Recession or not, there will be pain: Coping with corporate bonds
If the current economic expansion which began in June 2009 makes it to this July, it will set a record for the longest period of U.S. economic growth—beating the 1991 to 2001 boom. Economic expansions don’t die of old age, however, so what might bring this one to an end?
With memories of 2008-2009 still fresh, some observers have focused on corporate debt as the likely culprit. It’s true that corporate debt has risen rapidly during the expansion, both in absolute terms and in relation to corporate profits. But low interest rates mean that debt service—interest payments on this debt relative to after-tax profit—is about 25 percent, where it usually is during periods of expansion and not a cause for worry. Bank regulators are concerned about the rapid growth of leveraged loans and weaker lender protections. But they appear to be correct in their assessment that leveraged lending, despite a 20 percent growth since last year to almost $1.2 trillion, “isn’t a current threat to the financial system.”
Still, recession or no recession, there will be pain.
A large and growing share of corporate debt is “speculative debt”—either leveraged loans used to acquire target companies and burden them with high debt levels or high risk junk bonds. Many companies with high levels of speculative debt on their books were acquired by private equity in a leveraged buyout, meaning the PE firm used high amounts of debt to buy them. This is debt the target companies, not their private equity owners, are obligated to repay.
Often, these PE-owned companies are required to issue junk bonds and further increase their indebtedness in order to pay dividends to their owners. A 100-day plan imposed on company managers at the time of the buyout lays out the steps that the company will need to take to service this mountain of debt. Reducing labor costs is a big part of these plans, whether by closing less profitable stores and establishments, laying off workers at those it continues to operate, or cutting pay and benefits. After it takes these steps to manage its debt, the company is on a knife-edge.
If all the assumptions made by the private equity firm when it persuaded creditors to lend it boatloads of money hold up, the company will avoid defaulting on its loans and going bankrupt. But if these assumptions are upended—say, by a slowdown in the economy, defaults and bankruptcies will spike. Creditors who have loaned billions of dollars to finance private equity-sponsored leverage buyouts will experience losses. Establishments will be shuttered, some companies will be liquidated, workers will lose their jobs, and communities will lose businesses that have played a key role in the local economy.
In 2013, concerned that loading a company with debt greater than 6 times earnings increased the likelihood of default or bankruptcy, bank regulators—the Office of the Comptroller of the Currency (OCC), the Federal Reserve (Fed) and the Federal Deposit Insurance Corporation (FDIC)—updated lending guidance. Banks were advised to avoid making loans that saddled a company with debt greater than 6 times earnings unless they could show that the company would be able to pay back the loan.
Initially, this put a crimp in private equity’s ability to load up companies with excessive amounts of debt. But private equity firms soon found a way around this limitation. They set up their own lending operations and extended loans to other firms in the industry. Trump administration regulators have chosen to relax enforcement of the guidelines. The result? In the first quarter of 2019, six years after the updated guidance was issued, leverage used in buyouts has risen to an average of 6.96 times earnings, up from 5.80 times in the first quarter or 2013.
We don’t need to look far to understand how this will affect the viability of businesses and the outcome for workers. Bankruptcies of department stores and specialty shop chains are so widespread, they have been dubbed a “retail apocalypse.” Retail is a business that has always faced disruptors—consumer tastes can be fickle, innovations like fast fashion challenge traditional marketing, recessions lead customers to postpone purchases, e-commerce puts pressure on brick and mortar stores. Traditionally, retailers have prepared for this by keeping debt levels low and owning their own real estate—holding costs down so they can weather tough times and make the necessary adaptations in how they do business.
Private equity owners turn this formula for success on its head. The low debt levels of retailers are an invitation to load up the stores they acquired with high amounts of debt. Selling off some of the stores’ real estate in sale-lease back agreements enriches the PE owners who pocket the proceeds of the sale, but leaves the stores to pay rent on facilities they used to own. Stores are stripped of resources they need to modernize and keep up with the competition by owners that put their hands in the till to pay themselves generous dividends. Often the owners collect fees from these companies, even when company profits spiral downward. These measures guarantee that the PE firm will make its bundle. While private equity owners prefer a profitable resale of their companies, that’s really the second bite of the apple. Exiting investments via bankruptcy is increasingly common.
Private equity firms own only a fraction of U.S. retail chains, but they are behind a disproportionate share—financial news service Debtwire calculates 40 percent—of retail bankruptcies: Toys ‘R Us, Payless Shoes, Gymboree, Claire’s Stores, PetSmart, Radio Shack, Staples, Sports Authority, Shopko, The Limited Charlotte Russe, Rue 21, Nine West, Aeropostale. The list goes on.
Supermarket chains are a particularly important corner of retail, employing 2.8 million workers in local communities across the country. Grocery workers are the most unionized retail workers; 60 percent of the United Food and Commercial Workers International Union’s 1.3 million members work in supermarkets. Seven major private equity-owned grocery chains went bankrupt between 2015 and 2018, a period that saw no bankruptcy of a comparable publicly traded chain. They include A&P/Pathmark, Fairway, Tops, Fresh & Easy, Haggen, Marsh, and the Southeastern Grocers chains (BI-LO, Bruno’s, Winn-Dixie, Fresco y Más, and Harveys).
