What to Make of the Credit Cycle. Part 14.1. (Long Div Recaps; Long Blackstone; Short Refinitiv)

On Sunday in “What to Make of the Credit Cycle. Part 14. (Long Blackstone; Short Refinitiv),” we provided our colorful take on the fervent (and 2x over-subscribed) demand for the $13.5 billion Thomson Reuters’ Refinitiv loan and bond issuance. Our take was framed from the perspective of the high yield trader and was meant to provide some insight into the machinations that occur behind the scenes at a high yield fund. But what does this deal mean for private equity firms and leveraged buyouts?

Spoiler alert: all good things.

Reuters wrote:

The rousing results are likely to boost secondary pricing and will intensify pressure on primary pricing and other terms and conditions, after investors won a reprieve in the summer from aggressive transactions amid a surge in supply.

The SMi100, an index that tracks the 100 most widely held loans, stands at 98.73, the highest point since February. About 42% of US loans are now trading above par, according to LPC data. Average US high-yield bonds, meanwhile, have rallied sharply over the past couple of weeks to Treasuries plus 325bp, or just 3bp off post-crisis lows, according to ICE BAML data. (emphasis added)

Private equity firms likely smell blood in the water. More from Reuters:

The successes could also herald a more aggressive underwriting era as private equity firms squeeze arranging banks harder, which could open the door to another round of opportunistic repricings, refinancings and dividend recapitalizations that allow sponsors to take advantage of weak documentation.

“The next stuff behind the scenes is going to be punchy,” the global debt head said.

Ah, dividend recapitalizations. We miss those.

Reuters continued:

While the results are undeniably good for private equity firms, they may not be good for investors who are increasingly nervous about aggressive deals as an economic downturn draws closer at the end of an unusually long economic cycle.

With Refinitiv, Akzo and Envision, technical factors – primarily huge demand and a small visible pipeline of deals – overwhelmed any specific credit concerns and fears about aggressive documentation that allow sponsors to extract dividends quickly or make transformative asset sales and acquisitions without investors’ consent.

The three jumbo loans, each of which are capital-stretching, represent half of the forward calendar, which is already looking thinner. Worries about future supply encouraged investors to join the big, liquid deals in droves, particularly as new money carve-outs have previously proved to be particularly profitable.

All of this continues to worry financial regulators who are watching the fervor play out. The Bank of International Settlements recently warned that, per Bloomberg:

…likely distress among indebted borrowers may spread into the wider economy as central banks raise interest rates. It’s not just the total debt, but the fact that investors seem less and less concerned about protecting themselves against losses, the BIS said.

Yes, indeed. The return of covenant-lite debt has been well documented.

And the borrower-favorable market has been well documented.

“When there’s tons of liquidity, lenders don’t value covenants and they’re willing to lend at very high leverage values,” said Douglas Diamond, a finance professor at the University of Chicago Booth School of Business. “If you get a negative shock after that, you’ve now got a very vulnerable sector. The crisis won’t happen tomorrow but the vulnerability is there.”

The BIS report identified other concerns, including the prospect of fire sales by loan funds if ratings downgrades push some of their investments into junk. Diamond said there’s potential for such leveraged mutual funds to cause havoc.

“The borrowing that they do is usually from a bank,” he said in an interview. “They buy a loan from a bank, they borrow money from the bank to buy the loan from the bank -- not necessarily the same bank. So the risk would ultimately get back to bank balance sheets.”

But high yield mutual funds aren’t the only vehicles driving this meshugas. Don’t forget about CLOs, which, as we discussed in “💥The CLO Market is Going Bananas💥,” are in full-on volume mode. Relating to factors driving demand for borrower-friendly paper, Alexandra Scaggs wrote in Barron’s:

Another is the robust demand for floating-rate debt such as leveraged loans to protect against Federal Reserve rate increases. Funds investing in loans have seen $14.4 billion of inflows this year, according to EPFR, following on $16 billion of inflows in 2017 and $11 billion in 2016. It is not clear the scramble for floating-rate securities will stop any time soon, as the Fed is expected to raise rates four times in the next 12 months, according to Bloomberg data. The demand for loans has also been fueled by the rise of the market for collateralized loan obligations, securitized products that hold pools of loans as collateral and pay their investors the interest collected from those loans in order of tranche quality.

