Illustration by Jeremy Leung/II
Private equity firms excel at getting what they want.
They take over companies, in deals funded partly with debt, and influence their decisions with the aim of reaping a gain from their equity in the buyout. Along the way, they may help themselves to dividends from the companies they control, sometimes recouping a portion of their investment soon after buying them — and before it’s clear they will succeed in building their value.
Increasingly, they’re having their way with the people lending them money too.
Buyout funds have been demanding aggressive terms over the past several years that may help protect their interest in companies at the expense of lenders funding their deals. Debt investors are accepting fewer covenants based partly on the narrative that they too will benefit from increased flexibility for private equity owners.
“Private equity firms are basically masters of financial engineering,” says Michael DePalma, chief executive officer of PhaseCapital, a New York–based investment firm focused on credit and quantitative macro strategies. “It’s just hard to believe that debt investors are willing to give up so much, particularly when the covenant-lite market has not really been tested.”
Covenant-lite loans, which lack safeguards protecting lenders, have surged since the 2008 financial crisis. A record 89 percent of institutional loans issued last year by private equity-backed borrowers were covenant-lite, a portion that has soared from 6 percent in 2010, according to data from S&P Global Market Intelligence.
“What assumptions are we making that we’re okay with lending money over and over again, and basically saying, ‘You know what, if you have it, pay us back,’” says DePalma, who is avoiding covenant-lite deals for fear of unpleasant surprises.
“The additional yield you get for these things is not significant,” he says. “Are we that yield hungry out there? That must be it.”
A corporate debt bubble, created by ten years of low interest rates, has left investors so starved for yield that they are routinely willing to accept debt agreements with weak covenants, according to DePalma.
As an investor in private equity funds, Christopher Zook, founder of Houston-based multifamily office CAZ Investments, has seen up close some of the more egregious terms lenders have been willing to accept. “We’ve seen deals where the covenants are absurd,” he says.
For example, CAZ was invited last year to co-invest in a multibillion-dollar take-private deal under which the company could “literally sell off their assets and not pay down any debt — and the lender wouldn’t have any recourse,” according to Zook. “That’s crazy,” he says, declining to name the company that was taken private due to nondisclosure agreements.
For the equity holders, though, it was a good deal, says Zook, and CAZ, which oversees $1.25 billion of assets, decided to participate in the buyout.
“If they wanted to, tomorrow the company could sell all the assets and pay all the proceeds to me and others,” says Zook. “And the debt holders would be left holding nothing.”
The aggressive terms of the buyout funding show how far Wall Street will go to sell a deal, according to Zook. “Lenders just aren’t being paid enough interest rate to take that kind of risk,” he says. Particularly as it’s their job to be paid back.
Craig Manchuck, a bond fund manager at Osterweis Capital Management, has steered away from funding buyouts with weak lender protections, including Blackstone Group’s $17 billion purchase of Refinitiv last year. (Blackstone declined to comment for this article.)
The dangers lurking in bond indentures and credit agreements might not be a problem — until a company is in trouble.
Manchuck has seen private equity firms ask for financing terms allowing a unit producing the majority of a company’s earnings to be deemed a non-guarantor subsidiary. Should things go wrong and the company file for bankruptcy, the equity holders may continue to see income from the non-guarantor subsidiary, while debt investors have no claim on the assets, he says.
For the past seven or eight years, buyout firms have aggressively sought to eliminate lender protections to ensure their equity stakes are less at risk of being harmed, according to Manchuck.
“They’ve now got all the advantages,” he says. “The bondholders and the lenders on the loan side retain fewer and fewer controls to make sure that things are being done correctly.”
While Zook agrees debt investors may end up hurt from some riskier buyout deals, he says he likes the returns private equity provides his multifamily office. They include gains from dividends funded by debt, a strategy where a buyout firm directs a company it owns to borrow to finance the payout.
“There’s a fine line a private equity firm has to walk between delivering the best returns they can for their limited partners,” Zook says, and “making sure that they’re good stewards of the companies they acquire.”
Arguably, it’s a line they don’t always walk well.
Consider, if you will, EP Energy Corp.
The Houston-based oil and gas developer is struggling under the debt load that helped fund its $7.2 billion buyout by Apollo Global Management in May 2012. The company is now trading for less than $1 a share and was warned by the New York Stock Exchange in January that it no longer meets its listing standards.
