The Manager's Commentary - February 2011
Henry Kravis, co-founder or KKR & Co recently said his firm received its cheapest financing ever to fund their recent $5.3 billion takeover of Del Monte Foods. While Del Monte has some outstanding branded pet food products that are reasonably recession proof, total leverage for the deal was 6.5 times cash flow. The coupon on the bond, the most junior debt, is 7.625%. Historically businesses with this level of leverage would have coupons closer to or above 10%.
Nevertheless, more worrying than the lack of compensation in the Del Monte bond, is the extremely loose covenants that were attached to the loans that are senior to the bonds. During the credit crisis of 2008 and 2009, borrowers amended their credit agreements to allow the company and/or their private equity sponsor to buy loans below par. Fast forward to today and this is automatically being written into credit agreements such as Del Monte’s. In this specific case, KKR could purchase up to 30% of the loans of Del Monte. This option gives KKR, as the equity investor the ability to potentially influence any future debt restructurings and potentially protect their equity investment to the detriment of bond investors.
There have also been many loan refinancings that have reduced the coupons (i.e. cash interest for the investor is trending lower) and adjusted both leverage and interest coverage ratios so that companies can carry larger debt balances and require less of a cash flow cushion above interest payments.
These trends are very concerning to us and we believe it is prudent to build flexibility into the fund to take advantage of potential market dislocations that could arise in the future. Catalysts of potential volatility, in addition to the previously highlighted negative credit issues, seem to be around every corner; peak earnings margins, middle east volatility, and still low interest rates…to name a few. With this in mind we are focusing on short term (3 to 24 month) cash proxies that in some cases can generate yields above 6%.
Our feelings towards the high yield market today can be best summarized by the character Nero in Nassim Taleb’s “Fooled by Randomness: the hidden role of chance in life and in the markets” who in understanding that the large players in the high yield market used fundamentally shallow quantitative tools to assess risk believed the “…high-yield market resembles a nap on a railway track. One afternoon, the surprise train would run you over.”
Matthew Shandro
February, 2011