The Outlook for Distressed Debt

A little over a week ago, I penned a piece entitled Credit = En Fuego. On that day, August 10th, the HY12 Index closed at 91.125-91.375. Today, the market closed at 87.4375-87.6875. Call it down 3.5 points or approximately 4%. In the same time, equity markets, as measured by the S&P have moved from 1007 to 996 or a cumulative move of 1.1% down. What gives?

First of all, and most of my credit brethren will have noticed this, but it seems like the equity markets have started to disconnect from the credit markets. This happens sometimes and more often than not it portends a shift in underlying technicals / fundamentals. Unfortunately, I am not a tea-leave kind of reader and I can't tell you where markets will be a week, a month, or even a year from now. But I pride myself on calling the extremes, and as of a week ago, credit markets were at an extreme.

That being said, and given the dearth of posting around these here parts, what is the outlook for distressed debt in the coming years? And I do not mean in terms of return; I mean in terms of opportunity set.

Henry Kravis, an investor I highly respect, was on the KKR Private Equity Investor LP call yesterday. Here are some interesting quotes from the prepared comments and Q/A...

"For the first half of the year, the S&P Loan Index return was up 32.2% as compared to a 2008 record loss of 29.1%. The Merrill Lynch High Yield Index returned 29.4% through June as compared to a loss of 26.4% in 2008.

Returns on both entities increased further through the end of July 2009. These positive indicators are tempered by continued weakness in consumer spending, consumer confidence, retail sales, and a very high unemployment rate.

We characterize the current environment as one of stabilization. Capital markets are calm, liquidity has improved. But as a general rule, businesses continue to drive earnings growth more through cost reductions than revenue improvements."

What has really frightened me after listening to a myriad of conference calls throughout a number of industries is the serious lack of top line growth / stabilization / confidence in the future. If more Americans are contributing more to their 401k or more to their bank account, what does that do for earnings momentum in the future, especially considering fixed costs can only be cut so much before quality of service/product is reduced. An analogy I made in the past to investors was such: Assume you have a company trading at 18x earnings and nominal

earnings growth drops from 8-10% per annum to 3-4% per annum. How many turns would you deduct from said enterprise? Generally I get a number of 4 or 5 turns. Well this is exactly the situation the S&P is in right now. Assume, just for a second, that Warren Buffett is right in that ROE's across the U.S. markets generally approach 12%. Current book value per share on the S&P 500 is nearly 500 points. So let's say normalized earnings are $60. Deducting those 4 or 5 turns from the 18x leaves us with 13-14x earnings or $780-$840 versus a current value of $996.

What I am saying is something has to give. Earnings growth is limited from expense cuts. By projecting a massive growth in earnings on the market in the aggregate, you are essentially saying that gross margins are going to reach multi-century highs or sales growth is going to be robust. Can anyone point me to one or two supporting data points that sales growth is going to be robust?

More stuff from the conference call:

"As you are undoubtedly aware the global debt markets faced a looming wall of debt maturities over the next few years with approximately $560 billion of leverage loans and $420 billion of high yield bonds maturing prior to 2015."

And this is where it gets exciting. I am going to lay out a lovely graph, taken from LSTA's Distressed Loan Market Conference.

This chart lays out maturing levered loans, and the ability of the CLO machine to refinance those maturities.

The big, humped line (colors are hard to tell from this cut/copy job) is refi'ing Term Loans. And the declining lines are theoretical reinvestment curves of CLOs. Unfortunately, for all market participants, CLOs accounted for more than 60% of all loan demand from 2001-2006, with the second highest participation coming from distressed and high yield hedge funds. Well lets make two common sense assumptions: 1) there are less CLOs and 2) there are less distressed and high yield hedge funds. In aggregate, there are a lot less dollars to feed the refinancing machine.

The current balance of CLOs is slightly over $250B over a set of nearly 575 deals. Sadly, most of those CLOs are already full on their CCC baskets, which makes appetite for high risk issues / issuers even less robust. A recent LSTA poll has 29% of participants answer that the $500B+ of levered loans will not be able to be refi'd. Need I remind you 29% of $500B is nearly $150 billion.

$150 billion of defaulted paper. Holy cow. Assume that paper trades in the aggregate at 50 cents on the dollar and you have now $75B of capital needed to soak up lingering supply. That is a lot of money. Especially considering that is just corporate loans. That number excludes all structured product and all high yield bonds that also may default / teeter on default.

Well, what is the solution? Borrowers can do distressed exchanges, can raise equity, pay down their debts with operating cash flows, or restructure (in or out of court). We have seen a myriad of distressed exchanges in the past few months. Unfortunately, that game will have to end when the re-investment period for CLOs are up. I doubt the equity markets will be robust enough to support that kind of volume and as mentioned above, I don't see how OCF is going to grow in the aggregate. So you are left with in and out of court debt restructurings. In other words, our hunting grounds.

That is why, at least in my opinion, one does not have to be super aggressive now and chase return (i.e. the mistake of 2007 all played out again). One can wait, take market independent bets (DIPs, merger arbitrage, basis trades), with the occasional directional play, and put up decent low double digit returns. And then, in the coming monsoon of defaults, you get to swing and swing big in situations with 40-50% IRRs with limited downside.

All I can say is: Get long bankruptcy attorneys.