Apollo, the private equity firm run by billionaire Leon Black, led an investment group that purchased EP Energy, the exploration and production assets of El Paso Corp., before oil prices began to plunge in mid-2014. The new owners were quick to recoup a portion of their investment before the steep decline, directing the company to issue debt to finance the payout.
The group — which includes private equity firm Riverstone Holdings, Korea National Oil Corp., and Access Industries, the conglomerate controlled by billionaire Len Blavatnik — extracted a $200 million leveraged dividend in August 2013, before taking EP Energy public in early 2014. The company also issued $350 million of pay-in-kind notes in December 2012 to fund a distribution to its owners, repaying the debt with proceeds from the initial public offering, regulatory filings show.
Apollo stands out among private equity firms for aggressively taking dividends, according to a Moody’s Investors Service report in October. Buyout firms are considered “particularly aggressive” when the dividends are large or taken within about a year of a buyout, Moody’s said. (Apollo declined to comment on EP Energy and its use of debt-funded dividends.)
Borrowing to fund a faster return on capital doesn’t help build the value of a company. It benefits the private equity owners while adding interest expense that eats into cash flow.
Buyout firms can “supercharge” their internal rates of return by taking dividends before they exit their deals through a sale or a public offering, says Manchuck, who co-manages the $5.5 billion Osterweis Strategic Income Fund. Osterweis has avoided exploration and production companies for more than two years, he says, because they tend to lack free cash flow.
Borrowers in that position can find themselves stuck with an unsustainable debt problem. EP Energy is no exception. The oil and gas developer will burn cash this year to fund production, according to S&P Global Ratings analyst Sarah Sherman.
“Its biggest issue is the capital structure,” Sherman says in a phone interview. It’s difficult for the oil and gas developer to pay down debt, according to S&P, which rates the company CCC+, or seven levels below investment grade.
EP Energy had $365 million of interest expense last year, as total debt rose to $4.4 billion at the end of December, according to its annual report filed with the Securities and Exchange Commission. “That interest burden really makes it difficult for them to dig themselves out of where they are now,” says Sherman.
Absent higher oil prices, the credit rater said in a February report, the company could attempt a distressed-debt exchange for some breathing room as it approaches a debt maturity next year.
EP Energy’s buyout in 2012 was financed with $4.25 billion of debt and $3.3 billion of equity, a regulatory filing shows. Now operating amid lower commodity prices, its high leverage makes aggressive growth spending hard. This year, EP Energy will see a $130 million shortfall in free cash flow, S&P estimated in the February report, co-authored by Sherman.
Meanwhile, there’s still a lot at stake for the private equity group in control of the company.
The oil producer’s biggest stakeholder, Apollo, had at least $809 million of capital at work in the company at the end of 2012, making it one of the firm’s largest private equity investments at the time, according to a document the alternative asset manager filed with the SEC.
After the buyout, Apollo owned about 54 percent of the company, with Riverstone, KNOC, and Access each holding a 15 percent stake, a filing from EP Energy shows. Apollo invested in the company through Fund VII, a $14.7 billion buyout fund that closed in 2008, and Apollo Natural Resources Partners, according to a regulatory filing.
The IPO diluted the Apollo-led group’s ownership to a combined stake of about 85 percent, a regulatory document shows. And while the offering helped relieve the company’s debt burden, it shined a light on the various fees the owners pocketed.
EP Energy used proceeds from the offering to pay down borrowings — including the notes that financed the dividend — plus deliver $83 million in fees to the sponsors, according to the document. The payment was tied to the company’s management fee agreement with the sponsors for consulting and advisory services.
Within two years of the buyout, the Apollo-led group of sponsors received around $200 million in fees, filings show.
Certain investors in the group, including Apollo, pocketed a one-time $71.5 million “transaction fee” paid by EP Energy at the time of its 2012 buyout for related services such as arranging financing. That same year, the sponsors received about $15 million under their management fee agreement with the company. In 2013, they collected $26 million in management and other fees. And the next year, EP Energy paid them a total $90 million in fees, all of which, including those covered with the IPO proceeds, was recorded during the first quarter of 2014, filings show.
Not surprisingly, the company has routinely alerted its investors about the power of its private equity owners.
