Hard Times Could Return For Portfolio Companies

In some ways, market conditions have been historically benign since the financial crisis began to ease in mid-2009. Today, the stock market is up, and interest rates remain near historic lows. At the same time, yield-hungry investors are making credit available to deal-makers on generous terms.

Some market watchers believe the environment is too good to last. “Next year is going to be much more of a defensive year than an offensive year,” said Mark Okada, co-founder and chief investment officer of Highland Capital Management LP, a Dallas-based collateralized loan obligation manager, hedge fund manager and investor in distressed assets. At a meeting with reporters to discuss the credit and distressed investing outlook, Okada predicted a higher cost of capital in 2013. “That’s going to keep spreads wide.”

Even so, defaults by high-yield issuers remain around 3 percent, low by historical standards, according to data from Moody’s Investors Service Inc. But in a sign of potential trouble around the bend, Moody’s downgrades to speculative grade issues have outnumbered upgrades since June, and the agency said downgrades would have been higher except for strong investor demand.

In the meantime, a handful of high-profile portfolio companies have stumbled in recent weeks, and while their difficulties can be attributed to unique circumstances in their businesses, they also could be a sign of more widespread credit problems if financial markets become less friendly.

The most prominent example involves Energy Future Holdings Corp., the giant Texas utility that was taken private by a group of buyout firms in 2007, in the largest LBO. The company refinanced $1.6 billion of its debt in a transaction that ratings agencies widely viewed as a “selective default.”

The move promises to give Energy Future Holdings—backed by Kohlberg Kravis Roberts & Co., TPG Capital, Quintana Capital Group LP and AXA Private Equity SA—some time to get its house in order. That’s at least in part because the new notes include a pay-in-kind feature enabling the company to make its semi-annual debt payments for the next three years not in cash but in additional PIKs.

Other portfolio companies also are raising red flags for credit agencies. One of them is inVentiv Health Inc., a holding of Thomas H. Lee Partners, which suffered a ratings downgrade by Moody’s in November when its aggressive expansion through acquisitions outran its EBITDA growth.

If interest rates turn higher, more portfolio companies could feel the pressure, said John Lonski, the chief capital market economist in Moody’s capital markets research group. “For the macro outlook, the downside risks outweigh the upside potential,” Lonski said on a conference call to discuss the leveraged lending environment. He argued that high-yield loan spreads, currently averaging about 550 basis points above Libor, should be of 620 to 660 bps based on current economic activity. “According to almost every conceivable macro measure of U.S. business activity, the high-yield spread is too thin.”

Rates seem to be in no hurry to rise. The Federal Reserve said in December that it would continue to take action to hold down broad-based interest rates until U.S. unemployment drops to 6.5 percent. Still, if rates do increase, it could deprive struggling companies of time.

That appears to be what happened to Hostess Brands, a snack maker that converted its Chapter 11 reorganization into a Chapter 7 liquidation in November, stranding backers including buyout shop Ripplewood Holdings and hedge funds that include Silver Point Capital. Hostess blamed its union workers, who had been out on strike since October, while the union blamed the company’s lack of investment in its operations.

The truth may simply be that the company never got on its feet after an earlier bankruptcy. Hostess, formerly known as Interstate Bakeries Corp., was in bankruptcy from September 2004 until 2009, when Ripplewood and its group of investors took a chance on the strength of the company’s union concessions and other financial moves as part of its exit from bankruptcy. That made Hostess, which returned to Chapter 11 in January, what financiers call a “Chapter 22,” representing a company that has suffered multiple defaults.

Whatever the cause of the collapse at Hostess, some observers expect a tougher economic environment in the coming year. “2013 is going to be a year when we sort out winners and losers,” said Okada of Highland Capital. He predicted the year ahead will be much like 2010, when credit markets swung open and shut, depending on credit investors’ short-term attitude toward risk. “Certainty of execution in getting deals done is going to be choppier.”

And that could make debt investors cautious, said Christina Padgett, a senior vice president in Moody’s corporate finance group. “Private equity has been actively taking advantage of the current debt markets. Any downward pressure on valuations will leave investors in highly leveraged companies poorly positioned.”