I have one chum of old – he’d hang me if I called him an old chum – who plies his trade as a credit strategist here in London. I am a regular reader of his output and was wondering recently how many ways there are to say that credit spreads are fundamentally tightening but technically widening again, from time to time, although the underlying environment remains boringly predictable.
Even the chapter on AT1 paper is becoming mildly repetitive as we’ve now all more or less worked out what they are and pricing is coming close to finding a level of equilibrium where the free lunches are being cancelled. The first test of that market cannot be far away as investors look to switch existing positions into new issuance and the Street will have to show where the true value of secondary paper is.
Those investors which have piled into CoCos and hybrid corporate debt have generated eye-watering returns but so were emerging market funds not so long ago.
I did speak to a senior character at a credit hedge fund yesterday who made it quite clear that they are happy to stag the new issue market but that they, at this point in time, had no intention of building a core position in the sector. The person in question evidently agrees with my own view that CoCos cannot be correctly valued until the market for them has been stressed and we have seen how they will behave in challenging circumstances.
As they are neither a construct of natural investor nor of issuer demand but of regulatory imposition, it is impossible to predict where they might end up. Who, one might ask oneself, will catch the falling knife and, more challengingly, at what level. I also heard, in conversation, from one institutional buyer of funds that they had queried the manager of one of the mutuals they hold who had also assured that they have not piled into the CoCo sector but that they were, nevertheless, comfortable with the risk inherent in traditional Tier I paper.
Those investors which have piled into CoCos and hybrid corporate debt have generated eye-watering returns but so were emerging market funds not so long ago. Either issuers mispriced when they came to market or investors are mispricing now. Both cannot be right; at least one of the is wrong and maybe both.
Private leverage crush
Having commented yesterday that private equity is beginning to register on my radar again, I find overnight that Energy Future Holdings Corp. apparently has no future. Formed by Kohlberg Kravis Roberts (the original Barbarians at the Gate of RJ Reynolds fame), Texas Pacific and Goldman Sachs Capital Partners, EFH was the vehicle used to launch a $49bn leveraged takeover bid for US energy provider TXU. It remains the largest ever LBO and was really nothing more than a huge punt on natural gas prices. The discovery and efficient extraction of shale gas has blown the economics to pieces and now there is panic speed activity to prevent the total collapse of EFH. Currently it has over $31bn of outstanding debt, term loans included.
I’m always fascinated when I look at the capital structure of these leveraged outfits, especially when it comes to the PIK issues launched six or twelve months after the transaction has closed and which are frequently there in order to pay a “special dividend”. These look to me to be ways of paying the private equity sponsors back for the equity they purchased which leaves them holding the equity at no or next to no cost and with all the risk vested with creditors. The raiders are left with not a lot more than risk than that to their reputation.
The secret of big-time private equity deals is that all the upside goes to the sponsors and all the downside goes to the bondholders. Now, that really is about creating shareholder value. TXU’s underlying business would probably have been fine of it hadn’t been crushed by debt and although bondholders will end up bearing a lot of pain they will in all likelihood not get wiped out. How much of the cost, however, is borne by KKR, TPG and GSCP is a different matter entirely.