For the uninitiated, here is an excellent recently published primer from S&P Global Ratings on how CLOs function. Pour yourself a cup of coffee and give it a perusal. It’s worth it. CLO dynamics will definitely play into the next cycle.

*****

In a separate segment on Sunday, we snarked about over-the-transom strategic-alternatives pitch deck” and banker boredom. Distressed and high yield investors are, no doubt, equally if not more bored. Aside from Q1, 2018 has been a barren wasteland for restructuring and bankruptcy professionals looking for things to do. Long bitching come bonus time.

But all of this flippant high yield activity has to come home to roost at some point. The question, as always, remains “when?”

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Oil & Gas is Back Baby

Long the West Texas’ Permian Basin; Short Anadarko

If you’re Steve Rogers, Encino Man, or were otherwise frozen somehow from 2014 through 2017 and missed the oil and gas downturn, Bethany McLean’s “Saudi America” will give you a nice high-level overview of American oil policy and fracking. It discusses Aubrey McClendon, the Obama-era change oil export policy, President Trump’s notion of energy independence, the rise of the West Texas’ Permian basin and more. She writes:

“What people still fail to understand is that the most cyclical number we have is the theoretical break-even,” one oil man says. “There will be stories about how the $40 break-even became the $70 break-even, and people will say ‘Who lied to me?’”

And so it is that the most important factor in the comeback of shale is the same thing that started the boom in the first place: The availability of capital. “It came back because Wall Street was there,” says longtime short-seller Jim Chanos. In 2017, U.S. frackers raised $60 billion in debt, up almost 30 percent since 2016, according to Dealogic.

Wall Street’s willingness to fund money-losing shale operators is, in turn, a reflection of ultra-low interest rates. That poses a twofold risk to shale companies. In his paper for Columbia’s Center of Global Energy Policy, Amir Azar noted that if interest rates rose, it would wipe out a significant portion of the improvement in break-even costs.

But low interest rates haven’t just meant lower borrowing costs for debt-laden companies. The lack of return elsewhere also let pension funds, which need to be able to pay retirees, to invest massive amounts of money with hedge funds that invest in high yield debt, like that of energy firms, and with private equity firms — which, in turn, shoveled money into shale companies, because in a world devoid of growth, shale at least was growing. Which explains why Lambert, portfolio manager of Nassau Re, says “Pension funds were enablers of the U.S. energy revolution.”

Ah, yield baby yield.

A lot of the U.S. energy revolution and recovery from ‘14-’17 is coming from the West Texas’ Permian basin. McLean writes:

In 2010, the Permian Basin was producing just shy of 1 million barrels a day. In 2017, that had more than doubled to over 2.5 million barrels a day. By August, output from the Permian alone exceeded that of 8 of the 13 members of OPEC, according to Bloomberg. The International Energy Agency predicts that output will hit more than 4 million barrels a day within a few years. Production from the Permian is the primary driver behind skyrocketing estimates of how much oil the U.S. will produce.

Apropos, Bloomberg noted this week:

To get a toehold in the prolific Permian Basin, private equity is increasingly betting on a relatively obscure, and potentially risky, part of the pipeline industry.

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies, according to Matthew Phillips, an analyst at Guggenheim Securities LLC.

Specifically, Bloomberg is referring to midstream companies manufacturing gathering and processing pipeline assets that transport oil and gas across states. Producers commit to pay for space in the pipes over a period of years. Restructuring professionals are very familiar with these gathering contracts: they were the subject of many a dispute during the recent downturn.

…investors in gathering pipes and processing plants are forced to lean on long-term projections, since their projects depend on continuous output over time from the same area.

