Leveraged-buyout firms led by billionaire Leon Black’s Apollo Global Management LLC (APO:US), seeing fewer bargains in acquiring companies, are loading up on high-risk debt being abandoned by the world’s biggest banks.
Apollo’s credit unit has swelled to $103 billion in assets from about $4 billion in seven years, first by buying loans from banks hurt by the 2008 financial crisis and now by benefiting from regulations designed to prevent a repeat of that event. The expansion has put the company co-founded by Black, known for acquiring companies such as Vail Resorts Inc. (MTN:US), at the forefront of private-equity firms from Blackstone Group LP to KKR & Co. scooping up debt as banks unload.
This shift carries its own risk, as returns on credit assets have plunged to about half what they were a year ago, after the Federal Reserve said it would trim its $85 billion a month stimulus program. Still, private-equity firms see an opportunity to offset a buyout market that has shrunk 80 percent in six years, looking especially at Europe, where banks have sold more than $1.1 trillion of assets since the end of 2011, according to the European Banking Authority.
Banks are retreating and firms like Apollo are there to fill the void. “It’s not cyclical, it’s a secular change,” James Zelter, head of New York-based Apollo’s credit unit, said in an interview.
The shift comes as buyout deals are drying up. The number of global transactions has been sliding since 2010, including a 14 percent drop last year, as higher prices made it a better time for private-equity firms to sell than buy. The volume of deals in 2013 was down 80 percent to $141 billion from its 2007 peak of $696 billion, according to data compiled by Bloomberg.
Credit accounts for about 66 percent of Apollo’s assets, compared with 24 percent for Blackstone (BX:US) and about 23 percent for KKR.
Buyout firms are getting into credit as gains on corporate debt retreat. Returns on speculative-grade loans last year fell to 5 percent from 10.5 percent in 2012, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index. High-yield, high-risk bond returns dropped to 7.4 percent from 15.6 percent in 2012, according to the Bank of America Merrill Lynch U.S. High Yield Index. The S&P 500 Index (SPX) of U.S. stocks rose 29.6 percent last year.
Banks arranged in 2013 a record $687.8 billion of leveraged loans, a type of high-yield, high-risk corporate debt that they sell to investors such as Apollo, as concern rose that their underwriting standards were deteriorating. The Fed and the Office of the Comptroller of the Currency sent letters to some of the biggest banks last year asking them to avoid originating loans that could be “criticized,” or having some deficiency that may result in a loss, Bloomberg News reported Oct. 24.
While the practice continues, the opportunities to invest in debt have changed in the last five years.
Apollo is seizing on “once-in-a-decade opportunities” to expand its credit business through investments in Europe and the U.S., including insurance assets and consumer loans, according to Zelter.
The firm last year bought Valencia, Spain-based Bankia SA’s auto and consumer loan unit, with a balance of more than 873 million euros (about $1.18 billion) of receivables. In September, Apollo’s European Principal Finance Fund II agreed to purchase EVO Banco, an 80-branch retail bank in Spain from NCG Banco SA, and this year it completed the purchase of Madrid-based Banco Santander SA’s non-performing real-estate loans and assets unit.
Apollo in 2012 acquired Stone Tower Capital LLC, a New York-based credit manager with about $19 billion of assets at the time of the deal, according to a regulatory filing. Its purchase of Gulf Stream Asset Management, a Charlotte, North Carolina-based manager of collateralized loan obligations in 2011 added $3 billion of assets.
Apollo’s Athene Holding Ltd., a life insurance company that provides fixed-annuity policies to retirees, bought London-based Aviva plc’s U.S. annuity operations in October, increasing its credit unit by about $45 billion of assets. The purchase brought Athene’s assets to $60 billion and Apollo will be steering a portion into its debt funds, according to a statement at the time.
The firm got into fixed-annuities as traditional providers found it harder to profit from them with interest rates so low, and began leaving the business, according to Brennan Hawken, a New York-based equity analyst at UBS AG. Rising rates will tempt insurance companies back into the market, increasing competition for Apollo, he said.
“The outlook for Athene to continue its growth is no longer nearly as robust” as before the Fed said it would taper its monthly bond purchases, sparking a rise in long-term interest rates, he said.
Black hired Zelter, 51, from Citigroup Inc. in April 2006, where he was the head of the New York-based bank’s alternative investments group. The amount of assets in Apollo’s credit unit is more than double the firm’s $43 billion in private-equity and is about two-thirds of its total $157 billion of assets. Apollo’s shares (APO:US) climbed 82 percent last year to $31.61, and were down less than 1 percent today to $31.63 at 12:21 p.m. in New York.
For Apollo, the credit unit is “critical” and will be the primary driver of growth over the next decade, Howard Chen said in a Dec. 3 interview while an analyst for Credit Suisse Group AG. New York-based Chen is now the bank’s global head of financial technology and financial strategies.
