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    Capital Markets | 4 min read

    Light a Match

    When you can’t borrow another buck from the bank or buy another case of booze, you bust the joint out. You light a match.”– Henry Hill – Goodfellas

    I have always wondered what the difference is between the mob “Bust Out” made famous in the movie “Goodfellas” and a Private Equity Leveraged Buy-out. In a mob bust out, your friendly organized crime gang becomes your business partner. If your business generates good cashflow and has decent access to credit, your new partners skim the cashflow and run up your credit with the purpose of putting lots of cash in their pockets until there is nothing left to pocket. Then, like Henry Hill said, you light a match.

    In a leveraged buyout, a private equity firm gets financing from usually a syndicate of banks, to purchase a target company while directing cashflow toward paying themselves and their investors in the form of fees and special dividends. In fact, with regard to special dividends, the private equity firm can actually borrow in the syndicated loan market (in the name of the acquired company) for the sole purpose of paying themselves a special dividend. I’ve never understood how something like that could happen legally but it happens all the time and regulators seem to be cool with it so who knows. Leveraged loans have been the rage for years now as we have been in some form of zero-rate, quantitative easing monetary policy since 2008. Trillions of investor dollars desperate for yield have been funneled into private equity investments.

    Private equity firms, armed with investor capital teamed up with banks, hungry to create large loans that brought them huge fees and structuring opportunities (Collateralized Loan Obligations), to take tens of thousands of companies over to “improve them.” Returns for private equity investors have generally been great, but you must wonder are all these companies so undervalued that leveraged buyouts should be so magnificently profitable? When the mob busts out a restaurant, it makes a fantastic return too, but nobody kids themselves about unlocking the untapped value of the restaurant! A good chunk of the outsized returns comes from leverage and redirecting cashflow into the private equity investor’s pockets.

    For this model for work, as it has for over a decade it needs two things, very low financing rates and very stable input prices. Many of the companies that make up the levered loan private equity acquisition financing (as well as financing for special dividends) are rated at the lowest levels of junk, B to CCC. Many of these companies have very tenuous cash flow profiles. Many of these companies make up a group labeled “Zombie Companies.” Zombie Companies are left negative cash flow after debt service. These companies, already in dangerous cash burn mode need to at least keep their profit margins intact. Therefore, if the Zombies cannot pass along the rise in input costs to the consumers of their products, they are in trouble. The zombies need demand for their product to be almost completely inelastic (demand for the goods or services a company produces does not change with price). Most legal product’s demand are not inelastic. Therefore, if rising cost of goods sold cannot be met with equally rising product pricing there is a problem.  

    Unfortunately, rising prices are not the only problem. As we saw this week, the Federal Reserve has gotten serious about taming inflation. A review of the FOMC member dot plot showed that the consensus estimate by Fed Governor and Fed Bank Presidents is three 25 basis point hikes in 2023. Raising the upper band of the Fed’s policy are from 25 basis points to 1% shouldn’t be that big of a deal as the rate would go from “extraordinarily low” to “very low.” However, when you are leveraged to the hilt and you are already burning through cash, raising higher funding rates becomes a huge problem. Currently, large, syndicated loan borrowers funding rates are indexed to Libor. What exactly happens when Libor goes away as it is supposed to do is for another day! Libor, in its current version, moves more or less lock steps with moves to the Fed’s effective Fed Funds rate so if the Fed raises 75 basis points, then junk company borrowing rates will move more or less by the same amount.

    For example, I took a large CLO deal and drilled down to the portfolio of junk loans in the deal. I picked one of the top holdings, a $783 million loan to YAK Access. S&P rates YAK CCC+, which is right near the lowest rung of junk. YAK looks like a very cool company. The build access “Mats” for access to pipeline, solar, and wind energy projects. Essentially, the mats protect the land that needs to be traversed while the energy source is being built or installed. This business seems to be very labor and material intensive; they are not making software or search engines. Continued elevated prices of material as well as labor have to be harming the company’s margins. Increased financing costs could be the killer. If the demand for these high-yield loans continues to be very strong, perhaps the company can refinance to a lower spread to Libor. Currently that spread is 500 basis points. However, the refinancing argument sounds eerily familiar to the subprime housing fiasco. “Don’t worry about the balloon payment, we’ll just refinance your loan to another teaser rate.” That worked out until it did not. Finally, there is the potential problem of demand elasticity. At a certain point, sharply rising costs can very well dent demand. With regard to a company like YAK Access that relies on environmental projects, the failure of President Biden’s Build Back Better bill, which included billions for alternative energy projects, should definitely hurt demand for their product.

    Over the last decade, as private investors have taken over thousands of companies, many of whom employ thousands of people, by adding leverage to balance sheets and redirecting cashflow. The balance sheets of the companies that collectively employ millions of Americans have been weakened to the point that it will not take much to tip them over. Inflation, elastic demand, and higher rates could be that tipping point to where it is time to “Light a Match.”

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    Investing involves certain risks, including possible loss of principal. You should understand and carefully consider a strategy’s objectives, risks, fees, expenses and other information before investing. The views expressed in this commentary are subject to change and are not intended to be a recommendation or investment advice. Such views do not take into account the individual financial circumstances or objectives of any investor that receives them. All indices are unmanaged and are not available for direct investment. Indices do not incur costs including the payment of transaction costs, fees and other expenses. This information should not be considered a solicitation or an offer to provide any service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Past performance is no guarantee of future results.

    Securities offered through SWBC Investment Services, LLC, a registered broker/dealer. Member FINRA & SIPC. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor, registered as such with the US Securities & Exchange Commission. SWBC Investment Services, LLC is under separate ownership from any other named entity. SWBC Investment Services, LLC a division of SWBC, is a nationwide partnership of advisor.

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    John Tuohy

    John Tuohy is CEO of SWBC Investment Services, LLC, a Broker/Dealer and SWBC Investment Company, an SEC Registered Investment Advisor (RIA). In his role, John is responsible for identifying, developing, and executing the division's strategic plan and all business development, sales, and marketing activities.

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