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Sunday, January 4, 2015

Restructuring Activity Likely to Pick Up in 2015

You would not know it from the mainstream media, but the financial crisis of 2007-09 produced less chapter 11s than the previous recession of 2000-02. After a 2-or-3-year trough in restructurings, engineered by the Fed's easy money policies, there are several indicators that activity will pick up in 2015. Here's why:

Sovereign defaults

As of right now, it appears likely that Venezuela, the most-mismanaged economy in the world, and Argentina, an honorable mention in that category, will both default sometime in 2015. And apparently it's a 50/50 proposition that Greece will default too.

Venezuela will be the most interesting for U.S. distressed investors and professionals, because, unlike Argentina, it has a number of state-owned companies that regularly engage in commercial activities that make for interesting attachment possibilities outside the scope of sovereign immunity. For example, its state-owned oil company, Petroleos de Venezuela, S.A., with over $6B of bonds outstanding, sells a good deal of oil into the U.S., creating dollar-denominated receivables that can be attached through domestic litigation. As well, there are a lot of US and other North American companies with large Venezuelan receivables that are substantially in arrears that could be sold into distressed hands, to enable the buyer to pursue collection efforts that the strategic holder might not be willing to undertake, due to image concerns.

I wrote a lot about Argentina in 2013, predicting all along that it would default for political reasons, and nothing has occurred since my last post to change my view.  The Economist's latest edition captures the points I made back then: the populist basis of the Kirchner government's hold on power makes it impossible for that government to knuckle under to the foreign holders.  They are better off in domestic politics having a Yankee enemy to demonize than to maximize the nation's economic welfare.  If some other party comes into power and does the rational thing of working out a deal, the Kirchners' political heirs will have a ready-made plank for their next campaign.  Argentina indisputably  has the means to pay the holdout funds -- it's debt-to-GDP level is one of the lowest in the world (largely because the dispute's existence has blocked the nation from closing any fnew-money deals in the bond markets). The nonpayment is strictly a political decision, which is why the U.S. courts have been in the right to turn the screws on them.

If the ultra-left Syriza party wins control of Greece's government this month, I expect Greece will default, for three reasons.  One, the core reason for Syriza's existence is to repudiate the terms imposed by the "Troika" (EC, ECB, and IMF) as part of the 2011 bailout and restructuring, so it doesn't really have a politically viable alternative to default, although I expect there will be an elaborate show of offers and counteroffers between its leadership and the Troika before a default occurs.  Two, even after the massive haircut inflicted on private creditors back in 2011, Greece was left with an unserviceable debt load, so it was inevitable it would get to the point of defaulting eventually, and there is a lot to be said on both sides to get it over with sooner rather than later, as opposed to the surplus-generating nations in the EU throwing good money after bad.  Last, those nations have to be worried about emboldening copycat repudiations by ultra-left parties in larger nations, especially Podemos in Spain, where there will be national elections in December, so it makes sense to let Greece make an example of itself that, one hopes, causes Spanish voters to avoid following in its shoes.
The counter-scenarios are that either (1) the bureaucrats in the Troika are not politically strong enough to take an action that effectively throws a member out of the EU, in part because they are bureaucrats to begin with and in part because France, Portugal, Italy and possibly Spain may want to see Greece treated liberally so they themselves can receive similar treatment.  In this view, the Troika will ultimately cave and kick the can down the road a ways, which is what Syriza's leader, Tsipras, is counting on when he says "the party’s program is non-negotiable. 'There will be a negotiation (with the country’s international lenders). There will be an agreement. And the Memorandum, along with the Troika, will become part of the past!'”.   The second counter-scenario is that, once Syriza comes to power, they will, like many before them,  soften their rhetoric, face up to reality and settle for some easy loan terms if the Troika pushes back hard enough and a deal will get done.  These are very possible, but at the end of the day, I think that, much like the Kirchners in Argentina, Tsipras will choose to play to the crowd with a populist repudiation.
There might be some new muni defaults (Illinois, New  Jersey, California being the most likely locations but conceivably an oil-patch municipality could get squeezed by declines in energy-related revenues) but I haven't researched that sector yet.
Macroprudential tightening.

Tighter banking regulations will put an end to "extend and pretend".  One of the causes of the bankruptcy wave of 2001-02 was the "guidance" issued by regulators to the banking sector to stop making "enterprise value" loans to emerging tech companies -- loans that were not supported by a cash flow cushion or traditional collateral coverage, but were only justified by the supposed margin of safety provided by the company's equity market cap.  Once credit market access became more difficult, those companies lost the fuel they needed to continue their growth stories, their stocks rolled over, triggering margin calls that accelerated further stock declines, and their capital structures just imploded. leading to restructurings.

Last year, federal banking regulators issued new / revised guidance requiring banks to tighten up the terms of leveraged loans on a variety of fronts, which will make it onerous for the remaining highly leveraged companies from the last cycle of LBOs to continue to extend the maturities of their credit facilities, which will force them into restructuring as soon as the auditors inform them that they have to add a going-concern qualification to their report on year-end financials.
In a year-end summary from Thomson Reuters, they state that banks have begun complying with regulators, such that debt-to-EBITDA multiples on new leveraged loans came down about 5% in Q4. Busisness Week has a similar story.