“Any time there’s massive supply growth, there is some risk-seeking behavior,” said Jeff Jorgensen, portfolio manager and director of research at Brookfield Asset Management Inc.’s Public Securities Group. There’s a tendency by some to “invest in production profiles that are, let’s just say, hilariously aggressive in their assumptions” for the future, he said.

It’s easy to see where that aggressiveness is coming from. Researcher IHS Markit predicts output in the Permian Basin will double by 2023 to reach 5.4 million barrels a day. That’s more than every OPEC country except Saudi Arabia. By 2035, it could hit 6.3 million barrels, according to Wood Mackenzie.

Bloomberg continues:

…with the surge of private equity money giving way to smaller players that may be taking on added debt to pay for pricey projects, the risk increases dramatically.

“There’s definitely some sloppiness in the gathering and processing space,” she said. “The cash flow isn’t going to be what they expected, so we could see some of the smaller players financially weaken, and that may lead to consolidation.”

With oil prices on the rise, however, the risk may seem worth taking. Memories are short. And confidence in break-even costs must be through the roof. Regardless of whether President Trump is happy with oil prices where they are.

The bottom line is that in this oil and gas recovery, there are clear winners and losers. The Permian is a big winner. This explains the recent S-1 filing of Riley Exploration — Permian LLC ($REPX)(owned by Yorktown Partners LLC, Bluescape Energy Partners LLC and Boomer Petroleum LLC), which has 65k+ net acres in the Permian as of June 30, 2018. Look at that name: they’re clearly sending a message that screams “pureplay Permian exploration and development company.” It’s like companies putting “.com” in their name during the dot.com bubble and “blockchain” in their name in the more recent crypto bubble. Smart move.

The Bakken in North Dakota appears to be back too. Per Bloomberg:

North Dakota’s oil production surged to a new record in July, putting the mid-western state on par with OPEC member Venezuela.

Home to the Bakken shale play, North Dakota pumped 1.27 million barrels a day in July, according to state figures released Friday. That’s roughly the same output as Venezuela during the month. The South American nation, whose oil industry has collapsed amid a prolonged financial crisis, saw production fall further in August to 1.24 million barrels a day -- about half the level seen in early 2016, according to data from OPEC secondary sources.

Where are the losers? Look at the Anadarko/Woodford area (read: West Oklahoma). In quite the juxtaposition to Riley Exploration, this week Tapstone Energy, a Blackstone-backed oil and gas exploration and production company withdrew its proposed $400mm IPO. Those closely watching Gastar Exploration Inc. ($GSTC) will find it located there too. The stock was delisted, trades over-the-counter at $0.06/share. The bankruptcy clock is ticking.

Like we said. Winners and losers.

💰Private Equity Own Yo Sh*t (Short Health. And Care)💰

Forget Toys R Us. Private Equity Now Owns Your Eyes and Teeth

It has been over a month since media reports that Bernie Sanders and certain other Congressman questioned KKR about its role in the demise of Toys R Us (and the loss of 30k jobs). At the time, in “💥KKR Effectively Tells Bernie Sanders to Pound Sand💥,” we argued that the uproar was pretty ridiculous — even if we do hope that, in the end, we are wrong and that there’s some resolution for all of those folks who relied upon promises of severance payments. Remember: KKR declared that it is back-channeling with interested parties to come to some sort of resolution that will assuage people’s hurt feelings (and pocketbooks). Since then: we’ve heard nothing but crickets.

This shouldn’t surprise anyone. What might, however, is the degree to which private equity money is in so many different places with such a large potential societal impact. It extends beyond just retail.

Last week Josh Brown of Ritholtz Wealth Management posted a blog post entitled, “If You’re a Seller, Sell Now. If you’re a Buyer, Wait.” Here are some choice bits (though we recommend you read the whole thing):

I’ve never seen a seller’s market quite like the one we’re in now for privately held companies. In almost any industry, especially if it’s white collar, professional services and has a recurring revenue stream. There are thirty buyers for every business and they’re paying record-breaking multiples. There are opportunities to sell and stay on to manage, or sell to cash out (and bro down). There are rollups rolling up all the things that can be rolled up.

