Even though the economy is looking a little brighter, the leveraged-loan market is still exposed to low recovery rates from corporate defaults.
(Bloomberg) — As corporate failures surge this year, debt investors are in a fight to salvage as much money as they can from the wreckage. The early skirmishes are going very badly.
The bankruptcy of GenesisCare, a cancer treatment specialist backed by private equity powerhouse KKR & Co. and China Resources Pharmaceutical Group Ltd., is the latest cautionary tale of how much value is being destroyed when companies go bust now.
In previous default cycles, leveraged-loan providers would expect to get 70% to 80% of their cash back from failing companies. Those days are over. Some GenesisCare investors are bracing for a mid-teen percentage, according to people familiar with the matter who aren’t authorized to speak publicly — a new blow to a lending market headed for record low recoveries.
It’s yet another financial weak spot exposed by the end of the easy-money era, as tighter credit pushes overindebted businesses toward the brink. While some investment banks hope for a softer economic landing than feared, the crash in leveraged-loan recoveries is ominous for lenders.
Like last year’s blowup of KKR-backed Envision Healthcare, the GenesisCare situation shows how companies are taking advantage of the looser loan protections that lenders swallowed as they hunted for yield in a low interest-rate world. GenesisCare has snagged a so-called “debtor in possession” financing, including a $200 million pledge to let it keep operating, that disadvantaged existing loan-holders, the people familiar say.
KKR declined to comment, and GenesisCare didn’t respond to a request for comment.
“Companies are engaging in financial alchemy because weak documents allow them flexibility,” says Fraser Lundie, head of fixed income at Federated Hermes in London. “Even if default levels are far lower than historical highs, if recoveries are looking far worse then perhaps you get to the same place.”
GenesisCare joins an expanding list of restructuring deals that have scarred US lenders lately. A first-lien loan to Envision is expected to recover close to zero, according to an August report from Bank of America strategists. Media firm Diamond Sports and air-miles specialist Loyalty Ventures have implied recovery rates running at about 10%, the report says, while tech company Avaya Inc. and energy firm Heritage Power are around 30%.
The strategists estimate recoveries from bankrupt companies are running at 25% on average this year — based on loan prices 30 days after a default — and they predict 50% in the long term.
The fate of GenesisCare, which borrowed in euros and dollars, also suggests the meager recoveries trend will go beyond the US. Europe won’t escape.
Investors such as Blackstone Inc., Bain Capital and HPS Investment Partners were able to get out of US GenesisCare loans — albeit some at punitive prices. But many firms have been stopped from selling out of a 500-million euro loan by Europe’s “whitelist” restrictions, which limit sales to a select group of buyers, people familiar with the process say.
The European loan is marked currently at a 12 euro cents bid price, according to the same people, and the dollar loan at 13 cents.
“Transfer restrictions can prove challenging and create air pockets with limited liquidity,” says Tristram Leach, head of European credit at Apollo Global Management. “With tight whitelist restrictions it’s harder for lenders to get out of loans they’re cooling on.”
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Although debt investors can trade more freely in the US, borrowers and buyout firms have been far more cutthroat in restructurings there. Loose loan documents have let companies strip valuable assets from existing creditors or take on new debt that pushes some or all of their lenders down the repayment queue, a tactic known as “uptiering” or “priming.”
Envision is the most notorious case. It devised an out-of-court restructuring that took its most promising division away from existing lenders and pledged it as collateral for a new loan, only to file for bankruptcy later.
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“Private equity firms will, with their backs against the wall, be inclined to use every tool available to preserve their returns,” says Derek Gluckman, an analyst at Moody’s Investors Service. “And the covenants give them many tools to allow that at investors’ expense.”
The outlook for lender rights isn’t bright either. In June a Texas judge upheld a 2020 emergency refinancing by Serta Simmons Bedding, which handed the mattress maker $200 million of new cash to stay afloat but pushed some lenders including Apollo back in the repayment line.
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“What’s different this time from previous default cycles is that distressed funds that have raised large pools of capital are sometimes willing to help private equity sponsors alongside their own interests, but to the detriment of other existing lenders,” says Trey Parker, chief investment officer at Sycamore Tree Capital Partners.
Many lenders have started to include “Serta blockers” in their loan documents by hardening up the legal wording, according to a recent report from Moody’s Investors Services. But about half the leveraged loans it examined still didn’t include protective language.
“It’s hard to fight back if you’ve already given up these protections,” says Gluckman. “Once the genie’s out of the bottle, you can’t unthink the idea.”
One glimmer of hope is the brightening economic outlook and the knowledge that market prices for loans don’t reflect precisely how much lenders will ultimately claw back. The sample size is relatively small still.
Nevertheless, even the most upbeat estimates see recoveries way below previous cycles. Leveraged loans involve a balancing of two risks: the likelihood of a borrower going under, and how much money you get back when they do. Even if default rates are better than feared, the result will be ugly for lenders if recoveries crater.
“Anybody expecting that we’re going to have a 70% recovery on average over the next 12 months is being overly optimistic,” says Roberta Goss, head of bank loans and CLOs at Pretium Partners, a US investment firm. “We expect recoveries in the low 40s.”
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