Perhaps this realization has something to do with the current Caesar's restructuring and it may bring Univision to the table sooner than would otherwise have been the case. Claire's Stores, Clear Channel (iHeart Media) and Toys 'R Us might also be lumped into this camp as well, judging by their bond prices.

Interest Rate Hikes

The Fed has signaled it will raise short-term rates sometime this year.  I don't expect it to be a material factor this year, as there is so much foreign demand for Treasuries, and not that much domestic demand for credit, to put other pressure on interest rates.  If anything, the end of QE, coupled with a divided Federal government keeping the fiscal deficit in check, and the macroprudential and other pressures on bank lending, all  mean the money supply probably won't be growing as much in 2015 as in the last few years, which will keep a lid on the economy and thus bias rates lower.  In the leveraged loan space, LIBOR floors will also absorb the first 100bps of any rate hike anyway.  So this will be a small factor against easy money and thus toward restructurings.

Mid to Late Cycle Default Trends

Martin Fridson, a veteran of all the high-yield cycles that have been, expounds the view that 2015 will bring the beginning of a new multi-year default cycle that, given the amount of HY bonds outstanding, will set records for the dollar volume of defaulted bonds.  He has predicted defaults by over 1000 issuers, respecting as much as $1.6T of HY bonds with losses, after recoveries, in the range of $752B.  "This is just a projection of what would happen in a normal cycle" he says (horrible picture, btw).

Energy Sector High Yield Issuers

As has been well reported, a good portion of the new high-yield issuance since the financial crisis has been in the energy sector, with particular concentration in exploration and production and oilfield services companies which now comprise nearly 10% of the entire HY universe.  The energy sector is the largest sector in the HY universe.  With the fall in the price of oil in the past quarter, dozens of these issuers are now trading as distressed credits.  Fridson says that energy credits now make up almost 29% of the distressed universe, three times their proportion of the total universe.  Creditsights, a respected credit research firm, projects the HY energy sector default rate to hit 8% next year.

A representative sampling of energy sector credits with debt >$1B, bond ratings of Caa1, CCC+ or worse, and recent bond quotes below 75 includes:

American Energy Partners; Cobalt International; EXCO Resources; Halcon Resources; Midstates Petroleum; Quicksilver Resources; and Samson Resources. 

Were I to loosen those three parameters a bit, as many people compiling such lists do, more names would obviously flow in to the net. In particular, a lot of names that have higher bond ratings will probably get downgraded in the next 3-4 months.  The watchlists I get emailed to me every week have several dozen other names on them.

Outside of E&P and oilfield services, there are eastern, mostly metallurgical, coal producers like Walter Energy, Alpha and Arch with debt at distressed prices for a variety of reasons -- falloff in China demand, Obama Administration regulations, etc., that are unlikely to disappear from their horizons anytime soon. 

In addition, there will be secondary effects on other industries from the drop in the price of oil.  For example, solar and other alternative energy companies may be pressured as oil becomes cheaper.  Further, and to my surprise, because I would have expected chemical companies to benefit from the fall in the price of oil which is a principal feedstock for their processes, it turns out some chemical companies make chemicals from ethane generated by fracking so a diminution in volume may hurt them.  Stocks like Lyondell Basell and Westlake Chemical have sold off in sympathy with the energy sector.  As well, aluminum companies may suffer because reducing auto weight is no longer as important. So there can be widespread secondary and tertiary impacts on certain sectors of the econony from a prolonged oil price drop, even as other sectors of the economy benefit. 


Petrobras is a combination of sovereign issuer and oil-price casualty.  And it's a gigantic issuer, with over $54B outstanding, so I give it its own hybrid category.  The corruption scandal at the company and just general mismanagement of Petrobras are widely reported.  As the links indicate, DOJ and SEC have launched criminal and civil probes of the allegations.  Already Aurelius has been alleging that Petrobras is already in default because the it failed to deliver its financial statements in timely fashion, due to the need to re-evaluate the accuracy of its books and records and prior statements in light of the corrupt practices.  Assuming the story is correct, and subject to any minimum notice requirements in their indentures, the company has only until early March to generate accurate audited financials or face a matured, albeit non-payment, default that could give rise to acceleration.  That said, Brazil has the wherewithal to stave off an acceleration, and I expect it to do so to avoid tarnishing the nation's global image. Among other resources, there is the state development bank, BNDES, that just possibly might have been used before for political purposes.  And Petrobras' leverage is not so great that it can't repair itself as prices recover over time.  But certainly no underwriter outside of Brazil can market any new Petrobras securities until all that is cleared up.  And the stock has just cratered the past few months.  Were it not for the implicit government backing, it would definitely be a restructuring candidate right now.

The Perennial Contribution from Retail and Consumer Names

In addition to names mentioned earlier in this post, companies such as Radio Shack, Guitar Center, Gymboree and Wet Seal are all in some stage of distress or restructuring. Casino names continue to raise worries and one maker of casino games, Scientific Games, is showing bond prices that embed heavy discounts, even though the issue is recent. 

Not all of these names will wind up in chapter 11.  Some will get capital infusions, as Linn Energy recently did, that enable them to postpone and hopefully avoid restructuring altogether. Others will not be so lucky, but could go out-of-court or pre-pack. 

In any case, business for restructuring professionals - especially in the oil patch -- seems likely to pick up from the trough of the past three years.