When I read this Bloomberg story, “Blackstone Risks Hedge Funds’ Return as LBO Lending Evaporates,” my first reaction was “conflict of interest”. My second was “lawsuit”. Everyone casts a blind eye at arrangements like this until the returns falter.
My third was that everyone interview seemed extremely reluctant to say anything critical of Blackstone. That says the sources either have the highest respect for the firm’s professionalism or do not want to alienate a possible meal ticket. You be the judge.
From Bloomberg:
When Blackstone Group LP, the world’s biggest buyout firm, was pursuing the takeover of the Weather Channel cable network earlier this month with General Electric Co. and Bain Capital LLC, Wall Street balked at providing financing.
So the New York-based company turned to GSO Capital Partners LP, the hedge-fund manager it acquired in March, to pull off the largest U.S. leveraged buyout this year.
Blackstone can’t wait for banks, stuck with almost $100 billion of debt from earlier LBOs, to start lending again. Instead, it’s pushing deeper into deal financing with GSO. The strategy may hurt the hedge-fund unit’s returns — some approaching 40 percent — if slowing economies lead companies taken private by Blackstone to default on their debt.
“The question is: Do you lose your objectivity when you do something so close to home?” said Paul Schaye, managing director of New York-based Chestnut Hill Partners, which helps LBO funds identify investments. “The lines get blurred in terms of who’s doing what and it raises questions as to what is truly arms-length.”….
“It’s a great time to do financing” because banks and investors are charging too much, said Daniel Fuss, manager of the $18 billion Loomis Sayles Bond Fund….
Blackstone must rely more on non-buyout businesses such as restructuring advice and hedge funds as private-equity fees plunge…
In a presentation to the Indiana Public Employees’ Retirement Fund in April, GSO said 14 investments made since 2005 have produced an internal rate of return of 38 percent….
In addition to loans, GSO is buying debt issued as part of leveraged buyouts, a business Blackstone was pursuing before the GSO purchase. Blackstone raised $1.3 billion to invest in distressed debt securities through a separate fund.
Such deals are especially attractive for buyout firms, which are snapping up LBO debt trading at less than 90 cents on the dollar in some cases. Since the debt often is associated with transactions researched by the firms’ dealmakers, the distressed funds can make fast, informed decisions….
“This is a good price for the private-equity firm,” said Matthew Wilcox, an analyst at KDP investment Advisors Inc. in Montpelier, Vermont. “Its an absolute mess for the banks. It’s tough for them to sell the debt at a lower price.”
Still, the strategy may increase Blackstone’s risk if those companies falter because it means the firm and investors may hold both equity and debt in a single deal.
The number of companies with high-yield or high-risk debt that fail to make interest payments probably will triple within the next 12 months to 6.3 percent, according to Moody’s Investors Service in New York. The pace of defaults would have been even faster were it not for loose loan covenants that allow many distressed issuers the ability to avoid defaulting.
That “failure to pay” figure looks awfully optimistic, although the real crunch may not hit until later in 2009 (note the Bloomberg language is inconsistent; failure to pay interest is a matter of fact; whether that constitutes an event of default depends on the provisions of the deal. Thus the number who fail to pay interest will be larger than the number that can be declared to be in default by virtue of permissive lending agreements).
In the last two recessions, junk bond defaults peaked at over 15% per Nouriel Roubini. More than half the bonds outstanding are rated junk, so one would assume that an average based on the number of bonds would show a peak of over 7% (although a weighted average might come in lower). And by all accounts, this downturn is likely to be nastier than average. Defaults recently have been well below norms, but that is part has been due to the ease of refinancing, which is no longer operative.
Update: The paragraph above was corrected per a reader’s comment. Roubini had apparently been referring to junk bond defaults in the presentation mentioned, since he compared the peak default rate to a historical default rate of 3.8%, which is the historical default rate for junk bonds, not corporate bonds as a whole. Even so, the 15% figure does look a tad generous. Several sources say junk bond peak defaults in the 1990 recession was around 12%; Fitch reported a junk bond default rate of 12.9% in the 2001 recession. That is less than 15%, however.
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Blackstone is merely being fiendishly clever. By larding up company after company, Blackstone itself becomes ‘too big to fail’. And we, the chump taxpayers of USA INC. know what that means!!
And so do Blackstone…..
The 15% historical default rates you quote are bogus. According to Moody's annual default rate survey, the highest annual default rate ever for all corporates was 8.4% in 1933, and has never even exceeded 4% since then. Even in junk bonds, 15% is the highest figure ever (again 1933), with the second-highest years all below 11%. Hence last two recessions < 5%
Thanks for the catch. I have corrected the post.
I am only as good as my sources, which in this case was Nouriel Roubini.
Roubini has cited Ed Altman with enthusiasm and deems him to be a world expert (Altman has written papers for the BIS on the implications of Basel II, for instance, and has modeled detailed debt ratings. Altman used to run a ratings service that he sold to Standard & Poors).
I realize Roubini was NOT necessarily referring to rated corporate debt, which by definition is what Moody's would publish. It is possible Roubini failed to clarify two different notions from Altman, or maysimply been referring to junk bonds. One would initially think the latter, since per the revised post, Roubini had contrasted the 15% default rate with a historic average of defaults of 3.8%, which per Altman, is the historical default rate for junk bonds, not corporate bonds as a whole. However, I see various sources saying that the peak default rate in the last recession was over 8%, inconsistent with Roubini’s statement that the peak default rate exceeded 15%. However, while the common stated factoid is “over 8%,” Fitch reported that the peak junk bond default rate in the 2001 recession (not all that deep, mind you) was 12.9% But that isn’t “over 15%” by any stretch. Similarly, the commonly reported peak default rate for junk in 1990 was 12%
I found this quote from Altman to be interesting. Even public debt that is not rated is much weaker in rating-equivalent terms than rated debt, so its inclusion (if Roubini were to have done that) would push the historical default rate higher. For instance, from paper from the BIS:
Figure 1 does show that unrated (NR) institutional, publicly filed loans had a cumulative default rate over the 1996-2000 (Q3) period that was higher than BB but lower than B rated loans. And, the default rate was higher than the average
leveraged (“junk”) loan. This data is interesting since there was a significant number of non-rated loans (276) compared to all leveraged loans issued (542) in the five year period 1995-1999.
Since the context of Roubini’s remarks was how banks and financial intermediaries would suffer in the recession, it is possible he used a broader data set.
Note Altman has also forecast that junk bond defaults could exceed 16% this cycle.
“…everyone interview seemed extremely reluctant to say anything critical of Blackstone”
Maybe they are confusing Blackstone with Blackwater? The latter would surely blow your head off.
;-)