Beware falling knives
The Mudrick Capital Management project was set in motion in 2008 to take advantage of a once-in-a-lifetime opportunity - “the largest supply of over-leveraged corporations ever seen” combined with the most severe recession since the 1930s “has kicked off a distressed cycle that will be unprecedented in terms of length and depth of supply”, its website declares.
Pension funds that get involved will do no harm at all to their beaten-up funding ratios, but they might also take heed of founder and CIO Jason Mudrick’s warnings about the “unique” nature of this cycle. Difficulties they may have allocating with smaller managers could end up leaving them with the wrong kind of exposure at the wrong point in the cycle, he argues.
“Some institutions are flexible enough to see me as a seven-year track record guy,” he says, referring to his time at Contrarian Capital Management, where he posted a six-year audited, unleveraged IRR of 19.5% (according to the HFR database, the Mudrick Capital portfolio is up 20% net of fees since inception last July, with no leveraged loans). “But elsewhere there is a lot of box-checking. The big distressed funds have been able to raise assets because the stable institutions found themselves the only guys able to allocate last year - and they are usually unable to allocate to people like us. But we expect to cross the $100m mark this summer, at which point there is a whole other level of investors we can talk to.”
The good news is that European investors, perhaps because Europe’s economy is recovering more slowly than that of the US, are less inclined to think that the bankruptcy cycle is already through - and catch the proverbial falling kn ife. The flight from risk that unsettled markets in May provided a stark warning of the downside still out there, after months of low rates and a massive credit rally had sucked out all the differentiation from the market. Until May, first and second-lien debt on leveraged buyouts (LBOs) was yielding an average of 6.5%. That’s fine for a conservative investor that does not believe these firms will default and restructure, but it will seem very expensive if a restructure leaves you holding equity.
“We think the yield should be more like 15%,” says Mudrick. “The problem is that these distressed loans aren’t trading at distressed levels anymore. We’re hearing that distressed funds are down 4-8% for May - it’s ugly for them.” (HFR has Mudrick’s portfolio down 92 basis points in May, net of fees).
So why are these funds holding this overpriced stuff? Because they are too big not to. The only way to avoid exposure is to move completely to cash, or to put together CDS hedge books full of complexity and unpredictable basis risk.
“If you’re $5bn or $10bn - and a lot of these shops are just getting bigger and bigger - you have to own Clear Channel first-lien bank debt, you have to own First Data first-lien bank debt,” argues Mudrick. “It’s unfortunate that pension funds have such difficulty allocating to guys like us, because smaller shops have a significant competitive advantage.”
Mudrick’s thesis depends upon a second wave of defaults, which he concedes would be a departure from previous LBO-driven cycles that have seen most filings done within 12 months of recession taking hold. But those cycles were financed with high yield bonds paying fixed coupons at 15% or more: companies missed interest payments the moment earnings faltered. This vintage was financed by the huge expansion of bank loans facilitated by the CLO boom, ‘covenant-lite’ paper with floating rate coupons at LIBOR plus 2%; even after a horrendous collapse in earnings has pushed already highly-leveraged companies’ debt-to-EBITDA ratios well into double digits, they have maintained interest payments or, failing that, amended terms in the creditor’s favour and extended maturities.
“Just because these businesses are not in default does not mean they are solvent,” says Mudrick. “Most did not de-leverage. Instead they amended and extended, or raised new capital against unencumbered assets. It’s the whole kick-the-can-down-the-road strategy.”
Is there any way these companies can de-lever? They can buy bonds back from the market - but that’s a drop in the ocean. They can go to IPO, but that’s a Catch-22. Rare examples of successful offerings like Bain Capital’s float of Burlington Coat Factory Warehouse Corp, which came to market with four times leverage, show that investors will only buy equity from firms with low gearing. Mudrick argues that there are many examples that look more like Clear Channel Communications - a deal sealed at 10 times EBITDA, which is now at 16 times, thanks to falling earnings - whose assets the market values at 7-9 times. In that state, an IPO is a pipe dream, so the firm kept alive by amending and extending and raising $2.5bn (at four times EBITDA with a 9.25% coupon) against Clear Channnel Outdoor, its unencumbered operating company.
That gives an indication of the kind of gearing the market will allow, and the yield it demands for the risk - and it looks a lot different from the 10 times at LIBOR plus 2% of the glory days. It also indicates how much earnings will have to recover in the time bought with these last-ditch efforts.
It doesn’t look promising. “Even if earnings grow back to peak levels and bring leverage back to 10 times EBITDA, it’s not possible to refinance that when the market is demanding 10% instead of LIBOR plus 2%,” Mudrick notes. “The maths just doesn’t work - all of your cash flow gets sucked out on interest expense before you even get to taxes and capex. But no-one really believes these companies will survive. The owners are out raising their next funds, so they have no interest in trying to do the right thing by the company by restructuring now. Clear Channel is an extreme example but, essentially, all of the big financials-sponsored deals are following this pattern.”
Mudrick uses camel’s humps as his metaphor to describe the shape of the default rate during this distressed cycle. The first hump came last year when there was some bottom-up work to be done on restructurings like CIT Group’s, but while the market’s collective can-kicking means that more than $1trn-worth of debt will mature to form the next hump, peaking in 2014, the trough is likely to last another 10-12 months.
“I worry that some distressed fund managers out there don’t get this camel’s hump pattern and might get caught holding stuff before it defaults,” says Mudrick. “Anyone who basically knows what they’re doing can make a lot of money buying bank debt at 50 cents on the dollar. What differentiates you is how you get from that cycle to the next - what you did in 2000 or 2008.”
So what is Mudrick doing in 2010? Sitting on cash? No. Despite owning no “pre-petition”, non-restructured first-lien debt, he remains fully invested. He points out that there is plenty of safe, new-issue paper yielding 9-11% out there. He’ll even buy the big distressed names if he can avoid the bank debt and find short-dated bonds whose credit duration doesn’t stretch into that second camel’s hump - like the rump of First Data’s 2011 bonds, for example, which outperformed its first-lien bank debt through May’s volatility.
He is also buying the more inefficiently-traded securities in these capital structures on the cheap - rather than the Wall Street bonds of government-sponsored auto and home loan provider GMAC Financial Services, for example, Mudrick bought GMAC Smart Notes that are sold to non-professional investors through regional brokers at a 25% discount. It is tricky building a portfolio out of small lots purchased here and there (and impossible for a really big fund), but selling is no problem as Wall Street always has a bid.
“We might underperform waiting for the big opportunity, but we’ll make money because we are still fully invested - and the return will be better risk-adjusted,” says Mudrick. “I’ll be happy to buy the stuff that the big guys are holding now in a couple of years’ time, when we think it’s priced correctly, but in the meantime our message to investors is simple: Either don’t be in distressed right now, or listen to our story that we can produce double-digit returns without owning any of this overpriced paper.”