Zombie Companies roaming LBO Land in a long distressed cycle

December 01, 2009  

There was a spike in defaults when the recession occurred, but these companies have a common characteristic: fundamental business or highly cyclical problems.

Jason Mudrick
Many investors are asking if this distressed cycle is over. The simple answer is absolutely not. We are, in fact, still in the first inning of a cycle that will not peak until 2014.

To provide some perspective let’s first distinguish between what happened in the last twelve months and what is likely to happen over the next five years. What happened in the fourth quarter of 2008 and first quarter of 2009 was a massive selling of assets caused by deleveraging and panic. This massive liquidity outflow resulted in many debt securities trading at distressed levels. However, these securities were trading at distressed levels because of distress in the market place, not because of distress among the issuers of the debt securities. Investing in the fourth and first quarter in any asset class was a great trade, but it was not distressed investing in the classic sense. Distressed investing is using the actual or potential balance sheet restructuring process as a catalyst to capture the spread between trading values and inherent values. This is often the result of a default.

There was a spike in defaults when the recession occurred, but these companies have a common characteristic: fundamental business or highly cyclical problems. However, there is another problem affecting hundreds of companies we analyze that are not in default, and that is extremely excessive leverage. Many of these companies actually have sound businesses but have terrible capital structures. This is the safest type of company for distressed investing. Because of the growth of yield seeking investment firms and, in particular, structured products such as CLOs that did not have to keep these leveraged loans on balance sheet, 2005 though 2008 witnessed in excess of $1.6 trillion in transactions financed often with extremely high leverage. According to Credit Suisse, average total debt to EBITDA multiples of LBOs consummated in 2006, 2007 and 2008 was 7.2x, 7x and 8.2x, respectively. These are the highest average multiples ever seen, and this was prior to the severe earnings contraction that occurred in this recession. These multiples now are all high single digit to low double digits, in some cases.

Many of these businesses are effectively insolvent, but have not defaulted. Why? Because the leverage employed in this credit bubble has extremely low floating rate coupons and little to no covenant protection. Low rates prevent interest payment defaults and lax or no covenants remove the mechanism historically used to force companies to restructure. Given what has happened to the banking and hedge fund sectors and how bad corporate earnings have been hit, many have chosen to kick the can down the road and deal with it later by amending and extending the terms of the loans –"extending and pretending." The problem is that banks and structured products no longer lend at 8x EBITDA, but rather at more normal levels such as 3-4x EBITDA, and they want to get paid for it. Accordingly, when these companies’ debts mature and they need to refinance, they will have a very big problem. They either will not be able to refinance their levered balance sheets or they will not be able to afford what it will cost them in interest expenses to do so. Regardless a balance sheet restructuring is inevitable, but in this cycle the catalyst will often be the debt maturity, not the recession.

Unfortunately, as is so often the case, spreads on these capital structures have been driven tighter not by distressed debt investors buying in anticipation of a restructuring, but by capital that has come out of low rate money market funds into high yield mutual funds and other retail targeted products that buy for yield. These types of buyers cannot hold defaulted paper and when defaults begin to accelerate again in the second half of 2010 and 2011 this could result in a bloodbath for these investors.

More than $1 trillion of leveraged loans and high yield bonds mature during the next five years peaking in 2014, most of which was raised during times of lax lending standards. Many of these companies are not technically in default, but are effectively insolvent. Insolvent companies that are focused on cost cutting demands by their financial sponsor owners and unable to do value creating exercises such as research and development and strategic acquisitions. These zombie companies, the walking dead, will provide supply of distressed situations for years to come as the clock ticks down on their insolvent capital structures.

Jason Mudrick is founder and chief investment officer of Mudrick Capital, a New York hedge fund firm launched in July 2009 focused on distressed and deep value event-driven investing. He was formerly a managing director and portfolio manager at Contrarian Capital Management where he oversaw a $400 million distressed portfolio.


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