Div-recaps add to ticking distressed 'time bomb'

Credit market euphoria is creating the next wave of distressed investment opportunities, according to Wilbur Ross and Apollo's Joshua Harris, who spoke at the Milken Institute's Global Conference this week.

High yield bond markets are making deal financing easier than ever to obtain, but smart private equity fund managers are watching cautiously from the sidelines and sticking to agreeing deals in sectors with idiosyncrasies.

That was the message delegates at the Milken Institute's Global Conference in Los Angeles heard from numerous private equity industry veterans including WL Ross' Wilbur Ross and Apollo Global Management co-founder Joshua Harris.

“What you're seeing now is the high yield market at 570 [bps] and then you're seeing companies put 6.5 even 7 times debt to EBITDA to consummate transactions,” Harris noted. “When you see the high yield market below 600 bps, run – do not walk, run – the other way.”

He warned against getting 'drunk' on cheap credit. “The bar is open, the bartender is serving lots of drinks.”

It should be a red flag that there have been record highs recorded for dividend recaps and cov-lite loan issuance, Harris added.

“There were more dividend recaps in the past 12 months than in 2007 – what that is, is really the creation of the next distressed cycle,” Harris said, noting it was in part the result of global monetary authorities expanding their balance sheets by upwards of $10 trillion. “You're seeing that lowering of rates and liquidity reverberate into the high yield market.”

WL Ross founder Wilbur Ross agreed, noting that “over 80 percent of the [recent bond] issues didn't add a thing of value to the company – it was just reshuffling the balance sheet – and the very fact that the preponderance of it was refinancings means [the companies] weren't generating the cash flow to repay the old debt.”

That's adding to a “bigger and bigger time bomb” which may explode when the next wave of maturities comes due in 2018-2020, Ross said, noting around $500 billion per year over that time period would mature.

Another contributing factor, Ross said, was that “something like a third of all the first time issuers last year were CCC or below in terms of rating. That's not a very good crop of names. There's no question a time bomb is coming. But it's not just in high yield,” he said, noting that if 10-year US treasury bonds went back to their average yield between 2000-2010, they would fall 23 percent. “If there's that much downside risk in the 10-year treasury, tell me how much risk there is in high yield or corporates … I think we'll look back and say the real bubble was debt.”

Harris predicted the next wave of distress would happen in 16 months or so. “What's going to cause that? Probably some unknown volatile event, be it geopolitical, some sort of issue in Europe, or if nothing happens, it will be ultimately when the Fed and other authorities start to rein in credit.”

He noted that recent high-profile mega-buyouts agreed proved that for the first time since 2008, sponsors can get $15 billion to $20 billion in debt for the right deal. “When you look at the Dell or Heinz situations, those are very unique.” But those were anomalies and large deals weren't making a comeback, he added.

A number of GPs, Harris continued, had learned lessons from large club deals struck between '06-'08 with easy credit, where in many cases value creation was not what was hoped for and getting all parties to agree on necessary actions also proved challenging

“You're not seeing a lot of large PE shops do a lot of [mega-buyouts] because as a general matter it's not tremendously sound in my opinion,” Harris said. “Paying a premium on an already highly valued company at the peak of leveraged finance markets” isn't the way to make outsized returns, he said. “By and large, the alternatives managers are sitting this one out sensibly.”