The Buyouts, IFR and peHUB teams recently spoke with Babson Capital about the state of the debt market. Here’s a few highlights from the conversation with Jill Fields, head of the firm’s high yield group, and Russ Morrison, head of the firm’s bank loan group, discussing why covenant light isn’t the enemy and why private-equity backed companies will lead defaults.
We’ve seen a few high yield issuances, is it a sign the markets are opening up?
JF: It’s critical we see markets reopened. We’ve done a few deals where there was more interest than was available. We got 1/10 of (the amount of debt) we asked for. So there is a demand, and it gives confidence that there’s liquidity in the market, but everyone wants quality. It also shows that the companies that see their debt come to maturity in the next few years can avert potential bankruptcies because they can refinance or do an equity exchange.
Is that the reason high yield has been coming back?
JF: Yes, many companies are seeking to take down or eliminate bank debt, or push back maturities. … Remember in the telecom cycle, the high yield market had bottomed the year before the defaults spiked.
Do you think private equity will represent a disproportionate amount of the defaults in this cycle?
RM: Well, the leveraged loan market is basically driven by private equity, so they represent a majority of the leveraged loans in the market. If the private equity-backed companies aren’t growing and are in decline, it is inevitable that PE will drive the defaults. For the debtholders, it depends on whether they underwrote the loan based on survival or growth. Many private equity firms modeled their returns based relying on the growth or cost cutting at the company, and capitalized the company as such. If the debtholders also bought into that and the company isn’t growing anymore, they might be in trouble.
Is covenant light going to change things this time around?
RM: You can make the case that covenant light is a bad thing. On the surface, yes it is. But a covenant light loan doesn’t determine a company’s survival. At the end of the day, a company is not going to need to restructure because it lacks covenants. There is also an argument that, with business models that are deserving of it, is can be a beneficial thing to a company. You can be comforted by the ability to draw on your revolver. The downside is that a company can conceivably run itself into the ground with no assets left to recover.
JF: But then the question is, do you want the company to go into the bank and be run by a bank with this much distress in the banking sector?
What about DIP lending? What happens when a company can’t get it?
RM: They may have to liquidate. We are seeing DIP loans happen, though, at historic terms. Loans can be anywhere from L+500 to L+1000 with up-front fees of 2% to 4%. In the prior cycle it was as low as L+300 with 1% or 2% up front.
Is Babson interested in distressed debt?
JL: On the high yield side, in general, we’d be very weary to be involved. Sometimes the price reflects distressed, sometimes it is technical. But the recoveries in a lot of the companies would be terrible. We’re interested in a few company-specific situations. Cable and satellite companies, waste management companies, high quality credit rating energy companies, companies in defensible industries and moderate leverage.
Are any of them LBO-backed?
What about on the loan side?
Rob: There are a few sides to the distressed loan market. First there are the loans that are considered distressed for purely technical reasons. These are high quality loans that are now trading at the “new par.” Then there’s two kinds of the loans below that: stressed and distressed. We’ll look at the stressed loans hat are trading in the mid-40s to mid-60s. There are some LBO candidates where bank debt was 40% to 50% of the capital structure and much of that was senior loans. We’re buying into that at 25 to 35 cents on the dollar if the company has unlevered cash flow. There are some attractive areas here, but it requires patience and a medium-term investment period of three to four years.
Babson Capital is based in Charlotte, and has more than $100 billion in assets under management.