Friday 15 May 2020

Has my equity contribution gone to money heaven or the land of the living dead?

Low rates, QE, fiscal deficits have forced institutions up the risk curve and down the liquidity one in this cycle and two of the worst areas, in my opinion, are LBOs and blue-chip CRE yielding 4-5%, particularly in 'Global Gateway Cities' like London which are so inflated ordinary people can't afford to live in them.

We were late-cycle before Covid hit. I don't actually think Covid is that big a deal if you are not vulnerable -we don't shut the economy down every Winter due to flu. But the lock-downs initially to stop ICUs being overwhelmed with otherwise survivable working-age patients, has now transformed into a huge recession and soon a solvency and default cycle.

So I think this year corporate margins will fall heavily and then not fully recover. Additionally, the demand for CBD office space will permanently fall. The exodus of ordinary people from Gateway cities will be accelerated etc. Potentially decades of change are being catalyzed by a few weeks shutdown and its aftermath.

So what should the impact be on these two popular LP plays, LBOs and blue-chip CRE?

LBOs have been done recently at 11-12x pro-forma EBITDA, late cyle, with more or less peak margins.

I present a few charts below from the prior blogs:

Longer run average after-tax profits as a percent of GDP are 5-7% vs 8.7% in Q3 2019, i.e. 5% after a downturn and 7% after a growth cycle. If US profits fell to the middle of that range, 6%, from 8.7% in Q3 19, profits would fall 41%, after the recovery

EDITDA is not as sensitive as after-tax profits, but let's assume a 41% profit drop equates to roughly a 30% EBITDA drop for an average LBO company. 
Let's assume a recent LBO with $1 of EBITDA was done at $11 enterprise value, financed with a $5.50 senior loan and $5.50 of equity. Then after a downturn the loan market is only willing to finance LBOs at 8.5x EBITDA. 
Using the $1 of current EBITDA, this drops to 70c. At 8.5x the 70c EBITDA the company is worth just $5.95. But the senior debt was $5.50, so the equity residual has fallen to just 45c, vs the original LP commitment of $5.50; that's over a 90% loss of equity driven by a fall in margins and a fall in mulitples. 
So you would assume this would breach loan covenants and the deal would be toast?
But here is where it gets more interesting. LBO GP's are judged, in part, on how many deals go to zero. So if a company's business has not blown up and the issue is more the amount of debt/ EBITDA, then the GP's have a huge incentive to keep a bad deal alive.
Over 5-10 years, as nominal GDP grows, most companies should see substantial revenue and therefore EBITDA growth, so by keeping a bad deal alive, even if it involves drip-feeding more equity in after a the downturn, it keeps management fees coming to the GP, a positive carry option for the GP on recovery and avoids difficult conversations with LPs, but all at the cost of the fund IRR and liquidity to the LP. 
In conclusion, with the incentives and ability of the GPs to keep bad deals alive, this looks more like a land of the living dead outlook for LBO LPs.

The situation is broadly similar in blue-chip CRE. 

With 4-5% yields recently and 7-8% post-GFC for several years. Land Securities in the UK predict a 20% drop in rent values as a function of remote working lowering overall demand levels. 
Setting aside whether I think 20% is a big enough rent drop:

Building rent: $1
4.5% yield value: $22.20
60% LTV CM: $13.30
40% equity: $8.90

Building rent: $0.80
7.5% yield value: $10.70
60% LTV CM: Capital loss of $0/ -$2.60 if no Directors Guarantee
40% equity: -$2.60 if there is a Directors Guarantee

In a 50% debt, 50% equity capital structure the debt would still be under the water by $0.40.

This scenario ignores anything like skipped rents this year leading to non-payment of mortgages, rental drops of more than 20%, occupancy slumps, auctions changing hands for higher yields than 7.5% yield or Class B or C properties performing worse or going empty... 

In conclusion, Commercial Real Estate looks more like a money heaven scenario - for existing investors. 

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