Some of these bankruptcies—like Toys ‘R Us, Gymboree and Marsh Supermarkets—have ended in liquidation, with all of the stores closed for good. Even short of liquidation, however, bankruptcies have resulted in large numbers of store closings and major dislocations and job loss for workers.
Loading companies up with large amounts of debt leaves little margin for error. A decline in revenue as the economy slows or business conditions change leaves highly leveraged companies vulnerable to failure. It is difficult, if not foolhardy, to predict which sector will be next to feel the pain of a wave of defaults. But it’s possible that the baton has passed to health care. Investors who once found comfort in the thought that people have to eat or reassured themselves that specialty retailers had dedicated customers, now tell themselves that an aging population and government payers like Medicaid and Medicare will make returns on health care investment resilient.
Globally, the volume of health care deals is up 20 percent in 2018 compared to 2017; deal value spiked to record levels and is up 50 percent in 2018 over 2017—with most of this activity in North America. KKR’s $10 billion leveraged buyout of physician staffing firm Envision Healthcare was one of PE’s largest 2018 deals. Consultants point to the headwinds an economic slowdown or political challenges would pose. But they remain optimistic about prospects in this sector, noting that “returns in healthcare PE markets have proven resilient through such storms in the past.”
The bankruptcy and liquidation of West Coast retailer Mervyn’s department store chain in 2012 was an early forerunner of the retail apocalypse. Does the struggle of Community Health System (CHS), at one time the largest hospital chain in the U.S. by number of hospitals, foretell a similar outcome in health care?
Hospital chain CHS was acquired by a private equity firm in a leveraged buyout in 1996. Following the PE playbook, it expanded by using LBOs to add-on hospitals. Even after it went public and was no longer owned by private equity, it continued to use leveraged buyouts to add hospitals, loading itself with dangerous amounts of debt. In 2013 CHS acquired hospital chain HMA in an LBO.
When the deal closed, CHS operated 206 hospitals, more than any other chain. By June 2015, CHS’ total long-term liabilities had increased dramatically. A year later, CHS was struggling. Its share price, which had risen to $65 a share in July 2015, fell to $13.96 in February 2016. in March 2019 its shares traded at just $3.85. In 2015, unable to meet its debt obligations, CHS began divesting facilities to pay down debt and avoid default. It has eliminated services at some hospitals, sold off others, and closed still others.
In April 2016 CHS did a spinoff of 38 small, mostly rural hospitals into Quorum Health Corp, a newly created public company. The spinoff yielded about $1.2 billion in net proceeds to CHS. Quorum, however, was loaded with roughly $1 billion in debt, which it needed to raise and pay off on its own. The debt was “speculative grade,” meaning Quorum was financing its spinoff from CHS with junk bonds. Not surprisingly, Quorum has not been a success story. In the three years following its spinoff from CHS, Quorum sold or shuttered 11 rural hospitals in health care markets that lack alternative acute care facilities. By March 2019, Quorum’s hospital count had fallen to 27, and the rural chain announced its intention to shed another nine.
High debt loads make it difficult for hospital chains to adapt to changing patient preferences for delivery of medical care. Changes in public policy, such as the attacks on Obamacare, can also wreak havoc on highly leveraged health care organizations. With the White House and Congress both calling for limits on surprise medical bills—unexpected charges from out-of-network doctors practicing at in-network hospitals, the profits of physician staffing firms are at risk. These firms supply doctors to hospitals’ neonatal intensive care units, emergency rooms, and anesthesiology departments. The largest of these firms—Envision and Team Health—have been in and out of private equity hands, acquired most recently by KKR and Blackstone respectively.
The next shoe to drop may not be in health care. But wherever the financial reckoning occurs, businesses and workers will be at risk. Long term, the solution lies in limiting the ability of private equity firms to load the target companies they acquire with excessive amounts of debt and strip them of resources.
It should not be legal to load an operating company with debt in excess of six times earnings, whatever the source of the loans—banks, private equity firms, hedge funds or real estate investment trusts. A company’s private equity owners should not be allowed to take dividends from the company for several years after acquiring it. The private equity firm should be required to make public the monitoring and transaction fees it charges the companies it owns so that investors in its funds and creditors considering lending the company money can judge the risks to the company’s viability of this transfer of resources. At the moment, the PE firm has no obligation to inform either its PE fund investors or its creditors about the amount of money it extracts annually from the company.
The immediate issue is mitigating the impact of job losses on workers as firms struggle to keep up with debt payments or, in the worst case, default on loans and enter bankruptcy. Mandating severance payments for all workers who lose their jobs through no fault of their own, as the Toys ‘R Us workers made clear, is a necessary step in enabling them to pick up the pieces of their lives. Two weeks’ pay for every year of service could make a real difference in workers’ lives and might give pause to creditors contemplating forcing the bankrupt business to liquidate. Many of the Toys workers had been with the company for as much as 30 years. Severance would amount to a year’s pay or more.
Bankruptcy reform, so that workers actually collect what is owed them, is also critical. At present, workers are at the end of the line in a bankruptcy when it comes to collecting back pay, vacation pay, WARN Act payments or other money the company owes them. Legislation introduced in 2017 would define workers’ claims as administrative expenses, moving workers to the front of the line in a bankruptcy and assuring that they would be paid in full, just like the investment bankers, consultants, lawyers and others hired to advise the company through the bankruptcy process.