From Bill Blain of Mint Partners
Blain’s Morning Porridge – How to catch rabies in the Junk Bond Market
I’m sure everyone has been following the Toy R Us meltdown in the bond market. Alongside chapter 11 bankruptcy, its bonds have crashed from 96 to 18% through the month. Have we seen this before? Of course you have. Happens all the time. But, Blain’s Market Mantra No 3 reminds us: “Markets have no Memory. Buyers have even less.”
There are a number of things that worry me.
First is the market doesn’t seem to think Toy R Us is symptomatic of wider problems across the whole hi-yield and LBO sector. According to some I’ve spoken to, Toys R Us is one of few and even the “only” company caught in a debt trap – oh no it isn’t! Profit of about $500mm per annum covering debt service costs of, say, about $500 per annum. FFS! As the FT comments: the capital structure is “extremely complicated” leading to doubts on what is and isn’t senior or subordinated to what. It’s what we call messy.
Second, high yield spreads continue to tighten against bonds. Why? The risks are very very different across the credit spectrum, yet simplistic credit analysis treats them the same. Mistake to chase yield without understanding the risks. And go read all the stuff from 2007 about LBOs and how diversified risk is not reduced risk.
Third, there was a great article in the FT on Wednesday about Stada – the German drugmaker. It’s subject to an aggressive LBO and issuing substantial amounts of debt (bonds and loans) to fund it, allowing the PE buyers to strip out the cash. However, “buried deep in the 766 page offering memo”, says the FT, is a carve out of the obscure “restricted payments” clause allowing the private equity buyers to raise even more guaranteed debt to pay them dividends – a clear case of “the erosion of European Covenant Protections”.
It feels like a wake up and smell the coffee for the junk market… but I’ve been saying that for years… So I wont say it again…
It looks to me that complacent investors have been misreading the signs – foolishly thinking low rates meant highly levered private equity targets were somehow safe from debt crisis? In fact, debt remains front and centre the problem: as newspapers have noted; “while Toy R Us should have been spending its management resources maintaining relevancy versus Amazon and EBay, it was struggling with a debt mountain.” Doh.
What’s very obvious is holders ignored the first rule of investing in Leveraged Buy Outs: Don’t. Unless the goals of equity holders and debt are very clearly aligned – don’t go near them. Alignment of interest twixt equity and debt is critical and misalignment seems the basis of many takeovers…
Its 12 years since KKR, Bain and Vornado bought out Toy R Us. Guess who is also involved in the Stada buyout? If you guesses Bain, give yourself a big pat on the back.
Anything is possible when markets are so distorted that the hunt for yield overcomes common sense and folk are willing to ignore the need for protection against unrewarded risk. Common sense is a very uncommon thing.
Back in the real world.. I suppose we can spend the weekend fretting about Norte Korea. I tried to read stuff on the German election, hoping to come out with a killer bon-mot about Merkel, but it was just too dull and boring to bother.
I’m off to Edinburgh later this evening… Have a great weekend.
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