Debt? Equity? Let’s Not be Nitpicky … Invested Capital!

Here’s an interesting trend: lots of investment banks and buyout firms buying debt from their own and others’ acquisitions (and, obviously, the most recent headline, something that sounds familiar). With recent developments it seems like some roadblocks have been removed to actually getting banks to sell these loans. However, one has to wonder what kinds of issues this will raise down the road… If, for example, Chrysler, TXU, or First data run into problems, how will things be different with the financial sponsor (P.E. firms) in the debt? (Although, for P.E. firms and investment banks that invest through funds that raise third party money, it’s obviously a requirement to have information barriers in place to prevent conflicts and all kinds of other illegal and improper behavior.)

Well, how about some current events to help answer the question? As one could read here Apollo’s portfolio company, Linens ‘n Things, is expected to file for protection under Chapter 11 of the United States Bankruptcy Code.  From the New York Post (as much as it pains me use this publication as a source…):

Apollo Management, which took the retailer private in 2005 for $1.3 billion, is weighing the idea of a potential “prepackaged” bankruptcy, sources said.

In such a plan, Apollo and creditors would settle on a restructuring plan before a Chapter 11 filing is made.

The speculation comes as the cash-strapped chain faces a clampdown on its $700 million revolving line of credit from GE Capital, sources said. While GE hasn’t cut off the flow altogether, sources said payments to vendors that supply sheets, towels, curtains and kitchenware have become more selective.

That, in turn, has prompted several of the largest suppliers to stop shipping merchandise during the past few weeks, sources said.

About half of the largest 25 vendors have halted deliveries because of late or insufficient payments, according to one source familiar with the matter.

(emphasis mine)

Now, this an interesting situation. Imagine “and creditors” reads “and Apollo’s debt fund” (or some other P.E. fund’s debt fund) or “and the institutions that depend on Apollo for fee revenue” (investment banks) … I wonder how things would be different. Anyone who works in finance, at some point, has seen a customer or other client of the firm go high up the food chain to make a “relationship call.” Certainly there are examples of very public outcomes that are both positive and negative for many “relationships.” But, honestly, isn’t a “top of the house” decision, when supportable, going to be in the favor of the house, versus the part of the house that has the upper hand in negotiating? The part about, “when supportable” is key, obviously. Why would Leon Black’s creditors accept his plan? As a matter of fact, if the company is going to default, then why would he even come out with a plan? Most likely because his plan doesn’t wipe out the equity holders. And why accept said plan? Because it’s probably unclear what the company is worth if it defaults (to the creditors). And, to be honest, can’t one almost always find a reason to go with a decision supported by numbers and projections instead of a protracted legal battle?

It’s instructive, also, to look at the entire process. P.E. firms were purchasing companies and financing those purchases with cheap debt that banks committed to providing. Some of these transactions, however, took over a year to close, like Harrah’s, for example. Now, with the credit crisis having gotten into full swing, the P.E. firms are relying on these below market debt commitments to generate their returns. Having seen this process from the inside, this isn’t really the intention. Have we seen any lowered purchase prices? Not really. Have we seen M.A.E. clauses engaged? Certainly a few, but mainly focused on business conditions and operating results (at least as reported and stated publicly), not related to financing. So what does this mean when a company is bought using debt, funded at 100 cents on the dollar, that is trading at 80 cents on the dollar? Twenty percent of th debt value is a wealth transfer from the financing institutions’ shareholders. Now, in ties of market turmoil, this kind of thing happens, but it’s certainly odd that some P.E. funds can wind up owning the entire capital structure (in different pockets or capital pools, most likely) of a company at a cost basis less than the purchase price. If a firm owns 100% of a company and paid greater than ten percent less than the buyout price that just sounds amiss soehow…

Now, also, think about this: If banks couldn’t even negotiate materially more favorable economics on these deals, and even refused to litigate or pursue valid avenues of breaking financing commitments, then how are they going to react when they own the debt o these same deals and these P.E. firms call them asking for amended terms? I wonder….

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