How Has Apollo Disappointed Investors? Let Us Count The Ways…

When I ask sources “What firm has been battered the worst by the economic mess,” I almost always get the same answer: Apollo Management. To better understand why that is, I’ve created a list of the firm’s recent failures, broken down into strategy missteps and ugly deals.

On Strategy:

1. Apollo companies are the most active PIK-togglers. Seven of Apollo’s portfolio companies have toggled their PIKs and another four have the option to do so. According to a list made by Buyouts’ Ari Nathanson, that is by far the most PIKs for any one sponsor.

Toggling a PIK substitutes debt payments with more debt, and the move is largely seen as prolonging the inevitable, and a bad sign in a credit crunch. Among them: Berry Plastics, Claire’s Stores, Metals USA Holdings, Momentive Performance Materials, Realogy, Rexnord Holdings and Harrah’s. See a full chart here. (sub req.)

2. Apollo missed the bottom on distressed debt. In March, the firm began aggressively buying up leveraged loans that they viewed as undervalued, including bonds of their own portfolio companies. At the time, loans were trading at unprecedented low prices averaging 85 cents on the dollar. Six months later, that average has dropped to 75 cents. Debt in some of Apollo’s own companies trades as low as a painful 20 cents on the dollar. Apollo spent $1 billion in March, and continued to deploy money before closing a dedicated fund last month.

3. Debt on Apollo’s portfolio companies trade below market in an already distressed market. Debt trading levels affect a company’s credit score and access to capital, even though they don’t directly damage performance or valuation. Like the stock market, they’re an indication of the market’s faith in that company’s future performance. According to Reuters Loan Pricing, most of the PIK-togglers in Apollo’s portfolio are trading below the market average. Here’s a sampling:

  • Berry Plastics: 66-68
  • Claires: 37.5-42
  • Momentive Performance Materials: 68-70
  • Realogy: Term Loan B 57-59
  • Harrah’s: Its 10 ¾ loans are trading at 23.5 on the dollar

4. Apollo has faced margin calls to the tune of $1 billion because it used leverage when purchasing distressed debt, as reported by peHUB and Dow Jones. The banks that provided the leverage can require Apollo to inject more equity into the funds, and did so after the prices of the debt sunk to such low levels.

5. Apollo often invests alone, which is in many ways admirable, but it does not spread the risk on big transactions. Many of its competitors did not feel comfortable doing the same thing, but Apollo did. So when investments fail, the firm will have to shoulder the fallout on its own. (The exception is the $30 billion Harrah’s, which included TPG.)

6. Apollo’s last fund was much, much bigger than its previous ones. Apollo’s last fund, fund VI, has $10 billion in commitments, which just barely places it in the double digit leagues of Blackstone and KKR. The firm’s prior fund, Apollo Management V LP, was a mere $3.75 billion pool that has actually posted very respectable returns. (CalPERS has earned 3x its money with a 46.3% IRR as of its 2008 annual report, and that’s including bankrupt Linens N’ Things.) But fund six probably won’t be so lucky. The firm itself even said, “Fund VI and Fund VII are several times larger than our previous private equity funds, and we may not be able to deploy this additional capital as profitably as our prior funds,” when listing risks in its S-1 filings.  Last week, the Wall Street Journal hinted the firm’s Q3 results could drive IRR on its sixth fund to zero. Meanwhile, the firm raised a whopping $15 billion for its seventh fund. More on that below.

7. The road to Apollo’s IPO has been slow. The firm has been listed on on GSTrUE, the private, Goldman Sachs exchange, and in March the firm filed to be listed on the NYSE. In the meantime, the IPO market has gone from dismal to depressing, and Apollos profitability has waned. The firm lost $57 million in its most recently reported quarter, Q1, thanks in part to claw-backs related to write-downs of portfolio companies. Similar to KKR, Apollo has AP Alternative Assets, a co-investment fund traded a European exchange. That stock trades at $2.69 a share; down from a 6-month high of $13 in September.

