The Prince will not be taking Tony James’ tongue and cheek advice to go forth and tell the people that covenant-lite and PIK Toggle financing is good for society. The covenants that were attached to LBO debt in Spring 2007 and 2006 were so wide on cash-flow and operation requirements that you could drive a semi-tractor trailer through them and not trip a covenant. "I think everyone here should go out and tell everyone they know that PIK toggles and covenant-lite debt structures are good for society at large," James joked at The Deal’s Private Capital Symposium.
Even though Tony’s call for the attendees to go out a tell the people about the benefits of covenant-lite and PIK toggle debt was a joke, he did put up a valiant PR/charm offensive to try to defend these kinds of financing. Basically, his argument amounted to an argument about the damage done to companies by debt holders through a company into a bankruptcy and getting DIP financing. James argued that in most cases a liquidation of a struggling sponsored owned company is not the right move. By having more flexibility to not trip covenants and toggle to interest payments tacked onto principle allows companies to continue to operate, not fire employees, and fix themselves.
He downplayed the damage that this kind of debt does to senior debt holders. It is alright if James doesn’t have a problem with the senior debt holders taking a bath, but he should not complain when the senior debt holders and senior subordinate debt holders do not want to give him aggressive terms. James may also just be wrong when he makes the statement that defaults are low and will stay low because of loose covenants. It may just be the case that because of covenant-lite and PIK toggle features of recent LBO related debt there will be fewer warning signs since covenants will not get tripped and once the companies do go into default, they will be more badly damaged before the restructuring specialists and distressed investors get their hands on them. Basically, PE firms may get more rope to hang themselves with if they can take senior debt holders for a ride longer because of covenant lite and PIK toggle features on the debt that finances their portfolio companies.
Richard Shinder, a director in Goldman Sachs’ (NYSE:GS) Special Situations Group, made basically these arguments which James disagreed with in Q&A. There are plenty of banks and distressed investors that are staffing up right now for a major ramp up of defaults, so obviously not everyone agrees with James. Shinder coming over from Avenue Capital in and of itself serves as an example of Goldman Sachs staffing up for the start of a distressed explosion. A representative of S&P at the conference said that their worst case scenario put defaults at 8.9% in 2008.
Other panelists at the conference thought that the debt markets were pricing in a 10-15% default rate in 2008. In fact, no one was as rosy on where defaults would be as James, but what did we expect him to say? James attributes the lack of defaults in the face of a slowing economy to the covenant-lite debt terms portfolio companies received in the boom times. James said that, "Covenant-lite debt structures are not only private equity’s interest, they’re in everyone’s interest … The only one you might argue is not better off is the senior secured. By keeping the company intact, the private equity owners are able to fix the problems, and by preserving the employees, the customers and the business society at large benefits."
Here are some interesting quotes from Shinder, courtesy of The Deal:
"There are important factors affecting the marketplace. Even in deals that weren’t covenant-lite, the covenants were looser in general … What that will mean through this cycle is that those early warning signs that you had in prior cycles won’t be there anymore."
"Because you will have not had the intervention from turnaround advisers, businesses will be presented to [distressed investors] in a different state … because the opportunities to save the patient will have been missed. They’ll be more badly damaged from an operational point of view because there was no earlier intervention."
Also, let The Prince just point out that James really misrepresented his firm’s activities when he said that they were conservative users of leverage. Blackstone (NYSE:BX) was one of the most aggressive users of leverage and demanded the most concessions on covenants during the boom. Almost any banker who worked opposite Blackstone during the boom will confirm this. Just look at Freescale. Who cares what the comps are trading at, 8.5 turns of leverage on a technology company is absurd. Keep in mind that cash flows from this kind of company are way more variable than the industrial/manufacturing companies that PE firms have bought for years with successful results.
Please also believe The Prince when he says that if Blackstone and its partners could have gotten 10 turns of leverage from their lenders, they would have taken it. Blackstone, like other big buyout shops, does try to improve operations but lots of their returns do come from leverage. James said something like only 10% of Blackstone’s PE fund returns in the past came from leverage. That figure is immediately suspect and clearly misleading. How would one even go about coming up with such a number? How would you calculate it or determine which parts of a return are attributable to leverage, multiple expansion, or operating improvements?
Tony James was quite smug on the performance of Blackstone’s portfolio. He defended the buyout of Freescale by saying that the acquisition was done at 8.5x EBITDA when the comps were trading at 12x. He also said that outside of cell phone chip sale weakness related to Motorola’s (MOT) weakness, Freescale had gain share in all other markets. He had a reason to be smug about Blackstone’s EOP deal. That deal is rumored to have been an almost immediate success because of the great prices that pieces of the portfolio were sold for.
James was also smug when he talked about how Blackstone saw opportunities to take advantage of many companies/individuals that bought EOP properties from Blackstone with short-term debt and no ability to roll the debt into long-term financing. Wow Tony, so nice of you to lend them a hand. With any luck you will get a chance to rip the faces off of the buyers of EOP properties from you once more.
The Prince must be allowed one ending digression on the smugness of Tony James and Blackstone. I think the Epicurean Dealmaker sums up the ethos of Blackstone conveyed by their annual report quite well in his latest post, Bubble Land. Here is an excerpt that The Prince found particularly funny but true:
Second, what kind of self-image do these images of Blackstone’s personnel convey? That they are so f**king powerful they use the streets of Manhattan for a conference room? That New York City itself is merely a vaguely fake-looking background to the important issues BX deals with every day? That BX functions in a surreal bubble devoid of all other human presence? That the Executive Committee likes to reenact scenes from Reservoir Dogs?
Third, what’s with the black cover? A sort of reverse Beatles White Album? An evocation of the all-powerful monolith from 2001: A Space Odyssey? A sympathetic black armband for pathetic unitholders who have lost somewhere between 35 and 50% of their investment value in BX shares since the IPO? Or just a "We’re so powerful and important we don’t need to put anything on our annual report cover" f**k-you?
And last but not least—although I admit the connection to semiotics or symbolism is tenuous at best—what the hell is with Steve Schwarzman’s suit? I mean, the guy is a f**king billionaire, and he looks like he’s wearing something The Men’s Wearhouse custom-made for MC Hammer. I haven’t seen pants that baggy below 116th Street since 1988.
Get a f**king tailor, man.
(Oh, and next time, hire someone who actually knows what they’re doing to design your annual report.)