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Cheap Financing Of Dogs Not Entirely Positive News

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I for one was heartened a few weeks ago by Petco's PIK-toggle dividend recap debt deal at 8.5%, which I interpreted as a moderately bullish signal of economic confidence while also keeping an open mind to the possibility that it was simply a one-off indication of investor love for dogs. Dogs! Today the Journal provides additional similar data points and the recovery seems to go beyond the pet-supply sector:

Debt issued to fund private-equity dividends has topped $54 billion this year, after a flurry of deals earlier this month, according to Standard & Poor's Capital IQ LCD data service. That is already higher than the record $40.5 billion reached in all of 2010, when credit markets reopened after the crisis.

Also some of these deals involve a risky type of debt known as "payment in kind toggle"—or PIK-toggle—bonds that give companies the choice to defer interest payments to investors. Instead, they could opt to add more debt to the balance sheet. The default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn't use the bonds, according to a study by Moody's Investors Service.

If you use PIK-toggle-dividend-recap as a barometer of economic activity, and of course you do, then yes it is definitely creeping toward its highest, "2006" setting. On the other hand another barometer isn't. Equally enjoyable was the Journal'scompanion piece on the bad news implied by dividend recaps:

For an explanation of why private equity chieftains are pushing portfolio companies to sell bonds and loans to pay for fat dividends, look at IPOs. More to the point, look at the lack of IPOs.

Blame it on Facebook, retail investors’ disillusionment with stocks or pervasive uncertainty about the economy, but the IPO market has been weak most of this year. Private equity-backed companies have raised less via IPOs this year through October 12 than in any full year since 2008. Conditions couldn’t be more different in credit, particularly in the junk bond and leveraged loan markets. Mutual funds, pension funds and alternative asset managers are scrambling to buy ever-riskier deals because of the higher yields they offer. ...

The choice private equity firms are making about where to finance boils down to market arbitrage. Credit markets are valuing the companies they own at higher multiples than stock markets, so companies are raising cash in the former.

This ends, as most things do, with a dire warning that arbitrages can't last forever, which is true as far as it goes, but also much further, insofar as arbitrages can't really last as long as it takes to, like, print an offering memorandum, so this isn't an arbitrage arbitrage but more of an "arbitrage" arbitrage. Not the $20 bill on the ground, but the penny in front of the bulldozer.

One dopey way to think about these trades is the old "equity is a call option on the company's assets" model. You've got a private company, considered loosely as a confederation of private equity owners and equity-owning executives. It sells the stuff that pays it the highest price. When options are highly valued in the market, it sells options on its assets, in the form of equity - IPOs. When options are cheap, it buys options on its assets, effectively, by selling debt and creating a more levered equity stake in the company. (When everything is systemically cheap, à la 2006, it's kind of dealer's choice.)

Loooooosely speaking options are cheap these days; option prices go with volatility and implied volatility is at basically post-crisis lows. You can frame this as "upside is low," and you should, "as forecasts of a disappointing third-quarter earnings season appear to trump signs that economic data, particularly in the US, are starting to improve." Or you could frame it as "downside risk isn't particularly frightening," which is perhaps less intuitive but still y'know realized and expected corporate defaults are low. Your low-volatility picture of the world might suggest that junk-rated private-equity-owned companies are unlikely to report gangbusters earnings but also unlikely to report massively negative earnings, so they look more attractive in the form of an 8-handle PIK bond than in the form of an IPO.

That model should make you less enthusiastic about Petco as an economic indicator than I was a few weeks ago: it indicates that dividend recaps represent not "weak belief in strong economic improvement" and more "intense belief in muddling through."

Still, arbitrage! The volatility model perhaps works to reconcile stock versus bond expectations, but it doesn't reconcile public market vs. private equity expectations. Private equity firms shouldn't just buy options when they're cheap by historical measures; they should buy options when they're actually cheap, that is, when the private equity firms believe that their companies will be more volatile than is implied by the market.1

Do they? Well, one, maybe: company insiders tend to be biased towards believing that they'll have strong future earnings; that's why they, y'know, work there (or LBO'ed the company), so they might be stronger believers in "volatility" in the sense of "earnings upside" than are their public investors. Two, maybe, who cares: private equity firms have structural reasons (pre-fiscal-cliff tax planning, perhaps need for cash for other investments though probably not) to want to take out cash now even if they don't think they're getting it particularly cheaply.

But, three, unlike the public market, the owners of these companies can do things to make more volatility, and thus make their option more valuable. By, for instance, levering up the company some more. I liked this explanation:

A Carlyle spokesman said the private-equity firms put more cash into the buyout [of dividend recapper Pharmaceutical Product Development LLC in December] than they would have normally because credit markets then were more stressed. With markets improved, he said, the firms are adjusting the debt load to a level more typical in leveraged buyouts. Also, he said, the company can handle the debt.

If people will give you cheap financing because your leveraged buyout looks less risky than their terrifying memories of 2006 vintage leveraged buyouts, take the money until it looks that risky. That's the best way to increase your option value.

Debt Fuels a Dividend Boom [WSJ]
Private Equity Plays Stock vs. Bond Arbitrage [Deal Journal]

1.Volatile not good! If you think you'll report gangbusters earnings, definitely lever up to make your shares more sensitive to those earnings. If you think you'll default, definitely definitely take money out now.