Markets & Finance

The Merchants of Red Ink


In recent years, with interest rates low and credit easy, U.S. companies have gorged on high-yield debt. There was more than $1 trillion worth of high-yield issues in the U.S. last year, up from $750 billion in 2002.

That has attracted the attention of a flock of private-equity investors and hedge funds, who are looking for investment opportunities as these debt-laden companies run into trouble. They're looking for companies with distressed debt, typically companies that have either filed for bankruptcy or are headed in that direction. The hedge fund and private-equity investors are looking for fundamentally sound companies that have taken on too much debt, so they can restructure them and sell them to another buyer for a profit.

But will these opportunities of ill fortune materialize? Despite the years of easy credit, the default rate on so-called junk bonds is at a record low. The percentage of defaults was just 1.6% last year, according to analyst Diane Vazza of Standard & Poor's. That's down from a recent peak default rate of 10.51% in 2001.

That's frustrated a number of hedge funds with an interest in distressed debt. Steven Persky, founder of Los Angeles hedge fund Dalton Investments, announced May 1 that he was closing two successful distressed-debt funds and returning $300 million to investors. "Although the past performance of these funds was excellent, we believe it will become increasingly difficult to produce above-average returns with a distressed strategy for the foreseeable future. We will best serve our investors by returning their capital so they can redeploy it in other strategies," Persky said in a written statement.

CREDIT CRUNCH. Many of the obvious opportunities in troubled industries such as auto parts and paper goods have been taken. Appaloosa Partners, a hedge fund run by former chief Goldman Sachs junk-bond trader David Tepper, bought 9.3% of auto-parts maker Delphi last fall (see BusinessWeek.com, 8/8/05, "Bankruptcy Is Delphi's Trump Card"). Other hedge funds such as Silver Point, of Greenwich, Conn., and Cerberus Capital Partners, of New York, have been making bets on distressed debt, as well. Cerberus bought a paper business from MeadWestvaco last year for $2.3 billion. Silver Point, run by Goldman alum Ed Mule, focuses on credit-related investments. "There's an awful lot of money chasing relatively few ideas at this point," says Steve Hurwitz, a portfolio manager at Omega Advisors, the hedge fund started by yet another Goldman alum, Leon Cooperman (see BusinessWeek.com, 6/12/06, "The Leadership Factory").

Still, some investors anticipate an increase in bad credit. Interest rates are rising, energy and commodity prices are going up, and the housing market is slowing down. The U.S. government reported on June 2 that the country produced only 75,000 jobs during the last month, less than half what was expected. For investors in distressed debt, that's a sign that the economy is slowing down, and that weak companies will be flushed out. Vazza expects the default rate on U.S. corporate debt to hit 2.6% by the end of this year. She forecasts that it will hit 4.6% by the end of 2007, returning it to its long-term average.

Many companies are carrying huge loads of debt. Corporate borrowers traditionally carry a debt load of perhaps five times their earnings before income taxes, depreciation, and amortization (known as EBITDA in finance circles). "But we are seeing companies with seven, eight, nine times EBITDA. Is that prudent?" says John O'Neill, a partner with Ernst & Young Transaction Advisory Services. O'Neill, a consultant who helps private-equity firms vet their deals, says many people expect that the high debt loads will be hard to service if the economy shifts into lower gear.

HOLDING THE BAG. Much of the debt has been accumulated in industries with hard assets that can be used as collateral in the event of trouble. Those sectors include auto parts, consumer goods, restaurants, and paper companies.

Buyouts are getting bigger all the time, and often involve huge amounts of debt. ANC Rental sold its Alamo and National car rental businesses to Cerberus Capital last year. Cerberus paid just $230 million, but took on more than $2.2 billion in debt. A group of private-equity investors bought financial firm SunGard last year for $11 billion, putting up just $3.5 billion in cash. In February, MeriStar Hotels sold itself to Blackstone for $2.6 billion, plus $1.6 billion in debt.

If the level of distressed debt rises, there could be an interesting dynamic between hedge funds and private-equity investors. Over the last few years, private-equity firms have acquired countless firms and loaded them up with debt, which increases the return on the private-equity firm's investment. But if these investments fail, hedge funds could step in, buy up the distressed debt, and replace the debt with equity as the failed company goes through bankruptcy. "Some private-equity firms could get left holding the bag," O'Neill says.

CHAPTER 22. There's plenty of risk to go around, though. Some private-equity players believe that it's the hedge funds that will wind up getting burned as the distressed-debt market heats up. Billionaire private-equity investor Wilbur Ross (see BusinessWeek.com, 12/22/03, "Is Wilbur Ross Crazy?") says the hedge funds' short-term investment horizon might not serve them well in the market for distressed debt. Ross has made $4 billion worth of private-equity investments in troubled companies since 2000, when he left Rothschild Investments and started WL Ross & Co. Ross says his firm takes a seat on the board of companies that it invests in, and works with management to improve the business over a period of several years.

But he says hedge funds often have a different approach. He says they typically offer "second lien financing" to companies that don't qualify for additional bank credit. These loans solve an immediate liquidity crunch. "But usually just putting money in isn't enough to fix a business," Ross says.

In some cases, hedge funds could be wiped out as distressed companies go back into Chapter 11 bankruptcy. "In our industry, that's called a Chapter 22," Ross says. The sheer volume of capital chasing distressed debt could depress the margins of distressed-debt investing. In the past, distressed debt often has traded at 50 cents or 60 cents on the dollar, or less. But there are so many potential buyers of troubled companies that the debt may get snapped up for 70 or 80 cents on the dollar. That means investors must pay more money to take control of a troubled company.

Even if a profitable exit can be found, the margins may be lower than they have been on distressed deals of the past.


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