Over the past year, much has been written about the coming “wave” of debt maturities; to add to the drama, some call it a tidal wave and others a tsunami. Regardless of the label that one uses, there is no dispute that several trillion dollars of debt will be coming due in the next few years. Much of that debt will be refinanced in the ordinary course because the borrowers have good businesses and adequate collateral. However, among those maturing debts are, according to a Moody’s February 2010 report, more than $800 billion of leveraged loans and high-yield bonds issued by “speculative-grade borrowers.” In an earlier era, the debt issued by such borrowers was known less artfully and more aptly as “junk.”
The term “junk” originated because of the high risk associated with holding such debt. During the heady LBO days of 2005-2007, easy credit and huge amounts of cash fueled irrational debt structures. Aggressive revenue growth and margin expansion were assumed in the financing of these transactions and were vital for repayment of interest (i.e., no room for error). Even if the borrower were to deliver on its plan, a refinancing at maturity was assumed. Nomenclature such as “leveraged loans” and “high-yield bonds” only serves to mask the true “junk” nature of many of these securities.
This roughly $800 billion is spread among nearly 1,000 different borrowers. Approximately 70 percent is bank debt and 30 percent is in the form of bonds. Most of this, about 87 percent, is due in 2012-14, with 2013-14 comprising about two-thirds of the total. Consequently, we have some time to go before the wave hits. Over the next few years, the situation may even resolve itself if the economy recovers, credit flows freely, interest rates don’t spike and inflation doesn’t develop. But don’t bet on it.
As discussed above, borrowers took on significant amounts of debt based on aggressive projections that would be difficult to attain even in a good economy. In the current economic environment, many of these projections will be virtually impossible to attain. In contrast to the ease with which these loans were granted by lenders, borrowers will face significant challenges keeping those lenders at bay if they breach covenants or require amendments or waivers to prevent defaults. Consequently, management teams and boards would be prudent to recognize these situations and begin the restructuring process as early as possible. They cannot rely on hope as their strategy.
Borrowers have more options when they have adequate time to work through their issues, and therefore they should consider being proactive in restructuring their debt. Options include debt-for-equity swaps, extending maturities, and even strategic and consensual bankruptcy filings. Furthermore, there may be fundamental flaws in their business models that could be addressed concurrently, such as a bloated corporate structure that may need to be downsized. There may be a non-core business that is distracting management and may be a source of liquidity if sold. What is important is that management teams and boards to have a complete understanding of the issues that they face and the time to work through those issues. In many cases, this requires a fresh, objective review of the business to identify issues that insiders frequently overlook for emotional or other reasons.
In addition to having a complete understanding of what is happening inside the business, there also are exogenous factors of which borrowers must be cognizant. Widespread trading in bonds as well as loans has complicated the process of working through these issues with lenders. Many of the original lenders in a deal sell all or part of their holdings—especially at the first sign of trouble. Therefore if a borrower waits until the last minute to try to solve an actual or pending default it may have a hard time getting enough lenders to approve an amendment or waiver. This can be especially troublesome when lender approvals require super majorities or 100 percent approval.
Solutions involving debt-for-equity swaps have also become more challenging since the advent of credit default swap or CDS. These contracts were originally developed to provide lenders with insurance to offset any losses incurred if a loan goes bad. With these insurance policies in hand, some lenders may have little or no incentive to restructure a loan (or exchange it for equity) because they may be entitled to a full recovery from their CDS. In fact, to a holder of a CDS, a company may be worth more dead than alive. Even more unsettling to borrowers is that CDS contracts are not tracked or registered on any exchange. In most cases, holders of CDS are difficult, and in some cases impossible, to identify. In fact, they may not have an insurable interest. Rather, they may be betting on the demise of the borrower and have determined that a CDS is the best way to make that bet.
In conclusion, borrowers will not be able to ride the wave to maturity and beyond. Early proactive behavior may allow companies to navigate out of the wave and into calmer waters and avoid the riptide and jagged rocks waiting at maturity.