This chunk of the economy could see a lot more than “some pain”
Interest rates hikes and inflation are here. That means trouble for the near third of US public companies that can't afford their loans.
But first, a story about Bob.
Bob and his family aren’t quite living the American dream. They have a big house in the suburbs that they can’t afford and a timeshare in Myrtle Beach that they rarely visit.
Bob’s kids asked for a pool, so Bob went all out to spend 60 grand. He financed it through a home equity line of credit and credit cards for which he fibbed about his annual income to get a bigger limit.
After covering his family’s needs, Bob’s household income isn’t enough to pay the interest on his debts, many of which have variable interest rates. Bob wants to take out a third mortgage to make ends meet.
No one would give Bob the loan, right? Right.
For a company, it’s a different story.
In fact, Bob’s situation resembles that of the 29 percent of public companies in the United States that don’t make enough income before taxes and interest (EBIT) to cover the interest on their debts. That figure excludes small firms below $500 million in enterprise value and financial services companies, which often take on more debt than most. Many of these companies, including Revlon, Boeing, and Bed Bath & Beyond, have obtained untenable levels of debt.
Companies can end up like this by adjusting their earnings that lenders use to decide how much debt borrowers can support. They negotiate “covenant lite” (“cov-lite”) terms that prevent creditors from inserting themselves when a borrower is in financial distress. And they pay for their debt with more debt.
Sometimes, borrowers even strong-arm their creditors to get more cash. For example, two months ago, Diamond Sports Group, an aggregator of local sports networks that most investors would say is worth $2 to $3 billion but has over $8 billion in debt, forced its creditors to give it a $600 million loan even though it continues to lose money.
Since the great financial crisis, corporate borrowers have avoided bankruptcy when they default on their loans. Rather than go through courts whose job it is to look out for a broad set of interests, companies cut deals with creditors through what are known as distressed debt exchanges. They negotiate down the amount of principal they need to pay. Often, they don’t trim enough debt. Companies that go through a distressed debt exchange are over 50 percent more likely to default on their loans again than companies that go through bankruptcy.
These companies just won’t restructure properly.
Many of the firms with less EBIT than their interest expense have a viable business model, but today those businesses cannot support the amount of debt on the books. Perhaps they never will.
Investors are playing a prolonged game of “chicken” with the dearth of living-dead companies. Like was the case for banks in Japan in the 1990s, borrowers want a chance to turn things around and creditors are incentivized to keep the dream alive.
Bankruptcies are expensive and they limit the optionality of managers. They kill the option value managers and equity sponsors hold to see upside from improving their business. And many creditors, especially those holding debt in collateralized loan obligations (CLOs), are structured in such a way that it doesn't make sense to push for a bankruptcy.
This could end painfully.
Federal Reserve Chair Jerome Powell reiterated this month that the U.S. central bank’s plans to cool the economy could cause “some pain.” This is after the Fed instituted the largest hike of its benchmark federal funds rate in two decades.
A combination of higher interest rates, inflation, and declining asset values will bring a world of hurt to companies that already have too much debt. Those same forces could turn struggling firms into zombie companies, firms that persistently are unable to service their debt.
Warren Buffett is quoted as saying “Only when the tide goes out do you discover who's been swimming naked.” Zombies don’t go down quietly; they drag others with them. Such was the case in Japan. If lending practices don’t tighten up, we might see a slew of exposed bums.
Given all of the regulation on bank balance sheets, most of the risky corporate lending in the US is done by asset managers deploying private capital. As borrowers come under pressure, investors in these funds should urge for tighter covenant language in new credit documents and amend the terms with their CLO managers to provide them with more flexible mandates. 90% of leveraged loans are funded with money from CLOs, most of which have mandates that make them passive investors in the issuance and administration of corporate debt. That is up from less than 20% after the great financial crisis.
If investors do not step in, regulators and legislators will.
Corporate zombies are a drain on the economy. Investors can do controlled burning before more tinder accumulates.
About the Author: Ben is an investor, MBA candidate at Stanford Graduate School of Business, and was the youngest director at Apollo Global Management, one of the largest private equity and credit asset managers. He is a student of capital structure and financial restructuring. Recently, he published "How Do Zombies Stay Alive?" a 30-page report on corporate distress and its links to debt markets.
