Trouble In Junk Bond Lala-Land

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Private Equity firms have seen this coming for months. They’re positioning themselves for it. In April, Leon Black, CEO of Apollo Global Management, explained it this way to an incredulous world: “We’re selling everything that’s not nailed down.”

At the time, there were rumors that the Fed would start tapering its $85-billion-a-month bond purchase program. It would cause bloodletting in the bond market, raise interest rates, and wreak havoc with the highly leveraged companies that PE firms have in their portfolios. The Fed’s purposeful cacophony has been getting louder. Goldman Sachs, the all-important factor in this, just gave the Fed the official go-ahead: Goldman economist Kris Dawsey predicted that tapering would start in September, and bond purchases would end by mid-2014. By which time the Fed’s balance sheet will have swollen to $4 trillion.

Yup, I know.

Alas, PE firms have trouble selling “everything that isn’t nailed down.” Their portfolio companies, unlike shares of publicly traded companies, can’t be sold with the click of a mouse. For them, it’s a drawn-out process. A good buyer would be a publically traded corporation that prints its own money via its stock and doesn’t mind using its inflated shares to pay an inflated price. Even better is an IPO. It reaches the best buyer of them all, the unsuspecting public. After some well-orchestrated hoopla, the stock would be slither into various mutual funds, and the ultimate owners would have no idea they’d own it. PE firms have been scrambling to sell whatever they can that way.

But there is a quicker way to extract a big chunk of money – and shift the risk to someone else: have the portfolio company issue a pile of debt and then pay a dividend to the PE firm. It increases the leverage of the already highly leveraged portfolio company. Interest costs soar. So does the already significant risk of default. The company doesn’t take on the debt to improve processes, develop new products, conquer new markets, or build a new plant. The money is simply sucked out.

These recapitalizations, as they’re called euphemistically, set a phenomenal record in 2012: companies owned by PE firms sold $64.2 billion in bonds that were used as private-equity payouts, the Wall Street Journal reported. That was nearly double the amount sold in 2011. During the financial crisis, this sort of thing fizzled. But in 2006, during the LBO craze – including the largest LBO ever, the $48 billion buyout of TXU, which went bankrupt earlier this year – bonds issued for payouts peaked at $30 billion. Less than half of last year’s total.

So far this year, $47.5 billion in PE payout bonds have been sold – 62% more than at the same time in 2012. And yet, In May and June, bond markets swooned when they temporarily came to grips with the possibility that the Fed’s money-printing and bond-buying binge wouldn’t last forever. Junk bonds got slammed and yields soared.

So in July, the Fed altered the tones of its cacophony with Chairman Bernanke’s wishy-washy backtracking on his May speech that had so rattled the markets. Or maybe it was just selling fatigue. At any rate, the pendulum swung back and reversed part of the damage on the ancient financial principle that nothing goes to hell in a straight line.

PE firms jumped into the lull. Historically, only 14% of the bonds that their portfolio companies sell are for payouts. They’re nauseatingly risky, and turned-off investors demand very high yields. Hence, they’re not that common. In July, that ratio was 60%.

And yields have been dropping! In 2012, the average interest rate on bonds sold for payouts was 9.8%, already low, considering the risks. The average so far this year dropped to 8.2%. Then came the buying panic of July.

PE firms BC Partners and Silverlake “noticed the shift and pounced, according to people familiar with the matter,” writes the Wall Street Journal. Their portfolio company MultiPlan sold $750 million of the riskiest kind of junk bonds in the universe, those with a “pay in kind toggle.” The PIK toggle would give the company the right to forgo making interest payments if it ran out of money; they’d be added to the principle. Investors would receive no yield, and the amount owed would grow. A horrible deal. PIK toggle bonds that fund payouts normally carry a big-fat interest rate to motivate investors.

But not in July. To fund a dividend of $838-million, MultiPlan sold $750 million in bonds with an interest rate of 8.375%. Then Michaels Stores, owned by Blackstone and Bain, sold $700 million in PIK toggle bonds to pay an $800 million dividend. The interest rate? 7.5%. Ha, not to be outdone, IMS Health sold $750 million in payout PIK toggle bonds, at 7.375%.

Frantic yield investors, such as insurance companies or pension funds whose models assume predictable returns of 6% or 7% or more, when high-quality bonds yield 3% or less, or even run-of-the-mill bond funds, they are all desperately chasing the yield that the Fed, in its infinite wisdom, has deprived them of, and so they take on risks, any risks, to continue, at least for a little while, the epic feeding frenzy. They’re loading up their balance sheets with time bombs at the worst possible time. Someone will end up holding the bag, but it’s not going to be the PE funds that received the cash.

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