Investment Dealers’ Digest – February 9, 2009
Salvation for PE Firms? Debt exchange offers may be the next lifeboat for the highly leveraged portfolio companies of PE firms
Investment Dealers’ Digest – Kelly Holman, 2009-02-09
With the economy slumping and their portfolio companies sagging under debt obligations, buyout groups are turning towards one transaction avenue to avoid bankruptcy and preserve equity in 2009: distressed debt exchanges.
The opportunity to exchange distressed, non-investment grade securities-whether subordinated notes or junk bonds-for new debt is helping issuers relieve onerous obligations. By exchanging their debt, a portfolio company of a private equity firm can avoid bankruptcy and preserve the equity investment of its owner.
Take, for example, the recent debt exchange orchestrated by Harrah’s Entertainment and the Las Vegas casino company’s backers, Apollo Management and TPG. Harrah’s completed its $6 billion bond exchange in December, reducing its debt load by $1.2 billion and extending its maturity to 2015 from 2010 and 2011.
The exchange was one of 12 distressed exchange offers launched last year, including eight in the month of December, according to Standard & Poor’s.
Other exchange deals noted by S&P involved Cerberus Capital Management’s automotive financing business, GMAC Financial Services. The financing arm of General Motors issued $11.9 billion in new senior notes and $2.6 billion in cumulative preferred stock as part of its exchange offer and plans to be recognized as a bank holding company. GMAC also reduced $435 million in debt due next year, which combined with the other actions resulted in an $11.4 billion gain for the business in the fourth quarter.
Additionally, Lightyear Capital construction equipment rental portfolio company Neff exchanged $230 million in 10% senior unsecured notes in its distressed exchange offer.
“We are expecting there are going to be more distressed exchange offers,” says Diane Vazza, managing director at Standard & Poor’s. “It may be in some cases a smart business decision to negotiate a distressed exchange offer to potentially preserve more value,” she adds.
While S&P notes that the exchange offers may give issuers clear benefits such as delaying maturity payment, near-term liquidity, reduced interest expenses, and preventing covenants from being triggered, the credit rating agency still views exchanges of distressed debt as equivalent to default because the issuer hasn’t met its obligations as expected. After an issuer completes a distressed debt exchange, S&P assigns a new corporate credit rating of ‘SD’ (selective default) to the rated debt as well as a ‘D’ rating on affected instruments.
Distressed exchange offers have piqued the interest of more than just financial sponsors seeking to keep their equity investments from being wiped out in a bankruptcy.
New York investment bank Morgan Joseph has moved to help businesses arrange exchanges for billions of dollars of debt, hiring Drexel Burnham Lambert alum James Schneider to spearhead the effort. Schneider, a managing director at Morgan Joseph, says the investment bank isn’t just seeking to target troubled businesses.
“We will do probably an equal number of healthy and distressed [companies],” he says. “What’s happening is the healthy companies see that it is flu season, and they don’t want the flu to turn into pneumonia.”
Schneider says the chance to capitalize on debt-distressed companies is just beginning.
One benefit of exchange offers is the speed at which they can be executed. By taking advantage of an exemption in securities registration, an issuer is able to avoid a potentially lengthy review by the Securities and Exchange Commission.
The highly leveraged portfolio companies of private equity firms, along with publicly traded companies, are expected to fuel distressed debt exchanges this year.
According to Fitch, Freescale Semiconductor is one candidate with “the potential for a distressed debt exchange.”
Fitch lowered the Austin, Texas-based semiconductor maker’s default rating to ‘CCC’ from ‘B’ in January after it assessed the company was generating $700 million to $800 million in capital expenditure and interest expenses. A Blackstone Group-led consortium acquired Freescale for $17.6 billion of equity in 2006.
The idea of swapping old debt for new debt or sometimes equity isn’t a new concept. Buying up tranches of deeply discounted debt or preferred shares of a company involved in a restructuring and exchanging debt for a majority equity stake has been done for years. Apollo was an early pioneer and other firms like KPS Capital Partners followed suit in acquiring and turning around troubled businesses.
Nicholas Kirk, a managing director at New York investment banking boutique The Hickory Group,
says that in certain instances owning a portion of debt makes sense. “It provides the holder with definable covenants and related performance terms to enforce and utilize.”
If the latest debt exchanges offer any indication, the attractiveness of debt as an investment option isn’t going to fade soon.