As the high-yield market continues its mystifying robustness, our nervousness grows. Last week, we wondered what lenders and buyers were thinking in fueling all this activity. Today, at the Fourth Annual Debtwire Distressed Debt Forum in New York, we got our answer: the high-yield market is akin to that scene in Reservoir Dogs where five people are all aiming guns at each other. Everyone is fully armed, and someone is going to get hurt.
It turns out that the high-yield market’s record activity is real, but it also disguises some cautiousness and misgivings (whew: we were wondering what they could possibly be thinking). And yet, there is optimism! And yet, that optimism is grounded by fear! Junk-bond pros are on a seesaw.
To get some insight into the market’s ambivalence, we rounded up some of the paradoxes we heard discussed at the conference this morning and contrasted them below, along with our analysis of what it all might mean:
We have record activity: There has been an insanely active high-yield financing market, with a record volume of $33.7 billion in April. Around 75% of the deals are “underwritten,” meaning that banks agree to guarantee the entire loan – the banks will take any unsold portions on their own balance sheets and get hit with the discount if any part of the loan doesn’t get placed with investors. Compare that to 2007, when only 10% of deals were underwritten and more like 90% were “best-efforts” deals in which the banks agreed to guarantee only part of the deal. If the debt didn’t find buyers in a best-efforts deal, the debt itself would be reduced or discounted and the deal shrunk, with no penalty to the underwriters.
And yet we also have: A pool of buyers that has been sliced by half. While there were 300 institutions who were potential buyers of high-yield debt in 2007, there are only 150 such accounts in the high-yield markets of 2010.
What this means: Fewer buyers buying more debt means more concentration – those buyers who are grabbing up high-yield seem to be doing so in quantities. Either they’re really convinced the market will keep soaring, or they’re going to get slammed when it crashes. The fact that so many of the current high-yield deals are “underwritten,” and thus have bank commitments, shows that buyers are looking for more security behind the debt they’re buying.
We have the return of the staple: Even if Fidelity National isn’t happening, private equity auctions are definitely back. Where there are auctions, there are stapled financings: Those little bundles of money that banks promise to buyers to make deals more attractive. True, these staples are not as lavish as those in the boom years, but they are still very popular. One wag we talked to called these more modest staples “paper clips.” There is still one question about them, though: Are they being used? Back in 2006, staples served mostly as a way for buyers to figure out how much of their own financing they needed to raise, and to get a good valuation for the company they were buying. But now, in 2010, financing is hard to come by, and we wouldn’t be surprised if buyers are a little more interested in staples.
And yet we also have: Banks getting more involved in high-yield underwriting than ever, but shying away from underwriting dividend recaps (refinancings of current debt-heavy portfolio companies). These deals have trouble clearing the market. So banks are willing to promise financings upfront (through staples) but good luck getting a commitment once a company is really in trouble after all that debt.
What this means: Smaller deals, but more activity. Staples used to be a feel-good gesture to make deals look friendly, usually in the middle-market range of $200 million to $2 billion. If staples actually come into play more often, banks will be committing to making leveraged loans again and you’ll have to watch their commitments closely. Let’s hope they don’t keep it on their balance sheets this time.
We have the return of bridge financings (even though Jamie Dimon once called them a terrible idea): In a bridge financing, a bank will loan a private equity firm a certain amount of money to cover the costs of an LBO between the time the deal is signed and the time that the longer-term financing actually becomes available. This ended up being full of pitfalls in 2007 as banks had trouble syndicating the loans, or selling them to other investors. The result: hung bridges, bad-loan exposure of nearly $200 billion, and deep writedowns as banks had to reduce the value of loans that became unmarketable.
And yet we now have: Bridges with terms that are designed to protect banks. It is true that banks are promising bridge financings again to private equity firms. But look deeper, and those loan terms show a certain skittishness. Banks are writing the contracts so that they only have to hold the debt for a short period of time, for instance – sometimes as short as four months. They also make more provisions for what bankers call “market-flex,” or the ability to change the loan’s price or structure in order to attract buyers. While PE firms only see that they’re getting bridge commitments from banks again, the banks are protecting themselves.
Overall, the paradoxical state of the high-yield market’s workings show that both private equity firms and banks are pursuing their old agendas again, even if they’ve dressed in stronger armor. They have two common goals:
- Getting new deals (and thus new fees) in through the door;
- Pushing off that massive wave of maturities for a little bit longer.
Banks and PE firms need both new fees and later maturities to survive. Finally, aligned interests in the high-yield market. Who woulda thunk it?