Henny Sender gets a
little bit ahead of herself in the WSJ today, although she does pick up
on something important: that as the price of debt falls, it’s starting to become
more attractive, on a relative-value basis, than equity.
The news is that hedge funds and private-equity shops are getting very enticed
by the high yields offered on discounted bonds.
Three weeks ago, with investors increasingly spooked, the banks that arranged
financing for private-equity giant Kohlberg Kravis Roberts & Co.’s buyout
of Goodlettsville, Tenn.-based retailer Dollar General agreed to sell some
of that debt for as little as 87 cents on each dollar owed. Hedge funds led
by TPG-Axon, an affiliate of TPG, swooped in, attracted by returns of close
to 18%.
Indeed, that could turn out to be a better return than what KKR earns as Dollar
General’s new owner, with far less risk, given how much KKR paid to buy the
dollar-store chain.
Of course, TPG hasn’t made any returns at all, yet. Yields are not returns,
and the value of Dollar General’s bonds can go down as well as up. It definitely
seems fair to say, however, that those bonds are less risky than KKR’s equity
in the company – and that there’s a good chance that at these levels they
will prove more lucrative, too. After all, if the bonds rise in price, you get
a nice capital gain on top of your big coupon payments.
Sender also sees more value in default than I do:
If the company encounters even stronger head winds and one day defaults,
the debt holders would wind up owning the firm…
The private-equity firms say that even if their companies have a lot of debt,
these companies are far larger and stronger than in the past and have such
flexible capital that they can withstand any storm. If they are wrong, of
course, debt today that trades at 87 cents on the dollar will obviously fall
much further.
But with current yields above 15% and the possible upside of debt turning
to equity, private-equity firms are increasingly embracing these trades.
When Sender talks about "the possible upside" of converting debt
to equity in default, does she mean that the value of the equity, post-default,
could be higher than the 80 or 90 cents now being paid for the debt? That seems
most improbable to me. There are distressed-debt trades which are designed to
profit from converting debt to equity, but they don’t have entry points at these
sort of levels. Normally, that trade only works when you buy the debt at truly
distressed levels in the mid-30s or so.