way sponsors could pay the higher prices was to ratchet up the percentage of equity invested. Imposing higher leverage on the target company was not an option for sponsors. After the Great Recession, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency's Leveraged Lending Guidance drew a soft line at 6x debt/EBITDA for bank loans.
Given that limitation, sponsors have had no choice but to add equity to their acquisitions. In other words, equity in sponsor acquisitions had been rising not because of a desire to improve the safety of investments, but because of a desire to get deals done in the face of rising PPMs.
But higher PPMs and higher equity contributions are not all bad news for sponsors. Those transactions may be safer than 6x debt/EBITDA suggests. As the senior investment banker noted, record-low interest rates mean significantly more free cash flow per dollar of debt, and therefore more cash available to enhance equity returns. And that cushion between cash flow and debt service increases the margin for error when the economy slows.
Data supports this. In 2007, when debt/EBITDA reached a historic record high of 6.2x, EBITDA/cash interest was 2.1x. In 2019, again with debt/EBITDA near 6x, that figure was 2.8x, based on new-issue large corporate leveraged buyouts tracked by LCD.
This story was written by Jack Hersch, who covers distressed debt for LCD.
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