The oil and gas producer warns in its annual reports that its private equity owners “may have conflicts of interest with us” or the company’s “public investors.” As long as they own the majority of its equity, or control the majority of its board, EP Energy says in the filings that “these investors will continue to be able to strongly influence or effectively control our decisions.”
The oil producer’s website shows that five of the directors on its 13-person board work at Apollo, while employees of Riverstone, KNOC, and Access also fill some seats.
According to EP Energy’s latest annual report, Apollo, Riverstone, Access, KNOC, and other legacy investors own more than 75 percent of the company’s shares. (Riverstone declined to comment. Donald Wagner, a managing director at Access Industries who sits on EP Energy’s board, did not return a phone call seeking comment.)
Giljoon Sinn, a former EP Energy board member who works for KNOC, did not respond to a message seeking comment that was sent March 25 over LinkedIn. However, that same day, Sinn notified the board of his resignation, which took effect April 1.
While fees collected by private equity firms may seem peculiar, they are, in fact, common — and flowing from various agreements with their investors and companies they own.
Eight-seven percent of Apollo’s distributable earnings last year stemmed from fees — a higher portion than rival alternative asset managers Blackstone Group, KKR & Co., and Carlyle Group, according to PitchBook. Fees raked in last year by Blackstone, the world’s largest private equity firm, made up 54 percent of its distributable earnings, PitchBook’s analysis shows.
These giant asset managers invest in private equity as well as other alternative strategies. The fees they generate from assets may stem from a variety of sources, including performance, fund management, or advisory services tied to their portfolio companies.
EP Energy paid no fees to its sponsors in 2018. But its annual report for 2017 shows $5 million in sponsor-related fees were paid to release a leadership team from another Apollo-backed company. EP Energy explained in the filing that in November 2017, it reimbursed that portfolio company about $4 million for money contributed to it by fund investors other than Apollo.
That same month, EP Energy shook up its leadership by naming Russell Parker president and chief executive officer. Parker was previously CEO of Phoenix Natural Resources, according to EP Energy’s annual report for that year.
Parker said March 15, during EP Energy’s conference call on its 2018 earnings, that the company has adapted to volatile commodity prices seen in the second half of last year and plans to stay disciplined. “We have a great set of assets and a committed group of exceptional employees that helped us deliver on our operating objectives,” he said during the call. “We’re very pleased with what we accomplished during the year.”
The oil producer has cut its full-time U.S. workforce in half over the past five and a half years.
And EP Energy’s efforts to reduce debt through asset sales, open market debt repurchases, and a distressed-debt exchange in January have not been enough to “right-size the company's capital structure,” S&P said in its February report.
Assuming oil prices of $55 a barrel, EP Energy expects it won’t have enough liquidity to repay its $182 million of senior unsecured notes maturing in May 2020 plus meet working capital needs and planned capital expenditures, according to its 2018 annual report. Crude was about $59 a barrel on March 25, down from about $75 at the start of October.
Based on a share price of 26 cents on March 29, the oil and gas developer has a market value of about $67 million. That compares with about $4.9 billion at the time of the IPO, which priced at $20 a share.
Meanwhile, members of the Apollo-led investment group have taken more than a half billion dollars in distributions, with regulatory filings indicating they were largely funded with debt. EP Energy’s filings show it distributed a combined $542 million to members in 2012 and 2013, and point to at least $537 million paid within about 15 months of the buyout.
One way buyout firms seek to salvage their equity in struggling companies is through distressed-debt exchanges — although this avenue can turn out to be at lenders’ expense.
Distressed exchanges became common during the financial crisis and have remained a prevalent tool for restructuring, particularly among private equity-owned companies that are struggling, according to Moody’s Investors Service.
“When successful, they can help overleveraged firms reduce debt enough to stay solvent and avoid bankruptcy,” Moody’s said in a March 2018 report on out-of-court restructurings. While they proved helpful in the 2008–2009 default cycle tied to the financial crisis, that cycle was shortened by unprecedented intervention from the Federal Reserve, according to the report.
Naturally, buyout firms want as much runway as possible to preserve their equity in a business.
“You’re hoping that something turns around and that you can save the business,” says Osterweis’s Manchuck. “But by doing so, you may be bleeding value away from the lenders, and their ultimate recoveries could be much more negatively impaired.”
Moody’s studied 30 years of defaults and found that 41 percent of the time “distressed exchanges did not shore up the capital structures of struggling companies enough to stave off another default” from bankruptcy or another round of distressed-debt swaps, according to the report.
