Here are the numbers. Peak chase-for-yield by institutional investors?
Most of the brick-and-mortar retailers that have filed for bankruptcy protection to be restructured or liquidated over the past two years have been owned by private equity firms – including the most recent major casualty, Toys ‘R’ Us. Part of how PE firms make money is by stripping capital out of their portfolio companies via special dividends funded by “leveraged loans” – more on those in a moment – leaving these companies in a very precarious condition.
So just how much have PE firms paid themselves in special dividends extracted from their portfolio companies? $4.76 billion in the third quarter, bringing the year-to-date total to $15.3 billion. So the year-total for 2017 is going to be a doozie.
In all of 2016, this sort of activity – “recapitalization,” as it’s called euphemistically – amounted to $15.7 billion, up from $10.5 billion in 2015, according to LCD, of S&P Global Market Intelligence. LCD’s chart shows the quarterly totals:
“This high-profile recap activity is a sign of the times in today’s still-overheated leveraged loan market,” LCD says:
Deals such as these typically proliferate when there is excess investor demand, allowing borrowers to undertake “opportunistic” issuance, such as corporate entities refinancing debt at a cheaper rate or, here, PE firms adding debt onto portfolio companies, then paying themselves an often hefty dividend with the proceeds.
As private-equity-owned retailers that are now defaulting on their debts have shown: this type of activity where cash is stripped out of the portfolio company and replaced with borrowed money is very risky.
Leveraged loans are provided by a group of lenders to junk-rated over-indebted companies. They’re structured, arranged, and administered by one or several banks. But leveraged loans are too risky for banks to keep on their balance sheet. Instead, banks sell the structured products to loan mutual funds or ETFs so that they can be moved into retirement portfolios, or they repackage them into Collateralized Loan Obligations (CLO) to sell them to institutional investors, such as mutual-fund companies.
A record $947 billion in leveraged loans are outstanding. They trade like securities. But the SEC, which regulates securities, considers them loans and doesn’t regulate them. No one regulates them.
So why can PE firms strip record cash out of their portfolio companies while loading them up with this risky debt? Because credit markets have gone nuts.
After years of yield repression by the Fed and other central banks, there is huge demand for products that yield just a little more, regardless of the risks. “Excess demand scenario” is what LCD calls this phenomenon. “Hence the relative surge in dividend deals, which are popular with private equity firms, for obvious reasons.”
Despite the risks, as LCD gingerly points out, “institutional investors are keen to maintain strong relationships with private equity shops, which borrow frequently, so in bull credit markets these deals continue to find a home.”
And these already risky leveraged loans have been getting even riskier for investors: In the first half of October, 82% of all leveraged loans issued were “covenant lite,” almost matching the full-month record of 84%, in August, according to LCD. As of September 30, 72.9% of all US leveraged loans outstanding had a covenant-lite structure, the highest proportion ever. So $690 billion in leveraged loans were covenant lite.
This chart shows the surge in the proportion of covenant-lite loans to total leveraged loans over the past three years:
So what’s the big deal? When there is no default, there is no problem. But when defaults do occur – as they have a tendency to do – or before they even occur, investors in covenant-lite loans have less recourse and fewer protections, and losses can be much higher. As long as investors clamor for risky debt in their energetic chase for a little extra yield, these covenant-lite loans are going to fly.
The leveraged loan market has been sizzling. The S&P/LSTA US Leveraged Loan 100 Index has now set an all-time high on every single day from September 25 through October 15. And that’s how it has been pretty much since the recent low on February 11, 2016:
In this kind of Fed-engineered credit market, where risks no longer matter, and where institutional investors are chasing yield and plow with utter abandon other people’s money into risky assets, it’s logical that PE firms are stripping as much cash as they can from their portfolio companies before these companies – like so many retailers now – are toppling.
Why is anyone still buying retailers from private equity firms? Read… IPO in March, Crushed Today: PE Firm Pushes another Retailer into Brick-and-Mortar Meltdown