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Is Private Equity Creating a New Subprime Debt Bubble?

If there's any certainty in the financial world these days, it's that low interest rates are going to be around for a while. The Federal Reserve has done everything in its power to keep rates low, going so far to employ novel new ideas to try to push rates ever lower.

While this may help borrowers, it can present a problem for those fixed-income investors who are looking for some return on their investments.

Luckily the brilliant minds that found a way to stamp AAA credit ratings on bonds made from selling negative amortizing loans to people without verifying their income are still around to help.

The Wall Street Journal posted an article yesterday evening highlighting a spate of debt issuances by private-equity owned companies. The companies aren't selling bonds to fund acquisitions or capital spending; they're adding debt to their balance sheets for the purpose of paying dividends to their private equity owners.

The Journal points out that Leonard Green and CVC Capital Partners, who took BJ's Wholesale Club private last year for $2.8 billion, have already repaid themselves the full cash investment. BJ's recently sold about $1.625 billion in bonds to help fund a $643 million cash dividend. The offering was among the factors that lead Moody's to downgrade the company's credit rating even deeper into junk status.

The bonds in these offerings may not be rated AAA like their housing-bubble counterparts, but there are plenty of investors willing to take on riskier assets as they try to keep inflation from eating into their portfolios.

Offerings like this are interesting for several reasons. First, by managing the deal this way, the private equity firms have already been made whole. The worst they can do from this point forward is breakeven. If they wanted to, BJ's could be sold tomorrow for the same or less than the original purchase price and the PE firms would still turn a profit. This removes the risk from the deal, and with it, much of the incentive to make sure BJ's is spun back out as a healthier company.

The second reason these deals are interesting is that as The Journal pointed out, these debt offerings are increasingly being issued using so-called “payment in kind toggle” of PIK toggle notes. These are instruments that allow the borrower to defer interest payments, adding the deferred amount to the balance of the loan. This sounds pretty similar to the pick-a-payment mortgages that blew up along with lots of other exotic and ultimately ill-advised loans written as the housing bubble inflated.

A study by Moody's Investors Service found that the default rate for PIK-toggle bonds sold between 2006 and 2012 was 13%, double the rate for comparably rated companies who issued more traditional debt. This is likely because the ability to defer interest payments allows companies in an already shaky financial position to dig themselves into hole. Add in a group of private equity owners who have already taken their risk off the table and these deals like a disaster waiting to happen.

Bobby Raines is the Managing Editor of the Market Intelligence Center. He has degrees in Mass Communications and History from Emory & Henry College. Bobby worked at a mid-sized daily newspaper before making a switch to covering the financial industry full time in the years leading up to the financial crisis. He has been a member of the Fresh Brewed Media team since 2011 and has served as a writer and analyst. You can write to him at braines@marketintelligencecenter.com.

 

Bobby Raines

Bobby Raines is the Managing Editor of the Market Intelligence Center. He has degrees in Mass Communications and History from Emory & Henry College. Bobby worked at a mid-sized daily newspaper before making a switch to covering the financial industry full time in the years leading up to the financial crisis. He has been a member of the Fresh Brewed Media team since 2011 and has served as a writer and analyst. You can write to him at braines@marketintelligencecenter.com or follow him on Twitter: @BRatMICenter.