Mother of All Debt: Life or Debt?
In January of this year affiliates of Elliott Management and Vista Equity Partners executed a $16.5bn leveraged buy-out of Citrix, a software company, to tap into the pandemic-driven boom in cloud computing. Investment bankers agreed to underwrite the $15bn debt to finance the transaction. Nine months later, the banks tried to offload the debt and reportedly collectively nursed losses of $600m after selling them off at a steep discount, with much of it remaining on their balance-sheets.
In another example of how debt deals are posing trouble for lenders, is the credit entanglement of Envision Health, whose PE owner was trying to restructure roughly $7.5 billion of debt. Embedded in the documentation were ‘loose documents’ which have become the norm rather than the exception according to the co-head of restructuring at Davis Polk & Wardwell. As Bloomberg reported, “If we go into a real recession, we are going to see more and more borrowers and sponsors seeking to exploit document loopholes to create leverage against and among their creditors.” Credit rating companies and analysts have warned that these looser protections could leave debt investors struggling to recover their money when borrowers file for bankruptcy or pursue out-of-court restructurings.
A “risk-off” investor sentiment is highlighted by Partners Group after very modest volumes of loan issuance across Europe in Q3, with pricing rising for new single-B-rated institutional term loans rising from EURIBOR + 452bps, and a yield to maturity of 5.38%, to EURIBOR + 515bps, and a yield to maturity of 7.44% plus the widest new-issue spreads and yields observed since 2011-12.
However, Wellington Management are relatively sanguine about the high-yield debt market, expecting a better year in 2023 and advising investors to be patient. An underweight position in emerging markets and European debt is described as defensive, and, despite further possible downside, a potential snapback is anticipated if the macro conditions improve as “investors scramble to cover their underweights.” PGIM are also optimistic, estimating that current spread levels on European high yield debt more than compensates investors for the anticipated default losses. Quantitative easing is thought to have lowered borrowing costs, boosting cash flows and kept loan-to-value ratios under control. They cite improvements in the proportion of European high-yield index rated BB and CCC since 2010 – up from 59% and 12% versus 69% and 5% today. Furthermore, they point out that recent defaults are mostly restructurings that involve investors accepting a partial “haircut” on the debt and/or swapping debt for equity. In their recession scenario default rates are expected to peak at around 2% in 2024 with the real estate, financial, travel/transport, and food businesses sectors most affected.
Emerging Trends Europe recorded the lowest confidence in the availability of debt and equity since 2012 and 2009 respectively. Debt funds are taking advantage of other lenders scaling back by moving down the risk curve whilst still achieving the same return. “Our debt guys are happier than I’ve seen them since we initiated the business, frankly. They’ve big grins on their faces,” one fund manager says. “They are able to lend large tickets for fairly good collateral at 400 to 500 over.”
The position today is radically different to 2009 when Emerging Trends Europe reported that debt had “vanished.” The overarching philosophy now revolves around relationship lending and more conservative LTVs. The big names that have been lost to property lending, including Eurohypo, Hypo Real Estate and Royal Bank of Scotland, have been replaced today by a new breed of alternative lenders as well as well-capitalised German banks and US investment banks. The challenge for these lenders in the next few years will be the affordability of finance in a rising interest rate environment.
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There was a widespread view among the industry leaders canvassed for the report that the debt funds have enabled property companies to manage capital requirements more efficiently. Moreover, that they will provide the innovation required in real estate finance and, as some interviewees believe, adopt a more prominent role around the “manage-to-green” retrofit challenge. One interviewee responded: “The industry has a diversity of capital now. The debt funds are easy to deal with, faster, more aggressive and it’s been healthy for the market because these are the lenders that will help drive change and innovation. Banks, which are slow to evolve, will follow their lead.”
The rising cost of debt has however hit the value of Brookfield’s stake in the Canary Wharf estate, which it owns in a joint venture with the Qatar Investment Authority, from $3.5bn at the start of the year to just under $3.3bn at the end of September, although this is still higher than the September 2019 valuation of $3.2bn. Brookfield has $36.3bn of secured debt, with $11.2bn and $9.8bn coming to maturity in 2023 and 2024 respectively. The company said it was confident of refinancing the debt, but highlighted it had stopped making payments on 1.2% of its debt, about $360m, and was in restructuring talks with lenders.
One lender that has proven not to have been so cautious is Corestate with write-downs exceeding €500m on its financing subsidiaries HFS and Corestate Depreciations. Corestate has also had to relinquish its advisory mandate for the Swiss credit fund Stratos II, after it had to be frozen following massive investor redemption requests.
In the core senior lending market, which remains dominated by banks, there has been a narrowing of spreads between banks and alternative lenders as increased funding costs have fed through into higher margins. Hanno Kowalski, managing partner of German debt fund specialist FAP Invest, explains: “Many insurers need to service returns of about 3.5% annually, which means they need to earn at least 4% before costs. This has become increasingly difficult with core real estate investments”. If senior lenders continue to lend at lower LTVs this could provide opportunities for junior lenders to plug funding gaps in new refinancings. For example, whereas historically KKR has originated real estate debt at LTVs of 65% to 70%, that LTV is now in the 60% to 65% range.
With the market slowing most lenders are focussed on their backbooks, but new lending vehicles are raising substantial firepower. KKR, the New York-based firm, is targeting $1bn-$2bn in originations in the region next year amid a ‘super-interesting time’ for non-bank lenders with transaction volume to scaling up ‘by multiples’ over time. The Starz fund reached €1bn+ lending capacity with new investment. Swiss-based central European property investor Empira is preparing to launch a major senior debt fund focussed on Austria, Germany and the Benelux, and Westbrook has launched a lending strategy in the UK.
Between 2007 and 2009 the international financial system almost collapsed. Federal Reserve Chairman Ben Bernanke, New York Fed president (and later secretary of the Treasury) Tim Geithner, and secretary of the Treasury Hank Paulson, co-ordinated the U.S. response. 10 years after the crash Bernanke, Geithner in Paulson got together to reflect on the lessons of 2008 and authored a book called ‘Firefighting: the financial crisis and its lessons’. In it, they write “In a panic, it can be difficult to tell whether a troubled firm is truly insolvent. Markets are not always right or rational, and it's always possible that security is nobody wants during a spiral of fear will turn out to be solid once confidence returns.” This could be said of the above debt which could be fundamentally sound but unfortunately timed, or for that matter real estate debt positions which if held to maturity would ride out the interim value destruction. Later, the authors write “One crucial lesson of 2008 is that financial crisis can be devastating even when the responses relatively aggressive and benefits from the formidable financial strength and credibility of the United states. The best strategy for a financial crisis is not to have one. And the best way to limit the damage if there is one is to make sure crisis managers have the tools they need to fight before things get too bad.” With the varied and multitudinous debt sources today, with their ability to move up and down the capital stack, there are plenty more market participants and tools at disposal to buoy borrowers business plans and safeguard lenders balance sheets.