It’s certainly in the best interest of private equity firms to seek a distressed-debt exchange over a bankruptcy, according to Moody’s analyst David Keisman. “If you’re in bankruptcy, you’re wiped out, usually,” he says in a phone interview.
Distressed exchanges were “not really a meaningful form of default” before the financial crisis, says Keisman. But after the Fed put trillions of dollars of liquidity into the market, borrowers watched as default rates diminished and said, “‘Why don’t we do a distressed exchange and get us out of this cycle and then worry about it?’” Keisman says.
Borrower-friendly financing terms have also become more prevalent, making it easier, in some cases, for the value in a company to be removed from creditors and placed into the hands of equity holders, according to Derek Gluckman, a Moody’s analyst who specializes in covenants.
“Covenant protections continue to be degraded,” he says. “That’s something we see year over year over year, and I don’t expect that to change until market conditions will no longer permit that.”
Covenant-lite loans, which were introduced to the market before the crisis, can help companies endure a rough couple of quarters without harming lenders, according to Manchuck. The problem arises when covenant-lite debt permits the borrower to keep extending the runway for a potential turnaround while the business continues to deteriorate, he says.
In other words, creditors may recover more value from a company that files for bankruptcy protection instead of drawing out — because a lack of covenants permits it — an unsuccessful turnaround attempt in a long downturn.
Buyout firms first started asking for covenant-lite loans to defend against overzealous, or hostile, debt investors as credit markets evolved, says Manchuck. Banks were holding a shrinking portion of the loans backing their deals, prompting concern that their buyout debt could trade into the hands of a distressed investor, who might force a restructuring at the slightest stumble, he says.
But in the past several years, private equity firms have become more aggressive in asking for terms that favor their position as equity holders. In aiming to build the value of companies they own to produce big returns for their investors, they’re playing for the upside. Lenders don’t share that same upside potential, but they’ve increasingly given up downside protection to help fund their buyouts.
“The system has tilted far in favor of the sponsors,” Manchuck says. “Whose fault is it? I’d say it’s the fault of the lenders, but the lenders have been boxed into a supply-and-demand equation.”
Osterweis is able to ignore aggressive deals because it’s “benchmark agnostic,” according to Manchuck. But for high-yield managers seeking to beat a particular benchmark, it can be tough to pass on deals that will be included in it for fear of “locking themselves into underperformance,” he says. Instead, they may overweight or underweight borrowers in a bid to outperform the benchmark, he explains.
“As more and more money shifts to benchmark strategies — and the growth of ETFs contributes to that — it makes it easier for sponsors to do deals with weaker structures,” he says. “Some of these deals may work out fine, but there’s this lurking risk that you don’t have the protection if you own some of these deals.”
Meanwhile, private equity firms have continued to attract institutional investors in droves.
In his recent conversations with global investors, Zook says “there’s the perception that we’re getting pretty close to the recession.” Investors who contribute to a private equity fund that closes this year are anticipating it will put money to work at much better valuations than the past two or three years, he explains. The valuations will soften in a contracting economy.
“I think that’s what’s motivating money to continue to flow to some of these very large mega-funds that are out there,” says Zook. “The private-equity business model itself is doing extremely well.”
Private equity produced a 14.8 percent internal rate of return globally for the year through June 2018, according to PitchBook data. The industry produced a 15.1 percent IRR for the five years through June.
As for dividends, Zook says he loves getting back his money quickly from private equity deals as it increases IRRs. But he adds that they should be financed with a reasonable amount of debt and warns that private equity firms have been successfully loosening covenants to give themselves more flexibility for payouts.
Debt-funded dividends shouldn’t take a company’s leverage to “ridiculous” levels that it may struggle to bear in a downturn, he says. And caution is needed with cyclical borrowers like oil producers, he adds, as commodity prices are known to be volatile.
Over time, the prevalence of covenant-lite loans in private equity may prove to be a double-edged sword. The notion that private equity firms will manage to muddle through a downturn and come through “okay on the other end” because of loose covenants has led lenders to feel more comfortable taking on more risk, according to Zook.
“The place that I think there will be some that get hurt are the people making overleveraged loans with very weak covenants,” he says. “They’re the ones that are going to be left holding the bag.”
