Monday, June 16, 2008
the PIK-toggle 'debt-bomb'
The buyout boom removed hundreds of stocks from the coverage lists of Wall Street equity research shops. But while private-equity firms have lessened the burden of stock jockeys, their debt-laden purchases have created more work for bond analysts. And a year after the credit crunch ground the LBO craze to a halt, these debt researchers are beginning to digest all this new debt that surrounds them.
And they don’t like what they see.
Standard & Poor’s analyst Diane Vazza issued today the niftily titled report “PIK-tok, PIK-tok, Delaying the Inevitable.” The piece looks at PIK-toggles, the risky debt structure created during the easy-money LBO boom. “Payment-in-kind toggles” allow a company to shut off cash payments and pay interest by issuing more debt instead. While the flexible financing terms allow companies to conserve cash during stress periods, Vazza writes that “for firms with poor financial prospects, the issuance of PIK-toggle notes might only be delaying the inevitable and could likely deteriorate the recovery prospects for non-PIK debt holders.”
Vazza singles out Welsh Carson’s buyout of U.S. Oncology as a poster child for the problematic situation where companies exercise the toggle feature when earnings are declining. The health-care outfit flipped the toggle switch on during the first quarter, at a time when its pretax earnings declined 37.5% from the year-earlier period.
The S&P report follows one issued Thursday by the debt analysts over at Fitch, who also are none too keen on the crop of LBO deals done from 2004 to 2007. They looked at about 200 “golden age”-era LBOs and concluded that the credit quality of these companies has “visibly eroded” since last summer.
“The risk of default is rising,” they write, sounding a warning bell for the roughly $450 billion of LBO-linked leveraged loans that came to market in those halcyon days of yore. About half of the companies they analyzed had a negative outlook or were on review to be downgraded (with only 3% having a positive outlook).
The report leads off by mentioning the high-profile bust of Apollo’s Linens ‘n Things, and suggests that Linens could be the tip of the default iceberg in retail/consumer land. Consumer cyclical LBOs, which account for about a quarter of the companies Fitch examined, are “particularly sensitive to the type of macroeconomic weakness and consumer retrenchment the US economy is currently experiencing.”
just another, less publicized aspect of the potentially catastrophic debt bubble-and-unwind we are now facing. commenter darkcloud offered this note from financial sense, which cites through the banking times the june 2008 quarterly review published by the bank of international settlements. the BIS has (to its credit) been sounding the alarm on an underestimated potential for disaster for more than a year. the view is gaining adherents, it seems -- yves smith passes on the comments of stricken insurer AIG's analyst bernard connolly, who discourses on a "crisis of capitalism" and warns against raising policy rates. says smith:
While I am not certain I agree fully with Connolly's analysis, I do think the Fed has cut too deeply, too fast. As much as it would be better for rates to be higher, I'm not certain if we can get from A to B right now. The financial system is a mess. For instance, banks for some time have been well behind on foreclosures; it appears this is by design, so as not to alarm the public and shareholders. Similarly, the Bank of England says banks are hoarding cash, another sign of fragility. The Fed somehow hoped that banks would recapitalize in this window of improved market conditions, but they haven't to even remotely the degree necessary, and the losses in the pipeline are probably worse than the Fed has been willing to admit to itself.
As much as I don't like coddling banks, my sense is things are far more precarious than they appear. I'd rather see the Fed sit tight for three or four months and see if demand destruction due to high oil prices and a cut in subsidies in developing countries (particularly China, which has said it will lower supports and may take action after the Olympics) puts some downward pressure on oil prices.