In my own industry, private equity firms have come in to both make acquisitions as well as to back existing strategic acquirers. This isn’t brand new, but the pace is furious and the deal size is going up. I’m hearing and seeing similar things happening with medical practices and accounting firms and insurance agencies.

Anything that can be harvested for its cash flows and turned into a bond is getting bought. The competition for these “assets” is incredible, by all accounts I’ve heard. Money is no object.

Here’s why – low interest rates (yes they’re still low) for a decade now have pushed huge pools of capital further out onto the risk curve. They’ve also made companies that rely upon borrowing look way more profitable than they’d ordinarily be.

This can go on for awhile but not forever. And when the music stops, a lot of these rolled-up private equity creations will not end up being particularly sexy. Whether or not the pain will be greater for private vs public companies in the next recession remains to be seen.

The Institutional Investor outright calls a bubble in its recent piece, “Everything About Private Equity Reeks of Bubble. Party On!” They note:

The private equity capital-raising bonanza has at least one clear implication: inflated prices.

Buyout multiples last year climbed to a record 10.2 times earnings before interest, taxes, depreciation, and amortization, according to S&P Global Market Intelligence. This year they remained elevated at an average of 9.5 times ebitda through May, a level surpassing the 2007 peak of the precrisis buyout boom.

When you’re buying assets at inflated prices/values and levering them up to fund the purchase, what could possibly go wrong?

*****

What really caught our eye is Brown’s statement about medical practices. Ownership there can be direct via outright purchases. Or they can be indirect, through loans. Which, in a rising rate environment, may ultimately turn sour.

Consider for a moment the recent news that private equity is taking over from and competing with banks in the direct lending business. KKR, Blackstone Group, Carlyle Group, Apollo Global Management LLC and Ares Management LP are all over the space, raising billions of dollars, the latter recently closing a new $10 billion fund in Q2. They’re looking at real estate, infrastructure, insurance, healthcare and hedge funds. Per The Wall Street Journal:

Direct loans are typically floating-rate, meaning they earn more in a rising-rate environment. But borrowers accustomed to low rates may be unprepared for a jump in interest costs on what’s often a big pile of debt. That risk, combined with increasingly lenient terms and the relative inexperience of some direct lenders, could become a bigger issue in a downturn.

Regulators like that banks are wary of lending to companies that don’t meet strict criteria. But they are concerned about what’s happening outside their dominion. Joseph Otting, U.S. Comptroller of the Currency, said earlier this year: “A lot of that risk didn’t go away, it was just displaced outside of the banking industry.”

What happens when the portfolio companies struggle and these loans sour? The private equity fund (or hedge fund, as the case may be) may end up becoming the business’ owner. Take Elements Behavioral Health, for instance. It is the US’s largest independent provider of drug and alcohol addiction treatment. In late July, the bankruptcy court for the District of Delaware approved the sale of it the centers to Project Build Behavioral Health, LLC, which is a investment vehicle established by, among others, prepetition lender BlueMountain Capital Management. In other words, the next time Britney Spears or Lindsay Lohan need rehab, they’ll be paying a hedge fund.

The hedge fund ownership of healthcare treatment centers thing doesn’t appear to have worked out so well in Santa Clara County.

These aren’t one-offs.

Apollo Global Management LLC ($APO) is hoping to buy LifePoint Health Inc. ($LPNT), a hospital operator in approximately 22 states, in a $5.6 billion deal. Per Reuters:

Apollo’s deal - its biggest this year - is the latest in a recent surge of public investments by U.S. private equity, the highest since the 2007-08 global financial crisis.

With a record $1 trillion in cash at their disposal, top private equity names have turned to healthcare. Just last month, KKR and Veritas Capital each snapped up publicly-listed healthcare firms in multi-billion dollar deals.

