Skip to main content

August 26th, 2013

Covenant Lite Debt, The Stretch Mark Of PE

Covenant lite debt, the stretch mark of PE, has returned in abundance to the marketplace. Its coenzyme, high leverage multiples, is appearing in similar robust form. Can one say “# 2007 redux?”. The derivative of an easy credit, covenant free environment is the elevation of price levels in the PE market. Feral buyers are very willing to pay, and are paying, double digit multiples to purchase companies. A cursory review of historical literature reveals no expected upside to multiples on exit and substantial downside. The literature also suggests coupling a market recession with such high leverage creates cash plows out of the investments. During this summer, many sale processes for decent companies have required 9.5x–10x EBITDA minimum bids even to get to the second round. Dodd Frank purported to be a remedy for some of the problems of 2008, but a leading harbinger of risk is leverage and Dodd Frank does not even place a guardrail near it.

Perhaps the most visible and saddest story of the summer has been the bankruptcy of Detroit, once a symbol of American manufacturing prowess, now a case study in urban decay. A meaningful cause of the fiscal problem of Detroit is its pension fund obligation. For years benefits were raised to match those of the nearby auto employees, but when the auto companies’ fortunes and employee benefits changed those of Detroit’s pensioners did not. Like their fellow municipalities, Detroit continued to calculate their unfunded liability by assuming an investment performance much better than the pension funds had ever achieved which, in turn, resulted in understating the actual funding gap by billions of dollars. In perhaps the most intellectually heftless twist, several years ago the State of Michigan passed legislation mandating that no pension benefit agreement can ever be reduced. This is a fascinating exception that presumes everyone on the funding side will always have the money to pay, or if not, who backs up this promise: The State of Michigan, as guarantor of all pensions? Setting aside the notion that a pension is declared to be the only contract not subject to change, it is interesting to note in the “faux bankruptcy” of General Motors, the federal government reduced the pension benefits of GM’s salaried workers in Michigan. As this protest by the pension community wends its way through the courts, the UK court system has recently declared pension schemes do not go to the head of the creditor line and need to stand in the queue with others.

Finally, we turn to the land of unintended consequences. In 1988, Olympus was the first PE firm to offer a preferred return on investor capital. The preferred return rate was the seven year treasury rate at the time of each investment. The idea was to pair the current risk free rate with an investment as it was made. If risk free rates rose the preferred would follow suit and the reverse was also true. Over time the market moved to a fixed preferred rate which made the preferred return a layup in time of rising rates and a challenge in a Sharia-compliant era such as like today. A look at the data is instructive. Alignment of interest is the professed goal of the PE investor community. Yet, per recent Cambridge Associates data for vintage years 2006-2009, 100 of 267 reporting PE firms are reporting net IRR’s less than 8%, today’s market rate for preferred return. In other words, nearly 40% of maturing PE funds managers are not aligned with their investors and the math suggests the GP incentive is no longer in the carried interest on the funds, but rather in simply staying open. The move from 7% to 8%, as the preferred rate in this sample, increased the number of unaligned managers by 25%. Despite it being a riskier category this feature is not demanded by investors in venture capital funds. The preferred return is birthing more Zombies than Hollywood. A similar phenomenon is occurring in the monitoring fee category. Understandably, investors are unhappy to see separate cash streams travel to PE firms with investors’ capital as the benefactor. The “cure” for this has been to change the sharing ratio on all fee streams to “no sharing” as 100% now flows to the investor. The recent consequence as reported in Pitchbook: 2013 has recorded a 70% reduction in monitoring fees as few seek a fee in which they do not participate. The economic result is net fees to investors rise and their rates of returns decline. Perhaps a reconsideration of actions and consequences would be productive to end an endless game of structural “Whack a Mole.”

I’m Rob Morris and I approved this blog.

Back to Rob's Blog