Deals Gone Bad:

8. Realogy was purchased seven months before the housing bubble burst. Couldn’t have timed it worse, and now, with revenue down 21% this year, the company is trying to renegotiate its $1.15 billion in debt with a swap. It’s a relatively desperate move. In the renegotiation filing, Realogy admitted that “there can be no assurance that we will not violate … covenants… or that this will not result in a default.” Realogy’s bonds trade at 20 cents on the dollar, according to a recent NY Times article.

9. Linens N Things went bankrupt after years of declining performance. The firm must’ve thought that Linens would make it out of bankruptcy, because it had purchased some of the Linens debt, according to Debtwire. But the company was such a disaster it had to liquidate, making Apollo a double loser in the situation. Purchased out of Apollo’s fifth fund, Linens N Things cost the firm $1.3 billion, with a $650 million equity check. Its unclear which fund backed the debt purchases.

10. Claire’s Stores’ has seen declining sales and operating losses in 2008. In 2007 Apollo bought the company in a $3 billion-plus heated auction. Apollo learned from Linens N Things, where it lost its 50% equity check, and only contributed 19.4% in equity to Claire’s. As a result, the company has a heavy debt to Ebitda ratio of 8.1 to 1. That debt has been continually downgraded, earning it its current Caa2 rating from Moody’s.

11. Harrah’s has operated at a consistent loss this year, and its massive debt load has proven to be too burdensome. Both TPG and Apollo have written down their stakes in the $30 billion buyout by about 20%, according to reports. Yesterday the company announced that it managed to swap some of that debt for notes with a later maturity. Didn’t seem to affect performance of the company’s loans on the secondary market.

12. Huntsman/Hexion. What more can be said about this disaster? The short story is that Apollo has been forced by the court to manage an unwanted merger that will result in a big insolvent mess. Furthering the insult is the fact that Apollo had aggressively pursued Huntsman, topping rival bidders. The firm and its lenders have pulled every lever and offered every conceivable excuse to wiggle its way out of the deal. The jury is out on how the lenders’ latest dodge and burn moves will play out, but I’m sure Apollo and its investors are crossing their fingers it’ll all just disappear.

As one investor put it, “And these are the ones we know about.”

So what does all this mean for Apollo’s fund performance and the firm’s future? Performance-wise, expectations are low. But can a firm in such dire straights really go out and spend a $15 billion fund with no repercussions? It raises the question of how much turmoil LPs can handle before they say “enough is enough,” and possibly pull their commitments, killing the new fund. This is apparently possible if it’s done before the firm calls any capital, although I have no idea of its likelihood.

The firm has argued that its specialty is distressed investing, and that now is the perfect time for it to strut its stuff in that area. (Apollo itself didn’t respond by press time, I’ll update if/when it does.)

I take issue with this for two reasons. For one, the point of distressed investing is to buy things cheaply. If Apollo is going to buy at a discount, then why does it need $5 billion more than it had last time around, when that sized fund already proved to be difficult for the firm? And does it have the manpower to support that many companies?

Second of all, how do we know Apollo will stick to its distressed knitting? From an outsider’s point of view, it looks like Apollo took advantage of its flexible mandate during the go-go period. The firm was lured into the seductive world of bidding wars and leveraging mediocre companies and got burned. It seems that if Apollo had played it cool in the frenzied, PE-centric upswing, the firm would now be ready to pounce on all kinds of distressed deals. Instead, the firm is busy putting out fires in its portfolio companies and fielding calls from annoying inquisitive reporters like me.

WSJ’s Peter Lattman wrote: As for Apollo VI, its problems bring to mind the classic line from the film “Apollo 13,” when the astronauts tell mission control, “Houston, we have a problem.”

In response, a colleague remarked, “I think the G-forces pulling against Apollo VI’s J-curve are a lot stronger than the ones Apollo 13 had to deal with.”