In addition to supplementing Apollo’s “more mature” private-equity side, the credit business will provide relatively stable earnings from senior debt, Chen said. Moody’s Investors Service estimates the global speculative-grade default rate will be 2.3 percent at the end of this year, down from 2.6 percent at the end of 2013 and below the historic average of 4.7 percent since 1983.
Apollo was co-founded in 1990 by Black, Joshua Harris and Marc Rowan, all of whom worked at Drexel Burnham Lambert Inc., where Michael Milken was pioneering the use of high-yield junk bonds in leveraged buyouts.
Apollo’s growth in credit jumped after Lehman Brothers Holdings Inc.’s September 2008 failure, to $15.1 billion at the end of that year, from $4.4 billion in 2006, as the firm took advantage of frozen markets to buy corporate loans at steep discounts. Banks were stuck holding billions of dollars of LBO loans they underwrote before the financial crisis, and unloading that risk from their balance sheets meant selling it at a discount.
The average price of bank debt rated below investment-grade fell as low as 59.2 cents for every dollar of face value in December 2008, three months after Lehman failed, from 100.3 cents at the start of 2007, according to the S&P/LSTA U.S. Leveraged Loan 100 index. Prices were at 98.56 cents yesterday, after climbing to 98.9 cents on Jan. 17, the highest since July 2007.
The $1.5 billion Apollo Credit Opportunity Fund I LP, raised in 2008 primarily to invest in leveraged loans, had a 30.4 percent gross internal rate of return at the end of September, according to a regulatory filing. The $1.6 billion COF II, formed the same year, had a 13.8 percent return, the filing shows.
Apollo is raising its third credit opportunity fund, with almost $700 million of new capital in the third quarter, according to a transcript of a November earnings call with analysts. The firm’s investors include pension plans, sovereign wealth funds, endowments and wealthy individuals, who are increasingly giving Apollo broad flexibility to invest in various types of debt, Zelter said.
The “ultimate challenge” is to increase returns in an otherwise low, nominal yield environment, John Skjervem, chief investment officer for the Oregon State Treasury, said in a telephone interview. The Treasury manages $87.5 billion of state assets, including the $68 billion Oregon Public Employees Retirement Fund, which invests in Apollo’s private-equity funds and engaged KKR for a separate account targeting credit. About 20 percent of the fund’s holdings are in fixed-income, including high-yield bonds and bank loans, Skjervem said.
Apollo is still finding returns above 10 percent for its investors by “filling in a variety of funding gaps,” according to Zelter.
“There’s a whole host of activities as a result of the financial crisis and the changing world,” with attractive investments in everything from shipping loans to credit card debt, said Zelter, who after graduating from Duke University in Durham, North Carolina began his career on Wall Street trading high-yield bonds at Goldman Sachs Group Inc. “Banks, in terms of proprietary activities, have dramatically reduced their lending in these areas.”
The Volcker Rule, named after former Fed Chairman Paul Volcker and a part of the financial overhaul mandated by the Dodd-Frank Act in 2010 to prevent a repeat of the global financial crisis, was adopted on Dec. 10 by all five U.S. regulators. It bans banks with federally insured deposits from using their own capital to place speculative bets that could threaten their stability.
JPMorgan Chase & Co., the largest U.S. bank, is seeking to sell its $2 billion Global Special Opportunities unit, which invests the New York-based bank’s money in distressed debt, non-performing loans and private equity, Bloomberg News reported in December.
Credit Suisse, the second-biggest Swiss bank, plans to trim risk-weighted assets at businesses it will exit by 58 percent by the end of 2015 from Sept. 30 levels, the Zurich-based company said in a Jan. 7 statement on its website.
While firms such as Apollo are regulated by the U.S. Securities and Exchange Commission, they don’t have the same constraints as banks because they don’t hold deposits.
“Almost all the action today is around the debt business,” Apollo co-founder Rowan said Dec. 10 at Goldman Sachs’s financial services conference. “We have been given this incredible investment opportunity which is the secular rotation out of the banking world and into the investment world, and the primary products that are coming are credit.”
The firm last year owned debt of companies including First Data Corp., Laureate Education Inc. and Avanti Communications Group plc, according to a regulatory filing in November. It’s among lenders negotiating the reorganization of Energy Future Holdings Corp., the Texas utility formerly known as TXU Corp. that was bought by KKR, TPG Capital and Goldman Sachs for $48 billion in the biggest buyout ever.
Apollo was the ninth largest global manager of CLOs, which buy junk loans, at the end of June based on $9 billion of assets, according to Moody’s, while raising its first European pool last year. Apollo increased CLO assets to $9.8 billion at the end of September, according to a regulatory filing.
Zelter is now pushing into dollar-denominated senior secured credit in emerging markets, bringing on a team over the last nine months to invest in investment-grade and high-yield debt. The firm is targeting developed areas of Latin America, the Middle East and Asia, including Korea and Malaysia, according to Zelter.
“Credit markets are bigger than the equity markets,” he said.
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