Indeed, hospital operators are alluring to investors, Cantor Fitzgerald analyst Joseph France said. Because their operations are largely U.S.-based, hospital firms benefit more from lower tax rates than the average U.S. company, and are also more insulated from global trade uncertainties, France said.

Your next hospital visit may be powered by private equity.

How about dentistry? Well, in July, Bloomberg reported KKR & Co’s purchase of Heartland Dental in that “Private Equity is Pouring Money Into a Dental Empire.” It observed:

In April, the private equity powerhouse bought a 58 percent stake that valued Heartland at a rich $2.8 billion, the latest in a series of acquisitions in the industry. Other Wall Street investment firms -- from Leonard Green & Partners to Ares Management -- are also drilling into dentistry to see if they can create their own mega chains.

Here’s a choice quote for you:

"It feels a bit like the gold rush," said Stephen Thorne, chief executive officer of Pacific Dental Services. "Some of these private equity companies think the business is easier than it really is."

Hang on. You’re saying to yourself, “dentistry?” Yes, dentistry. Remember what Brown said: recurring revenue. People are fairly vigilant about their teeth. Well, and one other big thing: yield baby yield!

The nitrous oxide fueling the frenzy is credit. Heartland was already a junk-rated company, with debt of 7.4 times earnings before interest, taxes, depreciation and amortization as of last July. KKR’s takeover pushed that to about 7.9, according to Moody’s Investors Service, which considered the company’s leverage levels "very high."

Investors were so hungry that they accepted lenient terms in providing $1 billion of the leveraged loans that back the deal, making investing in the debt even riskier.

Nevermind this aspect:

Corporate dentistry has come under fire at times for pushing unnecessary or expensive procedures. But private equity firms say they’re drawn by efficiencies the chains can bring to individual dental practices, which these days require sophisticated marketing and expensive technology. The overall market for dental services is huge: $73 billion in 2017, according to investment bank Harris Williams & Co. Companies such as Heartland pay the dentists while taking care of everything else, including advertising, staffing and equipment. (emphasis added)

Your next dental exam powered by private equity.

Sadly, the same applies to eyes. Ophthalmology practices have been infiltrated by private equity too.

Your next cataracts surgery powered by private equity.

Don’t get us wrong. Despite the fact that we harp on about private equity all of the time, we do recognize that not all of private equity is bad. Among other positives, PE fills a real societal need, providing liquidity in places that may not otherwise have access to it.

But we want some consistency. To the extent that Congressmen, members of the mainstream media and workers want to bash private equity for its role in Toys R’ Us ultimate liquidation and in the #retailapocalypse generally, they may also want to ask their emergency room doctor, dentist and ophthalmologist who cuts his or her paycheck. And double and triple check whether a recommended procedure is truly necessary to service your eyes and mouth. Or the practice’s balance sheet.

Private Equity & Toys R Us (Long Active Management. Yield Baby Yield)

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A Canadian Property Bubble? ($HCG, $OCN, $APO, $BX)

Last week we mentioned Canada's emerging property bubble. After reading this warning from BlackRock and then this alarming report by RMG Investment Management (out of the UK), perhaps we should've been a bit more focused on it. In a nutshell, they query whether the Home Capital Group (HCG) collapse roughly a week ago - taking a massive and expensive credit facility, stock plummeting, short seller Marc Cohodes ranting and raving - is the precursor to "the bubble" bursting. At five pages, the report is a bit lengthy but it's worth it. The chart within juxtaposing Canadian housing vs. US housing is particularly interesting. As is the fact that Steve Eisman's investment idea at the Sohn Conference in 2013 was to short Canadian housing, including HCG. We wonder if he had the patience to maintain that short over this duration. Either way, perhaps this is all a moot point if, as reported by Reuters, buyout firms such as Apollo Global Management LLC, Blackstone Group LP and Centerbridge Partners LP are looking to buy HCG. Meanwhile, stateside, Ocwen Financial's problems seem to be mounting.