With recessions predicted for many countries this year or next, the difficult situation will be an important trading source for future investors.
But what matters is whether the target is permanently damaged or can be recovered. His two real-life scenarios of the early ’80s debt bubble and subsequent credit crunch offer helpful pointers.
Cyclic variability, or dislocation
British investment firm Candover acquired hygiene products maker Ontex in 2002 for €1 billion and 8.1 times EBITDA. bog standard Six times the total return on senior and mezzanine loans.
Despite strong economic growth, Ontex’s EBITDA margin fell from 17% to 12% within three years, mainly due to rising oil prices. Because petroleum is a key ingredient in the absorbent powder in Ontex’s diapers, and the company’s products are sold by Walmart, Tesco, and other oligopolistic price-makers, the company passes that cost on to its customers. could not be transferred. As a private label manufacturer without the ability to ship directly to consumers and without a strong brand, Ontex is price conscious.
But this was no new development. In the past, Ontex’s profitability has languished whenever oil prices have soared. Still, excess leverage hasn’t been a bad investment for his Ontex. Rather, its debt packages had rigid structures with set repayment schedules and tight margins where market cyclicality required more agile lending terms.
When TPG and Goldman Sachs acquired Ontex from Candover in 2010, covenant-lite loans became a commonplace vehicle to give borrowers the flexibility to adapt to such economic turmoil. rice field. That was what Ontex needed. As oil prices rose more than 160% from early 2016 to late 2018, the company’s EBITDA margin fell from 12.5% to 10.2%.
Structural change or destruction
But there are other types of distress scenarios where market changes are more widespread.
Private equity (PE) firm Terra Firma completed a leveraged buyout (LBO) of renowned record label EMI Music worth £4.2 billion in 2007. Unlike Ontex’s debt structure, EMI had all the tricks of the PE toolkit. A friendly cov-lite package with unlimited rights to stock cures and generous EBITDA adjustments. However, the deal turned out to be disastrous.
The internet revolution rocked the record industry and EMI struggled for years to adapt. To turn EMI’s fortunes around, Terra Firma planned to raise money in the bond market and secure funding from the recurring cash flow of EMI’s music catalog. It also hoped to restore profits by reducing its workforce, outsourcing some activities, renegotiating contracts with artists, streamlining its real estate portfolio and shrinking its expense account. Terra Firma similarly focused on new revenue streams such as concerts, online services, merchandising and artist management, and sought to recruit new technical talent to implement the digital transition.
But despite multiple stock bailouts, EMI’s sole lender, Citi, took over EMI in 2011 and hastily sold it piecemeal. It turns out that EMI isn’t going through a temporary turmoil, it’s a permanent turmoil. Due to online piracy, U.S. compact disc (CD) shipments plummeted by two-fifths between 1999 and 2007. In the pre-acquisition fiscal quarter, EMI CD sales were down 20%. It turned out to be unwise to pay more than 18 times EBITDA for such a business.
It was unwise to add leverage to a business facing such serious challenges. EMI’s net debt-to-EBITDA ratio remained above 8 throughout the LBO period. This restructuring strategy did not improve profitability enough to withstand the increase in debt.
risk pyramid
EMI’s experience shows that significant execution risk does not mix well with leverage during a major restructuring. Cost reduction, asset disposal, contract renegotiation, refinancing, securitization and other traditional strategic and operational tools are no match for disruptive innovation.
So a dislocation cannot be confused with a fracture. The former is temporary and periodic, and manageable even if it is recurrent in nature. Destruction, by contrast, is permanent and structural. For many companies, it is a terminal threat. Disruption requires adaptation, which can be addressed by incremental changes in corporate strategy, but disruption requires reinvention, which requires companies to redesign their operations. Extensive use of debt is a very bad idea in such a basic scenario.
The risk pyramid below visualizes this dilemma. Leverage sits above many other risk categories. Companies have little room to tolerate financial risk, or liability, when faced with market, operational and strategic headwinds. Under the weight of so much uncertainty, additional leverage could crush corporate borrowers.
risk pyramid structure
Gluttony
Unprecedented financial stimulus after the Global Financial Crisis (GFC) and during the pandemic should provide fertile ground for distressed investing in the years ahead. Excess capital is often misallocated, leading to wasteful and reckless investments. It can kill returns.
Debt-swelled acquisitions and overcapitalized start-ups But thanks to capital accumulation ($12 trillion in assets, including $3 trillion in dry powder), the private market correction could take a long time. Although the Nasdaq did not bottom out until October 2002 after his March 2000 high, many dot-com companies were still reeling when the global financial crisis erupted. The culling of today’s private market could similarly be protracted. PE and venture capital (VC) firms prefer to hold on to impaired assets and continue to earn fees rather than be aware of the true state of their portfolios. But recent bank failures could dry up the bridge loans needed by startups to postpone down rounds.
Active use of leverage allows financial sponsors to manage downside risks by negotiating softer loan agreements and boosting numbers. But too much debt can turn borrowers into zombies, making it harder for distressed investors to intervene. Investors may have to wait for it to end, as Citi did in the inevitable collapse of EMI in the aftermath of the global financial crisis.
Dealing with market cracks
The financialization of markets raises broader questions. Does the growing insolvency represent a temporary turmoil, or a more fundamental disruption in the modern economy?
The cost of expanding the balance sheet varies. Businesses cut investments. Credit Downgrades Lower Equity Earningsbusiness owners are looking for alternative employment; Workers become uncooperative.supplier Promote stricter payment terms; the client switches to A more reliable service provider; Lender increase the cost of borrowing or cut off access to credit altogether.
Even if endemic over-leverage does not lead to widespread economic destruction, dislocation-prone industries may ultimately suffer more permanent damage. Today’s high inflation, for example, might be seen as just a minor hurdle for Ontex. The company’s EBITDA margin fell to 5.5% from 11.2% in 2020 as oil prices rose from below $0 a barrel in 2020 to over $120 a barrel two years later. last year. Leverage exceeded 6x earningsLike 20 years ago in the Candover LBO era, the EBITDA margin was 17%.
But the COVID-19 pandemic has caused demographic instability, making it even more acute for companies like Ontex, which serve both young and old through the sale of diapers and incontinence products. can have an impact.Excess mortality surged Europe and the America. This trend may be short-lived, but it follows a stagnant global life expectancy. America, european unionand England and Wales. The benefits of improved sanitation and sanitation have probably temporarily reached their limits.
The pandemic has also triggered another demographic evolution. Instead of the expected baby boom caused by the new coronavirus infection, the lockdown “baby bust” in the postCovid-19 economic stimulus helps fertility recovery Even with a return to pre-pandemic levels, demographic challenges remain.In a recession such as Japan, Spainand Italy, Declining fertility rates have long been the norm. But as fertility shifts and flat life expectancies become more entrenched, they are not just disruptions like cyclical oil price spikes, but deeper market fissures that affect long-term demand for hygiene products. It will be
The impact will clearly extend far beyond any single company or sector. That is where the difficulty of investing lies. The market is dynamic. Macroeconomic turmoil and socio-demographic shifts can turn value plays into distressed assets.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of the CFA Institute or the author’s employer.
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