Which Sector Will Be Hit The Hardest? (w/ Dan Rasmussen & Greg Obenshain)
DAN RASMUSSEN: Right. So, Greg, we've talked before about this concept of the financial accelerator- - as funding gets cut off, as new lending gets cut off, as refinancing risks like this market volatility starts to scare investors away from pretty much doing anything, that financial accelerator really whipsaws through the market. You've talked about triple-b's. You sound pretty bullish on BBBs. If that financial accelerator hits, where do you think it's going to be hit hardest, what sectors of the market? What is the CMBS explosion of 2008, today? Where do you really see problems emerging if this type of financial accelerator continues to accelerate? GREG OBENSHAIN: Yeah. And we've written about this quite extensively, and it's really in anybody who's taken on a whole lot of leverage and left themselves with no flexibility. Because this is an environment where you need flexibility to get you through. And obviously, private equity funding-- done through private credit and also done through the leveraged loan markets-- is done at very high leverage levels, because it has to be. To win a deal, you need to put a lot of leverage on your deals for the most part, especially for the big mega deals. And so, these companies are in a position where they will probably need to take on new debt or restructure their debt in order to be able to survive this environment. They might not call it default, but it is going to be equivalent of default. And the problem with leverage isn't so much the dollar portion of leverage, it's that you need to service that debt through interest payments. And that diverts your ability or prevents you from reinvesting in your business. And so, one of the, I think, surprising things about companies that are reasonably levered in the higher part of high yield is they have enterprise value to debt coverages of anywhere from two to four in some are ridiculously higher times. And so, it doesn't seem like there's a whole lot. They could easily add more debt. But a lot of these businesses actually reinvest in their business. And that's not something you can do if you put a whole bunch of debt on your balance sheet. You've taken away all your flexibility. It's those companies that have preemptively eliminated their flexibility before a crisis that are going to be in a lot of trouble. DAN RASMUSSEN: So, I think you and I share a similar bearishness on what had been going on in private equity, right, where deal multiples had been going up and up. Those deals multiples were funded by very cheap debt coming from the private credit market, and I think as recently as a few months ago, we were seeing deals that, on a GAAP basis, were probably done at about 16, 15 times EBITDA on average, with seven or eight [indiscernible] of net debt to EBITDA. Greg, from your analysis of individual credits, what is that debt to EBITDA level where you get really worried and say, gee, any recession or market volatility is going to wipe that company out or put it in a pretty difficult position? And what percent of private equity and private credit would you say today is above that threshold? GREG OBENSHAIN: So, we're talking debt to EBITDA here, which is actually interesting, because it's actually not the greatest metric to use-- free cash flow metrics and other metrics work better, but we'll talk debt to EBITDA, because I think it's a good shorthand for how people think about it. And so, debt to EBITDA- - traditionally, a really good safe loan would be at three times. A stretch would be five times. Almost all private equity deals now are done well above five times. And when you do unadjusted to EBITDA- - so without all the gimmicks-- you're looking at deals that are six, seven, eight times levered in some cases. The truth is, in an environment like this where you have a really substantial hit to cash flow for a lot of businesses, even four or five times is going to be difficult. That's still a lot of leverage. And it's going to cause a lot of pain. And equity holders in the public markets would never fund that business. Those are exactly the businesses in the public equity markets right now that are getting absolutely hammered. If you're a public equity analyst, one of your first questions right now is, how much debt does it have? Well, if you did that for private equity company and actually saw what would happen to their equities if they were traded in the public markets today, it would be brutal. It would be absolutely brutal, because nobody wants companies that have leverage that could bankrupt them.