Buyout Boom Brings Reason To Worry
A: When money is cheap and tax code is friendly, leveraged buyouts (LBO) become very popular; as it has been for the past few years. With tons of liquidity out there and almost any company a potential takeout target, equity markets have been surging providing a great wealth effect for investors. This wealth effect translates to big bucks on wall street and the like and provides the Manhattan marketplace with very healthy and high quality demand on the buy side. But what if the takeout party ends? What if liquidity dries up a bit? How will that effect our housing marketplace? Before theorizing on the trickle down effect of all this, lets start simple and look at what is happening today and HOW these buyouts are being funded to see if there should be something to worry about. One side of the discussion focuses on covenant-lite loans, which have become increasingly popular as the method of funding LBO's.
First, lets break down what the two main types of covenants in this case are.
Positive Covenants - require a borrower (a company, private equity house or other financial sponsor) to meet set standards such as providing certain information at defined intervals. These type of covenants tend to be pretty ‘boilerplate’ and require the borrower to pay taxes, act legally, pay interest on loans and so on
Negative Covenants - restrict the borrower from certain courses of action, such as restricting dividends, limiting capital expenditure or other financial variables
And now, the definition of a cov-lite loan that removes some of these maintenance or controlling measures from the lender.
Covenant-Lite Loans - Is the general description of financial structures whose main terms have fewer or no maintenance covenants. A ‘cov-lite’ loan does not include the legal clauses which allow a lender to control and track the performance of a company and if needs be declare a default if certain criteria are breached. With covenant-lite loans, a bank can only act if a borrower attempts to take specific actions, such as adding more debt or making an acquisition. More-traditional maintenance covenants allow banks to step in at any point if a borrower's performance drops below a certain benchmark. Not so with covenant-lite loans.
According to a recent S & P report on the topic titled, "Recover chances lower for cov-lite loans" -
The popularity of "covenant-lite" loans that made up almost a third of new leveraged loan structures this year may result in lower recoveries when borrowers default...Recovery estimates for covenant-lite loans, which lack traditional financial covenants that allow lenders to require minimum levels of leverage and interest rate coverage, are typically 8 percent to 14 percent lower than for equivalent borrowers with full maintenance covenants, according to S&P.
"This means by the time a default occurs, there may not be much business enterprise value left to recover," S&P analyst Ana Lai said in the report.
Here is a list of some leveraged buyouts using covenant-lite loan structures:
Now these are some big names and obviously don't represent the biggest threats. These are just a few noted in the article making it easy for me to give you real life examples. If you want to get a visual on the growth in popularity of these types of loans over the past year, just look at this chart on the right which shows you how through June of this year $97B of loans were structured using cov-lite versus $24B for all of 2006:
My Point - Forward thinking. I am by no means an expert of leveraged buyouts, credit risk, derivative products, cdo/abx markets, etc.. However, it doesn't take an expert to see how the industry adapts to continue to be able to lend to support such massive buyouts in the private equity sector. I'll repeat this again --> Right now you are seeing an environment that is a result of years of ultra cheap money and tons of liquidity. What is yet to be seen is the effect of globally rising interest rates to levels we see today; that will take 1-2 years. For the near future, I don't think the end result will be that bad, in fact I think the environment will remain bullish for some time. However, red flags are waving for the years to come when we will be able to look back at how many of these massive buyouts were successful, and how many caused major problems to banks and other lenders. If the latter proves worse than anyone expects, well, that will dry up liquidity, cause equities to correct, and result in higher rates across the board. Something that very well could trickle to real estate here in Manhattan. A discussion to revisit down the road!
