Patrick Keane
September 09, 2016
Principal, Lampe, Conway & Co. LLC

Reality Comes Into Focus

Perhaps you’ve heard this one: An optimist, a pessimist and an optometrist start discussing the high-yield market... The optimist points to transactions like Dell’s $84 billion financing of EMC and exclaims “all’s right with the world, Full steam ahead!” The pessimist shakes his head and warns “the Fed will need to raise rates to try to stave off an economic calamity from 7 years of ZIRP.” The optometrist argues that a debate over whether the market is half full or half empty misses the point. The focus should not be on macroeconomic predictions but on the reality of what we see happening right in front of us at the lower end of the leverage finance market. Our inner optometrist sees opportunities developing more rapidly now than we’ve seen in the past 5 years. Here is a recent example: 

Logan’s Roadhouse:   Operates 234 restaurants in 23 states employing 19,000. The company was acquired by Kelso & Co. in 2010 for $620MM, including a cash equity stake of $230MM. With FY 2010 EBITDA of $73MM, Kelso paid an aggressive purchase multiple of 8.5X. Since then the company has been plagued by poor operating performance, higher commodity prices and an excessively levered balance sheet. Unable to meet its October 2015 coupon, the company completed two debt-for-debt exchanges that reduced its cash interest charges but was still forced to forego another coupon in April 2016. The company engaged a financial advisor and began negotiations with stakeholders and filed for bankruptcy on August 8th. Negotiations between Logan’s management and bondholders culminated with a “pre-packaged” Chapter 11 filing whereby 84% of the $378MM of second lien notes supported a plan that effectively eliminated $300MM of debt in exchange for all of Logan’s new equity . The Logan’s saga illustrates some interesting characteristics of the lower middle market credit markets: 1) Accommodating capital markets enabled Kelso to pay an excessive price for Logan’s, mostly funded by high-yield debt; 2) Opportunities are not necessarily generated by interest rate movements; coupons and maturities are often the ultimate catalysts; 3) Refinancing capital is not necessarily available to smaller, struggling companies. 4) Logan’s $145MM of 10.75% Second Lien Notes (the “Unexchanged Notes” were trading at a face value of $7MM just prior to bankruptcy offering potentially attractive risk/reward opportunities.

Logan’s Roadhouse is but one example of a growing wave of small over leveraged companies struggling in the current low-growth economy. As illustrated in the graph to the right, bond rating downgrades and negative indicators are rising at the fastest clip since 2009, with high-yield bond defaults expected to surpass 5% by year end. Market optimists have supported rising high-yield bond prices by underestimating deteriorating company and market fundamentals. Pessimists, on the other hand, have been dismissive of distressed opportunities overall, particularly those in the lower middle market. The reality is there has been no miraculous recovery in middle market company fundamentals to justify the rising high-yield market.  That market’s recovery has been nothing more than a resumption of investors’ reaching for yield. Small and troubled companies are now struggling to refinance their debt maturities because investors are starting to discount higher default risk into their pricing. As we have illustrated in previous commentaries , the inventory of lower middle market distressed opportunities is strong and growing by the day. We expect fundamentals will continue to deteriorate for the foreseeable future, presenting many more distressed investment opportunities in the coming months and quarters.


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